The Theroy Of The Firm

Front 1

Definition of the theory of the firm

Back 1

This theory is concerned with the ways in which firms in different markets determine: price, output and competitive strategies

Front 2

What’s the only objects of a firm according to this theory and what is the reality

Back 2

According to this tradition of theory of the firm, firms have only one objective which is profit maximisation. However in the modern world, firms have alternative objectives such as; Growth, survival, CRS profit satisfying

Front 3

Definition of profit

Back 3

This is the difference between the total revenue and total costs

Front 4

The difference between the definition of total costs of economics and accountants

Back 4

For instant total cost according to accountants our expenses incurred in the production of goods to produce more goods to distribute the products, such as taxes imposed by the government.

Well economists defined total costs as payments made to the factors of production such as rent interest wages and profits ( including opportunity cost )

Front 5

Name the two different types of profits and economists defines

Back 5

1) normal profits : this is the minimum amount of profits required by an entrepreneur to be in a particular line of a business

In measuring normal profit, we include the opportunity cost of

This means that if this amount is not monitored and then supraneural have to leave the industry for the next profit of business venture. This is also known as opportunity cost.

2) Supernormal profits. This is achieved and the total revenue equal is greater than the total cost and the difference is positive.

Front 6

When is normal profit achieved

Back 6

This is achieved when total revenue equals total cost zero profit

Front 7

Therefore what is the main difference between the definition of total costs and accountants and economists

Back 7

When Economist calculate total cost will include opportunity cost or profit which accountants do not

Front 8

Definition of the short-term production of a firm

Back 8

In the short run one factor of production is fixed, e.g. capital. This means that if a firm wants to increase output, it could employ more workers, but not increase capital in the short run (it takes time to expand.)

This means that during this perioda firm can increase more output by increasing the amount of variable factors

Front 9

Describe the relationship between the factor input and the final output

Back 9

The relationship between the factor inputs required to produce a product and the final output is called production function. This simply means that the total output depends on the important factors.

Front 10

Def of law of variable proportions/ diminishing returns

Back 10

In the short run when variable factors are added to fix factors they return from the variable factors will eventually diminish. This is also known as the law of diminishing returns or a lot of variable proportions

Front 11

Describe the relationship between the factor input and the final output

Back 11

The relationship between the factor inputs required to produce a product and the final output is called production function. This simply means that the total output depends on the important factors.

Front 12

Def of law of variable proportions

Back 12

In the short run when variable factors are added to fix factors they return from the variable factors will eventually diminish. This is also known as the law of diminishing returns or a lot of variable proportions

Front 13

Describe the relationship of VF and Fixed factors in the short run

Back 13

Back (Definition)

Front 14

Def of fc

Back 14

These are costs which do not depend on the level of output, such as Cost of buying machines and factories.

Salaries of managers and supervisors who are needed

Front 15

Def of variable costs

Back 15

These are costs which change with the change of output, for example Raw materials. Aluminium, plastic, rubber, coffee beans. All the materials used in the productive process are variable costs

Increases when a firm produces more output and falls when a firm produces less output

Front 16

Draw the FC, VC, TC

Back 16

Draw

Front 17

Def of average FC

Back 17

This is the total fixed cost per unit

Average fixed costs (AFC) = FC/Q. As more goods are produced, the average costs will fall.

Front 18

Def of average FC

Back 18

This is the total fixed cost per unit

Average fixed costs (AFC) = FC/Q. As more goods are produced, the average costs will fall.

Front 19

Def and draw the average VC

Back 19

AVC. This is the variable cost per unit

Average variable costs (AVC) = VC/Q

Front 20

Def of average FC

Back 20

This is the total fixed cost per unit

Average fixed costs (AFC) = FC/Q. As more goods are produced, the average costs will fall.

Front 21

Def and draw the average VC

Back 21

AVC. This is the variable cost per unit

Average variable costs (AVC) = VC/Q

Front 22

Why is the VC curve U shaped

Back 22

At the initial stage, as you add variable cost to fixed cost, the physical output will increase very fast. Therefore the average fixed cost curve will fall.

Eventually as you continue to add the variable cost to the fixed cost, the return of variable costs will start falling. And therefore the physical output will start falling and this is where we experience an increase in average variable cost

Front 23

Def of marginal costs

Back 23

Marginal Cost is the cost of producing an extra unit.

