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Theory of the Firm
05/01/2023 2
What is a Firm?• Firm is a unit of organization that transforms
inputs into outputs.*Produces homogeneous commodity
*Technology is represented by a production function.
• Neoclassical Theory: Firm as a collection of Resources that is transformed into products demanded by the consumers.
• Cost of Production: Governed by available Technology
• Output Produced and Selling Price are determined by Market Structure
• Aim of firm: Maximize Profit
05/01/2023 3
House-Holds
ProductMarkets
FactorMarkets
Firms
Money spent
Goods Demanded
Money Earned
Goods
Supplier
Money Costs
Input
DemandedInput
Supplied
Money Incomes
Circular Flow of Economic Activity
05/01/2023 4
Rational of Existence of Firm
Why cannot we offer separate contract for each function of a firm?Ex (1): Car Manufacturing through individual contracts and
Coordinated through Prices.Ex (2): A Shoe Manufacture contacts a COBBLER to make the Shoe Cobbler has bilateral transaction with TANNER to get Tanned Leather Tanner Transacts with BUTCHER Finally SHOES is sold in the Market
Outcome: High Transaction cost Multilateral Contract or complex set of contracts would be costly to negotiate.
Cost can be reduced through BILATERAL CONTRACTS
05/01/2023 5
Rationale for the firm
• In the absence of firm, Cost of Producing any rate of output would be higher. – High Transaction Cost: Cost of a firm entering into
contract with other entities.• Cost of obtaining information on prices, cost of negotiating, cost of having
separate contracts for each step of the production Process, Cost of Enforcement of contract and Coordinating Transaction.
Transaction Costs are influenced by Uncertainty (inability to know future outcome with accuracy) Hence not feasible to include all contingencies in a contract especially Long term Contract
What is the Way Out:Trade-off between External Transaction Costs and Costs of Internal Operations
05/01/2023 6
Firm’s existence……..Choose to Allocate the resources between External Transactions and
Internal Operations to ensure MINIMUM TOTAL COST
External Transaction: Outsourcing/Off shoring• Outsourcing peripheral activities noticed earlier
• Outsourcing Core Activities-Recent Phenomenon
• Off shoring (firm source its product in another Country)
– Ex. 80 per cent of Kodak’s reloadable Cameras and all of its digital Cameras are outsourced in ASIA (Keat & Young: 2006)
Compaq Computer (prior to merger with Hewlett-Packard) made only about 10 per cent of the computers sold to consumers
Use Third Party for Recruitment of Employees(Ex: Corporate Sector in India)
Transfer of White-Collar Jobs to Foreign Countries where salaries and Wages are Low
05/01/2023 7
Transaction Cost …….*Opening of Call Centres
Wave of Outsourcing of highly Technical Jobs (production of Software)
India: one of the largest supplier of these services. How (Large pool of Well-Educated Labour Force and low Salary as compared to
US and other Western Countries)
– Government Interference leads to INCREASE in Cost of ProductionEx: Sales Tax applies to transaction among firms not within
firmsReal Estate/Construction Company: Pay Tax for buying
Furniture. No tax if it is done internally by hiring a person
05/01/2023 8
Large Firm vis-à-vis Small FirmIF COST OF PRODUCTION DECLINES in a FIRM then Why can’t there be a Large
ONE Firm like Hindustan Lever, Proctor & Gamble so on (which produce variety of goods and Services)?
Cost of Organizing Transactions increases with increase in Size of Firm
Sometimes Internal Transaction Cost is equal to Transacting in the Market
Ex: SHOULD AUTOMOBILE PRODUCERS (General Motors) BUY TYRE from MRF, GOODYEAR or Build Plant to Produce Own Tyre .
Cost of Developing New Management Skill for a Different Type of Production (TYRE) can be Higher.
05/01/2023 9
Rationale of having Small Firm• Limitations of Entrepreneur’s Organizational Skill:
If firm size exceeds the manager’s ability to control the operation then resources may not be efficiently allocated in the firm.
Production cost Per unit of Output tends to rise as firms grow larger because of limited managerial ability-Known as DIMINSHING RETURNS TO MANAGEMENT
The Way out: Decentralize by Establishing number of separate divisions or profit centre
05/01/2023 10
Why do firms Exist…….?• Ronald Coase (1937): Production is organised in firm rather
than through series of Individual contracts. Why?
– To reduce Transaction Cost
– Higher Productivity under Team Work(Group production can offer Benefit of Specialization)
Drawbacks: ‘Shirking’ and ‘Free-riding’ in Group Production Difficult to Assess Contribution of Each Employee
The Way Out: Hire Monitor to Discipline the Team.
