IB Economics/Microeconomics/Theory of the Firm (HL)

2.3 Theory of the Firm (HL)Edit

Limited Liability

  • Financial liability is limited to a fixed value, commonly a person's investment in a company/partnership established with limited liability
  • The separation of management and ownership through limited liability 500 years ago is the key to why firms have been able to grow so rapidly and to become so large
  • In the US only 1000 companies account for 60% of the GDP, the remaining 40% is produced by 11 million businesses and other institutions
  • The large firms are 17,000 times larger on average than the small firms
  • Limited liability allows companies to raise money easily, because individuals are not so afraid of losing everything in the case of bankruptcy
  • A typical company pays out half its earnings in the form of dividends, the rest is re-invested
  • Firms finance:
  • Fixed capital (usually associated with K) by borrowing money from the bank or by selling bonds in the bond market or through retained earnings
  • Risk capital (usually associated with the entrepreneurial input) by issuing shares
  • Working capital (usually associated with the L and NR used in production) from retained earnings or by short term loans from banks
  • Firms must profit maximize in order to earn at least the Opportunity Cost Rate of Return, otherwise their share value will fall, and another firm will buy them out and force them to earn at least the Opportunity Cost Rate of Return

Multinational/Transnational companies/Multinational enterprise

  • Enterprise/firm that manages production or delivers services in more than one country
  • A corporation which has his managerial head quarters in one country known as the HOME country and operate on several other countries known as the HOST country (ILO)
  • Internationally there are 600 multinational companies (MNCs), more than half are involved in banking and finance, petroleum and chemicals
  • MNCs have flourished:
  • Rather than fight tariff and non-tariff barriers, MNCs just set up production in the host country
  • Tastes are different, MNCs produce locally to tailor services to the local market
  • Advances in telecom and transportation have allowed firms to globalize
  • Transfer pricing allows prices of FoP WITHIN an organization (this may reduce taxable revenue within a country)
  • Very powerful: some have budgets that are greater than entire country GDPs
  • Small Firms: most small companies fail for three reasons:
  • Marketing: owners do not understand how to serve the market
  • Poor financing: most do not know how to invest money so that it repays the capital as well as the carrying costs
  • Poor management: most owners do not know how to delegate tasks, organize a business in an efficient manner, or coordinate tasks

Cost theoryEdit

  • Companies must balance revenues and costs so as to maximize profits
  • Factors of production are priced at opportunity or user cost:
  • Labour: firms pay a wage for labour service
  • Capital can be rented but is often owned, a cost must be imputed (estimated) for the capital services, where:
  • P refers to the cost of the capital,
  • r refers to the interest on the loan to buy the capital or if the company owns the capital it is the Opportunity Cost Rate of Return that could have been earned on the money tied up in the capital
  • δ is the depreciation rate on the capital
  • Natural resources are either treated like capital if the firm owns them, or treated as an input that must be purchased
  • Firms carry inventories which act as shock absorbers so production and sales never need to stop
  • There are three types: raw materials, intermediate (semi-finished) goods, and final goods
  • Inventories must be financed by working capital and require storage space

Types of costs

  • Total cost is the sum of fixed and variable costs:
  • Fixed costs are associated with the fixed factor, usually capital, sometimes referred to as overhead cost
  • Costs a firm bears in the short run regardless of output
  • A firm could produce absolutely nothing and still face fixed costs (e.g., rent, or anything that is contracted for a period of time)
  • Variable costs are associated with the variable factors, usually labour and raw materials
  • Costs which depend on the level of production
  • Average cost is total cost divided by quantity of output or the sum of average fixed and average variable costs:
  • Total cost divided by units of output
  • If fixed costs are truly fixed, then as output increases, average fixed costs must be declining steadily
  • Marginal cost is incremental cost:
  • Cost of producing one extra unit of output
  • Fixed costs are fixed, there can be no incremental costs coming from K
  • Marginal cost is equal to marginal variable costs only

