1.5 Theory of the firm Flashcards
What does short run mean?
A time period during which at least one input (one factor/cost of production) is fixed and cannot be changed.
What is the long run?
A time period during which all inputs (all factors/costs of production) are variable and can be changed.
Define: TP
Total Product: the total quantity of output produced by a firm.
Define: MP
Equation?
Marginal Product: The additional output resulting from one additional unit of variable input e.g. labour.
The rate of change of Total Product.
MP = ΔTP / Δunits of input
Define: AP
Equation?
Average Product: the total quantity of output per unit of variable input e.g. labour.
AP = TP / units of input
How would you diagrammatically present:
a) TP
b) MP
c) AP
a) a positive correlation line to a maximum point, where it curves and starts to decrease
b) a line that starts very positive, then curves quickly and starts to decrease into the negatives (when TP starts to decrease)
c) a shallow curve that is maximum when AP=MP, after which slowly decreases
What is the law of diminishing returns?
AKA: Law of diminishing marginal product.
As more and more units of variable input (e.g. labour) are added to one or more fixed inputs (e.g. land), the marginal product of the variable input first increases, but then comes a point when it starts to decrease.
What are explicit costs?
Examples?
Payments made by a firm to outsiders to acquire resources for use in production. These are usually financial costs.
Such as resources, rent, wages, menu costs.
What are implicit costs?
Examples?
The sacrificed income arising from the use of self-owned resources by a firm. Usually opportunity costs.
E.g. opportunity costs of foregone income, entrepreneurial talent, land which could’ve been rented out.
What is the difference between accounting profit and economic profit?
Accounting profit = revenue - explicit costs. Like a balance sheet.
Economic profit = revenue - (explicit and implicit costs). Like a business decision sheet.
Which will always be lower: economic profit or accounting profit?
What does this mean?
Economic profit will always be lower as economic costs will always be greater than explicit (accounting costs).
This means that despite a firm is making an economic loss, it could still be making accounting (financial) profit.
What does an economic loss mean?
What does an accounting loss mean?
Economic loss indicates that the way that a firm is being run is illogical, despite it making money. E.g. you could be making more money if you were employed by a different firm.
Accounting loss indicates that the firm is losing money.
What are fixed costs?
Examples?
Costs that do not change as output changes, arising from fixed inputs.
E.g. rental payments, interest on loans, insurance, salaries.
What are variable costs?
Examples?
Costs that vary (change) as output changes, arising from the use of variable inputs.
Define: TC
Define: TVC
Define: TFC
Total Costs: the sum of fixed and variable costs.
Total Variable Costs: the sum of all variable costs.
Total Fixed Costs: the sum of all fixed costs.
Define: AC (ATC)
Define: AVC
Define: AFC
Equations?
Average (Total) Costs: (Total) costs per unit of output.
Average Variable Costs: Variable costs per unit of output.
Average Fixed Costs: Fixed costs per unit of output.
ATC = TC / Q | AVC = TVC / Q | AFC = TFC / Q
Define: MC
Equations?
Marginal Cost: is the additional cost of producing one more unit of output.
MC = ΔTC/ΔQ = ΔTVC/ΔQ
How would you diagrammatically show:
a) TC
b) TVC
c) TFC
a) A curve that starts at TFC at Q=0, which goes up, flattens, and then curves up again.
b) The same shape of TC but starts at 0 when Q=0.
c) A horizontal line at TFC for all quantities.
How would you diagrammatically show:
a) MC
b) AFC
c) AVC
d) ATC
a) A curve that goes downwards, turns, and then goes up again.
b) Like a 1/x function, just keeps decreasing but by less each time.
c) A shallow U-shaped curve with a minimum when MC = AVC
d) An L-shaped curve with a minimum when MC = ATC
What shows the law of diminishing returns?
The U-shape of ATC and then n-shape of AP
Define: Constant returns to scale
Output increases in the same proportion as all inputs: the percentage change of outputs is the same as the percentage change of inputs
Define: Increasing returns to scale
Output increases more than in proportion to the increase in all inputs. Given as the percentage change of output is greater than the percentage change of inputs.
Define: Decreasing returns to scale
Output increases less than in proportion to the increase in all inputs. Given as the percentage change of output is smaller than the percentage change of inputs.
What is the long-run average total cost curve (LRATC)?
How is it drawn?
A curve that shows the lowest possible average cost that can be attained by a firm for any level of output when all of the firm’s inputs are variable.
It is a curve that is tangent to each of the many short-run average total cost curves. Also known as a planning curve.
Define: Diseconomies of Scale
Increases in the average costs of production as a firm increases its output by increasing all its inputs.
Define: Economies of Scale
Decreases in the average costs of production over the long run as a firm increases all its inputs.
Why might economies of scale occur?
(6)
- Specialisation of labour (they are also specialised to the individual firm).
- Specialisation of management
- Efficiency of capital equipment
- Individibilities of capital equipment
- Individibilities of efficient processes
- Spreading of certain costs, such as marketing, over larger volumes of output.
What are the types of Economies of Scale?
(5)
Tony’s Mother Found A Rabbit
Technical - As a firm grows, it can use machinery to the full capacities, or employ more efficient machinery
Marketing - As a firm grows, it only has to advertise itself (as a brand) rather than individual products.
Financial / Purchasing - As a firm grows it can benefit from financial discounts (e.g. low interest loans) / It can benefit from lower costs due to bulk-buying.
Administrative / Managerial - As a firm grows, it can employ specialist workers / It can set up an efficient management system.
Risk bearing - As a firm grows, it can sell lots of products in different markets to spread out the risk (economies of scope)
Why might diseconomies of scale occur?
(3)
- Co-ordination and monitoring difficulties
- Communication difficulties
- Poor worker motivation
What is the minimum efficient scale?
The point on the LRATC curve that represents the lowest level of output at which the long-run average total costs are minimum.
Define: TR
Equation?
Total Revenue: it is the sum of all the income a firm receives for producing its good at a certain output level.
TR = Price x Quantity
Define: MR
Equation?
Marginal Revenue: The additional revenue received from one additional unit of output.
MR = ΔTR/ΔQ
Define: AR
Equations?
Average Revenue: The revenue per unit of output
AR = TR/Q
AR = P
What is normal profit?
The minimum amount of revenue that the firm must receive so that it will keep the business running (as opposed to shutting down).
What is the break even point?
When a firm earns normal economic profit.
Total revenue = Total economic costs.
What is supernormal profit?
When a firm is receiving more revenue than what is required to keep it running.
Total revenue > Total economic costs
What is economic loss?
When a firm earns revenue that is less than what is required to keep it running.
TR < Total economic costs
What are the goals of a firm?
- Profit Maximisation
- Sales Maximisation
- Sales Revenue Maximisation
- Sales Growth Maximisation
- Profit Satisficing
- Managerial Utitily Maximisation
- Corporate Social Responsibility
When is profit maximised?
MC = MR
What is sales revenue maximisation? When does it occur?
What is sales growth maximisation? When does it occur?
Sales revenue maximisation is when (price x quantity) is maximum. At MR = 0
Sales growth maximisation is for lowest price, maximum output. Usually when price = average cost.
What is managerial utility maximisation?
Managers may act in a way to fulfil their own objectives rather than the firms, causing profits to decrease.
This is linked to the principal-agent problem and a divorce of ownership.
When will profit satisficing please the most stakeholders?
When a firm receives normal profits
What is the principal-agent problem?
A conflict in priorities between a person or group and the firm that authorized them to act on its behalf.
What is the divorce of ownership and control?
When the owners of a business do not control the day-to-day decisions made in the business, it is left up to the managers and workers.