Solution: Compare Benefit of Greater Productivity under group Production with Cost of Monitoring
Offer Incentives (BONUS, PERKS) etc to IMPROVE PRODUCTIVITY
05/01/2023 11
Firm and Industry: A Comparison
Industry: A group of firms producing the SAME product or SIMILAR product.
Exp: Sugar & Automobile Industry
Number of firms selling cheese, butter, milk are part of Dairy Industry (Nandini, Amul, Indore Dairy….)
05/01/2023 12
Market and Industry
• Market consists of buyers and Sellers that communicate with each other for voluntary exchange
Market and Industry do not convey the same Meaning always
Exp: Footwear Market consists of products that are supplied by more than one industry
(leather, rubber and so on)Packaging Material supplied by other industries
05/01/2023 13
Market vis-à-vis Industry
An industry’s product cater to the needs of more than one marketExp: Aluminum Industry meets demand for Utensils, Electricity wire and so on)
Difference between Market for Electricity and Electricity Industry
Electricity Industry consists of Sellers only (State Electricity Board, GRIDCO) while Electricity Market consists of Buyers (Households, Industry) and Sellers.
05/01/2023 14
Objectives of Firm• Profit Maximization (Max. Market Share)-
Major Goal
• Subsidiary Goals: Large volumes of sales/ Company Image
• But can a firm afford to Maximize profit always by compromising on Ethical Issues?
05/01/2023 15
Profit = Revenue - Cost
• Total Profit = Total Revenue – Total Cost
• Total Profit will be maximum at that level of output where vertical distance between TR and TC curves is maximum (TR exceeds TC with high margin)
• Total profit is maximum at that point where slopes of both TR and TC curves are the same, i.e.,
•
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
0 5 10 15 20 25 30 35
-2
-1.5
-1
-0.5
0
0.5
1
0 5 10 15 20 25 30 35
STC
TR
Tp
MCMR
$
$Q
Q
05/01/2023 16
Marginal Revenue = Marginal Cost• Marginal Revenue
-0.1
0
0.1
0.2
0.3
0.4
0.5
0 5 10 15 20 25 30 35
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0 5 10 15 20 25 30 35
MCMRM pMR
MC Marginal Cost
Mp
Marginal Profit M
Maximum Profit
M: Marginal Profit- Rate of change in total profit of firm w.r.t changes in level of output=(∆T / ∆T Q)= (T 2-T1)/Q2-Q1.
05/01/2023 17
Profit Maximization….
• For profit Maximization, profit to be gained by producing additional unit of output (marginal profit), must be zero (M =0).
• Or Slope of TOTAL PROFIT curve is zero at that point
• M =0 implies MR= MC ( at the profit maximizing level of output, additional revenue to be generated from one unit of output must be equal to additional cost the firms incur by producing it).
• Total Profit is not maximized at the point where Marginal Profit is maximum rather at zero Marginal Profit.
05/01/2023 18
How to Maximize Profit?• Total Profit (T )= Total Revenue- Total Cost
= TR-TC
• Total Revenue: Total amount of money that the firm receives by selling a given quantity of output
(In fact, sales of a firm are equal to current year’s production plus opening stock minus the closing stock of finished goods, but let us assume that total sales volume of a firm is equal to the level of output produced).
Profit Maximization Condition of a firm
Equilibrium Condition (Firm)Necessary Condition (a) MC= MR
Output will be expanded to the point where Marginal Cost is equal to Marginal Revenue
05/01/2023 19
Profit Maximization…..
Sufficient Condition (b)
Slope of MR curve < Slope of MC curve(MC cuts MR from Below)
When MR > MC, If firm expands output then it will add more to revenue than to costs.It is rational to expand production of output and add more profit.
If MR < MC, then expansion of output will add more to costs than to the output- Reduce Profit
05/01/2023 20
Level of Output and Profit of a Firm
Q P TR=P*Q TC Profit MR MC (TR-TC) 1 2 3(=2*1) 4 5(=3-4) 6 70 10 0 12 -12 - -
1 10 10 14 -4 10 2
2 10 20 15 5 10 1
3 10 30 17 13 10 2
4 10 40 20 20 10 3
5 10 50 25 25 10 5
6 10 60 35 25 10 107 10 70 50 20 10 15
8 10 80 81 -1 10 31
05/01/2023 21
When does a firm Stop Production?Breakeven Analysis (Volume-Cost- Profit Analysis)
• Used in Actual Business Situations for understanding Effect of a change in Quantity of a Product on Profit of the Firm
• Investigates the relationship between Quantity of the Product, the Cost to Produce this quantity, and the Profit (Keat & Young: 2006)
Popularly known as VOLUME-COST-PROFIT Analysis
05/01/2023 22
Breakeven Analysis ………
• Break-even point: Output level at which Total Revenue of a firm equals to Total Cost implying Total Profits equal to zero.
