Notes on the Theory of the Firm (ECON 262)
WHAT IS A FIRM?
Why does a firm exist? One explanation is given by Ronald Coase.
Two ways to organize productive activity:
Markets (trade):
Internalization:
So when internalization takes place -- we have a firm. So why internalize?
Internalization will happen when it is cheaper than using the market due to transaction costs. Basically, it is the old "make or buy" decision.
COST CONCEPTS:
Economic costs (implicit costs) are opportunity costs (example is foregone income).
Accounting costs (explicit costs) are out of pocket costs (example is costs of goods sold). These are historical costs.
The difference between economic and accounting profit is that accountants only take into consideration accounting costs (explicit costs), whereas the economist also considers opportunity costs (implicit costs). Therefore, if an entrepreneur's firm is making $10,000 in accounting profit per month, that means that the total revenue (TR) of the firm is $10,000 more than the total costs (TC) -- but only including explicit costs such as labor expenses, overhead, costs of goods sold, etc. The economist would then ask what income is forgone because this person is operating a business. Foregone income could include the salary the entrepreneur could have earned working for someone else, or the foregone interest the entrepreneur is not earning because he or she used the money in the business. If the total opportunity cost (or total implicit costs) equal $10,000, then the entrepreneur is just making a zero economic profit (just earning what he or she could earn in their next best alternative). This is also known as a normal rate of return or normal profit. If the implicit costs are less than $10,000, then the entrepreneur is making an economic profit in the business. He or she is making more than their opportunity cost. If the implicit costs are greater than $10,000, there is an economic loss -- the entrepreneur could make more doing something else.
Let's do an example (Deb's Deli vs. Professor Deb):
Why is Economic Profit or Loss Important?
As we have already discussed, it economic profits and losses are signals to entrepreneurs. They tell entrepreneurs where to utilize scarce resources such that people's wants are met. Without them, we have massive shortages or surpluses, etc.
Why economic profit and not simply accounting profit? Because an entrepreneur has to be paid as well. Including their opportunity cost in their profit/loss calculation allows them to determine where they are best utilized as well.
Economic profit:
This will induce other firms to enter the industry and compete.
Economic loss:
This will induce some firms to exit the industry.
THEORY OF THE FIRM: COST CONCEPTS
The following costs discussed below are economic costs (they include opportunity costs).
Total cost (TC) = Fixed Costs (FC) + Variable Costs (VC)
Fixed Costs -- costs that do not vary with output level. A good example is rent on a building. These costs relate to fixed inputs. Fixed inputs cannot be changed or varied in the short-run (by definition).
Variable Costs -- costs that vary with output level. A good example is labor costs. These costs relate to variable inputs. Variable inputs can be changed or varied in the short-run.
Average Total Cost (ATC) is the per unit cost. It is TC/Q. Q = output level.
Average Fixed Cost (AFC) is the per unit fixed cost. It is FC/Q.
Average Variable Cost (AVC) is the per unit variable cost. It is VC/Q.
Marginal Cost (MC) is the additional cost of producing an additional unit of output. It is the change in TC/the change in Q (which we define as 1 if we want to know the MC of one additional unit of output).
These costs change with changes in technology or with changes in input prices.
THEORY OF THE FIRM: PRODUCT CONCEPTS
Total product (TP): the total output produced in a given period.
Average product (AP): TP/quantity of an input. For example the average product of labor is the total product divided by the number of people employed.
Marginal product (MP): The change in total product that results from a one unit increase in the quantity of labor employed. How much does hiring one additional person add to the total production of the firm?
Increasing marginal returns: When the marginal product of an additional worker exceeds the marginal product of the previous worker. Arises from division and specialization of labor.
Decreasing marginal returns: When the marginal product of an additional worker is less than the marginal product of the previous worker.
