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# The Theory of the Firm

In microeconomics, the theory of the firm deals with important subtopics on the producer side of the market.
by

## Asligul Armagan

on 14 May 2012

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#### Transcript of The Theory of the Firm

THEORY OF THE FIRM Short run: period of time in which at least one factor of productıon is fixed.
All production takes place in the short run Long run: period of time in which all factors of production are variable, but technology is fixed.
All planning takes place in the long run. TYPES OF PRODUCT The total output of the firm. The output produced by each unit of a variable factor. Extra output produced by using extra unit of variable factor. Total Product Average Product Marginal Product Cost Theory TYPES OF COST Total Costs Average Costs Marginal Costs a) Total fixed cost: total cost of the fixed assets that a firm uses in a given time period.
b) Total variable cost: total cost of the variable assets that the firm uses in a given time period.
c) Total cost: total cost of all the fixed and variable factors used to produce a certain output. a) Average fixed cost: fixed cost per unit of output.
b) Average variable cost: variable cost per unit of output.
c) Average total cost: total cost per unit of output. Marginal cost is the increase in total cost of producing an extra unit of output. The MC curve cuts the AVC and ATC curves at their lowest points. AFC falls as output increases and, since it is the difference between ATC and AVC, the vertical gap between ATC and AVC gets smaller as output grows. In theory, the long-run average cost curve (LRAC) is an "envelope" curve, i.e. it envelopes an infinite number of short-run average cost (SRAC) curves. This relationship is shown on the left. What are Economies and Diseconomies of Scale? Economies of scale:
- Decreases in long-run average costs.
- All factors of production are altered to increase scale of output.
- Increasing returns to scale. Disconomies of scale:
- Increases in long-run average costs.
- All factors of production are altered to increase scale of output.
- Decreasing returns to scale. Diminishing Returns Diminishing Marginal Returns Diminishing Average Returns As extra units of variable factor are added, output for each additional unit will eventually diminsh. As extra units of variable factor are added, output per unit will eventually diminsh. Revenue Theory TYPES OF REVENUE Total Revenue Average Revenue Marginal Revenue Total amount of money that a firm receives from selling a certain amount of good or service in a given time period. The revenue that a firm receives per unit of its sales. Extra revenue that a firm gains when it sells one more unit of a product in a given time period. AR and MR when price elasticity of demand is perfectly elastic (i.e. perfect competition). Profit Theory Total Profit: Total Revenue - Total Cost
(costs include fixed, variable, and opportunity costs) 1. Shut-down price Level of price that allows a firm to cover its variable costs in the short run. P=AVC Level of price that allows a firm to cover its total cost in the short run. P=ATC 2. Break-even price 3. Profit-maximising level of output MC=MR (quantity)
Depends on demand curve. Perfect Competition -Large number of firms in the industry
-Firm is so small that it cannot affect supply curve of price
-Produce homogeneous products
-No barriers to entry
-Perfect knowledge of the market Abnormal profit is being made in the short run. Loss is being made in the short run. Two possible scenarios in the short run: If the firm is making abnormal profits in the short run, new firms will be attracted to the industry. This will cause the demand curve to shift down and reach a break-even price in the long run. If the firm is making a loss in the short run, firms will want to leave the industry. This will cause the demand curve to shift up and reach a break-even price in the long run. In the long run: Normal profit is made in the long run. Productive efficiency: Allocative efficiency: Firms produce at lowest possible unit cost. MC=AC Suppliers produce at optimal mix of goods and services required by consumers. MC=AR Productively and allocatively efficient in the long run. Monopoly -One firm in industry; firm is industry
-Barriers to entry exist
-May make abnormal profits in the long run. What are "Barriers to entry"? -Economies of scale. Monopolies have it, new firms don't.
-Natural monopoly. Only enough economies of scale to support one firm.
-Brand loyalty.
-Anti-competitive behaviour. "Price war". If the monopolist is making abnormal profits in the short run, they will continue to do so in the long run. This is because barriers to entry prevent new firms from entering the industry. If the monopolist is making a loss in the short run, they will have to close down firm and industry in the long run. This is because the demand curve for the firm is also the demand curve for the industry, so it will not shift. Monopolies are not productively or allocatively efficient. Note: Monopolistic Competition -Fairly large number of firms in the industry
-Firms are small relative to the size of the industry (able to act independently)
-Firms produce slightly differentiated products
-No barriers to entry/exit What is the difference between Monopolistic Competition and Perfect Competition? In monopolistic competition, there is product differentiation. For example: brand name, colour, appearance, packaging, design, quality, etc.
This causes brand loyalty.
Therefore producers are price makers and will have a downward sloping demand curve. Other firms will be attracted to the industry. Demand curve will shift to the left (decrease). Some firms will want to leave the industry. Demand curve will shift to the right (increase). Long-run normal profits. In monopolistic competition, there is no productive or allocative efficiency in the short run, or the long run.
BUT
This efficiency is due to the consumers' desire for variety. Oligopoly -Few firms dominate the industry
-Distinct barriers to entry (large-scale production/strong branding)
-There is interdependence
