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3 Theory of the Firm (HL ONLY) Part I

Sub-topic Production and costs Production in the short run: the law of diminishing returns HL Core Assessment Objectives

AO2 Distinguish between the short run and long run in the context of production. Long run is the planning stage in which all factors of production are variable apart from technology; short run is in the production stage in which at least one factor of production is fixed. AO1 Define total product, average product and marginal product, and construct diagrams to show their relationship. Total product is the total output that a firm produces using its fixed and variable factors in a given period of time. Average product is the output produced on average, by each unit of the variable factor (AP=TP/V). Marginal product is the extra output produced by using an extra unit of the variable factor (MP=TP/V).

AO3 Explain the law of diminishing returns. *NOTE: You must be able to calculate total, average and marginal product from a set of data and/or diagrams. As labor increases marginal returns increase (see diagram above showing relationship between Total, Average and Marginal product in the long run). However, after a certain point marginal returns diminish because there is so much labor that production becomes inefficient. If labor continues to increase there will be negative marginal returns. Economic costs are the opportunity cost of all resources employed by the firm (including entrepreneurship). AO2 Distinguish between explicit costs and implicit costs as the two components of economic costs. Explicit costs are factors of production purchased from others and not already owned by the firm. Implicit costs are factors of production already owned by the firm. One must consider the opportunity costs of both explicit and implicit costs. Even if one is not paying for factors of production as with explicit costs, the firm could close down if it is not covering the opportunity cost of implicit costs (it could be making more money in another business). AO3 Explain the distinction between the short run and the long run, with reference to fixed factors and variable factors. In the short run, at least one variable is fixed. In the long run, all factors are variable except the state of technology. AO2 Distinguish between total costs, marginal costs and average costs. Total costs are the sums of fixed (total costs of all fixed assets that a firm uses in a given time) and variable costs (total costs of all variable assets a firm uses in a given time). Marginal costs are the costs of producing one extra unit of output. Average

Costs of production: economic costs

Costs of production in the short run

costs are the costs per unit output. AO3 Draw diagrams illustrating the relationship between marginal costs and average costs, and explain the connection with production in the short run. The marginal cost has to intersect the average cost at its lowest point. While the marginal cost is below the average cost, the average cost will continue to decrease. When the marginal cost increases above the average cost, however, average cost too will increase, so that is why marginal cost equals average cost at its lowest point. AO3 Explain the relationship between the product curves (average product and marginal product) and the cost curves (average variable cost and marginal cost), with reference to the law of diminishing returns. (See diagram above) To start with, as output increases average cost decreases as does marginal output. After a point, however, due to diminishing marginal returns, both the marginal and average cost increases. (See diagram left) Similarly, due to diminishing returns, after a point, increasing the input will only cause output per unit input to decrease instead of rising. This will cause marginal product to drop. However, it is only when marginal product is less that average product that average product will also start to drop. Hence, the marginal product intersects the average product at its highest point. *NOTE: You must be able to calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable costs, average total costs and marginal costs from a set of data and/or diagrams. AO2 Distinguish between increasing returns to scale, decreasing returns to scale and constant returns to scale. In the long run, as output per period increases, cost per unit output decreases due to economies of scale (e.g. benefits of specialization). As a result of the decrease in average cost, there are increasing returns to scale. However, due to diminishing returns, after a certain point cost per unit output does not decrease but remains the same and there are constant returns to scale. If output per period continues to increase there can be decreasing returns to scale due to diseconomies of scale (e.g. strained control and communication). AO1 Outline the relationship between short-run average costs and long-run average costs.

Production in the long run: returns to scale

Costs of production in the long run

The LRAC (Long Run Average Cost) curve is Ushaped because of economies and diseconomies of scale. The SRAC (Short Rune Average Cost) curve is U-shaped due to the law of diminishing returns. In the short run (the production stage) costs increase as output increases because at least one fixed factor of production restrains further growth. In the long run (the planning stage) all factors of production are variable, apart from technology, so production can move to a new short-term curve. Once production begins the firm is again stuck on the new short-term curve. In the next wave of planning, however, the firm can again increase all factors, apart from technology, and move to a new point on the LRAC curve. AO3 Explain, using a diagram, the reason for the shape of the long-run average total cost curve. As output per period increases, cost per unit output decreases due to economies of scale. After a certain point, due to diseconomies of scale, there are only constant returns to scale and eventually cost per unit actually starts increasing with rising output.

