Theory of the Firm

Question 1

Perfect competition

Answer 1

• Theoretical, unrealistic
• Many firms
• Firms have no influence on market
• Homogenous products
• No barriers to entry

Question 2

Theory of the firm

Answer 2

The sum of different economic theories that describe the ways in which firms – companies, individual producers, corporations – act.

Firm’s primary objective is profit maximisation.

Question 3

Corporate social responsibility

Answer 3

• Firms have to be conscious o their environmental and ethical behaviours
• Firms may voluntarily take on negative externalities for ethical standards
• CSR may not stem from anything more than self interest

Question 4

Market Share

Answer 4

Firm revenue divided by total revenue

• Percentage of total sales for a single firm in the market
• Large market share = ability to achieve economies of scale
• Helps judge success
• Focusing on maintaining a certain level of market share can be a way to ensure performance

Question 5

Growth maximisation

Answer 5

• Goal of the firm: increase size
• Can achieve economies of scale and lower average costs to produce
• Diversify into production of different goods and services

Question 6

Satisficing

Answer 6

• A decision-making strategy that aims for a satisfactory or adequate result, rather than the optimal solution
• The idea that firms try to achieve satisfactory rather than optimal or ‘best’ results

Against:
- Each group within a firm may have its own goals (may overlap and conflict)

Question 7

Monopolistic competition

Answer 7

• Many firms
• Every firm has a small impact
• Heterogenous goods
• Low barriers
• Very common

Question 8

Oligopoly

Answer 8

• A few firms in the industry that are dominant and able to control the market
• Products can be homogenous or heterogenous
• Concentration ratios: shared with government organisations to prevent collusion and to manage
• High barriers to entry
• For example: Pharmaceutical industry

Question 9

Collusion

Answer 9

When firms work together to achieve common goals

• Illegal in most countries (if firms from the same country are working together)
• Legal if the firms are from two different countries

Question 10

Monopoly

Answer 10

• One firm that dominates
• None today (unless regulated by governments)
• Homogenous
• Controls output and price (within limits of demand)
• There are some “state-run monopolies”
• No substitutes
• High barriers to entry

Question 11

Profit formula

Answer 11

Profit = Total Revenue - Total Costs

Question 12

Alternative business objectives

Answer 12

Corporate Social Responsibility
(Ethical Concerns)
(Environmental Concerns)
Market Share
Growth Maximisation
Revenue Maximisation
Satisficing

Question 13

Long run

Answer 13

All FOPs are variables

Question 14

Total product (TP)

Answer 14

Quantity of output produced by a firm

Formula: TP/v

Question 15

Marginal product

Answer 15

The extra or additional quantity of output produced by a firm when the firm adds one more unit of the variable factor of production.

Formula: ΔTP/Δv

Question 16

Law of Diminishing Marginal Returns

Answer 16

As more units of variable inputs (labour) are added to fixed inputs (land) the marginal product will first increase and then, after a point, decrease. This assumes that technology remains fixed too.

Question 17

Marginal cost (MC)

Answer 17

Total Cost (TC) is the cost to the firm for the production of a good or service.

Marginal Cost is the additional cost of producing one more unit of output.
Marginal cost tells us how much the Total Cost increases by when one more unit of a good is produced.

Formula: MC = ΔTC/ΔQ

Question 18

Marginal productivity

Answer 18

As MP decreases, MC increases
As MP increases, MC decreases

Question 19

Explicit cost

Answer 19

If the firm must pay for the factor of production (buy or rent), then it is an explicit economic cost. These explicit costs involve payments.

Question 20

Total fixed cost (TFC)

Answer 20

Total Fixed Costs (TFC) – total costs of all fixed assets (assets which do not change in the short-run).
TFC will be a constant amount – since fixed assets don’t change.
TFC is the same no matter how many units a firm produces; will not vary over the time period.
TFC = # of Fixed Assets x cost of each fixed asset

Question 21

Total variable cost

Answer 21

Total Variable Costs (TVC) - cost of the variable assets
They will increase as the firm uses more of those assets.
TVC = # of Variable Factors x costs of each of the Variable Factors

Question 22

Average fixed cost (AFC)

Answer 22

Average Fixed Cost = TFC/q (q = level of output or # of units produced)
Because TFC is a constant AFC drops as the number of units produced increased (the denominator in the fraction gets bigger)

Question 23

Average variable cost (AVC)

Answer 23

Average Variable Costs = TVC/q
AVC tends to fall sharply initially as output increases, but then increase sharply as the output increases past a certain point
This is because of the law of diminishing average returns
At first, as more variable factors are applied to the fixed factors, the cost per variable factor will drop
Then, too many variable factors applied to the same number of fixed factors becomes inefficient and the output per variable factor drops resulting in a rise in average costs

Question 24

Average cost

Answer 24

Average Total Costs = TC/q = AFC + AVC
It is the combined curve of AFC + AVC and as a result acts like the AVC curve – although to a lesser extent.

Question 25

Productive efficiency

Answer 25

When MC = AC

When a firm produces at the lowest possible unit cost to produce
This occurs when the AC curve is at its lowest
Which is when the MC curve cuts the AC curve

Question 26

Economies of scale

Answer 26

Specialisation
Division of Labour
Bulk Purchasing
Financial Economies
Transport Economies
Large Machinery
Promotional Economies

Question 27

Diseconomies of scale

Answer 27

These are increases to long-run costs that happen when a firm increases all factors of production to increase output.
They result in decreasing returns to scale.
These are more serious than you think and can occur at different points depending on the type of production – might happen quite early on if your business is based on high quality/human touch and grows too quickly.
Control and communication problems
Alienation and loss of identity