Short runEdit

Period of time in which at least one cost for FoP is fixed (quantity of at least one input is fixed)

  • In the short run capital is fixed, firms do not have time to build new plant and equipment or get rid of obsolete ones
  • Only labour can be varied in the short run
  • As more labour is added to a fixed plant, total product will increase
  • Average and marginal productivity will rise at first and then tend to fall as workers have less and less capital equipment to work with
  • In the long run capital can be varied, new plant and equipment can be built, old ones destroyed or sold off
  • It is a planning period to allow the building of new capital, it can actually be shorter than the short run!
  • In the very long run, it is assumed that new techniques can be invented and applied which will increase productivity

Law of diminishing returns

  • As additional variable units are added to fixed units, after a certain point- the marginal product of the variable unit declines
  • As more and more of the variable factor is applied to a fixed amount of the other factor, eventually each additional unit of the variable factor will add less to productivity

Total product: Total output produced by factors of production

Average product: The output per unit of variable factor

Marginal product: The extra output from employing an additional variable factor

Production Function

  • Describes the precise physical relationship between factor inputs and output:
  • Marginal product is the increment in output from an extra worker:
  • MP rises at first as each worker can specialize in doing the task for which they are trained (specialization and division of labour), but eventually starts to decline at the point of diminishing marginal productivity
  • Average productivity is given by:
  • Eventually, each additional worker will add less to output than the previous worker, and AP will start to decline (diminishing average productivity)
  • The AP curve slopes up as long as MP is above the curve: if the increment is greater than the average, then it must pull up the average
  • As soon as MP falls below AP, it must start pulling it down: MP is equal to AP at the maximum point of AP

Short Run Cost Curves

  • Unlike productivity curves, cost curves vary with output: greater productivity on the part of labour means more output for less labour cost
  • AC and MC tend to fall at first for the same reason that AP and MP rose: specialization and division of labour, it costs less to produce the next unit
  • AFC is constantly falling
  • At first AC (or ATC) is falling because both AFC and AVC are falling: wL↑ < Q/L↑
  • Eventually, with diminishing returns, AVC must turn up because, wL↑ > Q/L↓, and after a certain point this effect outweighs the constantly falling AFC and pulls up the AC curve
  • The MC curve cuts the AC curve at its minimum point
  • The vertical difference between AC and AVC is just the AFC, and gets narrower as AFC gets smaller
  • We never need to draw AFC again, as we know it is already on the diagram between AC and AVC
  • The output associated with minimum AC is called the capacity of the firm:
  • The largest output that can be produced without average costs rising
  • Firms operating below this point are referred to as having excess capacity
  • A firm can produce beyond this point, but to do so would lead to rising unit (average) costs

Input or Factor Costs

  • Up to now we have assumed that input prices remain constant
  • Costs rise and fall strictly because of changes in productivity not because of changes in factor costs themselves (wages per hour stay constant for labour)
  • A rise in the price of any of the inputs will lead to the whole set of curves shifting upward
  • If it is a rise in the cost of K, then AFC will shift up
  • If it is a rise in wages, then AVC and MC will shift upward
  • A fall in the price of inputs leads to a fall in the curves
  • If there is an increase in K, then productivity will rise and the AVC, MC, and AC curves will all shift down
  • There is a different set of curves for each amount of K, that is size of plant

Long runEdit

Period of time when all costs for FoP are variable (quantities of all inputs are variable)

  • The firm reaches long run equilibrium when there is no opportunity for cost reducing substitutions: the ratio of MPs to factor costs is equal
  • Firms are motivated to use less of factors that become scarcer to the economy and more of the factors that become more plentiful
  • The same will be true for regions and nations: if a country has relatively more land than labour, farming will tend to use the cheaper land more extensively while economizing on the more expensive labour
  • In China where labour is abundant and K is scarce, a much less mechanized method of production is appropriate

