CHAPTER 9, STUDY UNIT 8

Types of firms:

  1. Individual proprietorships
  2. Partnerships
  3. Companies
  4. Close corporations
  5. Cooperatives
  6. Trusts
  7. Public corporations
  8. Informal businesses

Goal of the firm: to seek maximum profits. Firms may have other objectives, like to dominate the market (even if it means reducing the firm’s profit margins), or some managers may pursue their own objectives, such as expanding the size of the firm, since their status, power and remuneration tend to increase as the firm grows

Profit: he surplus of revenue over cost.

Total revenue: the total value of sales and is equal to the price (P) of its product multiplied by the quantity sold (Q). TR = (P x Q)

Average revenue: total revenue divided by the quantity sold. If all units are sold at the same price then the average revenue is equal to the price of the product

Marginal revenue: additional revenue earned by selling an additional unit of the product.

Relationships between total, average and marginal revenue:

  1. Total revenue increases when marginal revenue is positive
  2. Total revenue falls when marginal revenue is negative
  3. Total revenue remains unchanged when marginal revenue is zero
  4. Average revenue increases when marginal revenue is greater than average revenue
  5. Average revenue decreases when marginal revenue is less than the average revenue
  6. Average revenue remains unchanged if marginal revenue is equal to average revenue

Explicit costs: monetary payments for the factors of production and other inputs bought or hired by the firm

Implicit costs: those opportunity costs which are not reflected in monetary payments

Economic costs of production: opportunity costs. Explicit costs + implicit costs.

Total cost: the cost of producing a certain quantity of the firm’s product

Average cost: the total cost divided by the quantity of the product produced

Marginal cost: addition to total cost required to produce an additional unit of the product

Relationships between total, average and marginal cost:

  1. Total cost increases when marginal cost is positive
  2. Average cost increases when marginal cost is greater than average cost
  3. Average cost decreases when marginal cost is lower than average cost
  4. Average cost remains the same when marginal cost is equal to average cost

Normal profit: equal to the best return that the firm’s resources could earn elsewhere and forms part of the cost of production. When total revenue equals total economic cost.

Total (accounting) profit: the difference between total revenue from the sale of the firm’s product(s) and total explicit costs

Economic profit: the difference between total revenue from the sale of the firm’s product(s) and total explicit and implicit costs. It is equal to the amount by which revenue exceeds the opportunity cost of all the resources used in production.

Economic loss: if total economic costs exceed total revenue

Short-run: a period within which at least one of the inputs is fixed. In the short run the firm can expand output only by increasing the quantity of its variable inputs. This is limited by the fixed inputs; at some point output can no longer be increased by increasing the variable input.

Fixed input: an input whose quantity can’t be altered in the short run

Long-run: a period that is long enough for a firm to change the quantities of all the inputs in the production process as well as the process itself. There are no fixed inputs. All inputs, including all the factors of production, are variable. The law of diminishing returns does not apply in the long run. Marginal product also has no meaning in the long run since it can only be derived if all the other inputs are held constant.

Variable input: an input whose quantity can be changed

Short-run simplifying assumptions:

  1. The firm produces only one product
  2. All units of given input are identical or homogeneous
  3. The units can be used in indefinitely divisible amounts
  4. The technical relationship between inputs and output (production function) is given and can therefore not be changed
  5. The prices of the product and of the inputs are given
  6. The firm uses fixed inputs and one variable input

Marginal product: the marginal product of the variable input is the number of additional units of output produced by adding one additional unit of the variable input

Average product: the average number of units of output produced per unit of the variable input

Law of diminishing returns: as more of a variable input is combined with one or more fixed inputs in a production process, points will eventually be reached where first the marginal product, then the average product and finally the total product start to decline.