Theory of the Firm (Product, Cost, Revenue, Profit)

Microeconomics
by: Shadi A. Razak 1
Theory of Firm

Objectives
• Understand what the Theory of The Firm
means
• Explain the firm behaviour to minimise cost
• Understand the firm behaviour to increase
productivity and economics efficiency.
• Explain the firms behaviour to maximise
profit
• Understand the concept of Economy of Scale

Structure
• Introduction
• Theory of Firm
• Production Function
• Cost Theory
• Revenue Theory
• Profit Theory

Tale of a Firm
• 2010 : $63.5 Billion Revenue Year
• 2015 : $58 Billion Revenue for Q2 only
INTRODUCTION
HL

Tale of a Firm
• 2010 : Filling for bankruptcy
• 2015 : $2.5 Billion Revenue in Q2
INTRODUCTION
HL

Tale of a firm
INTRODUCTION
HL

Critical Questions
INTRODUCTION
How should the firm
use resources to
make a profit?
How should the firm
reduce costs, be
efficient and
maximize profits?
What is the best
price to obtain the
most revenue?
How many units
should the firm
produce to make the
most revenue?
How should the
firm plan for the
future in terms of
price and quantity?
What are the
advantages and risks
of the firms market
environment?
How can the firm
respond to the
business cycle?
HL

Theory of Firm
INTRODUCTIONTHEORY OF FIRM
Theories about a firm’s
behavior in the market
place, the nature of
that market place and
how they produce and
price their goods.
Production
Function
Cost Theory
Revenue
Theory
Profit Theory
HL

Theory of Firm
• Help us identify:
– Best level of output
– Best price to sell at
– Best price to breakeven
– The price to shutdown
– Optimum level of profit
HL

Theory of Firm
• Firms are analysed in:
– Short run: some factors fixed and cannot be
increased/reduced
– Long run: time taken to vary all factors of
production
HL

Production Function
INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTION
Output
Process
(Product or service generated and value added)
Input
(Land, Labour, and Capital)
HL

Production Measurements
• Total Product (TP)= total output of a firm
• Average Product (AP) = TP/V (Units of the
Variable Factor)
• Marginal Product (MP) = Change in TP/Change
in V (Units of the Variable Factor)
PRODUCTION FUNCTION
HL

• Total Product (TP)= total output of a firm
• Average Product (AP) = TP/V (Units of the
Variable Factor)
• Marginal Product (MP) = Change in TP/Change
in V (Units of the Variable Factor)
PRODUCTION FUNCTION
HL

HL

Total Product Curve

Average and Marginal Product
Curve
Diminishing Average Value
(Returns)
As extra units of a VF are added to a
given quantity of a FF, the output per
unit of the VF will eventually diminish.
Diminishing Marginal Value (Returns)
As extra units of a VF are added to a given quantity of a
FF, the output from each additional unit of the VF will
eventually diminish.

Cost and Product
INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY
Product
Fixed
Costs
Variable
Costs
Variable Costs (VC)
are the focus as Fixed
Costs (FC)cannot
change in the short
term.

Types of Cost
• Economic cost = Explicit cost + Implicit Cost
– Explicit cost represent the business accounting
cost, which consist of:
• Fixed cost
• Variable cost
– Implicit cost represent indirect costs:
• Entrepreneurship skills
• Time spent running the business
• Ideas

Total Cost
Total Costs (TC) = total cost to produce a
certain output. TC = TFC + TVC
Total Variable Costs
(TVC) = total cost of
the variable assets
that a firm uses in a
given period of
time.
Total Fixed Costs
(TFC) = total cost of
fixed assets used in
a given time period.
HL

Average Cost
Average Fixed
Costs (AFC)
Average Variable
Costs (AVC)
Average Total
Costs
(ATC)
HL

Marginal Cost
Marginal Cost
(MC) = increase in
TC of producing
an extra unit of
output
HL

Total Cost Curve
HL

Average Cost Curves
HL

Average Cost (Long Run)
HL

Economies & Diseconomies of
Scale
Economies of scale LRAC
 as Output constant
Diseconomies of scale
LRAC  as Output
constant
Constant returns to scale
LRAC is constant as
Output 
HL

Economies & Diseconomies of
Scale
HL

Economies of Scale Means
Economies
of Scale
Specialization
Bulk Buying of
Inputs
Financial
Savings
Transport
Savings
Technology
Advertising
and
promotion
HL

Diseconomies of Scale Cause
Diseconomies
of Scale
Loss Control
and
Communication
Workforce
Alienation and
dissatisfaction
HL