Long Run Average Cost

  • In both the long run and the short run a minimum achievable cost can be found for each possible level of output, and a curve can be constructed called the long run average cost curve (LRAC)
  • Factor prices are assumed to be fixed - if factor prices rise, the whole LRAC rises
  • Technology is assumed to be fixed
  • To move from one point on the LRAC to another is very different from the short run AC: it requires an adjustment in all factors, a new plant must be built
  • All the possibilities are given by a variety of SRAC curves, one for each plant
  • The LRAC is the envelope of the SRACs, it is tangent at just that output where K is optimal in the MP/P formula above
  • LRAC is falling at first due to economies of scale (increasing returns to scale) which arise from:
  • Increased opportunities for specialization and division of labour due to larger plant size: a bigger company can employ specialist staff
  • Some factors of production are indivisible, so that to make full of them a large output is required: large, specialized equipment which can only be profitable if used at large volumes of output
  • Falling research and development (R&D) costs
  • Certain types of marketing which are cheaper the more units made and sold
  • Economies realized through bulk buying, cheaper financing, and transportation discounts
  • Economies of scale = an increase in a firm's scale of production leads to lower average costs per unit produced
  • After a point, LRAC starts to rise due to decreasing returns to scale (diseconomies of scale) which arise from:
  • Difficulties of managing and controlling large enterprises
  • No more opportunities to substitute large scale machines
  • Limits to the economies associated with discounts for large scale purchases
  • Diseconomies of scale = an increase in a firm's scale of production leads to a higher average cost per units produced
  • For some industries, there is a flat section between the falling and rising parts, and this is referred to as constant returns to scale

Technical Innovation

  • In the long run there is great potential to drop costs through technical innovation
  • Indeed, sustainable growth in the future cannot come about through greater and greater use of natural and environmental resources, it must come from technological change
  • Loss of technical knowledge is very rare, thus technical change always causes the LRAC curve to fall:
  • Labour: through better health and education, productivity of labour inputs can rise dramatically
  • Natural resources: through better engineering and refining and processing techniques, better materials can be obtained from natural resources
  • New products are invented which reduce costs dramatically such as the new wall screen TVs which will be out shortly
  • Capital:
  • During the industrial revolution capital has been substituted for labour
  • With the information revolution: thinking machines are replacing human intelligence
  • Resequencing of production has led to a new lean production system as workers learn by doing:
  • Workers are organized as teams, individuality and initiative are emphasized
  • Parts are delivered by suppliers just in time
  • A worker stops production when a fault is discovered
  • Defective parts and problems are analyzed for a pattern of causes that need to be understood
  • As the sources of problems are found and solved, work stoppages decrease
  • Design teams are non-specialized and work closely with production engineers and parts producers:
  • As new products are developed, tool designers can start developing the tools that will be needed

Measuring Technical Change

  • The rate of increase in productivity provides a measure of the progress caused by technical change:
  • Q/L: We usually measure productivity as output per hour of labour
  • K/L: As the price of labour relative to capital has risen, firms have substituted K for L
  • Quality of K: Machines have grown more and more productive over time (Q/K↑ ), but this has increased dependence on energy
  • No limits to growth: The growth in knowledge and its application has expanded so rapidly that firms are now able to squeeze more out of limited resources faster than the expanding population
  • Technical change is often endogenous (it is in response to something going on in the production process rather than just some accidental discovery going on in a totally unrelated way)
  • Often it is the result of R&D expenditures, and tends to rise as profit incentives rise
  • The US, Germany and Japan have all invested heavily in R&D, and productivity growth has been excellent for them

