W5 Topic 4.THEORY OF FIRM
W5 Topic 4.THEORY OF FIRM
W5 Topic 4.THEORY OF FIRM
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FIRM’S OBJECTIVE: MAXIMIZING
PROFIT FROM SELLING GOODS
● The difference between total revenue and
total cost.
Profit = Total revenue - Total cost
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EXPLICIT AND IMPLICIT COST
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EXPLICIT AND IMPLICIT COST
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EXPLICIT AND IMPLICIT COST:
EXAMPLE
Mr Wong currently works as a Manager
earning RM80k a year. He quits his job as a
manager and opens a pizzeria.
Total revenue a year is RM200k.
He spent RM2k on plates, RM3k on cheese,
RM20k for rental.
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ACCOUNTING, ECONOMIC AND
NORMAL PROFIT I
EP AP-IC
=
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Accounting Profit vs. Economic Profit
Example:
• Suppose James is earning RM22,000 a year as
a sales representative for a T-shirt
manufacturer.
• At some point he decides to open a retail store
of his own to sell T-shirts.
• He invests RM20,000 of savings that have been
earning him RM1,000 per year.
• And he decides that his new firm will occupy a
small store that he owns and have been
renting out for RM5,000 per year.
• He hires a clerk to help him in the store, paying
her RM18,000 annually.
Accounting Profit vs. Economic Profit
Example:
• A year after he opens the store, he totals up
his accounts and finds the following:
RM RM
Total revenue 120,000
Cost of T-shirts 40,000
Clerk’s salary 18,000
Utilities 5,000
Total (explicit) costs 63,000
Accounting profit 57,000
Accounting Profit vs. Economic Profit
• Accounting profit of RM57,000 generated
ignores the implicit costs and thus overstates
the economic success of his venture.
• Economic profit can be calculated as follows:
EP AP-IC
=
RM RM
Accounting profit 57,000
Forgone interest 1,000
Forgone rent 5,000
Forgone wages 22,000
Total implicit costs 28,000
Economic profit 29,000
Accounting Profit vs. Economic Profit
POSITIVE ACCOUNTING PROFIT
RM RM
Total revenue 120,000
Cost of T-shirts 40,000
Clerk’s salary 18,000
Utilities 5,000
Total (explicit) costs 63,000
Accounting profit S 57,000
Accounting Profit vs. Economic Profit
still continue operate
• ZERO ECONOMIC PROFIT break-even point),
=>
• NORMAL PROFIT
RM RM
Accounting profit 28,000
Forgone interest 1,000
A
no matter 4
• EXCESS PROFIT
RM RM
Accounting profit 57,000
Forgone interest 1,000
Forgone rent 5,000
Forgone wages 22,000
Total implicit costs 28,000
Economic profit 29,000
Accounting Profit Economic Profit
• Accounting Profit
• = TR – EXPLICIT COSTS
• = RM 120,000 – 63,000
• = RM 57,000
Accounting Profit Economic Profit
• Economic Profit
• = TR - EXPLICIT COSTS
-IMPLICIT COST
• = RM 120,000 – 63,000 – 28,000
• = RM 29,000
• OR Economic Profit = AP – IC
• RM 57,000 – 28,000 = RM 29,000
PRODUCTION AND COST:
FIXED AND VARIABLE INPUTS
Production is a transformation of resources
or inputs into goods and services
Fixed Input - An input whose quantity
cannot be changed as output changes.
Variable Input - An input whose quantity
can be changed as output changes.
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Production
• A fixed input is an • A variable input is an
input whose quantity input whose quantity
cannot be changed as can be changed as
output changes in the output changes in the
short run. short run.
• The costs associated • The costs associated
with fixed inputs are with variable inputs are
fixed costs. A fixed variable costs. A
cost doesn’t change as variable cost changes as
output changes. output changes.
PRODUCTION AND COST:
SHORT AND LONG RUN
Short Run - A period of time in which some
(at least one) inputs in the production process
are fixed. Fixed Variable +
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PERIODS OF PRODUCTION, INPUTS,
AND COSTS
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PRODUCTION IN THE SHORT RUN
Suppose two input (resources), labour
(column 1) and capital (column 2), are used to
produce some good (column 3).
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MARGINAL PHYSICAL PRODUCT
(MPP)
Marginal Physical Product (MPP) - The
change in output that results from changing
the variable input by one unit, holding all
other inputs fixed
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PRODUCTION IN THE SHORT RUN
AND THE LAW OF DIMINISHING
MARGINAL RETURNS
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LAW OF DIMINISHING MARGINAL
RETURNS
● Law of Diminishing Marginal Returns - As
ever-larger amounts of a variable input are
combined with fixed inputs, eventually, the
marginal physical product of the variable
input will decline.
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LAW OF DIMINISHING MARGINAL
RETURNS
Example:
Agricultural workers (variable input) are added to acres of land (fixed
input).
The workers must clear the land, plant the crop and then harvest the
crop.
In the early stages of adding labour to the land, MPP rises as each
worker has abundant units of fixed input to work with.
