Core Concepts

• Firms are assumed to operate with the primary objective of maximizing economic profit.
• Profit calculation requires understanding both Total Revenue (TR) (from sales) and Total Economic Cost, which includes explicit monetary outlays and implicit opportunity costs.
• A firm's Production Function dictates the relationship between inputs and outputs, influencing its cost structure, often characterized by Diminishing Marginal Product.
• The Market Structure (e.g., perfect competition) significantly impacts a firm's pricing power and revenue generation.
• Firms make optimal output decisions by comparing Marginal Revenue (MR) and Marginal Cost (MC).
• Operational decisions (shutdown, exit) depend on comparing price to average variable cost (short run) and average total cost (long run).

Key Term Definitions

• Firm: An entity that combines inputs (labor, capital, materials) to produce goods or services for sale.
• Profit: The difference between total revenue and total cost.
• Total Revenue (TR): The total amount of money received from the sale of a firm's output.
• Total Cost (TC): The market value of all inputs used in production, including both explicit and implicit costs.
• Explicit Costs: Input costs requiring a direct outlay of money by the firm.
• Implicit Costs: Input costs that do not require an outlay of money; they represent the opportunity cost of using resources owned by the firm (e.g., forgone wages, forgone interest).
• Economic Profit: Total Revenue minus Total Economic Cost (Explicit + Implicit Costs).
• Accounting Profit: Total Revenue minus Total Explicit Cost.
• Production Function: The relationship between the quantity of inputs used to make a good and the quantity of output produced.
• Marginal Product (MP): The increase in output arising from an additional unit of a specific input, holding other inputs constant.
• Perfect Competition: A market structure with many buyers and sellers, identical products, and free entry/exit, where individual firms are price takers.

The Objective of the Firm

The Objective of the Firm - Definition

• The primary goal assumed for firms in standard microeconomic analysis is the maximization of economic profit.

The Objective of the Firm - Key Insights

• While firms might have other goals (social impact, market share), long-term financial sustainability necessitates profitability.
• Economic profit guides decision-making as it accounts for all costs, including the opportunity cost of the owners' resources.

Understanding Costs

Understanding Costs - Definition

• Total Cost (TC): The sum of all costs incurred in production. Can be divided into various categories.

Understanding Costs - Cost Types & Classification

• Explicit vs. Implicit Costs:
  • Explicit: Direct payments (wages, rent, materials).
  • Implicit: Opportunity costs of using self-owned resources (forgone salary, forgone interest).
• Economic vs. Accounting Costs:
  • Economic Cost: Explicit Costs + Implicit Costs.
  • Accounting Cost: Explicit Costs only.
• Fixed vs. Variable Costs:
  • Fixed Costs (FC): Costs that do not change with the quantity of output produced (e.g., rent). Incurred even if output is zero.
  • Variable Costs (VC): Costs that vary directly with the quantity of output produced (e.g., raw materials, hourly labor).
• Sunk Costs: Costs already incurred that cannot be recovered. They are irrelevant to future production decisions.

Understanding Costs - Key Insights

• Economic costs provide a more comprehensive measure for decision-making than accounting costs.
• The distinction between fixed and variable costs is crucial for short-run decisions. Fixed costs are often irrelevant for the marginal decision of producing one more unit but are relevant for the overall profitability assessment.
• Sunk costs should be ignored when making decisions about future actions, as they cannot be changed.

Understanding Costs - Comparisons

• Economic vs. Accounting Profit: Economic Profit = TR - (Explicit + Implicit Costs); Accounting Profit = TR - Explicit Costs. Therefore, Economic Profit ≤ Accounting Profit. Firms aim to maximize Economic Profit.
• Fixed vs. Sunk Costs: Fixed costs are ongoing obligations tied to fixed inputs (relevant for profit calculation), while sunk costs are past, unrecoverable expenditures (irrelevant for current output decisions).

Understanding Costs - Formula

Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

Production and Costs

Production and Costs - Definition

• Production Function: Describes the technological relationship transforming inputs into outputs.
• Marginal Product (MP): The additional output produced by using one more unit of an input.

Production and Costs - Key Insights

• Diminishing Marginal Product: A common property where the marginal product of an input declines as the quantity of the input increases, holding other inputs fixed. This implies that producing additional output requires increasingly larger amounts of the variable input.
• The shape of the total cost curve is directly related to the production function. Diminishing marginal product leads to an increasing marginal cost, causing the total cost curve to become steeper as output increases.

Production and Costs - Examples

• Adding more workers (variable input) to a kitchen with fixed equipment (fixed input). Initially, output increases significantly, but eventually, workers get in each other's way, and the contribution of each additional worker (MP) falls.

Cost Curves in the Short Run

Cost Curves in the Short Run - Definition

• Curves representing the relationship between a firm's costs and its level of output in the short run (when at least one input is fixed).

Cost Curves in the Short Run - Key Cost Measures & Curves

• Total Cost (TC): TC = FC + VC. Rises as output increases.
• Average Fixed Cost (AFC): AFC = FC / Q. Always decreases as output (Q) increases.
• Average Variable Cost (AVC): AVC = VC / Q. Typically U-shaped due initially to increasing returns/efficiency and later to diminishing marginal product.
• Average Total Cost (ATC): ATC = TC / Q = AFC + AVC. Typically U-shaped. The minimum point of the ATC curve represents the efficient scale of production.
• Marginal Cost (MC): MC = ΔTC / ΔQ. The cost of producing one additional unit. Typically rises with output due to diminishing marginal product.

Cost Curves in the Short Run - Key Insights

• The U-shape of ATC reflects the interplay between falling AFC and rising AVC (driven by MC).
• The MC curve intersects both the AVC and ATC curves at their respective minimum points.
  • If MC < ATC, ATC is falling.
  • If MC > ATC, ATC is rising.
  • If MC = ATC, ATC is at its minimum. (Similar logic applies to MC and AVC).