Front 24

Def of marginal costs

Back 24

Marginal Cost is the cost of producing an extra unit.

Marginal cost is often shaped like this in the short term because of the law of diminishing marginal returns.

Therefore as MP increases MC declines and vice versa

Front 25

Def of marginal costs

Back 25

Marginal Cost is the cost of producing an extra unit.

Marginal cost is often shaped like this in the short term because of the law of diminishing marginal returns.

Therefore as MP increases MC declines and vice versa

Front 26

Draw the MC

Back 26

Back (Definition)

Front 27

Def of average TC

Back 27

This is the total cost per unit

TQ/Q or ATC=AFC+AVC

Front 28

Draw MC,AVC, AFC,ATC and explain the U shape of the ATC

Back 28

1) at initial stage of production when VC are added to the FC, the return to the VC increases at an increasing rate.

This makes the AVC to increase slowly. However over the same range of products, the AFC will fall rapidly.

The effect of AFC will outweigh AVC. This will make the AVC to fall.

The firm will realise an increasing returns in the shorts run. This will happen at the lowest point of the AC curve where the MC instersects AC. This is known as optiom level of production or productive efficiency

2) any production above this point, the AVC will start increasing rapidly while the AFC over a wide range of products will start decreasing slowly.

The effect of AVC will outweigh the AFC, making the ATC to increase over a wide the same range of products. This is where diminishing returns will occur

At this point, MC will be increasing faster than AC. This gives the U shape of AVC

Front 29

Def of normal profit and when is it achieved

Back 29

Normal profit is a situation where a firm makes sufficient revenue to cover its total costs and remain competitive in an industry.

In measuring normal profit, we include the opportunity costs of working elsewhere.

When a firm makes normal profit we say the economic profit is zero.

This is because Normal profit = total revenue- total costs

Front 30

Def of normal profit and when is it achieved

Back 30

Normal profit is a situation where a firm makes sufficient revenue to cover its total costs and remain competitive in an industry.

In measuring normal profit, we include the opportunity costs of working elsewhere.

When a firm makes normal profit we say the economic profit is zero.

This is because Normal profit = total revenue- total costs

Front 31

What happens when normal profit is not met

Back 31

This means that the enterprise will leave the industry for the next best profitable business venture. This is also can be taken as opportunity cost.

Front 32

Def of supernormal profits

Back 32

This is the excess profit a Guam makes above the minimum return to keep a firm in the business.

This is achieved when TR> TC . This is a type of profit that acts as an incentive for other firms to enter in the industry

Front 33

What’s profit maximisation

Back 33

An assumption in classical economics is tang firms seek to maximise profits. Profits is = TR-TC.

Therefor profit maximisation will occur at the biggest gap between total revenue and total costs.

A firm can maximise profits if its produces at an output where MR=MC

Front 34

How do firms operate in the perfect and impefect market

Back 34

Firms in a perfectly competitive market are said to be “price takers” - that is once the market determines an equilibrium price for the product, firms must Accept this price.

While, in the imperfect market, firms are price makers which means that individuals can set their own prices to products since they have power to control market conditions of demand and supply. For eg, a firm can reduce price to increase QD

Front 35

Explain why profits will maximise profits at a pint where MC=MR ( Equilibrium point for firms )

Back 35

At this point MP=0 which means there is no additional profits a firm can revive a this level of output.

1) from the above diagram, any production below the output, Q, the MR> MC. This means the MP is positive. This means that any additional unit a firm produces will produce will increase the amount of profits.

A firm stufo be encouraged to produce more output

2) any production above output, Q, MC> MR and the MP is negative. This means that any addition output at this point will only lead to a fall in profits l. Therefore a girls should reduce or cut down production.

Therefore firm can only maximise when MC=MR and MP=0

Front 36

Does achieving MC=MR lead to supernormal

Back 36

Not always, this is because a firm can either achieve loss or profit

Front 37

Other objectives of a firm

Back 37

However, in the real world, firms may pursue other objectives apart from profit maximisation.

1) profit satisfying. Profit satisficing is a situation where there is a separation of ownership and control. As a result, the owners are likely to have different objectives to the managers and workers. This is a problem because although the owners may want to maximise profits, the managers have much less incentive to maximise profits because they do not get the same rewards, (share dividends)

2. Sales maximisation

Firms often seek to increase their market share – even if it means less profit. This could occur for various reasons: Increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run. Increasing market share may force rivals out of business. E.g. the growth of supermarkets have lead to the demise of many local shops

3. Growth maximisation

This is similar to sales maximisation and may involve mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in order to increase in size and gain more market share. More market share increases its monopoly power and ability to be a price setter.