Slowdowns in Productivity Growth

  • There have been slowdowns in productivity growth:
  • For industrialized countries there is less possibilities for gains in productivity
  • Rising oil prices in the 1970s contributed to a slowing down in productivity growth
  • There has been a shift in the population from younger to older people (older people are harder to train in new techniques and less innovative)
  • Services: over the last 15 years there has been a massive shift over to the service sector
  • We have moved from goods industries where increases in capital per worker led to enormous increases in productivity
  • The growth in productivity does not appear to be as rapid for services as there are less opportunities to substitute machines for people
  • Pollution: there has also been increasing pollution and environmental degradation which has lowered the quality of life
  • Crowding out: government deficits have drained the savings from the private sector which would normally have been invested in K and in R&D
  • The institutional climate has become very hostile to innovation (this is one of the main reasons for the emphasis on deregulation)


Price of the good times the number of units sold

  • Total revenue: total amount that a firm takes in from the sale of its product
  • Average revenue: revenue gained from the sale of a single product
  • Marginal revenue: additional revenue that a firm takes when it increases output by one additional unit


Difference between total costs and total revenues (sometimes also called net revenue)

  • If a salary is imputed for the owner, and a cost of capital imputed for the owner's investment:
  • One would expect there to be zero profits on average,
  • If profit is greater than zero, the firm is earning supernormal or abnormal or pure or economic profits
  • Return on investment (ROI) (in the US it is called IRR: internal rate of return):
  • The net revenue is divided by the total investment in the firm
  • If there is no attempt to impute a salary and cost of capital for the owner:
  • The return on investment would be expected to be equal to the Opportunity Cost Rate of Return, and firms will stay in the industry
  • If it is greater than the opportunity cost rate of return, the firm is earning a supernormal profit, this will become known and firms will attempt to enter the industry
  • If it is less than the opportunity cost rate of return, firms will leave the industry

Profit maximization

  • As profit maximizers, firms would like to increase revenues and decrease costs (thus profit maximization implies cost minimization)
  • In the long run all factors of production are variable
  • Short run cost curves show minimum cost per unit for different levels of output, given a fixed factor
  • There are an infinite number of short run curves: as a firm changes its fixed factor over time, a new short run average cost curve emerges
  • Firms substitute inputs in the long run until they achieve the most cost efficient combination

Where: • PK refers to the rental price of capital (PK{r + d}) • PL refers to the wage rate

• If the price of K rises: o  : the firm will substitute L for K: o The MP of L will fall, and MP of K will rise, equality will be restored.

  • Profit maximization occurs when the marginal revenue (revenue gained from producing one extra unit of output) equates the marginal cost of producing that extra unit
  • Though a firm may have its primary goal of profit maximization - in the case of most corporations, other goals may exist e.g., sales volume maximization, the maximization of revenue, and environmental concerns)
  • For example, the Body Shop before being incorporated, proceeded to include many animal friendly measures, which prevented the firm from maximizing profit
  • However, the main goal is indeed profit maximization, rare cases exist where it is otherwise, and indeed these are valid examples, but they are a small minority in today's business world

Distinction between normal (zero) and supernormal (abnormal) profit

  • Normal (zero) profit is where all costs are covered including the expected return of the entrepreneur, anything gained beyond that is considered supernormal profit

Perfect CompetitionEdit

Industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products = price takers

  • Assumptions of the model: Perfect competition is an industry structure which holds numerous assumptions. It is also theoretical.
  • There are numerous buyers and sellers of which none are able to influence the market.
  • Products are homogeneous
  • There are no barriers to entry and no barriers to exit the market
  • Everyone - both buyers and sellers - have perfect information about the market
  • Examples include the agricultural market and stock market

  • Demand curve facing the industry and the firm in perfect competition
  • Profit-maximizing level of output and price in the short run and long run
  • The profit maximizing level of output is where MC = MR.
  • The possibility of abnormal profits/losses in the short-run and normal profits in the long-run.
  • Short run- yes
  • Long run- never.
  • Shut down price, break-even price.
  • Company has to shut down (in the short-run) if variable costs are not being covered. In the long-run it's all about covering the average costs.
  • Definitions of allocative and productive (technical) efficiency
  • Allocative efficiency occurs when output is at society's optimum level. P=MC
  • Productive efficiency is when a firm produces at the lowest possible cost per unit. AC=MC
  • Efficiency in perfect competition
  • Perfect competition is both allocatively and productively efficient. However, it is dynamic efficient, in the sense that products can't be differentiated and no new technology can be produced. In the long run, no firm will have any profit to spend on research and development.