• Assuming a Constant Price, Constant Average Variable cost and specific level of fixed costs, decision has to be taken about the level of output for the firm to cover its Total Costs.
• Or firm has to decide the level of output to be produced so as to cover its total costs and achieve target level of income.
• TO BREAK EVEN, A FIRM’S REVENUE MUST BE EQUAL TO COST
05/01/2023 23
TFC
TC
TR
TVC
Qb: Break-Even Output
Cost , Revenue
05/01/2023 24
Break-Even Analysis• At the Break-even point TR = TC
TFCTVCTR
TFCAVCPorQTFCQAVCQorP
TFCQAVCQP
)()()(
)()(
AVCPTFCQBEP
or
therefore:
05/01/2023 25
Break even….• (P - AVC) is known as the UNIT CONTRIBUTION
MARGIN.
• (P-AVC) indicates the contribution that each unit sold will make towards covering fixed cost and eventually generating profit.
05/01/2023 26
Units of Output Fixed Cost Variable Cost Total Cost Total Revenue Profit
('000s) (Rs in '000) (Rs in '000) (Rs in '000) (Rs in '000) (Rs in '000)
1 2 3 4(=2+3) 5 6(=5-6)0 20 0 20 0 -20
5 20 15 35 25 -10
10 20 30 50 50 015 20 45 65 75 10
20 20 60 80 100 20
25 20 75 95 125 3030 20 90 110 150 40
35 20 105 125 175 50
40 20 120 140 200 60Source: Keat & Young (2006) Break-Even: Total Revenue=Total Cost Production of Quantity beyond
10,000 units will result in Profit. Drops in quantity below 10,000
leads to Loss.
Break-Even Analysis
05/01/2023 27
Application of Break- Even: Restaurant in Indore
Rs
Fixed Cost (per month) 60,000Avg. Price of Soft drinks, sandwich etc 6
Average Variable Cost (per unit) 3.6
How much quantity to sell per month to BREAK-EVEN?
QBEP= (60,000)/(6-3.6)
= 25,000
To make a Target income of Rs 24,000 per month
how much quantity (no. of units) to serve (sell)
Q= (60000+24000)/2.40
= 35000 (units)
05/01/2023 28
Break-Even Analysis Example
• Product Cost (Avg Variable) is Rs 3.60 • Product Price is Rs 6.00 per unit• Total Fixed Costs are
Rs60,000/month.
0
50
100
150
200
0 10 20 30 40
Q(1000's)
Rs(1
000's
)
TFC
TVC Total Variable Cost
TC
Total Cost
TR
Total Revenue
BEP Break-even point at 25,000 products / month
PROFIT
Profit at higher sales volumes grows without bound
05/01/2023 29
Issues in Break-Even Analysis
• Break-Even Point when one or more variables Changes?– Increase in AVC…..Increase in Slope of Total cost
curve……Increase in Break-Even Point– Change in Unit Price of Commodity….Change in
Slope of Total Revenue cure. Price Increase will decrease Break-Even Point.
– Change in Fixed Cost. Increase in FC….. Parallel Shift in Cost Curve….Increase in Break-Even Point
05/01/2023 30
Shutdown Point• Firm Maximizes profit by producing the output where MC=MR as
long as PRICE is GREATER than or EQUAL to AVERAGE VARIABLE COST.
If a firm makes loss in the SHORT RUN then is it rational to STOP Production?
• Loss implies Total Cost > Total Revenue
• In the short run: At least one FIXED factor and other VARIABLE Factors
• The firm has to bear FIXED INPUT COST in the SHORT RUN irrespective of its decision to Produce or not?
Variable Cost depends on level of output Produced
• Again, it is Difficult to EXIT the industry in the short run. WHY?
05/01/2023 31
Decision Issue:• MANAGER has to DECIDE
First: Whether to Produce or SHUT DOWN (Produce zero output and hire none of the variable inputs)
Second: If go for production, Choose the Optimal Level of OUPUT that MINIMIZES LOSS to the firm
05/01/2023 32
The Way Out…
• COMPARE LOSS to be incurred for SHUTTING DOWN production with loss from DECIDING to PRODUCE
CHOOSE The OPTION that MINIMIZES COST
• Case I: If TR> TVC or P > AVC then it can produce. Why?
