Producer’s Rationality

• A commercial organization that operates for profit

and by selling goods and/or services to consumers.

• Firms are accorded legal protection depending

upon how they are created.
• Sole proprietorship
• Partnership
• Corporations
• Others (HUF, Cooperative, Family-owned, PSU etc.)

What is a firm?
Production
• Firms undertake production activities, which include the
transformation of inputs into output.
• Outputs are sold in the market at market prices.
• Market prices are determined by the market structure.
• The structure of the market is determined by how much power each
constituent has.
Market without power
• Perfectly competitive market
• Features associated with perfectly competitive firms?
Market with power
Monopolistic
Monopoly Oligopoly
Competition
• Single Firm • A few Firms • Many firms
• Perfect • Significant • Significant
market market market
power power power in the
subject to short run
the behavior
of other
firms
THE GOALS OF PRODUCTION

• In the business sphere, it is normally essential that one of the goals of

production be to make a profit.
• What is profit?
• In economics, for a firm
• Profit= Total Sales (Revenue) – Total Cost
• Here cost includes both explicit and implicit cost.
• Implicit costs include opportunity cost of owned inputs
Social Construction of Businesses and their
Goals
• At the same time, every period of history provides examples of
businesses that have behaved unethically in the pursuit of profits,
including violence against workers.
• However, norms of what is generally acceptable change over time,
sometimes swinging toward more social disapproval of harsh business
practices, and at other times accepting—even celebrating—a “culture
of greed,” as seemed to be the case in the last quarter of the
twentieth century and into the twenty-first century.
• Let us study some other goals of businesses.
Social Responsibility of firms
• Before the Civil War in the United States, corporations were fully
accountable to the public to ensure that they acted in a manner that
served the public good.
• Corporate charters could be revoked for failing to serve the public
interest and were valid for only a certain period of time.
 Social Responsibility of firms: The recent
discourse

• Decline in the confidence in the role of the State in development

• Global deregulation since 1980s
• Increasing role of market actors and civil society even in the provisioning
of basic amenities
• Greater role of businesses
• But can this role be performed through business-as-usual practices,
voluntarily and through the market, or does it need to be guided,
regulated and driven by broader state-led developmental priorities?
Triple Bottom Line
• Businesses are increasingly operating with a broader set of objectives,
often referred to as the triple bottom line.
• This perspective reflects a commitment to social and environmental
goals, as well as making profits.
This is not to say
that the generation
of profit is the only
goal pursued by
businesses.
Corporate Social
Responsibility?
• Clearly, an offshoot of market ideology.
• Mainstream perspectives on CSR held out the promise that corporate self-
regulation and voluntary initiatives could be harnessed to address many
social and environmental problems – where the state had failed, private
enterprise and non-state actors could succeed.
• Although a variety of non-state actors, notably business associations, non-
governmental organizations (NGOs) and various company stakeholders,
played a role in this new approach, in practice, it was large firms, in
particular transnational corporations (TNCs), that engaged more directly
with the discourse and instruments of CSR.
• But does CSR do what it claims to do?
Make poverty business?
• It is argued that fortune is waiting for the businesses that target product
at the ‘bottom of the pyramid’.
• Addressing poverty within business via provide things to the poor but still
make profit.
• It is put forward that cumulatively poor have large amount of disposable
income but firms poorly serve their purpose.
• Make Poverty Business: Increase profits and Reduce Risks by Engaging
with the Poor!
Philanthropy?
• ‘What goes where, from whom, and who misses out?’
• How do donations support social capital and to what extent do
territories and regions seek out or depend on philanthropy for their
well-being? (also, diaspora…)
• The tendency of super-philanthropists to favour cultural and
educational institutions with which they have prior associations, in
effect funding ‘their own’.
• Donations are better construed as investments intended to achieve
economic, political, cultural and other forms of outcome that align
with the giver’s ideological and social position?
Public Private Partnership?
• One of the most acceptable form in which private sector (often profit
making firms) can collaborate with the Government.
• Although, PPP can acquire any form, most predominant is the form in
which the government sets goals and provides funds, the private
partner delivers.
• How to take care of inherent contradictions?
Perfectly competitive firms make no super-
normal profit!
• Starting in the 1960s, some economists began to argue that business
managers should only seek to maximize profits, without concern for
any broader social or environmental objectives.
• [T]here is one and only one social responsibility of business—to use its
resources and engage in activities designed to increase its profits so
long as it stays within the rules of the game. –M. Friedman
Production Function
Definition: The technical engineering relationship between the
quantity of inputs used to make a good and the quantity of output of
that good.