Monopolistic CompetitionEdit

Industry structure in which there are many firms, producing slightly differentiated products - each firm has a small 'monopoly' on its own product

  • Assumptions in the model
  • Large number of small firms.
  • (Almost) perfect knowledge.
  • Differentiated products/branding important
  • There are close substitutes for the product of any given firm - competitors have slight control over price
  • There are relatively insignificant barriers to entry or exit and success invites new competitors into the industry
  • Examples include home builders and restaurants

  • Short-run and long-run equilibrium:
  • In the short-run abnormal profits can be earned (at MC=MR)
  • In the long-run only normal profits can be earned.
  • Product differentiation:

MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate goods as substitutes. Technically the cross price elasticity of demand between goods would be positive.In fact the XED would be high. MC goods are best described as close but imperfect substitutes.The goods perform the same basic functions. The differences are in "qualities" and circumstances such as type, style, quality, reputation, appearance, and location that tend to distinguish goods. For example, the function of motor vehilces is basically the same - to get from point A to B in reasonable comfort and safety. Yet there are many different types of motor vehicles, motor scooters, motor cycles, trucks, cars and SUVs.

  • Efficiency in monopolistic competition:
  • Monopolistic competition is an inefficient market structure.
  • In the short-run/long-run neither allocative nor productive efficiency is achieved!


Industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated

  • Assumptions of the model:
  • Competition between a few firms
  • many buyers, few sellers
  • differentiated products
  • oligopolists will try to block entry
  • the oligopolist believes that if he puts his price down his competitors will follow his example
  • therefore in oligopolistic competition there is non-price competition, for example supermarkets compete in terms of:
      • car parks
      • loyalty cards
      • trollies
  • Each firm is large enough to influence this industry
  • Barriers to entry and exit are difficult, but exist
  • Examples include aircraft manufacturers, tire manufacturers, camera/electronics manufatureres, car manufacturers, supermarkets
  • Collusive and non-collusive oligopoly:
  • Non-collusive Oligopoly: where firms compete against each other in a normal way
  • Collusive Oligopoly: where firms try to come to an agreement to reduce the amount of competition.
      • It is usually illegal
      • they will fix the output of the industry and then share the output between them - this is often called a cartel
  • Cartels:
    • When firms have a formal agreement. One example: OPEC
  • Kinked demand curve as a model to describe interdependent behaviour:
    • The kinked demand curve basically illustrates the downward-stickiness of prices. The kinked demand curve shows how a change in e.g. raw material costs does not bring about a change in the price of the final good, due to the concept of downward-stickiness. The fear of changing prices and then loosing numerous customers is too big to actually change prices.

  • Importance of non-price competition: Oligopolistic firms avoid competing through price cuts. Such strategy could lead to a competitive downward spiral in prices (a price war) which could leave all firms worse off. Non-price competition can take several forms such as: advertising, branding, gifts, coupons, continuos product differentiation, extended guarantees, aftersales service and volume discounts.
  • Theory of contestable markets:

The contestable market theory assumes that even in a monopoly or oligopoly, the existing companies will behave competitively when there is a lack of barriers, such as government regulation and high entry costs, to prevent new companies from entering the market.


