Theory of Firm 1- Microeconomics

 Short run vs long run

A small firm sets up a plant making teddy bears. The firm has a small production unit,
two teddy bear making machines and two operators. There is one manager, who owns the
firm, and carries out all non-production activities. There is also an unlimited amount of
the materials needed to make the teddy bears.

(i) Identify the fixed factors required to make teddy bear.

(ii) Identify the variable factors required to make the teddy bear.

There is an increase in the demand for teddy bears and the firm decides to satisfy this
demand with the existing factors.

(iii) What will the firm do?

The increase in demand persists and so the firm now decides to expand the production
unit, bring in two extra machines and employ two more workers.

(iv) The planning takes place in which time period?

(v) What are the fixed factors now?

(A) Product Theory (Short run)

Total product (TP) - Total product is the output produced by a firm in a time
period

Average product (AP) – Average product is the total quantity of output per unit
of variable input, or labour

𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡
Average Product (AP) =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑓𝑎𝑐𝑡𝑜𝑟 (𝐿𝑎𝑏𝑜𝑢𝑟𝑒𝑟)

Marginal product (MP) - Average product the change in Total output/product due
to change in the number of variable factor.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝒑𝒓𝒐𝒅𝒖𝒄𝒕

Marginal Product (MP) =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝑭𝒂𝒄𝒕𝒐𝒓

1 A young entrepreneur named Ben sets up a new business, which is a small hamburger
stand on a busy street corner. The stand consists of a very small shop, containing a
refrigerator, a grill and some countertops for preparing burgers. There are also the
implements for making burgers. When he starts out, Ben works alone and prepares
everything himself. He makes the burgers, cuts the onion, lettuce, and tomatoes, heats
and buns, and sells the hamburgers to the customers. He can make 2 burgers per hour.
Ben finds demand to be high and he cannot make enough burgers, so he hires his friend,
Caroline, to help. They divide up the jobs and manage to produce 5 burgers each hour.
The hamburgers become even more popular and Ben and Caroline agree that they need
another worker, so Nick joins them. They divide up the work again, with each
specialization in task, and produce 9 burgers per hour. Demand continues to rise, so they
bring in Niki. With the four workers together, they produce 14 burgers per hour. The
number of hamburger per hour increased till 8th worker but it remained same with 9th
worker. After 9th worker it started falling the number of hamburger started falling. Now
complete this following table
Units of variable input Total product Marginal product Average product
(labour)

0 0 -

1 2

2 5

3 9

4 14

5 18

6 21

7 23

8 24

9 24

10 23

11 21

2 Plot TP, AP and MP curves in graph paper. Take separate axis in plotting TP and
separate to plot AP, MP curves.
(B) Cost Theory

 Economic Cost = Implicit costs + Explicit costs

 Implicit costs are the opportunity costs of using self owned resources and explicit
costs are the costs for using all external factors of production (not self owned)

Short run vs long run cost

Short run costs

 Fixed costs arise from the use of fixed inputs that do not change as output changes.
 Variable costs arises from the use of variable input, vary as output increase or
decreases.
 Total costs are the sum of fixed and variable costs.
 TC=TVC+TFC
 Average costs are costs per unit of output.(TC/Q)
 AC=AVC+AFC
 Marginal costs is the extra or additional cost of producing one more unit of
output.(Change in total cost/change in output)

Complete this following table

Total TFC TVC TC AFC AVC ATC MC

product or
output
0 200

2 300

5 400

9 500

14 600

18 700

21 800

23 900

24 1000

6 Plot them in one graph paper but divide into two parts. In one graph plot TC, TVC.
TFC and bottom of that plot MC, AFC, ATC, and AVC.
 From the above table and diagrams answer these following questions

(i) Why Total cost is parallel to total variable cost curve?

(ii) Why AFC curve is downward sloping?

(iii) Why AC tends to fall as output increases but start to rise again as the output
continues to increase?

(iv) What is the relationship between AC, AVC and MC curve?

(v) Why MC curve is ‘U shaped’ ?

Long run cost

Long-run is imagining the long-run as several different short-runs spread out over a
larger range of output. The graph below will illustrate this concept for you.