-Price rigidity The Two Types of Oligopoly: COLLUSIVE NON-COLLUSIVE Collusive oligopolies exist when firms collude to charge the same prices for their products. This way, they behave monopolistically. In Formal Collusion , the firms that are colluding openly agree on what prices they will charge. These collusive oligopolies are called Cartels, and are generally banned by governments. However, sometimes collusion is allowed between governments, such as OPEC. In Tacit Collusion , the firms that exist in an oligopoly charge the same prices without negotiating with one another. Oligopolists that are collusive act as monopolists In a non-collusive oligopoly, firms do not collude. Therefore they must be aware of the reactions of other firms. The firm knows only one point on the demand curve - the one it holds. If firm raises raises price: competitors would not raise theirs, demand curve would be lost. Demand is relatively elastic above P1. If firm lowers price: competitors would follow. Competitors would gain sales. Less elastic below P1. Non-price Competition: Brand names Packaging Special features Advertising Sales promotion Personal selling Publicity Sponsorship deals Free delivery After-sales service Market Failure in... Perfect Competition Positive externality: Since there are a large number of firms, no firm can control the price of the industry against the wishes of the consumers. This is a benefit to society. Negative externality: Since there is perfect knowledge regarding all aspects, including the technology used by the firm, firms do not have the incentive or the means (economies of scale) to develop new technology. Elasticity in... Perfect Competition As there are no barriers to entry or exit, the producer can decide on which industry to enter depending on the YED and PED. The producer will choose whatever good makes the greatest profit (even though in the long run, producers cannot make abnormal profit). XED does not play a role in the production of these goods as all goods and services are homogeneous.
YED will show the responsiveness of change in the consumer's income. If the good is low income elastic, the prices can be increased to increase revenue. These are usually necessities such as bread. However, the prices cannot be increased too much, as the government will interfere, since not all consumers will be able to afford their basic necessities. Market Failure in... Monopoly Positive externality: Monopolies have the ability to reach large economies of scale because they can produce for the whole market without sharing parts of it with other firms. Research and development can therefore be funded with these high profits and economies of scale. R&D means improved products for the society. Negative externality: Monopolies are inefficient; they do not produce at the socially efficient level of output. Monopolies can restrict output and increase prices; they do not have to produce where MSB equals MSC. There is a loss of consumer and producer surplus. The welfare loss is due to the quantity of good not produced. Elasticity in... Monopoly Since a monopolistic market has barriers to entry and exit, there are no substitutes for the goods and/or services produced/consumed. Therefore the PED is relatively inelastic. Responsiveness for income and cross-elasticity can be measured. These show how the change in income and change in the price of another good affect the demand for the good/service produced. Depending on the results, the producer can either increase or decrease the price in order to increase revenue. As PED is relatively inelastic, the producer will usually increase the price to increase profit. YED and XED help in decision-making. As there are no substitutes (the market is imperfect) the producer can sell the exact same product to different consumers at different prices (price discrimination), which increases the producer surplus. Market Failure in... Monopolistic Competition Positive externality: In monopolistic competition, the products produced by each producer are slightly differentiated (and not homogeneous as in perfect competition). This gives consumers a greater choice, and can therefore be considered a positive externality, because social benefit exceeds private benefit. Negative externality: Monopolistic competitors us packaging, distribution, advertisements to develop brand loyalty. They use up scarce resources, so this may represent a misuse and a cost to society. Elasticity in... Monopolistic Competition As firms are completely free to enter or leave the industry, any firm can enter or leave the industry. By measuring the responsiveness to certain changes, the firm can decide on which industry to enter to make maximum profit. PED and YED are required in deciding which industry to enter. XED helps the producers to make specific changes. In monopolistic competition there is product differentiation, meaning the products are different from the products of other producers in some way, which includes: brand name, colour, appearance, packaging, design etc. The differentiation increases or decreases the demand for the good/service. Hence due to XED, the producer will know whether or not to increase or decrease the price of their goods/services. Market Failure in... Oligopoly Positive externality: Since there is interdependence in the market (a change in the price of a firm affects the price of other firms), the price cannot rise to a large extent because the firm would only lose market share. Negative externality: Oligopolies use packaging, distribution, advertisements to develop brand loyalty. They use up scarce resources so this may represent a misuse and a cost to society. Elasticity in... Oligopoly Oligopoly is where a few firms dominate the industry. A large proporiton of the industry's output is shared by just a small number of firms. Therefore XED is used in order to see whether or not to change the price of the product. Some produce almost identical products, slightly differentiated products or highly differentiated products. Therefore, XED helps in the decision making for the price level. Most of the time prices will not change, as goods are close substitutes. However, if highly differentiated, producers can increase prices in order to increase total revenue.
If XED is a high positive value, firms can collude in order to make maximum revenue and eliminate competition, meaning that demand is kept high. If XED is a high negative value, firms can also collude in order to make maximum revenue and prevent from decreasing the demand for the other producer. YED will show the reponsiveness of change in the consumer's income. If the good is low income elastic, the prices can be increased to increase revenue.
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