Theory of the Firm

Economic profit
Economic profit = Total revenue - Total cost

• The economic profit is the difference between

the amount a firm receives for the sale of its
output minus the total cost of production.
• Total costs include the market value of the
inputs a firm uses in production.
• Total cost of production include both implicit
and explicit costs.
 Costs
• Explicit costs: The input costs that require a direct
outlay of money by the firm.

• Implicit costs: Input costs that do not require an

outlay of money by the firm.
– Includes the opportunity cost of production
– Foregone income from an alternate employment or
the value of the next best alternative
– Foregone interest income from invested savings in the
firm
 Accounting Profit
• Total revenue minus explicit costs.
• Accountants ignore opportunity cost of
alternate employment and cost of capital or
foregone interest income.
• Consider costs for which there is a clear outlay
of expenses.
Economic Profit & Accounting Profit
• Economists measure a firm’s economic profit as total
revenue minus total cost, including both explicit and
implicit costs.

• Accountants measure the accounting profit as the

firm’s total revenue minus only the firm’s explicit costs.

• When total revenue exceeds both explicit and implicit

costs, the firm earns economic profit.
– Economic profit is smaller than accounting profit.
 Example 1
• Consider Neha decides to set up a bakery. She’s a lawyer an
can earn ₹100,000 per month if she practices law. She also
chooses to invest ₹30,000 of her own savings in the bakery
to buy the land.
• Neha spends ₹50,000 on furniture, ₹20,000 on hiring labor
and another ₹25,000 on raw materials like flour, ovens and
kitchen equipment.
• What is the value of explicit costs and implicit costs ?
 …continued
Explicit Costs: Costs that require an outlay of money

• Furniture = ₹50,000

• Labor = ₹20,000

• Raw Materials = ₹25,000

• Invested savings = ₹30,000

• Total explicit costs = ₹125,000

 …continued
Implicit costs: Includes all forms of opportunity cost
• Foregone Income or the opportunity cost of opening
the bakery = ₹100,000
• If r = 5% is the rate of interest on savings she loses 5%
of ₹30,000 (or ₹1500) per annum as interest income.
• Total implicit cost = 100,000 + 1,500 = ₹101,500.
 Producer’s Theory

• Production decisions of a firm are similar to

consumer decisions.
– Can understood in three steps..
 Production Technology

 Describe how inputs can be transformed into

outputs.
• Inputs: land, labor, capital and raw materials
• Outputs: cars, desks, books, etc.

 Firms can produce different amounts of outputs

using different combinations of inputs.
 Cost Constraints

 Firms must consider prices of labor, capital and

other inputs.

 Firms want to minimize total production costs

partly determined by input prices.

 As consumers must consider budget constraints,

firms must be concerned about costs of
production.
 Input Choices

– Given input prices and production technology,

the firm must choose how much of each input to
use in producing output.

– Given prices of different inputs, the firm may

choose different combinations of inputs to
minimize costs.
• If labor is cheap, firm may choose to produce with
more labor and less capital.
 Production Decisions
• If a firm is a cost minimizer, we can also study:
– How total costs of production vary with output?
– How the firm chooses the quantity to maximize its
profits?
 Production Function
• Production set : The set of all combinations of
inputs and outputs that comprise a
technologically feasible way to produce is
called a production set.

• Production function : It measures the

maximum possible output that you can get
from a given amount of output.
 Isoquant
• An isoquant is the set of all possible
combinations of inputs that are just sufficient
to produce a given amount of output.

• Isoquants are similar to indifference curves?

Examples of Production Functions
• Perfect substitutes
• Perfect complements
 Marginal Product
• How much more output we will get per
additional unit of factor 1.
 Technical Rate of Substitution
• It measures the rate at which the firm will
have to substitute one input for the another in
order to keep output constant.

• It is the slope of the isoquant.

Diminishing Marginal Product
– 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

 Product Curves
q q MP is slope of line tangent to
corresponding point on TP
112 curve

TP 30

60 15
AP
30 10
A MP
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Labor Labor
 Law of Diminishing Marginal Returns:
Revisited
• When the use of labor input is small and
capital is fixed, output increases considerably
since workers can begin to specialize and MP
of labor increases.
• When the use of labor input is large, some
workers become less efficient and MP of labor
decreases.
 …continued
• Typically applies only for the short run when
one variable input is fixed.
• Can be used for long-run decisions to evaluate
the trade-offs of different plant configurations.
• Assumes the quality of the variable input is
constant.
Source: Econ Open Source, Lumen Learning.
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.
 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
 Costs: average vs. marginal

• 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.

