Theory of the Firm - A2 Economics

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Business Economics: Microeconomics by Robert Nutter

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Theory of the Firm
Production in the shortrun
Assume a firm has been set up to produce furniture and has hired a factory unit and
machinery in order to carry out this production.
No. of workers Total product Average product Marginal product
1 3 3 3
2 7 3.5 4
3 16 5.3 9
4 28 7 12
5 45 9 17
6 60 10 15
7 63 9 3
Initially, the firm has incurred some fixed costs in terms of hiring the factory and the
machinery. The owners of these will expect to be paid for their use, regardless of whether
production has started or not. We also assume ceteris paribus ­ all other factors other than
price remain fixed, including the quality of the products made.
The shortrun is where fixed costs of production cannot change. The longrun is a
period of time where all factors of production are able to change.
As the firm commences production of furniture, we assume that it is in a shortterm (run)
situation where at least one FOP remains fixed ­ here, it's the size of the premises. To
increase its output, it will take on extra workers and as it does so, it will find, up to a point, that
each worker will add more to the total output than the previous worker, due to specialisation.
In the table above, the marginal product of worker number 3 is 9, while the MP for worker 4 is
12 ­ they produce 12 more units as a whole. This is known as increasing marginal returns,
where increasing the amount of the variable factor increases the output more than
As the firm grows and orders increase, it will continue to employ more workers and purchase
more raw materials. However, there will come a point where the premises cannot
accommodate the extra workers and their presence will reduce the output of the existing
workers. The MP rises up until worker 5 (each successive worker adds more to output than
the previous ones) but with worker 6, MP starts to fall. However, average product rises and
as the MP is above the average, it pulls up the average. Employment of the 7th worker only
adds 3 units of output as the fixed factors are now becoming overloaded as there are too
many variable factors for the size of the fixed factor.
In the shortrun, the firm can only change its rate of output by combining more or less of the
variable factors with the fixed factor. The table indicates that initially, the firm experiences
increasing returns where output rises more than proportionately to the increase in output, but
then the firm experiences diminishing marginal returns, where the increase in output is less
than proportional to the increase in labour/variable input. This is known as the law of
diminishing marginal returns.

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Costs: calculations and diagrams
Fixed costs: They do not vary with output e.g. rent. They can be contractual ­ something you
can be forced by a court to pay. As they are not related to output, they need to be paid even if
it produces nothing or runs 24 hours a day.
Variable costs: These costs do vary directly with output. Increasing output will require an
increase in things like raw materials, power and labour.…read more

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Marginal costs: The amount added to the total cost of production by the next unit of output ­
essentially, the cost of producing one more unit. The MC is calculated by taking the total cost
and deducting the total cost of the previous unit.
Short run production and the law of diminishing returns
If more workers were added to the kitchen at a busy restaurant, output can raise at a faster
rate than the number of workers employed, because of specialisation.…read more

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Output Total cost Marginal cost
1 100
2 180 80
3 250 70
4 300 50
5 380 80
Hence MC falls at low levels of output (where every extra unit has a greater impact on output)
but as soon as the law of diminishing returns sets in, each worker hired adds less to the total
output than the previous worker taken on. Total costs rise faster than output, leading to a rise
in MC.…read more

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The relationship between marginal and average curves has a number of applications:
Production theory ­ MP/AP
Cost theory ­ MC/AC/AVC
Revenue theory ­ MR/AR
After diminishing returns sets in at point D, the MC curve starts to rise, but the AVC curve
continues to fall. Eventually, the MC curve rises through the AVC curve, causing the AVC
curve to also rise. As a result, the ABC curve is Ushaped, with the MC curve cutting through
it at its lowest point.…read more

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This is partly due to labour specialisation ­ the division of
labour by specialised tasks.
After adding more and more labour to that land, we reach a point of maximum or optimum
efficiency and then, as we add more labour, we encounter one of the most important
economic laws: the law of diminishing returns.…read more

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In the long run, all factors of production are available. This has the effect on costs as output
changes. To start with, long run costs fall as output increases, economies of scale are then
said to exist. E.g. a firm quadruples its output from 10,000 units to 40,000, however, total
COP only increase from 10,000 to 20,000. The average COP consequently falls from £1 per
unit to 50p per unit.
Economists have found that firms do experience economies of scale.…read more

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Technical economies
Economies of scale can exist due to increasing and decreasing returns. These are from the
production process e.g. using machinery for the maximum amount of time available e.g. a
cement mixer for 5 out of 5 days. Large scale production is often more productively efficient.
Diseconomies of scale
These arise mainly due to management problems, cultural problems, issues with
coordination and communication. Firms try to complete with these issues through
decentralisation.…read more

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If when the firm expands, it moves onto a higher SRAC curve, it is experiencing
diseconomies of scale
Explanation 2
Long run costs
The long run is defined as a period when the enterprise can alter its scale of plant (either
expand or contract size). All FOP thus become variable. It is likely that, as the scale of plant
increases, the enterprise may enjoy the benefits of internal economies of scale.…read more

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The different types of revenues
How we can calculate it: Total Revenue = Quantity x Selling price
Average revenue: Total Revenue divided by the units sold
Marginal revenue: Receipts from extra unit
Revenue curves
Different curves can be drawn from the different assumption about average revenue.
What happens to revenues when the price stays the same?
One assumption is that a firm receives the same price for each good sold.…read more



This is an excellent 16 page set of notes covering costs, revenues, growth, economies of scale. Students can use it for their notes or adapt it for their own revision purposes.

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