Topic 5: Theory of the Firm

5.1 Production

• Short run: at least one factor fixed (usually capital).
• Long run: all factors are variable.
• Law of diminishing returns: adding more of a variable factor (labour) eventually reduces marginal output.
• Returns to scale:
• Increasing → output rises faster than inputs.
• Constant → output rises proportionately.
• Decreasing → output rises more slowly than inputs.

 

5.2 Costs

• Fixed costs (FC): don’t change with output (rent, salaries).
• Variable costs (VC): change with output (raw materials).
• Total cost (TC) = FC + VC.
• Average cost (AC) = TC ÷ output.
• Marginal cost (MC) = change in TC ÷ change in output.
• Key relationship: MC cuts AC at its lowest point.

Memory cue: MC is the knife that slices AC at the bottom.

 

5.3 Revenues

• Total revenue (TR) = Price × Quantity.
• Average revenue (AR) = TR ÷ Quantity (same as price in perfect competition).
• Marginal revenue (MR) = change in TR ÷ change in output.
• In perfect competition: AR = MR = Price.
• In monopoly: AR downward sloping, MR below AR.

 

5.4 Profit

• Normal profit: minimum reward to keep the entrepreneur in business (TR = TC).
• Supernormal profit: TR > TC.
• Loss: TR < TC.

 

5.5 Market Structures (comparison table)

Feature	Perfect Competition	Monopoly	Oligopoly	Monopolistic Competition
Firms	Many small	One	Few large	Many small
Product	Homogeneous	Unique	Differentiated	Differentiated
Entry barriers	None	Very high	High	Low
Price control	None (price taker)	Strong	Some collusion	Some, limited
Efficiency	High (allocative + productive)	Low	Mixed	Medium

 

5.6 Efficiency

• Allocative efficiency: resources are used where consumer satisfaction is maximised (P = MC).
• Productive efficiency: lowest possible cost (AC minimised).
• Dynamic efficiency: innovation over time.
• X‑inefficiency: lack of competition → firms waste resources.