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Economics - Theory of the Firm

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Study GuideEconomics–Theory of the Firm1. Production Costs and Firm Profits1.1The Firm’s GoalThe main goal of a firm is tomaximize profit.Profit depends on two things:•Revenue(money earned from selling output)•Costs(money spent to produce output)Because costs reduce profits, understanding different types of costs is very important for decidinghow much output a firm should produce.1.2Explicit and Implicit CostsExplicit costsare the direct, out-of-pocket payments made by a firm.These include:•Wages paid to workers•Payments for raw materials•Fees paid to lawyers, bankers, or consultantsThese costs are easy to see and are recorded in accounting books.1.3Implicit CostsImplicit costsare theopportunity costsof using the firm’s own resources without receiving directpayment.Examples:•If the firm uses itsown building, it gives up rent it could have earned.•If the owner works in the firm without taking a salary, they give up wages they could earnelsewhere.

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Study GuideThese costs:•Donot appear in accounting records•Are still real economic costsImportant idea:Economists always considerboth explicit and implicit costswhen analyzing firm behavior.1.4Accounting Profit, Economic Profit, and Normal ProfitAccounting ProfitAccounting profit =Total revenue − Explicit costsEconomic ProfitEconomic profit =Total revenue − (Explicit costs + Implicit costs)Or simply:Economic profit = Accounting profit − Implicit costsNormal ProfitA firm earnsnormal profitwhen:•Economic profit = 0This doesnotmean the firm earns nothing.It means:•The firm covers all explicit costsand•Fully compensates the owner for all implicit costsNormal profit is theminimum profit needed to keep the firm operating.

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Study Guide1.5Fixed Costs and Variable Costs (Short Run)In theshort run, at least one factor of production is fixed.Fixed Costs (FC)•Fixed costsdo not changewith output•They must be paid even if output is zeroExample:•Cost of machinery or capital1.6Variable Costs (VC)•Variable costschange with output•To produce more, the firm must hire more variable inputsExample:•Wages paid to workers1.7Numerical ExampleAssume:•Capital =1 unit (fixed)•Cost of capital =$100•Wage per worker =$20

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Study GuideThis table shows labor input, output, fixed cost, variable cost, total cost, and marginal cost.1.8Total Cost and Marginal CostTotal Cost (TC)Total cost =Fixed cost + Variable costFrom the table:•Fixed cost stays at$100•Variable cost increases as more workers are hired1.9Marginal Cost (MC)Marginal cost measures:Theextra costof producingadditional outputFormula:Marginal Cost = Change in Total Cost ÷ Change in OutputExample:•Output rises from0 to 5 units

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Study Guide•Total cost rises from$100 to $120•MC = $20 ÷ 5 =$4When output increases from5 to 15 units:•Total cost rises from $120 to $140•MC = $20 ÷ 10 =$21.10Marginal Cost and Marginal ProductMarginal cost is closely related tomarginal product of labor.•When marginal productincreases, output rises quickly•→Marginal cost falls•When marginal productdeclines(law of diminishing returns)•→Marginal cost risesThis explains why:•Marginal cost firstfalls•Thenrisesas output increases1.11Average CostsCosts can also be measuredper unit of output.Types of Average Costs•Average Variable Cost (AVC)= VC ÷ Output•Average Fixed Cost (AFC)= FC ÷ Output•Average Total Cost (ATC)= TC ÷ Output
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Document Details

University
Texas A&M University
Course
Economics
Subject
Accounting

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