Cost Curves in the Short Run - Formula

AFC = FC / Q

AVC = VC / Q

ATC = TC / Q = AFC + AVC

MC = ΔTC / ΔQ (where Δ denotes 'change in')

Firm Behavior in Perfectly Competitive Markets

Firm Behavior in Perfectly Competitive Markets - Definition

• A market structure characterized by: (1) Many buyers and sellers, (2) Homogeneous (identical) products, (3) Free entry and exit in the long run.

Firm Behavior in Perfectly Competitive Markets - Key Insights

• Firms in perfect competition are price takers, meaning they must accept the market price determined by overall supply and demand. They cannot influence the price.
• The demand curve facing an individual competitive firm is perfectly elastic (horizontal) at the market price.
• For a competitive firm, the price is equal to both its average revenue and its marginal revenue.

Firm Behavior in Perfectly Competitive Markets - Formula

Average Revenue (AR) = TR / Q = (P * Q) / Q = P

Marginal Revenue (MR) = ΔTR / ΔQ = P (since each additional unit sells for the market price P)

Therefore, in Perfect Competition: P = AR = MR

Profit Maximization

Profit Maximization - Definition

• The process by which a firm determines the price and output level that returns the greatest profit.

Profit Maximization - Key Insights

• Firms use the marginal principle: Increase activity (production) if marginal benefit (MR) exceeds marginal cost (MC); decrease activity if MC exceeds MR.
• The profit-maximizing output level is found where Marginal Revenue equals Marginal Cost (MR = MC).
• For a perfectly competitive firm, since P = MR, the rule becomes: Produce the quantity where Price equals Marginal Cost (P = MC). The relevant portion is where MC is rising.

Profit Maximization - Examples

• If P = $10 and **MC** of the next unit is$8, producing it adds $2 to profit ($10 revenue - $8 cost).
• If P = $10 and **MC** of the next unit is$12, producing it reduces profit by $2 ($10 revenue - $12 cost).
• Profit is maximized when producing the last unit for which P ≥ MC.

Profit Maximization - Graphical Representation

• Profit = (P - ATC) * Q
• If P > ATC at the profit-maximizing quantity (where P=MC), the firm earns positive economic profit.
• If P < ATC at the profit-maximizing quantity, the firm incurs an economic loss.
• If P = ATC at the profit-maximizing quantity, the firm earns zero economic profit (break-even).

Profit Maximization - Formula

Profit Maximization Rule: MR = MC

In Perfect Competition: P = MC

Operational Decisions and Supply

Operational Decisions and Supply - Definition

• Decisions firms make about whether to produce or not, based on market conditions and costs, in the short run and long run.

Operational Decisions and Supply - Short-Run Decision: Shutdown

• Condition: A firm should temporarily shut down if the revenue from producing does not cover its variable costs. Fixed costs are irrelevant as they must be paid anyway.
• Rule: Shut down if Total Revenue < Total Variable Cost (TR < VC) or, equivalently, if Price < Average Variable Cost (P < AVC).
• Short-Run Supply Curve: The portion of the firm's Marginal Cost (MC) curve that lies above its Average Variable Cost (AVC) curve. Below minimum AVC, quantity supplied is zero.

Operational Decisions and Supply - Long-Run Decision: Exit/Entry

• Condition: A firm should exit the market permanently if the total revenue from producing is less than its total costs. In the long run, all costs are variable (no fixed costs).
• Rule: Exit if Total Revenue < Total Cost (TR < TC) or, equivalently, if Price < Average Total Cost (P < ATC).
• Entry Rule: A firm should enter if Price > Average Total Cost (P > ATC).
• Long-Run Supply Curve: The portion of the firm's Marginal Cost (MC) curve that lies above its Average Total Cost (ATC) curve.

Operational Decisions and Supply - Key Insights

• The decision rules differ because fixed costs are unavoidable in the short run but can be eliminated in the long run by exiting.
• A firm might operate at a loss in the short run (P < ATC) as long as it covers its variable costs (P > AVC), minimizing its losses compared to shutting down and still paying fixed costs.

Long-Run Equilibrium in Perfect Competition

Long-Run Equilibrium in Perfect Competition - Definition

• A market state where firms have no incentive to enter or exit the industry, and economic profits are zero.

Long-Run Equilibrium in Perfect Competition - Key Insights

• If existing firms earn positive economic profits (P > ATC), new firms are incentivized to enter, increasing market supply, and driving down the price.
• If existing firms incur losses (P < ATC), some firms will exit, decreasing market supply, and driving up the price.
• This process continues until economic profits are driven to zero.
• Zero economic profit occurs when Price = Average Total Cost (P = ATC).
• Since firms maximize profit where P = MC, the long-run equilibrium requires P = MC and P = ATC. This condition is only met at the minimum point of the Average Total Cost curve.
• In long-run equilibrium, firms operate at their efficient scale (minimum ATC). The market price equals this minimum ATC.

Long-Run Equilibrium in Perfect Competition - Formula

Long-Run Equilibrium Condition: P = Minimum ATC

Conclusion

The behavior of firms is fundamentally driven by the pursuit of maximum economic profit. This requires careful consideration of both revenues, determined largely by market structure (like perfect competition where P=MR), and costs, which stem from the production process (often exhibiting diminishing marginal returns) and include both explicit and implicit components. Firms optimize output where MR=MC and make crucial short-run (shutdown based on P vs. AVC) and long-run (exit based on P vs. ATC) operational decisions, ultimately leading perfectly competitive markets towards a long-run equilibrium where firms earn zero economic profit and operate at their efficient scale (P=min ATC).