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# THEORY OF THE FIRM

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## Kent Reschke

on 23 October 2013

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#### Transcript of THEORY OF THE FIRM

Production
Costs
Short Run vs. Long Run ATC
Perfectly Competitive Firm
PART A
THEORY OF THE FIRM
Production Function
With each additional input, production totals will go up. As economists, we must think on the margin
3 parts
Increasing Marginal Product
Diminishing Marginal Product
Negative Marginal Product
Can you find the three phases in this graph?
Marginal product will increase before eventually decreasing.
Why is that so?
Diminishing Marginal Product
*What is the relationship between Marginal Product (M.P.) and Marginal Cost (M.C.)?
Total Cost
TC = FC + VC
There are three curves on this graph: TC, VC, and FC. Can you label them?
Fixed Costs
Do not change with increase in output.

Ex. I can make 5 pizza's or 5,000 and this cost will not change.
rent, bills, etc.
Variable Cost
These costs do change with an increase in output.

Ex. Labor, raw materials, these are all marginal costs
Average Total Cost
ATC = Total Cost / Quantity
How much does it cost to produce...
Why is it "U" shaped?
ATC and MC
The relationship is significant

Notice when ATC starts increasing.

Marginal Cost
How much does it cost to produce just one more?

The shape is a mirror image of Marginal Product. As we see the law of diminishing marginal product set in, we also see and increase in marginal costs.

MC = Change in Total Cost / Change in Quantity
What it all looks like put together
You should be able to:
Know what each of these curves measure
Why the curves are shaped the way that they are
The relationship between the curves.
Three Important Reminders
1. At low levels of production, additional labor produces more than a proportional increase in output. Division of labor; specialization; each person has more of the capital to use; has a larger share of the fixed costs. There are increasing marginal returns to labor and diminishing marginal costs.
2. Then the law of diminishing marginal returns begins to kick in: raising the quantity of an input initially increases, but eventually decreases its marginal product, if the quantity of other inputs remains constant
3. At high levels of production, additional labor produces less than a proportional increase in output. Each person has less and less of the capital to use; has a smaller share of the fixed costs. There are decreasing returns to labor and increasing marginal costs.
Short Run ATC
We are holding at least one variable constant.
This is typically capital.
This is how we have been viewing it so far

What if a company wants to expand and add more capital?
Short Run Average Total Cost (SRATC) for different sized firms
The image shows the SRATC for different sized firms.
Why do you do this? Although total costs may be initially higher because of increased capital, variable costs will be lower, because more capital is available to each unit of production. Total costs are higher at low levels of output, but lower at higher levels of output.
When should you try to change these fixed costs? WHEN YOUR ATC BEGINS TO RISE. This is when we want to change the scale of our operation.
in the long run, a firm can adjust its capacity / scale to any of the SRATCs to find the optimal point on the LRATC curve.

Long Run ATC
3 different phases.
Economies of Scale
Constant returns to Scale
Diseconomies of Scale
Economies of Scale
On the left, at as production levels begin to increase, costs are decreasing = economies of scale. As the firm grows, they initially see costs decrease overall. A given increase in scale gives MORE than proportional output. Double all your inputs and get more than double the output. We’ll get to why in a minute.
Reasons Why
Specialization
Capital invisibility
Marketing
Financial leverage
Constant Returns to Scale
In the middle, costs level out. This is the optimal scale of production, or, the minimum efficient scale. A given increase in scale gives the same proportional output.
Diseconomies of Scale
On the right, at higher levels of production, costs are increasing = diseconomies of scale. As the firm grows very large, they initially see costs increase overall… A given increase in scale brings LESS than proportional output.
Reasons Why
Poor Communication and Coordination
Poor Morale
Characteristics
1. What are the 3 main characteristics of a competitive market?
2. What are the equations to calculate the following: Total Revenue, Average Revenue, Marginal Revenue.   What relationship do you see? Where is the demand curve (from the perspective of the supplier)