When we examine the long-run ATC more closely, it becomes apparent that there are in
fact lots of little short-run ATC curves along the length of the long-run curve. Each of the
gray lines in the graph above represents a short-run period in which this firm opened a
new factories. There are three distinct phases of this firm’s long-run ATC:

Economies of scale: As this firm first begins to grow and open new factories, it becomes
better and better at what it is producing, is able to get more output per unit of input, and
thus experiences lower and lower average total costs as it grows larger. “Scale” is
a synonym for size. The bigger the firm’s size, the lower its costs of production: this is
called “economies of scale”. My favorite illustration of the concept of economies of scale
is to think about two shoe companies: Nike and Luigi’s Fine Italian Shoes. Nike makes
shoes in giant factories in Indonesia, ships them in giant containers to all corners of the
world in shipments containing 100,000 shoes each. Luigi makes shoes in his basement in
Milan, has two employees, and ships shoes one at a time to customers around Europe.
Who will have a lower average total cost of producing shoes? Luigi or Nike? Clearly,
 Nike has economies of scale, Luigi does not. If Luigi were to grow his business, chances
are his average total costs would decline.

Constant Returns to Scale: For the firm above, economies of scale assure that the
larger it becomes, the lower its average total costs get. Efficiency in production improves
whether through the lower price of inputs achieved through bulk-ordering, its ability to
attract and hire skilled managers, the lower per unit cost of shipping larger quantities of
products, or other such benefits of being big. At a certain point, however, the benefits of
getting larger begin to diminish. This firm’s tenth factory is its minimum efficient
scale: The level of total output this firm must achieve to minimize its long-run average
total cost. Beyond this level of production, as this firm continues to grow, it will see no
further cost benefits; in other words, it will achieve constant returns to scale (size).
Diseconomies of scale: Why did the Mongol, the British and the Soviet empires
collapse? Some historians argue it was because they became too big for their own good.
When an organization (whether it’s a country or a firm) becomes TOO big, it begins to
experience inefficiencies. When a firm grows so large that it has factories in all corners of
the world, a dozen levels of management, and countless opportunities for corruption and
miscommunication, its efficiency decreases and its average total costs begin to increase.
In the 1980’s General Motor Company began to lose lots of business to smaller Japanese
rivals. The outcome was the gigantic corporation broke up into smaller divisions, which
then began to operate as different firms. For a while, GM remained competitive, partially
because as a smaller firm, it was more efficient and able to compete on cost with its
foreign rivals.
Diminishing Returns versus Economies of Scale: A common area of confusion for
economics students is the difference between these two seemingly similar concepts. The
difference lies in the two curves above, the short-run ATC and the long-run ATC.
 The shape of short run costs (MC, ATC and AVC) are determined by the law of
diminishing returns. Since short-run costs are determined by the productivity of the
variable resource in the short-run (labor), diminishing returns assures that at first, since a
firm can expect to get MORE output for additional units of labor (as fixed capital is used
more efficiently) ATC declines as output increases. But beyond a certain point,
diminishing returns sets in and the additional output attributable to more units of the
 variable resource declines. Inevitably, a firm will experience higher and higher average
costs as its output continues to grow, since it’s only able to vary the amount of labor
used, not capital.

 The shape of long run ATC is determined by economies of scale (and diseconomies of
scale). All resources are variable in the long-run, but lower costs cannot be guaranteed
the larger a firm gets. At first, efficiency is improved as the firm grows, but at some point
it becomes “too big for its own good” and costs start to rise as productivity of resources
(land, labor and capital) is inhibited due to the firm’s massive size.

(C) Revenue Theory

 Total revenue is obtained by multiplying the price at which a good is sold by

the number of units of the good sold.
TR = P × Q
 Marginal revenue is the additional revenue arising fro the sale of an
additional unit of output.
MR = Change in TR/ Change in output
 Average revenue is revenue per unit of output sold.

𝑇𝑅 𝑃𝑟𝑖𝑐𝑒 ×𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
AR= = = Price
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑂𝑢𝑡𝑝𝑢𝑡 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦

 The nature of AR, MR and TR depends on the nature of Firm

Types of Firm

Price Maker Price Taker

When firm can When firm has no
control the price control over price
When firm can control the price

7 Complete this following table for revenue curve.

Units of output Price TR MR AR

0 0
1 12
2 11
3 10

4 9
5 8
6 7

7 6
8 5
9 4
10 3

7 Plot them in one graph paper but divide it into two parts. In one graph plot TR and
bottom of that plot AR and MR.
When firm cannot control the price

8 Complete this following table and plot TR and MR, AR in separate axis in the same
graph paper.

Output Price TR MR AR
0 10
1 10
2 10
3 10
4 10
5 10
6 10
7 10

(D) Profit Theory

(i) Economic profit- Total Revenue - Economic costs (explicit + Implicit cost)

(ii) Normal profit or break even point

 TR= TC

(iii) Positive economic profit or super-normal profit

TR ˃ Economic cost

(iv) Zero economic profit

TR = Economic cost
(v) Negative economic profit or loss

TR˂ Economic cost

Rule for profit maximization

 TR – TC is maximum or

 MR = MC