AO2 Describe factors giving rise to economies of scale. There are a number of factors giving rise to economies of scale. Economies of scale are any decreases in long-run average costs that come about when a firm alters all of its factors of production in order to increase its scale of output. Economies of scale lead to the firm experiencing increasing return to scale There are both internal and external economies of scale. Internal economies of scale are the reduced costs brought to a single firm from being large. Internal economies of scale include: Specialization: In large firms, there can be specialized managers who have individual areas of expertise, such as production, finance or marketing and can therefore be more efficient. Division of labor: Breaking down the production process into small activities that workers can perform repeatedly and efficiently allows unit costs to be reduced (e.g. assembly lines). Bulk buying: As firms increase in scale they are often able to negotiate discounts with suppliers that they would not have received when they were smaller, the cost of their inputs is then reduced, which in turn reduces the costs of production. Financial economies: Large firms can raise financial capital more cheaply because banks tend to charge

lower interest rates to larger firms, since the larger firms are considered to be less of a risk than the smaller firms, and are less likely to fail to repay their loans. Transport economies: Large firms making bulk orders may be charged less for delivery costs than smaller firms. Also, as firms grow they may be able to have their own vehicles, which will cost less because of not having to pay other firms, who will include a profit margin. Large machines: A large firm can have its own large machinery and would not have to pay other firms, who will include a profit margin, thereby reducing unit costs of production. Promotion economies: Since the costs of promotion tend not to increase in the same proportion as output, the cost of promotion per unit output falls, as a firm gets larger. External economies of scale are the benefits of the concentration of firms in an industry (e.g. technical firms in Silicon Valley). For instance, due to the concentration of firms special courses are offered in university in and near the area so that there is a talented labor force for firms to pick from. AO2 Describe factors giving rise to diseconomies of scale. Factors giving rise to diseconomies of scale include problems of coordination and communication (it is difficult to maintain control over a large organization, also decision making can take longer and everyones points of view may not be taken into consideration) and alienation and identity loss (workers may feel that they are an insignificantly small part of the organization as a whole and receive no individual recognition for their work this could cause a lack of motivation and staff morale). An external diseconomy of scale is that with more firms there is more demand and costs of labor and supplies rise. Revenues Total revenue, average revenue and marginal revenue AO2 Distinguish between total revenue, average revenue and marginal revenue. Total revenue (TR) is the total amount of money that a firm receives from selling a certain amount of a good or service in a given time period (TR = pq). Average revenue (AR) is the revenue that a firm receives per unit of its sales (AR = TR/q = pq/q = p). Marginal revenue (MR) is the extra revenue a firm gains when it sells one more unit of a product in a given time period (MR = TR/q). AO4 Illustrate, using diagrams, the relationship between total revenue, average revenue and marginal revenue.

As previously states, AR is equal to price and so it falls as output increases, since the price has to be lowered in order to sell more products. This is shown in the diagram above where the demand curve is labeled as AR. MR also falls as output increases but twice as steeply as AR and also goes below the x-axis. This relationship holds for all downward sloping AR curves and the MR curves relating to them. MR is below AR

because in order to sell more products the firm has to lower the price of the products being sold losing revenue on the ones that could have been sold at a higher price in order to get the revenue from the extra sales. For TR, extra units are being sold so TR rises; however, in order to do this the price has to be lowered. As a result, for a normal downward sloping demand curve TR rises at first but eventually starts to fall due to lowered prices. NOTE: You must be able to calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams. Profit Economic profit (sometimes known as supernormal profit or abnormal profit) and normal profit (zero economic profit occurring at the break- even point) Economic profit is the case where total revenue exceeds economic cost. Normal profit is the amount of revenue needed to cover the costs of employing selfowned resources (implicit costs, including entrepreneurship). Economic profit is profit over and above normal profit, and that the firm earns normal profit when economic profit is zero. Loss is negative economic profit arising when total revenue is less than total cost. AO3 Explain why a firm will continue to operate even when it earns zero economic profit. A firm will continue to operate because it may able to cover its average variable costs. This is the most important because if it cannot cover these costs in the short run, it will have to shut down in the short run. NOTE: You must be able to calculate different profit levels from a set of data and/or diagrams. Goals of the Firm Profit maximization Alternative goals of firms The goal of profit maximization is where the difference between total revenue and total cost is maximized or where marginal revenue equals marginal cost. AO2 Describe alternative goals of firms, including revenue maximization, growth maximization, satisficing, and corporate social responsibility. Revenue maximization is the measuring of success by the amount of revenue a firm makes. If this is the case then they may attempt to maximize their sales revenue by producing where the marginal revenue is zero. They will actually produce above the profit maximizing level of output (MC=MR). Growth maximization is targeting growth in the short run, rather than profits, in order to gain a large market share and then dominate the market in the long run. Growth may be measured in many different ways, such as the quantity of sales, sales revenue, employment or the percentage of market share. Satisficing is when firms work hard enough to cover the opportunity costs, so to a satisfactory level, rather than maximization. This allows them to pursue other goals. In general people who do not actually own these firms run them (e.g. shareholders who are not involved in running the company and are therefore managed by employed non-owners). Corporate Social Responsibility is where a business includes the public interest in its decision making. It adopts an ethical code that accepts responsibility for the impact of its activities on areas such as the workforce, consumers, the local community and the environment.