•Average product of an input is the average addition of output per unit

of the input used.
Average Product = Total output/Total Input
•Marginal product measures the increase in output from one
additional unit of input.
Marginal product = change in total output/change in the level of input.
The Production Function
• Diminishing marginal product is the property
whereby the marginal product of an input declines as
the quantity of the input increases.
• Example: As more and more workers are hired at a firm,
each additional worker contributes less and less to
production because the firm has a limited amount of
equipment.
• The slope of the production function measures the marginal
product of an input, such as a worker.
• When the marginal product declines, the production
function becomes flatter.
Production Function and Total Cost:
Hungry Helen’s Cookie Factory
 Quantity of
Output
(cookies
per hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10 Number of
Workers
0 1 2 3 4 5 Hired

Hungry Helen’s Production Function

Source: Econ Open Source, Lumen Learning.
From the Production Function to the Total-Cost Curve

• The relationship between the quantity a firm can produce and its
costs determines pricing decisions.

• The total-cost curve shows this relationship graphically.

• Total Cost function is a relationship between output and cost.
Ben Co’s Cost Curves
 (a) Total-Cost Curve
Total
Cost
$18.00 TC
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00

0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)
Big Bob’s Cost Curves
Costs: fixed vs. variable
• Costs of production may be divided into fixed costs and variable costs.
• Fixed costs are those costs that do not vary with the quantity of
output produced.
• Variable costs are those costs that do vary with the quantity of output
produced.
• Total cost (TC) can be broken down into:
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC) = TFC + TVC
• How much does it cost to make the typical cup of coffee?
• How much does it cost to increase production of coffee by
one cup?

• Average cost (AC) versus marginal cost (MC).

• Average total costs (ATC) = Total cost / output.
• Average variable costs (AVC) = Total variable costs / Output.
• Average fixed costs (AFC) = Total fixed costs / Output.

• Decisions are based on MC not on AC.

Costs: average vs. marginal

Diminishing Marginal Returns: Key Takeaway
 (b) Marginal- and Average-Cost Curves

Costs

$3.00

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)
Big Bob’s Cost Curves
Cost Curves and Their Shapes

• The average total-cost curve is U-shaped.

• At very low levels of output average total cost is high because fixed cost is
spread over only a few units.
• Average total cost declines as output increases.
• Average total cost starts rising because average variable cost rises
substantially.

• The bottom of the U-shaped ATC curve occurs at the quantity that
minimizes average total cost. This quantity is sometimes called the
efficient scale of the firm.
Long run costs
• The long run for a firm is a time horizon where the firm can alter a
number of fixed cost parameters.
• For example the size of the plant or capital invested as sunk cost such
as land, production capacity or plant size.
• Typically the long run allows the firm to expand its scale of
production.
• The long run average cost curve is a much flatter and U-shaped curve
compared to the short run average total cost curve.
• Long run average cost also called the Envelope curve.
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

$12,000

ATC in long run

0 1,200 Quantity of
Cars per Day
Average Total Cost in the Short and Long Run
• A competitive market has many buyers and sellers trading identical products so
that each buyer and seller is a price taker.
• Buyers and sellers must accept the price determined by the market
• As a result of its characteristics, the perfectly competitive market has
the following outcomes:
• The actions of any single buyer or seller in the market have a negligible impact on the market
price.
• Each buyer and seller takes the market price as given.
FIRMS ARE PRICE TAKER
AND NOT PRICE MAKER
The Competitive Firm
• Demand curve faced by an individual firm is a horizontal line.
• Firm’s sales have no effect on market price.
• Demand curve faced by whole market is downward sloping.
• Shows amount of goods all consumers will purchase at different prices.
 Price
Firm Price Industry

Demand
P P

Output Output

The Competitive Firm

Total, Average, and Marginal Revenue
for a Competitive Firm
Revenue of a Competitive Firm
• Total Revenue of a firm is equal to the price per
unit a firm receives for a unit of production times
the total output of the firm, i.e. TR = P x Q

