Unit 6: Theory of the Firm Flashcards
Firm
organization that brings together factors of production to produce a commodity which is sold for a profit
Short-run
period of tine during which at least one input is fixed, flexibility is somewhat restricted
Long-run
period of time during which all inputs can be varied, it is long enough to make a complete change
Law of variable returns
describes how the output of production process changes when you keep increasing one variable input while holding the supply of another input is fixed.
States that given one at least one factor fixed factor input and one variable factor input, as additional units of the VFI are added, total product increases but with a diminishing rate
Law of diminishing returns
if an increased number of one factor input is combined with a fixed supply of another, there will be a less-than-proportionate increase on output (MP falls)
Average product
number of units producer per variable factor input
formula: TP/L
Marginal product
refers to the extra output that is produced by adding one more unit of a specific input while keeping other inputs constant.
formula: change in TP/change in L
Inflection point
point at which TP stops increasing at an increasing pace and starts increasing at a diminishing rate
Why do returns vary?
returns vary as long as there is a fixed factor input and hence, L:K ratio varies
Stages of production
- Positive, increasing returns
- Positive, diminishing returns
- Zero returns
- Negative returns
Costs
what firms incur to produce a commodity
Implicit cost
opportunity cost
Explicit cost
cost actually paid
Total fixed costs (TFC)
independent on the number of units produced i.e. exogenous, these are unavoidable costs. It is illustrated by a horizontal graph
Total variable costs (TVC)
dependent on the number of units produced, costs increase directly with output. Such costs are avoidable
Average cost
cost of producing each unit
formula: TVC/TP
Marginal cost
change in total cost resulting from a one unit increase in total product
formula: change in TC/change in TP
Marginal cost curve
The typical U-shaped marginal cost curve:
- Decreasing marginal cost - when production starts, the firm might get more efficient, so the cost per additional unit goes down
- Increasing marginal cost - after a certain point, adding more resources causes the cost of each extra unit to go up because of overcrowding, limited resources or inefficiencies
Increasing returns to scale
an equi-proportionate increase in VFI results into a larger percentage increase in total product, resulting in average cost to fall
Diminishing returns to scale
an equi-proportionate increase in VFI results in a smaller percentage increase in total product, resulting average cost to rise
Constant returns to scale
a percentage increase in total product is brought about by the same percentage increase in VFI
Why is the term ‘scale’ used?
it is used in the long-run whereby the firm can move to a different scale of production
LRAC Curve
shows the least unit cost of producing different output levels, assuming the firm has complete flexibility. It is made up of numerous SRAC curves. AC is likely to be lower in the long-run due to flexibility
Economies of scale
reduction in the long-run average costs caused by employing more of all factors of production. Increases in output are more-than-proportionate to the increases in the scale of production.
e.g. technical, marketing, purchasing, financial, managerial, risk-bearing, research and development EOS
Types of Economies of Scale
- Technical EOS - AC falls due to technical advantages
- Marketing EOS - marketing costs increase less than proportionately than sales
- Purchasing EOS - large firms use their finances to buy in bulk and benefit from discounts so that each item purchased is at a lesser price than smaller competitors
- Financial EOS - ability to borrow funds to finance your investment projects at a lesser rate of interest than smaller firms
- Managerial EOS - managerial costs increase as the firm grows but at a lesser rate than the growth of output
- Risk bearing EOS - big firms can diversify and hence spread the risk
- Research and development EOS - monopolies can sustain R and D by spreading such huge costs onto a variety of products
Diseconomies of scale
an equi-proportionate increase in the scale of production results in a smaller increase in total product
External economies of scale
refers to factors influencing the firm irrespective of the size
e.g. labour force, modern infrastructure, tax regime, political and economic stability
External diseconomies of scale
traffic, lack of investment in infrastructure, tax harmonization, lack of stability
