Theory of the Firm Flashcards
State the Law of Diminishing (Marginal) Returns.
As we add successive units of one factor of production to fixed amounts of other factors, the increments, in total output, will eventually decline beyond a certain point.
The existence of a fixed factor imposes a limit on the gains from specialisation.
Define the Average Product of Labour.
The Average Product of Labour is output per unit of labour input. It measures the productivity of the firm’s workforce in terms of how much output each worker produces on average.
It is calculated using = Total Product / Units of Labour
Define the Marginal Product of Labour
The change in total product, due to a one-unit increase in labour.
It is calculated using = ∆TP / ∆L
Define Marginal Cost
The additional cost incurred by producing one extra unit of output. It is calculated using = ∆TC / ∆ Q.
Explain the difference between ‘variable’ and ‘fixed’ costs.
Variable costs vary as output varies. These include wages, cost of raw materials and electricity. TVC are also referred to as direct costs, as they increase directly with the number of units produced. Thus, such costs are avoidable during a shut-down.
Fixed costs do not vary as output changes. These include rent, insurance, and depreciation. These costs are unavoidable during a shut down.
In the short run some costs will be fixed and some variable. However, in the long run, all costs are variable.
Added together, TVC + TFC = TC.
Explain the graphs and shifts in the graph.
Distinguish between the long run and the short run.
The long run is a time period relating to the process of production during which there is is time to vary all factors of production (land, labour, capital and entrepreneurship), but not sufficient time to change the basic technological process being used - this is possible only in the very long run. All factors of production are variable. Since there are no fixed costs, if a firm is making a loss in the long run it should shut down its production - long-run shut-down point.
Firms in the long run benefit from increasing returns to scale. Because factors are variable, output increases more-than-proportionate to an equi-proportionate increase in all factor inputs. Firms can benefit from internal economies of scale - as output is produced on a larger scale, the average cost will decrease.
On the other hand, the short run is a time period in the production process where at least one factor of production is fixed. The fixed factors of production cannot be changed, but the level of utilisation of variable factors can be altered. Firms in the short-run can keep on making losses until they hit the short-run shut-down point - the lowest point of AVC curve. Firms can be loss-minimising firms in the short-run because of variable costs.
What is understood by the “law of diminishing marginal product”?
The Law of Diminishing Returns states that as we add successive units of one factor of production to fixed amounts of other factors, the increments, in total output will eventually decline beyond a certain point. When increasing the quantities of a variable factor, first the marginal and then the average returns to the variable factor will, after some point diminish. The effect of employing more units of labour for example, is that the Marginal Product of factors declines when they are employed in increasing quantities.
This can be seen in the downwards sloping MP curve. The MP curve starts to increase until it reaches its maximum point. After this point, diminishing marginal returns begins to occur and the MP curve declines.
Production in the short-run is subject to this law. More so, diminishing returns occurs because of over-utilisation of the fixed factor.
For example, a farm owner with one field might find that one man could produce two tons of grain; two men five tons of grain - more than twice as much (increasing marginal returns); but three men only seven tons of grain (positive decreasing marginal returns). The extra production gained from adding a worker started at 2, rose to 3, then fall back to 2.
However, diminishing returns should not be confused with negative returns - successively adding workers to a factory can increase its total output but at a falling rate; only when the factory becomes very overcrowded would the presence of an extra worker actually cause production to fall.
What are economies of scale?
The output of a firm is being produced at a larger scale, therefore the average cost will decrease. Costs change in proportion to the output produced.
In the long run, a firm may experience increasing returns to scale from its factors of production. The output increases more-than-proportionate than the factor of production, so as it produces more it will be using smaller amounts of factors per unit. Ceteris paribus, this leads the firm to produce more at a lower cost.
Why do economies of scale occur?
- Increased Specialisation: an ability to break down processes which will increase worker’s productivity.
- Indivisibility of Capital: equipment may be designed to produce large amounts, so small firms can’t fully utilise machinery.
- Linked Processes: less time wasted moving products from one plant to another, therefore smaller transportation costs.
- Increased Dimensions
- By-product
- Economies of Scope
- Principles of Multiples
What are diseconomies of scale?
Occur when a firm goes beyond a certain size. The costs per unit of output increase as the scale of production increases. The firm is also experiencing decreasing returns-to-scale.
High average costs means that the firm is inefficient and goods are more expensive to produce.
Why do diseconomies of scale occur?
- Management problems
- Communication problems
- Low morale of employees
- Inflexibility for workers
These all cause productive inefficiency in production
Distinguish between the short-run shut-down point and the long-run shut-down point.
Short-run shut-down point: the firm should shut-down if it can’t cover the cost of the variable factors (AVC) - wages.
However, if it can cover at least the AVC, then the firm should keep on operating. If it were to shut-down, it would incur larger costs. If such a firm were to remain open, its loss would exceed TFC.
This point can be found at the lowest point of the AVC curve.
However, in the long run there are no variable costs. Therefore, it the TR<TC, the firm should shut down permanently. This is the long-run shut-down point.
At what point on the TC curve, does the law of diminishing marginal returns begin?
The Inflection Point
What are the profit maximising rules?
- Produce where MC=MR
- Produce at the largest positive gap between TR and TC
- Produce at the point when MP=0
What are supernormal profits?
Supernormal profits are made when the firms is making an accounting profits over and above what is necessary for it to remain in the industry. This abnormal profit is made when TR > TC (including the opportunity cost).
Firms are generating revenue which exceeds all opportunity costs. Firms are earning a return which exceeds the minimum necessary to induce them to remain within the industry they currently occupy.
