Intro to firms slide 1

THEORIES OF THE FIRMTHEORIES OF THE FIRM

Theories of the firm try to explain supply.

Intro to firms slide 2

BACKGROUND TERMSBACKGROUND 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 competitionMonopolyMonopolistic competition, andOligopoly

Intro to firms slide 3

Perfect CompetitionPerfect 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 4

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 5

Infinitely elastic demand curve of a perfectly competitive producer of soybeans in Mason, Michigan:

price

quantity(hundred bushels)

P0

P0 is the current market price.

Intro to firms slide 6

WARNING!

The market demand curve is still negatively sloped:

price

quantity(hundred bushels)

P0

price

P0

quantity(million bushels)

D

MARKET FIRMS

Intro to firms slide 7

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 8

OTHER MARKET FORMS OTHER MARKET FORMS DEFINEDDEFINED

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 9

PROFITPROFITProfit 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 10

TWO EXAMPLES SHOWING THE DIFFERENCE BETWEEN OPPORTUNITY (a.k.a. ECONOMIC OR FULL) COSTS, AND ACCOUNTING COSTS.

Intro to firms slide 11

Jim’s H&H Mobil -- A Proprietorship Annual costs and revenues

Receipts from sales $200,000Costs

Employees’ labor $100,000Rent 25,000Gas, oil, parts, etc. 30,000

Total explicit costs $155,000

Accounting “profit” = 200,000-155,000=45,000Cost 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 12

BugOff Software, Inc. -- A Corporation

Receipts $400,000Costs

Employees’ Labor $100,000Disks, computers, advertising, etc. 100,000

Before tax accounting profit 200,000Profit taxes 50,000After tax profit 150,000

Dividends 100,000Retained earnings 50,000

Opportunity cost of capital = $125,000

ECONOMIC PROFIT = 25,000

Intro to firms slide 13

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 14

SHORT-RUN VS. LONG-RUNSHORT-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.)