• The change in total revenue by selling an additional

unit of output is called Marginal Revenue, i.e. MR
= ΔTR / ΔQ

• The total revenue divided by total output is called

the Average Revenue, i.e. AR = ?
PROFIT MAXIMIZATION
• The goal of a competitive firm is to maximize profit.
• This means that the firm will want to produce the quantity that
maximizes the difference between total revenue and total cost.
• Profit maximization occurs at the quantity where marginal revenue
equals marginal cost.
• Max π = TR – TC or when MR = MC
• A mathematical explanation
Profit Maximization: A
Numerical Example
 Costs
and The firm maximizes
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue.
MC2

ATC
P = MR1 = MR2 P = AR = MR
AVC

MC1

0 Q1 QMAX Q2 Quantity

Profit Maximization for a Competitive Firm

• When MR > MC, the firm should increase Q
• When MR < MC, the firm should decrease Q
• When MR = MC, the profit is maximized.

Profit Maximization for a

Competitive Firm
 Price (a) A Firm with Profits

MC ATC
Profit

ATC P = AR = MR

0 Q Quantity
(profit-maximizing quantity)

Profit as the Area between Price and ATC

 Price (b) A Firm with Losses

MC ATC

ATC

P P = AR = MR

Loss

0 Q Quantity
(loss-minimizing quantity)

Profit as the Area between Price and ATC

 Price

MC
ATC

P P = AR = MR

Loss

0 Quantity
(loss-minimizing quantity)

Producer’s Equilibrium in the long run

 Price (a) A Firm with Profits

MC ATC
Profit

ATC P = AR = MR

0 Q Quantity
(profit-maximizing quantity)

Profit as the Area between Price and ATC

 Price (b) A Firm with Losses

MC ATC

ATC

P P = AR = MR

Loss

0 Q Quantity
(loss-minimizing quantity)

Profit as the Area between Price and ATC

• Shutdown refers to a short-run decision not to produce
anything during a specific period of time because of
current market conditions.
• Exit refers to a long-run decision to leave the market.
• The firm considers its sunk costs when deciding to exit,
but ignores them when deciding whether to shut down.
• Sunk costs = costs already committed & cannot be recovered.
• The firm shuts down if the revenue it gets from
producing is less than the variable cost of production.
• Shut down if TR < VC or if TR/Q < VC/Q or if P < AVC

The Firm’s Short-Run Decision to Shut

Down
The Firm’s Short-Run Decision to Shut Down
• When should the firm shut down?
• If AVC < P < ATC, the firm should continue producing in the short run
• Can cover all of its variable costs and some of its fixed costs
• If AVC > P < ATC, the firm should shut down
• Cannot cover its variable costs or any of its fixed costs
 Price MC ATC
Losses
B
C

D P = MR
A
P < ATC but
P > AVC so AVC
firm will
continue to
produce in
short run

The Firm’s Short-Run Decision

q *
to ShutOutput
Down
• Supply curve tells how much output will be produced at different
prices
• Competitive firms determine quantity where P = MC
• Firm shuts down when P < AVC

MC as the Competitive Firm’s SR Supply

Curve
Price
This section of the
firm’s MC curve is MC
also the firm’s supply
curve.
P2

ATC
P1
AVC

? B

0 Q1 Q2 Quantity
MC as the Competitive Firm’s SR Supply Curve
Appendix
Fixed and Variable Costs
• Average Costs
• Average costs can be determined by dividing the firm’s
costs by the quantity of output it produces.
• The average cost is the cost of each typical unit of product.

F ix e d c o s t F C
A F C  
Q u a n tity Q
• Average Fixed Costs (AFC)
• V a ria b le c o s t V C
Average Variable Costs (AVC) A V C  
Q u a n tity Q
• Average Total Costs (ATC)
• ATC = AFC + AVC T o ta l c o s t T C
A T C  
Q u a n tity Q
Fixed and Variable Costs
• Marginal Cost
• Marginal cost (MC) measures the increase in total cost that arises from an
extra unit of production.
• Marginal cost helps answer the following question:
• How much does it cost to produce an additional unit of output?
( c h a n g e in to ta l c o s t)  T C
M C  
(c h a n g e in q u a n tity ) Q