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IB ECONOMICS HL

# The Theory Of the Firm

UPDATED ON - 12 MAY 2020

Table of Contents

## Total, average and marginal product curves

In Figures 1.16 and 1.17 the graphs for the total product, marginal product, and average product are drawn.

As you can see, TP is always rising but beyond a certain labor quantity (in this example a labor quantity of 3.5), TP is rising less rapidly (the slope decreases).

In the other graph, you can see that a labor quantity of 3.5 MP starts to decrease, meaning that from a labor level of 3.5 one additional unit of labor will add less to the total product than the previous one.

This phenomenon is called the law of diminishing returns; as more of the variable factor is added, there is a point beyond which TP only rises at a diminishing rate.

The AP curve will always intersect the MP curve at the highest point:

• When MP > AP, the average product will be increasing.
• When MP < AP, the average product will be decreasing.
• When MP = AP, the average product will be at the maximum.

## Costs in the short run

In Figure 1.18 you can see the general form of the TC, MC, and ATC curves.

## Costs in the long run

The long-run average cost curve (LRAC) is a combination of all short-run average cost curves (SRAC) that are present at fixed levels of production at fixed levels of factors of production.

In the short run, a producer can’t change the factors of production but in the long run, he
can. This shifts his SRAC curve along the LRAC curve.

The LRAC curve can be divided into three segments based on the returns to scale:

I. Increasing returns to scale (economies of scale): average cost is decreasing when production is increased.
II. Constant returns to scale: The average cost is constant when production is increased.
III. Decreasing returns to scale (diseconomies of scale): average cost is increasing when production is increased.

## Factors giving rise to economies of scale

Specialization: when firms grow they have the recourses to specialize their personnel in certain specific tasks of the production process, this decreases the average cost of the product because the person has more expertise in the part of the production process that they are contributing to.

Efficiency: when firms grow they can afford more efficient production methods (machines, bulk buying, etc.) this will lead to less average cost.

Marketing: when output increases the marketing cost typically will only increase slightly or remain the same. This decreases the average cost.

Indivisibilities: some production factors can’t be divided into smaller pieces, for example, large machines. Small firms will still have these large costs, even if production is low. When production is increased this indivisible cost can be divided by more products, lower average cost.

## Factors giving rise to diseconomies of scale

Problems of coordination: when the company grows larger, the company may need more managers to manage the logistics of the production. This will increase total costs and this increase in average costs.
Problems of communication: when a firm grows larger it generally needs more personnel. Communication with all personnel may be difficult. The company may need to hire more extensive management to streamline this communication. This will lead to a higher average cost of production.

## 1.4.2 Revenues

In the graph, you can see the general form of the TR, AR, and MR curves. Take note of the following when drawing these curves:

• The MR curve intersects the Q axis when TR is at maximum. This also makes sense: when MR> 0 every additional product will earn positive revenue, raising TR. However, when MR< 0 every additional product will earn negative revenue (a loss), decreasing TR.
• AR is downward sloping.

## 1.4.3 Profit

Why will a firm continue to operate at a normal profit?

At a normal profit, all costs are covered. Shutting down would mean not being able to cover fixed costs or not being able to pay off debt.

## 1.4.4 Goals of the firm

The most common goal of firms is profit maximization. This goal is achieved when the difference between total cost and total revenue is maximized (TC − TR= max). This is the case when the marginal costs are equal to the marginal revenue (MC = MR).

⇒ When MC > MR selling one more unit would lead to an additional loss.
⇒ When MC < MR, selling one more unit would lead to an additional profit.
⇒ So profit is maximized when MC = MR.

In addition to profit maximization, firms may also have some alternative goals:

## Revenue maximization. Growth maximization: the firm may want to maximize its growth. This growth can be measured in revenue, production, employment, or market share.

Satisficing: the firm tries to perform satisfactorily rather than to a maximum level.
Corporate social responsibility (CSR): the business includes a public interest in its decision making. This may be that the company wants to produce as

environmentally friendly as possible, provide good service for consumers, employ workers under favorable conditions, etc. Different firms may adopt different approaches to CSR.

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