But eventually, as we continue to add more workers to the land, there
comes a point where the land is overcrowded with workers.
Workers are stepping around each other, stepping on the crops, etc. due
to these problems., output growth begins to slow.
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PRODUCTION IN THE SHORT RUN
AND THE LAW OF DIMINISHING
MARGINAL PRODUCTIVITY
The point at
which
marginal
physical
product
decreases is
the point at
which
diminishing
marginal
returns have
set in.
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FIXED, VARIABLE, TOTAL AND
MARGINAL COST
Fixed Costs (FC) - Costs that do not vary with
output; the costs associated with fixed inputs.
Variable Cost (VC) - Costs that vary with output;
the costs associated with variable inputs.
Total Cost (TC) - The sum of fixed costs and
variable costs. TC = TFC + TVC
Marginal Cost (MC) - The change in total cost that
results from a change in output: MC = ΔTC/Δ Q.
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MARGINAL PHYSICAL PRODUCT
AND MARGINAL COST I
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MARGINAL PHYSICAL PRODUCT
AND MARGINAL COST II
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MPP MC
rises falls
MPP MC
falls rises
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RELATIONSHIP BETWEEN COST
AND PRODUCTIVITY
W = Wages (variable cost)
MPP = Marginal Physical Product
MC = Marginal Cost
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HOW MPP AFFECTS MC
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HOW MPP AFFECTS MC
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AVERAGE PRODUCTIVITY
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1. If the short run is 6 months, does it follow
that the long run is longer than 6
months? Explain your answer.
SELFTEST
No. The short run and the long run are not lengths of time.
The short run is that period of time when some inputs are
fixed and therefore the firm has fixed costs. The long run is
any period of time when no inputs are fixed (i.e., all inputs are
variable) and thus all costs are variable costs. The short run
can be, say, six months, and the long run can be a much
shorter period of time. In other words, the time period when
there are no fixed inputs can be shorter than the time period
when there are fixed inputs.
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AVERAGE FIXED, VARIABLE AND
TOTAL COST
Average Fixed Cost (AFC) - Total fixed cost
divided by quantity of output: AFC = TFC
/ Q.
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TOTAL, AVERAGE & MARGINAL
COSTS I
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TOTAL, AVERAGE & MARGINAL
COSTS II
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AVERAGE-MARGINAL RULE
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Example
• Suppose there are 20 persons in a room and each
person weighs 170 pounds.
• Average weight = 170 pounds [(170 x 20)/20]
• Let an additional (marginal) person enter the
room.
1. Suppose the weight of the marginal person = 275
pounds: new average weights = 175 pounds
{[(170x20) + 275]/21}. When marginal
magnitude > average magnitude : average
magnitude
2. Suppose the weight of the marginal person = 65
pounds: new average weights = 165 pounds
{[(170x20) + 65]/21}. When marginal
magnitude < average magnitude : average
magnitude
AVERAGE AND MARGINAL COST
CURVES
When MC > AVC
(ATC), the AVC (ATC)
curve rises (AVC is
rising);
When MC < AVC
(ATC), the AVC (ATC)
curve falls (AVC is
falling).
The average-marginal
rule does not apply to
the AFC curve, since
marginal costs do not
affect fixed costs
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TYING SHORT-RUN PRODUCTION
TO COSTS
What happens in terms of production (MPP rising or falling) affects MC, which in turn eventually
affects AVC and ATC.
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SUNK COST
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Sunk Cost
Example:
Jeremy buy a movie ticket, walks into the theater and settles down
to watch the movie. Thirty minutes into the movie, he realizes that
he dislikes the movie.
• The money he paid for the ticket is a sunk cost (the movie
theaters do not give your money back if you dislike the movie).
• The cost was incurred in the past, it cannot be changes and it
cannot be recovered.
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LONG-RUN AVERAGE TOTAL COST
CURVE (LRATC )
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ECONOMIES OF SCALE II
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Exhibit (a):
• There are 3 short-run ATC curves for 3 different
plant sizes. Suppose the manager of a firm wants
to produce output level Q1. Which plant size will he
choose?
He will choose plant size represented by SRATC1
due to lower unit cost incurred (i.e. Point A) if
compared to plant size represented by
SRATC2.(Point B).
• How about producing output at Q2?
Choose plant size represented by SRATC3 .(Point C)
• If we were to ask the same question for every
(possible) output level, we would derive the LRATC
curve.
LONG-RUN AVERAGE TOTAL COST
CURVE (LRATC )
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ECONOMIES OF SCALE I
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ECONOMIES OF SCALE II
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WHY ECONOMIES OF SCALE?
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WHY ECONOMIES OF SCALE?
ADVANCE IN TECHNOLOGY
Growing firms with more resources can take
advantage of highly efficient mass production
techniques and equipment that ordinarily require
large setup costs.
It is economical only if they can be spread over a
large number of units.
These machines will produce at maximum capacity
when they are fully utilized.
As output increase, the average cost per unit
will decrease.
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WHY DISECONOMIES OF SCALE?
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SHIFTS IN COST CURVES
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