Section 2.3 HL

Theory of the Firm

2.3 A Tale of Two Firms

Apple is currently the most popular and well loved firm in the US while JAL, to the dismay of the Japanese, recently declared itself bankrupt with 2.3 Trillion Yen in debt.

How can one firm be so successful while fail so spectacularly?

2.3 A Tale of Two Firms and Theory of the Firm

What advice could an economist give Apple to help it stay so successful and what advice could they give JAL so that it once again becomes the most successful airline in Asia.

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?

Crucial Questions All Firm Face

Theories about a firm’s behavior in the market place, the nature of that market place and how they produce

and price their goods.

Cost Theory

Revenue Theory

Profit Theory

Theory of the Firm Defined

Theory of the Firm The Goal

► Provide advice

► about the following:

► The best price

► The best output

► The most profit

► To breakeven price

► The shutdown price

Theory of the Firm

=Profit

-Fixed Costs Variable Costs

TRQuantity PriceX

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Cost Theory

Types of Costs: Fixed and Variable Costs

Fixed Costs

Variable Costs

Product

Fixed Costs

Variable Costs

Costs and Output (Product)

Variable Costs (VC)are the focus as Fixed Costs (FC)cannot change in the short term.

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)

Ways to Measure Output

The Total Product Curve

Average and Marginal Product Curves

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 Average 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.

Diminishing Marginal Returns

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.

Tota

l Costs

Total Fixed Costs (TFC)

Total Variable

Costs (TVC)

Total Costs

TC

Avera

ge C

osts

Average Fixed Costs

(AFC)

Average Variable

Costs (AVC)

Average Total Costs

(ATC)

Marg

inal C

osts

Marginal Cost (MC) = increase in

TC of producing an extra unit of

output

TFC, TVC and TC

Cost Curves

LRAC A firm altering all its factors to meet increasing demand

Economies of scale LRAC as Output

constant

Diseconomies of scale

LRAC as Output constant

Constant returns to scale

LRAC is constant as Output

Economies and Diseconomies of Scale

Economies and Diseconomies of Scale

Economies of Scale

Economies of Scale

Specialization

Bulk Buying of Inputs

Financial Savings

Transport Savings

Technology

Advertising and

promotion

Economies of Scale

Diseconomies of Scale

Control and Communicati

on

Alienation/work

satisfaction

Click icon to add pictureRevenue Theory

Total Revenue

Quantity Price

Total Revenu

e

X

=

Total Revenue

Quantity Price

Total Revenu

e

X

=

Marginal Revenue

Change in

Revenue

Change in

Quantity

Marginal Revenue

÷

=

Example 1 Demand is perfectly elastic PED = Infinity

Revenue Curves

Price ($)

Demand (q)

TR AR MR

5 1 5 5 5

5 2 10 5 5

5 3 15 5 5

5 4 20 5 5

5 5 25 5 5

5 6 30 5 5

5 7 35 5 5

Revenue Curves: Perfectly Elastic Demand

5

Price

Output

D=AR=MR

Revenue Curves for Normal Demand Curves

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Profit Theory

Accounting Profit

Total Revenue

Debit Total Fixed Costs

Debit Total Variable

CostsProfit

Economic Profit

Total Revenue

Debit Total Fixed Costs

Debit Total Variable

Costs

DebitOpportunity

CostsProfit

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

Profit and Loss

Which firm is making a Profit, which is making and Abnormal 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

Profit and Loss

Abnormal Profit Normal Profit Loss

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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

What advice would you give these firms?

Shut Down Price and the Break Even Price

Firm X Firm Y Firm Z

TR 80,000 120,000 150,000

TFC (in 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

Firm X should shut down as TR <TVC and TFCFirm Y should continue production as TR >TVC.Firm Z should continue to produce as TR >TVC& part of its TFC

Shut Down

Price = AVC

Break Even

Price = ATC

Determining the Shut Down Price and the Break Even Price

Shut Down Price

Break Even Price = P1 = ATC

When MR > MC then a firm

should increase production until

MC = MR

Profit Maximizing Level of Output

Profit Maximizing Level of Output with Perfectly Elastic Demand

Profit Maximizing Level of Output with Perfectly Elastic Demand

Profit Maximizing Level of Output with Normal Demand

Profit Maximizing Level of Output with Normal Demand

The profit per unit of output must be the difference

between the AR and the AC.

Therefore P = AR at q – AC at q X

Quantity (q)

Profit Maximizing Level of Output with Normal Demand

Normal Profit Normal Demand

Abnormal Profit Normal Demand

Loss Normal Demand

Is it alw

ays a

bout p

rofit?

Revenue and Sales maximization• Strategic =

increase market share in SR.

• Ignorance

Maximizing Employment • Large

workforce = Success

Environment AimsIncur added costs to be environmentally sustainable.

Satisficing • Keep

shareholders satisfied with performance

Profit, Sales and Revenue Maximization?

Profit, Sales and Revenue Maximization?

Profit, Sales and Revenue Maximization?

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Price Discrimination

Definition

Price Discrimination

• When firms actively adjust prices according to the willingness/ability of different consumers to pay.

Types of Price Discrimination

First Degree

• charge whatever the market will bear e.g. auction.

Second Degree

• discount for quantity purchases

Third Degree

• market separated into distinct groups

Third Degree Discrimination

Time•peak and off peak toll roads

Age•seniors, adults and children

Type •domestic and industrial uses of electricity

Income•Means tested government services

Location•books in Australia and US

Reasons for Price

Discrimination

Increase profits

Increase output and gain from economies

of scale

Gain market

share by predatory

pricing

Build brand loyalty

Promote goodwill

Achieve fairness

Pre-conditions for Price Discrimination

Different market

segments identifiable

Firm have market power

Arbitrage can be limited

Price Discrimination ExampleTotal Ticket Sales

Price Discrimination ExampleAdult Tickets

Price Discrimination ExampleAdult Tickets

Price Discrimination Example

MC = MR

600 tickets

at $5

TR = $3000

Adults are

less price

sensitive

therefore

the MR

Curve is

kinked.

Charging

Adults $9

yields

$1800

(200 x $9)

Charging

Students $7

yields

$2800

(400 x $7)

New TR=

$3600

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Efficiency

Productive Efficiency and Allocative Efficiency

Productive Efficiency is

achieved when goods

are produced at the lowest

possible cost per unit., i.e.

Minimum Average

Cost

Allocative Efficiency is

achieved when

resources are not

wasted i.e. Supply =

Demand and Price = MC

Productive Efficiency: Resources are not wasted

Allocative Efficiency / Socially Optimum Level of Output

Perfect Competition Versus Monopoly

Perfect Competition Versus Monopoly

Monopolies

Pros of Monopolies

Cons of Monopolies

Competition & the Theory of Contestable Markets

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Efficiency

Traditional Theories of Market Structure and Competition

Number of Firms

in Marke

t

Degree of Competiti

onInverse Relationship

Theory of Contestable Markets

Barriers to

Entry of

Potential

Rivals

Actual Degree of

Competitio

nInverse Relationship

Theory of Contestable Markets

If market is contestable (low barriers to

entry),

firms

will perceive

a threat of competition.

Accordingly

firms will

behave

competitivelyand

greater

efficiency and lowe

r prices will resul

t

Theory of Contestable Markets

Threat of

competition

influences price

and output of all firms

If cost of entry and exit is zero (perfectly

contestable market), firms will

challenge a firm that is

making abnormal profits and therefore that firm will keep

prices low.

In reality most firms

when entering a market will be faced

with sunk cost, i. e. costs that can not be

recouped by transferring

them to another

use.