Theory of the firm

Cost Theory

Short run Vs Long Run

Short run: Period of time in which at least one factor of production is fixed. All short run production takes place in short run (duration depends on fixed factors)

Long Run: All factors of production are variable but the state of technology is fixed. All planning takes place in the long run

For example:

Factors of production of restaurant


Total, average and marginal product

Law of Diminishing Returns

As extra units of variable factors are added to fixed factors, the output of the additional units of the variable factors will eventually diminish

Economics Cost

The economic cost of producing a good is the opportunity cost of the firms productions

Costs definitions

Average Costs: Costs per Unit of output

Total variable cost: price increase of each quantity

Total Costs: Variable Costs + fixed costs

Average fixed cost:  TFC / Quantity (Always falls as output increases)

Average Variable Cost:  TVC / Quantity (falls, then increases per unit, diminishing average returns)

Average total cost:  TC / q

Marginal Costs: Change in TC / Q (the total cost of producing one extra unit of output). This cuts the AVC and ATC at their lowest points.

Example question: Manufacturing Signs. Machine costs 10 000 EUR. Materials for each sign is 7 EUR.  250 signs are produced.

Short run vs long run

MC cuts the AVC and ATC at their lowest points.

AFC (ATC-AVC) falls as output increases. The vertical gap between AVC and ATC gets smaller as output grows

Long run average cost curve

Long run average cost or envelope curve. Curve shows all possible combinations of fixed and variable factors

Image result for returns to scale economics


Returns to scale

Changes in output resulting from proportional changes in all input.

increasing returns to scale: cost decreases as output increases

Decreasing returns to scale: cost increases as output increases

Image result for long run average cost and returns to scale

Economies and diseconomies of scale

Economies of scale

Any decreases in the long run avg cost when a firm alters all of its factors of production


Diseconomies of scale

Any increases in the long run avg cost when a firm alters all of its factors of production


Revenue Curve

Measurement of Revenue

Revenue curve and output for perfect competition

Revenue maximisation

TR is maximized when MR = 0 and PED = 1

Profit Theory


Accountant vs economist definition of profit

Account profit = Total Revenue - total costs

Economist Profit = TR - Economic cost (explicit and implicit costs)

Types of profit

Shutdown price, breakeven price, profit maximisation

  1. The shutdown price
    • Has to do with Variable costs. If the variable costs exceeds revenue, then a firm has to shut down
    • TVC = TR
  2. Break Even Price
    • Has to do with normal profit. Where normal profit is made.
    • Firm able to make normal profit in the long run
    • Covering all its costs in the long run
    • Price = Average total costs (all costs are covered)
  3. The profit- maximising level of output
    • MC = MR
    • Firm with perfectly elastic demand
    • Firm with normal demand curve

Image result for break even and shutdown point diagram

Maximizing other goals

Profit maximisation is not always the goal of a company sometimes they care about maximizing growth or CSR.


View count: 9096