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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…

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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…

Page 3

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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…

Page 4

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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…

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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…

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of labour is rising the extra output produced by that last unit of labour is greater than added
by his immediate predecessor. 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…

Page 7

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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…

Page 8

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4. 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…

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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.…

Page 10

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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…




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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