4) 5. Social/environmental concerns

A firm may incur extra expense to choose products which don’t harm the environment or products not tested on animals. Alternatively, firms may be concerned about local community / charitable concerns.

Some firms may adopt social/environmental concerns as part of their branding. This can ultimately help profitability as the brand becomes more attractive to consumers.

Front 38

Other objectives of a firm

Back 38

However, in the real world, firms may pursue other objectives apart from profit maximisation.

1) profit satisfying. Profit satisficing is a situation where there is a separation of ownership and control. As a result, the owners are likely to have different objectives to the managers and workers. This is a problem because although the owners may want to maximise profits, the managers have much less incentive to maximise profits because they do not get the same rewards, (share dividends)

2. Sales maximisation

Firms often seek to increase their market share – even if it means less profit. This could occur for various reasons: Increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run. Increasing market share may force rivals out of business. E.g. the growth of supermarkets have lead to the demise of many local shops

3. Growth maximisation

This is similar to sales maximisation and may involve mergers and takeovers. With this objective, the firm may be willing to make lower levels of profit in order to increase in size and gain more market share. More market share increases its monopoly power and ability to be a price setter.

4) 5. Social/environmental concerns

A firm may incur extra expense to choose products which don’t harm the environment or products not tested on animals. Alternatively, firms may be concerned about local community / charitable concerns.

Some firms may adopt social/environmental concerns as part of their branding. This can ultimately help profitability as the brand becomes more attractive to consumers.

Front 39

Def of long run

Back 39

This is a situation where all main factors of production are variable. The firm has time to grow and respond to changes in demand. For example, buying more machines

Front 40

Def of long run

Back 40

This is a situation where all main factors of production are variable. The firm has time to grow and respond to changes in demand. For example, buying more machines

Front 41

Explain the long run diagram

Back 41

From the above diagram, it shows that the firm has expended in three Machines. This has enabled him to produce in large scale. With the increase of growth, the LRAC falls. This results into economies of scale

Front 42

what is a principle agent problem

Back 42

Profit satisficing is a situation where there is a separation of ownership and control. As a result, the owners are likely to have different objectives to the managers and workers.

It is an example of the principal-agent problem. The shareholder is the principal. The workers are the agentThe owners of a firm are likely to have a goal of profit maximisation, however, they delegate the running of the firm to managers and workers.The owners employ managers on the expectation they will do a good job and try to maximise profits of the firm (and therefore maximise their dividends).

However, the owner cannot have complete knowledge about the effort and actions of their managers. In the everyday running of the firm, managers and workers will seek to make the firm relatively successful, but after satisfying certain goals (and minimum levels of expectation), they will consider other factors.

Front 43

Revenue vs Proft maximization and consider who will benefit the most from this change

Back 43

Some firms don’t make profit maximisation as their ultimate goal. They seek to maximise revenue or market share. Seeking to increase market share and sales will lead to lower profit, but can have advantages for firms, consumers and workers.

1) Increased brand loyalty. If a firm is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, the price is very important and getting a reputation for being cheapest supermarket can help attract customers.

2)

Front 44

Revenue vs Proft maximization and consider who will benefit the most from this change

Back 44

Some firms don’t make profit maximisation as their ultimate goal. They seek to maximise revenue or market share. Seeking to increase market share and sales will lead to lower profit, but can have advantages for firms, consumers and workers.

1) Increased brand loyalty. If a firm is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, the price is very important and getting a reputation for being cheapest supermarket can help attract customers.

2) Put competitors out of business. Pursuing sales maximisation may enable large firms to push rivals out of business. For example, a large supermarket with economies of scale could sell goods so cheaply; smaller rival firms can’t compete and go out of business. This enables the firm to have more market share and profit in the long-term. Consumers could benefit from lower prices in the short-term, but if firms do go out of business, then they will have lower choice and face prospect of less competition in the long-run.

Front 45

Revenue vs Proft maximization and consider who will benefit the most from this change

Back 45

Some firms don’t make profit maximisation as their ultimate goal. They seek to maximise revenue or market share. Seeking to increase market share and sales will lead to lower profit, but can have advantages for firms, consumers and workers.