• Whether a firm produce or not, it has to bear fixed cost.
• By continuing production, if it can cover variable cost (and something left to cover fixed cost) then it justifies decision to produce.
05/01/2023 33
Shut-down….• Firm Maximizes profit where MC=MR as long as Price
(P) is greater than or equal to Average Variable Cost (AVC).
Discontinue Production if PRICE falls Below AVERAGE VARIABLE COST.
If P < AVC; firm will not produce at all.
• This only works for the short-run.
05/01/2023 34
Does Firm wish to Max Profit?• Herbert Simon: ‘Firm with many divisions and with vibrant intra-firm
rivalries (between divisions), would be BETTER OFF if it sets its ASPIRATION levels between Unsatisfactory and Maximum Level of Profit, rather than at the Maximum Level of Profit’
• Non-Profit Organisation do not have objective of Profit Maximization– Ex: Hospitals, Rotary Clubs, Co-operatives…– (Operate with funds received from External Agencies/sources-
Donations).
• Public Sector Organisations owned by Govt. and operate where Pvt. Sector may not be keen to Enter do not aim at PROFIT MAXIMIZATION– Provision of Public Good: Defense, Light House
05/01/2023 35
Summary and Conclusion……
• Major goals of firm: Maximization of profit, sales max., growth maximisation
• Firm’s Short run Profit is maximized when MC=MR and MC cuts MR from below.
• Break-even point: the output level at which firm’s TR is equal to TC, implying zero profit.
• Shut-down point: output level at which Price is equal to Average Variable Cost and losses equal to Total Fixed Cost (irrespective of opting for production or not).
• Based on these criteria Manager has to take appropriate decision.
05/01/2023 36
Market Structure
05/01/2023 37
Market Structure: Imperfect Competition
05/01/2023 38
Factors Influencing Structure of the Market
(A) No of Independent Buyers and Sellers(Large no. of Sellers ……. Total supply controlled by individual firm is less….. Seller cannot influence the price by its own action)
Exp: Perfect Competition (Agricultural Output)
(B) Degree of Seller-ConcentrationPower to influence Market Price depends on Proportion of total output Controlled by Individual firm)
Exp: Electricity Supply-Duopoly (Tata, Reliance)
05/01/2023 39
Factors Influencing Structure of Market
© Product DifferentiationI. Product Identical (homogeneous)-Ex: Toilet soaps (Lux, Cynthol, Mysore sandal soap- Not perfectly substitute)If price increase marginally some buyers will opt for other competing brands
II. Perfectly Substitute (Exp. Potato, eggs etc.)Marginal increase in price of product in one firm- Reduce demand to zero for the Product
05/01/2023 40
(D) Degree of substitutability of product: Power to influence price depends on substitutability of products of competing firms
Depends on Cross Elasticity of Demand
(E) Condition of Entry:Barriers to Entry is high or lowEx: Monopoly- Barriers to Entry High
Free Entry: No of sellers will be large and degree of concentration will be lowEx: Perfect Competition
05/01/2023 41
Different forms of Market: An Overview• Perfect Competition:
A form of Market structure characterized by COMPLETE ABSENCE of RIVALRY among the individual firms.
• Exp: Agriculture (closely approximating), construction industry
Monopoly: (Mono: one, Poly: Seller) Form of Market Organization in which a single firm sells a product for which there are no close substitutes.
It can either set the price and sell the quantity or it can choose the quantity to sell and set the maximum price indicated by the demand curve, not both.
Exp: Production of defense equipment by Government of India, Dominance of Public sector in Electricity, Indian Railways, Indian Post
05/01/2023 42
Oligopoly & Monopolistic Competition
Oligopoly: Few sellers of a homogeneous or differentiated product. Action of each seller will affect other sellers.
Exp: Telecom Sector, Aviation Industry
Monopolistic competition: Market organization in which there are MANY FIRMS selling CLOSELY RELATED but not identical commodities. Entry into and exit from the industry is rather easy in the long run.
Exp: Different Toothpaste available in the market (Close up, Pepsodent etc
05/01/2023 43
Classifications of Different Markets
Types of MarketNumber of Sellers Entry Barriers to
SellersNature of Product
Perfect Competition
Many, small, Independent
None Homogeneous
Monopoly One Insurmountable Homogeneous
Monopolistic Competition
Many, small, virtually
independent
None Differentiated
Oligopoly Few, interdependent
Substantial Homogeneous or differentiated
Source: Madala, G S (2005): Microeconomics, Theory and Applications, Tata McGraw Hill, New Delhi.
05/01/2023 44
Thanks a Lot