 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?

(change in total cost) TC

MC  
(change in quantity) Q
 Returns to Input
• Production function with constant returns to an input.
– The marginal product of the input is constant, neither
increasing nor diminishing as the firm expands production.
• Production function with increasing returns to an input
– The marginal product of the input is increasing as the firm
expands production. Example?
• Important to recognize that most production functions
can display all 3 types at different levels of production.
Example?
Big Bob’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
 (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.
Cost Curves and Their Shapes
• Relationship between Marginal Cost & Average Total Cost
– Whenever marginal cost is less than average total cost,
average total cost is falling.
– Whenever marginal cost is greater than average total cost,
average total cost is rising.

• Relationship Between Marginal Cost & Average Total Cost

– The marginal-cost curve crosses the average-total-cost curve
at the efficient scale.
• Efficient scale is the quantity that minimizes average total cost.
 Costs: short run vs. long run
• For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.
– In the short run, some costs are fixed.
– In the long run, fixed costs become variable costs.
– Because many costs are fixed in the short run but
variable in the long run, a firm’s long-run cost curves
differ from its short-run cost curves.
 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
Economies and Diseconomies of Scale
• Economies of scale refer to the property
whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as
the quantity of output increases.
• Constant returns to scale refers to the property
whereby long-run average total cost stays the
same as the quantity of output increases
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Average Total Cost in the Short and Long Run
 Long run average cost curve
• All short run ATC’s lie on or above the long run ATC
• Each short run ATC represents a specific plant size
• In the long run plant size is variable
• Downward sloping part of the LATC characterized
by Economies of Scale
• Flat part of the ATC is characterized by constant
returns to scale
• Upward sloping part of the LATC characterized by
diseconomies of scale.
 Long run average cost curve
• Economies of scale: the property by which LATC
falls as the quantity of output rises
• Reasons:
– Higher production levels allow workers to
specialize, gains fro specialization lead to a fall in
average costs.
– At very high production levels often there are co-
ordination problems such as cost on information
and increased cost of managing large organizations,
this leads to diseconomies of scale.
 WHAT IS A COMPETITIVE MARKET?
• A perfectly competitive market has the
following characteristics:
– There are many buyers and sellers in the market.
– The goods offered by the various sellers are largely
the same.
– Firms can freely enter or exit the market.
 FIRMS ARE PRICE TAKER AND NOT PRICE
MAKER
– 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.
 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

 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
 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

q* Output

The Firm’s Short-Run Decision

 MC as the Competitive Firm’s Short Run
Supply Curve
• 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
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
 A Competitive Firm’s
Short-Run Supply Curve
• Supply is upward sloping due to diminishing
returns.
• Higher price compensates the firm for the
higher cost of additional output and increases
total profit because it applies to all units.
 In the long run, the firm exits if the revenue it would get from
producing is less than its total cost.
– Exit if TR < TC
– Exit if TR/Q < TC/Q
– Exit if P < ATC

 A firm will enter the industry if such an action would be

profitable.
– Enter if TR > TC
– Enter if TR/Q > TC/Q
– Enter if P > ATC

The Firm’s Long-Run Decision to

Exit/ Enter a Market
 THE SUPPLY CURVE IN A COMPETITIVE
MARKET
• Short-Run Supply Curve
– The portion of its marginal cost curve that lies
above average variable cost.
• Long-Run Supply Curve
– The marginal cost curve above the minimum point
of its average total cost curve.
 Profit in Perfect Competition

• Normal profit is the minimum profit necessary to keep a firm

in operation.
• In long-run, what happens when Economic Profits are made?
• When firms make more than a normal profit, firms enter the
industry. As supply increases, a downward pressure is put on
prices
• Similarly, losses lead to fall in supply and increase in prices.
• So, in the long-run, where is the equilibrium?
• At the price that enables firms to make a normal profit
• Long-run perfectly competitive equilibrium exists when:
P = MR = SRMC = SRATC = LRAC