1) Increased brand loyalty. If a firm is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, the price is very important and getting a reputation for being cheapest supermarket can help attract customers.

2) Put competitors out of business. Pursuing sales maximisation may enable large firms to push rivals out of business. For example, a large supermarket with economies of scale could sell goods so cheaply; smaller rival firms can’t compete and go out of business. This enables the firm to have more market share and profit in the long-term.

Consumers could benefit from lower prices in the short-term, but if firms do go out of business, then they will have lower choice and face prospect of less competition in the long-run.

3) Economies of scale. Lower price and higher sales can help firms with high fixed costs gain economies of scale (lower average costs). This could lead to lower prices for consumers.

4) increase long-term profitability. By gaining market share, firms enable economies of scale, greater sales and more market share. Therefore, in future, they will have greater ability to increase prices.

However, in theory, consumers are protected from firms which seek to pursue ‘unfair competition,’ i.e. selling below cost. Firms are not allowed to pursue ‘predatory pricing’ – which is the deliberate setting of prices below cost to force rivals out of business.

pursuing sales maximisation, the firm may have more incentive to cut costs leading to lower wages for workers, but on the other hand, expansion could create new jobs.

Front 46

Revenue vs Proft maximization and consider who will benefit the most from this change

Back 46

Some firms don’t make profit maximisation as their ultimate goal. They seek to maximise revenue or market share. Seeking to increase market share and sales will lead to lower profit, but can have advantages for firms, consumers and workers.

1) Increased brand loyalty. If a firm is able to cut prices and gain more customers, it will gain bigger exposure and brand loyalty. This enables the firm to be more prominent in the market. For example, in supermarkets, the price is very important and getting a reputation for being cheapest supermarket can help attract customers.

2) Put competitors out of business. Pursuing sales maximisation may enable large firms to push rivals out of business. For example, a large supermarket with economies of scale could sell goods so cheaply; smaller rival firms can’t compete and go out of business. This enables the firm to have more market share and profit in the long-term.

Consumers could benefit from lower prices in the short-term, but if firms do go out of business, then they will have lower choice and face prospect of less competition in the long-run.

3) Economies of scale. Lower price and higher sales can help firms with high fixed costs gain economies of scale (lower average costs). This could lead to lower prices for consumers.

4) increase long-term profitability. By gaining market share, firms enable economies of scale, greater sales and more market share. Therefore, in future, they will have greater ability to increase prices.

However, in theory, consumers are protected from firms which seek to pursue ‘unfair competition,’ i.e. selling below cost. Firms are not allowed to pursue ‘predatory pricing’ – which is the deliberate setting of prices below cost to force rivals out of business.

pursuing sales maximisation, the firm may have more incentive to cut costs leading to lower wages for workers, but on the other hand, expansion could create new jobs.

Front 47

EvaluTion of revenue maximisation

Back 47

It depends on the industry in question. For some industries, profit maximisation is necessary to finance investment and development. In other industries, pursuing short-term profit maximisation may lead to a big loss of market share and harm the firms prospects in the long run.

For consumers, they should benefit if firms cut prices to increase sales. However, if price cuts are so large that other firms are forced out of business, this could harm them in the long run.

Also, a degree of profit may help consumers if the firm uses it to improve quality of the product. But, there is no guarantee profit is used for re-investment.

Front 48

Benefits of profit maximization

Back 48

Classical economic theory suggests firms will seek to maximise profits. The benefits of maximising profit include:

1) Profit can be used to pay higher wages to owners and workers. (though if firm has monopsony power, the profit may not be shared equally amongst workers)

2) Profit can be used to invest in research & development. This investment can potentially benefit the consumer. For example, without large profits, drug companies would have less ability to develop new drugs.

However, this argument about research & development may depend on the industry. For example, it is now clear how much supernormal profit supermarkets need to be able to invest in research & development.

3)Profit enables the firm to build up savings, which could help the firm survive an economic downturn. For example, in a recession, a firm could see a temporary loss, but if the firm has a reasonable level of savings and history of profitability, the bank will be more willing to keep lending. However, profitable firms don’t necessarily save this profit for an economic downturn. Profit is often paid to shareholders in the form of dividends or used to finance expansion, such as mergers or takeovers.