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THEORIES OF THE FIRM
Theories of the firm try to explain supply.
Intro to firms
slide 1
BACKGROUND TERMS
Theories of the firm are organized around the
different kinds of market forms in which firms can
operate.
In this course, the market forms are grouped this
way:
Perfect competition
Monopoly
Monopolistic competition, and
Oligopoly
Intro to firms
slide 2
Perfect Competition
A market form with these characteristics:
1) Large number of firms.
2) Homogeneous product.
3) Easy entry and exit of firms.
Some economists add to this list that consumers and
firms also have cheap, accurate information about
prices.
Intro to firms
slide 3
What the assumptions boil down to is that each firm
in perfect competition is a price taker.
NO FIRM HAS ANY CONTROL OVER MARKET
PRICE.
This means that the demand curve the firm sees for
its product is infinitely elastic.
Intro to firms
slide 4
Infinitely elastic demand curve of a perfectly
competitive producer of soybeans in Mason,
Michigan:
price
P0 is the current
market price.
P0
quantity
(hundred bushels)
Intro to firms
slide 5
WARNING!
The market demand curve is still negatively sloped:
MARKET
price
S
P0
FIRM
price
P0
D
quantity
(million bushels)
Intro to firms
quantity
(hundred bushels)
slide 6
In competitive markets, market price is determined
by supply and demand.
If a firm were to raise its price above market price it
would lose all its sales. It would never be silly
enough to charge less because it can sell all it
wants at the going market price.
Intro to firms
slide 7
OTHER MARKET FORMS
DEFINED
MONOPOLY: a market with only one seller of
a product for which there are no close
substitutes.
MONOPOLISTIC COMPETITION: a market
with many firms, easy entry, and product
differentiation. (Each firm produces a slightly
different version of the product.)
OLIGOPOLY: a market with a small number of
firms.
Intro to firms
slide 8
PROFIT
Profit is the difference between total revenue and
total cost, or Profit = TR - TC.
In economics class cost means OPPORTUNITY
cost.
Because opportunity cost is often different from
accounting cost, economic profit has a very
special meaning and significance.
Intro to firms
slide 9
TWO EXAMPLES SHOWING THE DIFFERENCE
BETWEEN OPPORTUNITY (a.k.a. ECONOMIC
OR FULL) COSTS, AND ACCOUNTING
COSTS.
Intro to firms
slide 10
Jim’s H&H Mobil -- A Proprietorship
Annual costs and revenues
Receipts from sales
Costs
Employees’ labor
Rent
Gas, oil, parts, etc.
Total explicit costs
$200,000
$100,000
25,000
30,000
$155,000
Accounting “profit” = 200,000-155,000=45,000
Cost of Jim’s labor resources & effort = Value of Jim’s labor in next
best use (an implicit cost) = $35,000
ECONOMIC PROFIT = $10,000
Intro to firms
slide 11
BugOff Software, Inc. -- A Corporation
Receipts
Costs
Employees’ Labor
Disks, computers,
advertising, etc.
$400,000
$100,000
100,000
Before tax accounting profit
Profit taxes
After tax profit
Dividends
100,000
Retained earnings
50,000
Opportunity cost of capital = $125,000
200,000
50,000
150,000
ECONOMIC PROFIT = 25,000
Intro to firms
slide 12
The smallest amount of money that must be paid
to shareholders to keep them investing in the
company is sometimes called “normal” profit.
“Normal” profit is a cost. It is part of
opportunity costs.
Intro to firms
slide 13
SHORT-RUN VS. LONG-RUN
Short-run: a time period over which the firm has some
inputs it can’t change. (Short-run implies at least one fixed
input. In the short-run firms can’t enter or leave an
industry.)
Reasons:
Long-run: a time period over which the firm can choose the
amounts of all of its inputs. (Long-run implies no fixed
inputs. In the long-run firms can enter or leave an
industry.)
Intro to firms
slide 14