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Definition
FIRM is an organisation that
combines and organizes resources
for the purpose of producing goods
and/or services for selling in the
market
Existence of a firm
• Exists to avoid transaction costs
• Can’t grow larger and larger because of
management’s inability to control operation
as it becomes larger
Alternative Goals of a firm
• Profit Maximization
• Value Maximization
• Sales/Revenue maximization (W.Baumol, 1959)
– Adequate rate of profit
• Management utility maximization (Williamson,
1963)
– Principle-agent problem
• Satisficing behavior (Cyert & March)
• Growth
• Long Run Survival
Value of the Firm
The present value of all expected future profits
Relationship to functional areas
• TR = p X q
– P: marketing
– Q: sales
• TC = wl + rK
– L: HR
– K: Finance
Do firms really optimize?
• Herb Simon : firms follow ‘satisficing
‘behaviour
Theories of Profit
• Risk bearing
• Frictional
• Monopoly
• Innovation
• Managerial efficiency
2 LEARNING OBJECTIVE
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Costs
The Difference between Fixed Costs and Variable Costs
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Business versus economic profit
• Opportunity cost is the return a firm’s
resources could earn elsewhere in next most
valuable use
• Explicit costs are observable measurable
expenses such as labour, cost of capital
• Implicit costs refer to the value of inputs owned by a firm and
used in its production processes
– are not explicitly observable and fall into two categories
• Opportunity cost of using own capital, implied rental return( depreciation
+ foregone interest)
• Opportunity cost of time and financial resources of firm’s owners, normal
profit
– Represents what owners could have earned if they used their skills in another
activity
• Economic profit considers both explicit and implicit costs
Costs
11 – 1
Paper $20,000
Wages $48,000
Lease payment for copy machines $10,000
Electricity $6,000
Lease payment for store $24,000
Foregone salary $30,000
Foregone interest $3,000
Economic Depreciation 10000
Total $151,000
Quick Quiz 1!
• A firm has a total revenue of $ 50 million and uses $ 30 million
in labor and materials. Other costs include $ 100,000 in
foreggone interest, depreciation of $ 20,000, and normal
profit of $ 65,000. What is the economic profit of the firm?
– 19803,000
– 19815,000
– 19856,000
– 20000,000
The Production Function
QUANTITY OF MARGINAL
QUANTITY OF Pizza QUANTITY OF PRODUCT OF
WORKERS Machines PIZZAS LABOR
0 2 0 -
1 2 200 200
2 2 450 250
3 2 550 100
4 2 600 50
5 2 625 25
6 2 640 15
The Marginal Product of Labor and the
Average Product of Labor
An Example of Marginal and Average Values: College Grades
Marginal and Average GPAs 11 - 3
Stages of Production
• The relationship between AP & MP is mainly
indicated by three different stages of
production
• Stage I: When MP>AP, AP of labour rises
• Stage II: When MP<AP, AP of labour falls
• Stage III: When MP<0, Negative Returns
Diagrammatic Representation
TP
TP
O S
t L
AP,MP a
g
e
Stage I Stage III
II
AP
O MP L
Short-Run Cost Functions
Total Cost = TC = f(Q)
Total Fixed Cost = TFC (Does not change in short
run)
Example: Rent of the building, plant capacity,
Salary of Managers
Total Variable Cost = TVC (Changes with the level
of production output level)
Example: Raw Material Costs, Wages
TC = TFC + TVC
Short-Run Cost Functions
Marginal Cost
TC/Q = TVC/Q = w/MPL
Definitions on Short Run Costs
SYMBOLS AND
TERM DEFINITION EQUATIONS
Total cost The value of all the inputs used by a firm TC
Fixed cost Costs that remain constant when a firm’s level of
FC
output changes
Variable cost Costs that change when the firm’s level of output
VC
changes
Marginal cost The increase in total cost resulting from producing
MC
another unit of output
Average total cost Total cost divided by the quantity of units produced
ATC
Average fixed cost Fixed cost divided by the quantity of units produced
AFC
Economies of Scale
Long-run average cost curve A curve
showing the lowest cost at which the firm is
able to produce a given quantity of output in the
long run, when no inputs are fixed.
Economies of scale Economies of scale
exist when a firm’s long-run average costs fall
as it increases output.
Costs in the Long Run
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Don’t Confuse Diminishing Returns with Diseconomies of Scale
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Appendix 11A: Using Isoquants and
Isocosts to Understand Production and Cost
Isoquants
An Isoquant Graph
Isocost Lines
MPL MPK
w r