LAW OF DIMINISHING MARGINAL RETURNS (OR PRODUCT):
as variable inputs are added to a fixed input, the marginal returns (or product) to the variable input will eventually begin to decline. The fixed input will eventually be "overloaded" so-to-speak.
Example:
This in only a short run concept. Cannot happen in the long run by definition. (I will define the short and long run soon).
Let's ask the following question:
Should a firm hire an additional or marginal worker?
Answer - it depends.
Let's look at some information about hiring additional workers:
| Marginal Workers Hired | TP | AP | MP |
If, for example, a marginal worker is hired and total output for the firm increased by 10 units, then the marginal returns to that worker (a variable input) is 10. A firm will want to hire workers as long as the marginal product (MP) of a worker (multiplied by the price) is greater than the marginal cost (MC) of hiring him or her.
Therefore we have to first determine the:
Marginal Revenue Product (MRP):
The MP x Price of the output is known as the Marginal Revenue Product of the worker. If the firm sells all 10 of the units the worker produced for $5.00 each, then the worker's marginal revenue product is $50 (that's how much the worker brings into the firm). As long as the worker's salary is less than $50, the firm will benefit from hiring him.
This is basically true of any input. It is often difficult to determine the marginal product of inputs - even workers. But it is certainly worthwhile to try.
So as long as the MRP is greater than the wage -- hire the worker. Otherwise, NO.
THEORY OF THE FIRM: REVENUE CONCEPTS
Total Revenue (TR) = Price (P) x Quantity (Q)
Average Revenue (AR) is the per unit revenue. It is = TR/Q.
Marginal Revenue (MR) is the additional revenue brought in with the production of one additional unit of Q.
PROFIT MAXIMIZATION/LOSS MINIMIZATION (at what level of Q?): This is "mainstream" language. Of course in reality, the owners of the firm never really know if they have maximized or minimized anything. They do not have the perfect knowledge that is assumed in this mainstream model.
Theoretically, a firm will maximize profit (or minimize loss) at that level of Q where MR = MC. This is because at an Q level prior to this there is still profit to be made on each additional unit because MR>MC, whereas at an Q level beyond this point, MC>MR.
Understand this graphically as well.
GRAPH:
THEORY OF THE FIRM: DETERMINING PROFIT AND LOSS
Now that we have found the best (profit maximizing or loss minimizing) level of output -- how do we know if we are making a profit or not?
Remember, profit = total revenue - total cost
So if we use the same graph as above - we need to add in our average total cost curve (since we already have average revenue = price = marginal revenue). These are per unit costs -- so we can multiply these average costs x output to get total cost. We can also multiply our average revenue x output to get total revenue. Then we can find out profit or loss:
GRAPH:
Again, if firms a making a profit in an industry - this will pull resources in (and/or new firms will move in).
If firms a making a loss in an industry - this will push resources out (and/or firms will exit the industry).
THE TIMEFRAME OF THE FIRM (ECONOMIST'S DEFINITIONS):
Short run - have both variable and fixed inputs and costs. All of the above analysis has been in the "short run" - since there has been both variable and fixed inputs.
All of the theories we have discussed so far have been short-run theories.
Long run - everything can vary. Only have variable inputs and costs - therefore the size of the firm can change:
LET'S LOOK AT SOME LONG RUN CONCEPTS: WHEN THE SIZE OF THE FIRM CAN CHANGE:
ECONOMIES OF SCALE: As a firm gets larger, per unit costs (ATC) decrease.
Why?
DISECONOMIES OF SCALE: A firm can get too big and per unit costs (ATC) increase.
Why?
ECONOMIES OF SCOPE: As a firm takes on additional products or services (produces and/or sells them) - their per unit costs (ATC) of both goods/services fall (could be utilizing their facilities more efficiently, for example).
DISECONOMIES OF SCOPE: As a firm takes on additional products or services (produces and/or sells them) - their per unit costs (ATC) of both goods/services increase. There is not enough Synergy (two or more things functioning together to produce a result not independently obtainable), for example.