Industry structure where a single firm produces a product for which there are no close substitutes - price makers

  • Assumptions of the model
  • One single firm dominates a market for which there are no close substitutes.
  • Barriers to entry and exit.
  • Monopolists can set price = price makers - but are constrained by market discipline
  • Barriers to entry and exit exist and in order to ensure profits, a monopoly will attempt to maintain them
  • Examples include Microsoft's (former) virtual monopoly over the global PC operating system market and historical examples of AT&T and Standard Oil (US)
  • Antitrust legislation used to break up monopolies who abuse monopoly power via price gouging and lack of responding to consumer concerns

  • Sources of monopoly power/barriers to entry
  • Government legislation.
  • Patents and copyrights.
  • Control over supplies
  • Cost advantage, such as massive economies of scale.
  • Product differentiation.
  • Use of force.
  • Natural monopoly
  • A monopoly which has gained its status because of massive economies of scale.
  • Demand curve facing the monopolist
  • Profit-maximizing level of output
  • A monopoly maximizes profits when MC=MR.
  • Advantages and disadvantages of monopoly in comparison with perfect competition.

Monopoly: price - higher,Output- lower, Profit-Abnormal, Produces where Average costs are higher(inefficient)

  • However, a monopoly may use economies of scale therefore reducing costs and increasing output

Perfect Competition: Price- Lower, output- higher,Profit- normal, Produces Where average costs are lowest(efficient)

  • Efficiency in monopoly
  • A monopolist is neither allocatively or productively efficient. It may be dynamically efficient if it wishes to maintain its monopolistic position.
  • How to control a monopoly
  • Dogmatic Approach: This is the approach in the USA. Monopoly is illegal.
    • Anti-trust legislation bans monopoly
    • If a firm is accused of being a monopoly, they are taken to court and if found guilty, they are broken up.
  • Pragmatic Approach: Looking at monopoly with an open mind
    • looking at advantages and disadvantages and coming to a conclusion
    • the conclusion may be, for example, lowering prices
  • State control: the government takes over the monopoly because it is assumed that the government will run the firm for the 'benefit' of the country
  • A licence: you are given a licence to run a monopoly. If you run it well, it will be renewed, if not it will be cancelled.

Price DiscriminationEdit

  • Definition:
  • Price discrimination occurs when different customer groups are charged different prices for exactly the same good.

First Degree

  • Each person buying a good or service pays as much as they are wiling to pay. Auctions are a good example of this, as are the trades at local markets and bazaars.

In the diagram below, we can see that consumer surplus has been eroded because customers willing to pay above equilibrium will be charged taking that into account. Ideally, no consumer will pay less than he or she is prepared. The darker, triangular, box represents consumer surplus, and the profits attained through first degree price discrimination.

Price discrimination diagram.png

Second Degree

  • Consumers are charged differing prices determined by the quantity that they purchase.

Third Degree

  • Different market segments identified by the seller are charged at varying rates. Highly dependent on separating the market segments. Good examples are youth discounts or senior citizen rates.
  • Conditions for Price Discrimination:
  • Price setting ability (can only occur in an imperfect market)
  • Consumers with different Price Elasticities of Demand
  • Consumers must be separated so they products cannot be resold between consumers and there must be no leakage between markets e.g. cigarettes in UK are 5 pounds and in Poland are 1 pound, but markets are kept apart
  • Geographic separation
  • Lack of knowledge
  • Age
  • Reasons for price discrimination (Advantages to firm)
  • To maximize profits by eroding consumer surplus
  • Creates favorable conditions for economies of scale as more products are sold
  • Drive competitors out of an elastic market by using profits from an inelastic market to subsidize the product in the elastic market.
  • Effect on the consumer
  • Advantages
  • Can allow poorer consumers to purchase a product that wouldn't normally be within their purchasing power
Lawyers often charge lower rates for poorer clients but offset the loss with higher profits from wealthier clients.
  • Usually increases output of a product in the market, making it available to more consumers.
  • Better economies of scale may result in overall lower costs throughout market segments.
  • Disadvantages
  • Consumer surplus is eliminated
  • Some consumers will have to pay more that they would have in a non-discriminant market.
Last modified on 6 November 2012, at 14:18