Total Revenue
INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORY
Quantity
Sold
Sales
Price
Total
Revenue
X
=
HL

Marginal Revenue
Change in
Revenue
Change in
Quantity
Marginal
Revenue
÷
=
HL

Revenue Curves
P
Price
Output
D=AR=MR
DemandinPerfectElasticity
PED=Infinity
HL

Revenue Curves
TR rises then falls.
At first firm gains extra revenue by lowering price
because more are sold but eventually this is
outweighed by the loss in revenue from the units
that were being sold at a higher price but must now
be sold at a lower price.
MR falls at a steeper rate & becomes negative when a loss of revenue caused by lowering price
MR below AR because the firm, in order to sell more products, has to lower the price and thus revenue
is lost on the products that could have been sold at a higher price. In this way the firm will get more
revenue from increased sales.
AR = Price
This falls as output increases as the
price will be lowered in order to sell
more products.
HL

Types of Profit
INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY
• Accountant Profit:
Total Profit = Total Revenue – Total Costs
(variable and fixed)
• Economic Profit:
Total Profit = Total Revenue – Total Costs
(variable, fixed & opportunity)
HL

Profit and Loss
• Which firm is making a Profit, which is making
and Profit and which is making a loss?
Firm A Firm B Firm C
TR 200,000 200,000 200,000
TFC 40,000 40,000 40,000
TVC 80,000 100,000 120,000
Opportunity Cost 60,000 60,000 60,000
TC 180,000 200000 220,000
HL

Profit and Loss
• Which firm is making a Profit, which is making
and Profit and which is making a loss?
Firm A Firm B Firm C
TR 200,000 200,000 200,000
TFC 40,000 40,000 40,000
TVC 80,000 100,000 120,000
Opportunity Cost 60,000 60,000 60,000
TC 180,000 200000 220,000
Abnormal
Profit
Normal
Profit
Loss
HL

Normal Profit
• Normal profit is the minimum level of profit
needed for a company to remain competitive
in the market.
• Normal Profit takes place when TR = TC (fixed,
variable and opportunity)
• AC is the key for a firm to avoid loss and do
better than normal profits to achieve
abnormal profits.
HL

Normal Profit
• With Normal Demand:
HL

Abnormal Profit
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Loss Profit
HL

Shutdown and Breakeven
• What advice would you give these firms?
Firm X Firm Y Firm Z
TR 80,000 120,000 150,000
TFC (including
OC)
100,000 100,000 100,000
TVC 100,000 120,000 140,000
TC 200,000 220,000 240,000
Loss 120,000 100,000 90,000
HL

• Firm X should shut down as TR <TVC and TFC
TR 80,000 120,000 150,000
TFC (including
OC)
100,000 100,000 100,000
TVC 100,000 120,000 140,000
TC 200,000 220,000 240,000
Loss 120,000 100,000 90,000
HL

• Firm Y should continue production as TR ≥TVC
TR 80,000 120,000 150,000
TFC (including
OC)
100,000 100,000 100,000
TVC 100,000 120,000 140,000
TC 200,000 220,000 240,000
Loss 120,000 100,000 90,000
HL

• Firm Z should continue production as TR >TVC
TR 80,000 120,000 150,000
TFC (including
OC)
100,000 100,000 100,000
TVC 100,000 120,000 140,000
TC 200,000 220,000 240,000
Loss 120,000 100,000 90,000
HL

Shut Down
Price = AVC
Break Even
Price = ATC
HL

HL

Profit Maximizing
• If a firm wishes to maximize profits, it should
produce at the level of output where MC cuts
MR from below
When MR > MC then
a firm should increase
production until
MC = MR
HL

Profit Maximizing
• With Perfect Elastic Demand
HL

Profit Maximizing
• With Normal Demand
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Profit Maximizing
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Profit Maximizing
Therefore P = AR at q – AC at q X
Quantity (q)
The profit per unit of output must be the
difference between the AR and the AC.
HL

Its Not Always About Profit
• Maximize sales and revenue
• Maximize resources use
• Shareholder satisfaction
• Environmental goals
HL

Revenue Maximizing
HL

Sales Maximizing
HL

Summary
• Explained what is meant by ‘Theory of Firm’
• Differentiated between the firm different
behaviours to maximise profit and minimise
cost
• Identified the break-even and shut down price
• Explained the concept of Economies and
diseconomies of Scale

Theory of the Firm (Product, Cost, Revenue, Profit)

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