Note: The price line is horizontal because the Firm is a price taker.
1. There are many buyers and sellers in the market.
2. The products offered by the various sellers are largely the same [homogenous]
a. The individual firm has no control over the price of the product. “price taker”.
b. They can sell as much as they want at this one price, but nothing at any other price.
c. The demand curve is perfectly elastic – horizontal – from the perspective of the firm.
3. Firms can freely enter or exit the market -- no significant barriers to entry or exit in the industry
4. There is perfect knowledge. Sellers and buyers are completely informed about the prices of each firm in the industry.
Total Revenue = Price x Quantity
Average Revenue = Total Revenue / Quantity
Marginal Revenue = Change in Total Revenue / Change in Quantity

For a competitive firm: Price = Average Revenue = Marginal Revenue = Demand Curve
MR DARP acronym.
Profit Maximization
What is the Equation for Profit?
What does the relationship between Marginal Revenue and Marginal Cost have to do with Profit? Explain.
Where is the profit maximizing point?
Profit = Total Revenue - Total Cost

Total Revenue is the money that you make for selling a given quantity and Total Cost is the money you spent to make that given quantity. Profit is the difference between them.
The difference between Marginal Revenue and Marginal Cost shows the change in Profit.
When MR > MC , then profit will go up and there is room to make more profit if we increase the Quantity
When MR < MC, then profit will go down and we should decrease the quantity.
MR = MC
Never forget this one rule. It is one of the key rules in all of Microeconomics. Profit is maximized when Marginal Revenue = Marginal Cost.

Important to note that the Marginal Cost curve is the same as the supply curve in a competitive market (short run)
What it looks like on a graph
When to shut down and when to leave the market
Shut Down (short run)
Only applies to Short Run
A business will shut down if the Average Variable Costs is greater than the Marginal Revenue.
Fixed costs are already sunk (there is nothing to do about them) but as long as a business covers their variable cost, they can stay open.
Ex. Seasonal activities - Water sports in the winter? Snow skiing in the summer?
Exit the Market (Long Run)
Perfect Competition in the Short and Long Run
Short Run
What if there is a shift in the supply or demand curve?
What happens in the graph below?
Long Run
Suppliers will always find a way to bring price back to where it crosses ATC at its minimum point. Long run perfect competition graphs will always look like this because long run Supply is a horizontal line. Notice that Demand increased to have new equilibrium at point B. Other Suppliers see the profit potential and join the market driving the equilibrium to point C.

The Price of the good is \$6. A few things to note:
1. Marginal Revenue is also \$6 because price is \$6
2. Marginal Rev - Marginal Cost = Change in Profit.
Notice how Price = AR = MR
From the viewpoint of the firm, Demand also this line.
MR DARP
In Mr. Reschke's Words
In this circumstance, I like to think of the Average Variable Cost as a firm's operating costs because variable cost changes with output.
A firm needs to shut down (short run) if the money it makes from producing one more unit (marginal revenue) does not cover the operating costs (average variable cost)
Only applies in the long run meaning there are no fixed costs.
When the profit maximizing point is less than Average Total Cost, the company will lose money. No incentive to be in the market.
Finding Profit on a Graph
Quantity: where MR = MC
That same quantity to where it crosses ATC
Notice: ATC is not at minimum price. That is fine because the firm is producing at profit maximizing quantity.
When price is lower than the ATC = Loss.
Monopoly
Why Monopolies Arise?
There are three reasons.
A key resource is owned by a single firm
The government gives a single firm exclusive right to produce some of the good or service
The costs of production make a single producer more efficient than a large number of producers.
Types
Natural Monopoly
Government Monopoly
Technological Monopoly
Geographic Monopoly

Part of your homework is to take your own notes about these concepts. The book does a good job describing them.
Graphing and Profit Maximization
Looking at the Numbers
Equations are the same
Price, Average Revenue, and Marginal Revenue now have different values. This is because demand curve for the firm is the same as for the industry and the demand curve is downward sloping.
What curve will you look at to answer this question: How much revenue will the firm make if they sell _______ amount?
Average Revenue
Graph
Monopoly is a PRICE MAKER
Demand Curve is the same as Average Revenue
Marginal Revenue is always below Average Revenue.
Finding Profit
Profit is maximized where MR = MC
Use that quantity where MR = MC and ask yourself: "How much revenue does the firm get for selling that much and how much did it cost the firm to produce that much?"