Microeconomics

Chapter 6
The theory of the firm I:
Production, costs, revenues
and profit
Higher level topic
This chapter and the next are concerned with the behaviour of firms. Much of firm behaviour depends on the
type of market structure within which the firm operates, which will be studied in Chapter 7. The present chapter
introduces the fundamental concepts necessary to analysing firm behaviour: production, costs, revenues and profit.

6.1 Production in the short run: the • The long run is a time period when all inputs
can be changed. Using the example above, in this
law of diminishing returns time period the firm can build new buildings and
factories and buy more heavy machinery; it can
All firms use inputs (or resources, or factors of change all of its inputs. In the long run the firm has
production) to produce output. The quantities of no fixed inputs; we say all inputs are variable.
inputs needed to produce output is determined by a
technical relationship explaining why firms behave the Note that the short run and the long run do not
way they do. This technical relationship depends on a correspond to any particular length of time. Some
distinction between the short run and the long run. industries may require months to change their fixed
inputs while others may require years.
The short run and the long run
Total product, marginal product and
! Distinguish between the short run and long run in the average product
context of production.
! Define total product, average product and marginal
The difference between the short and long run is the product, and construct diagrams to show their relationship.
following:

• The short run is a time period during which at Understanding and illustrating total,
least one input is fixed and cannot be changed marginal and average product curves
by the firm. For example, if a firm wants to increase In this section, we will study the relationship between
output, it can hire more labour and increase inputs and output in the short run. Since we are
materials, tools and equipment, but it cannot studying the short run, we know the firm has both
quickly change the size of its buildings, factories fixed and variable inputs. For simplicity, let’s consider a
and heavy machinery. As long as these inputs are hypothetical firm that uses only two inputs, land and
fixed, the firm is operating in the short run. labour, where land is the fixed input and labour is the

Chapter 6 The theory of the firm I 139

 (9 − 5) 4
variable input; we can think of this firm as a simple farm. = =4
The only way the farm can increase the quantity of its (3 − 2) 1
output in the short run is by increasing the quantity of the marginal product of the sixth worker is
labour it uses. We can now distinguish between: 3
(21 − 18)
= =3
• Total product (TP) is the total quantity of output (6 − 5) 1
produced by a firm.
To find average product, we take the total product
• Marginal product (MP) is the extra or additional and divide it by the units of labour that produce that
output resulting from one additional unit of the amount of product. For example, the average product
variable input, labour; it tells us by how much of the third worker is
output increases as labour increases by one worker. 9 21
Marginal product is given by: = 3; of the sixth worker it is = 3.5
3 6
∆ TP
MP = The total, marginal and average products of
∆ units of labour
Table 6.1 are drawn in Figure 6.1. Part (a) plots the
• Average product (AP) is the total quantity of output total product data of column 2 of the table, while
per unit of variable input, or labour; this tells us part (b) plots the marginal and average product
how much output each unit of labour (each worker) data of columns 3 and 4. The vertical axis in both
produces on average. Average product is given by: figures measures units of output, and the horizontal
axis measures units of the variable input (labour).
TP
AP = Note that the scale of variable input units on the
units of labour horizontal axis is identical in both parts, so the MP
Table 6.1 shows an example of the total product that and AP curves in part (b) correspond to the TP curve
results as the number of units of labour working in part (a). Both (a) and (b) are divided into three
on the fixed land (the farm) increases. Once we are parts:
given the information in columns 1 and 2, we can
easily calculate marginal and average product. To find • Increasing marginal product. When labour
marginal product, we take an increase in TP and divide units are between 0 and 4, the marginal product
it by the increase in the units of labour. For example, of labour is increasing, as we see in part (b): the
the marginal product of the third worker is addition to total product made by each unit of

(1) (2) (3) (4)

Units of variable input Total product Marginal product Average product
(labour) (units of output) = TP (units of output) = MP (units of output) = AP
∆ TP TP
MP = AP =
∆ units of labour units of labour
0 0 − −
1 2 2 2
2 5 3 2.5
3 9 4 3
4 14 5 3.5
5 18 4 3.6
6 21 3 3.5
7 23 2 3.3
8 24 1 3
9 24 0 2.7
10 23 −1 2.3
11 21 −2 1.9

Table 6.1 Total, marginal and average products

140 Section 1: Microeconomics

 (a) Total product curve based on data of Table 6.1 (c) Total product curve

25
units of output
20

units of output
TP
15
TP
10

0 1 2 3 4 5 6 7 8 9 10 11 0
units of variable input (labour) units of variable input (labour)

units of output
increasing decreasing negative
6 marginal marginal marginal
5 product product product
4
units of output

3
2
1 AP AP
0
-1 1 2 3 4 5 6 7 8 9 10 11 0 MP
-2 units of variable input MP
-3 units of variable input (labour)
(labour)

(b) Marginal and average product curves based on data of Table 6.1 (d) Marginal and average product curves

Figure 6.1 Total, marginal and average products

labour gets bigger and bigger. When 4 workers are the tenth and eleventh workers that we see in
employed, marginal product, equal to five units of part (b).1
output, is maximum.
• Decreasing marginal product. When labour units The relationship between the marginal
are between 4 and 9, the marginal product of labour and average product curves
is decreasing (and positive, or greater than zero), Average product also rises at first and then falls
as we see in part (b). Here, the addition to total (see Figure 6.1(b)). Note the relationship between
product made by successive units of labour becomes the average and marginal product curves: when the
smaller and smaller. marginal product curve lies above the average product
• Negative marginal product. At 8 and 9 units of curve (MP > AP), average product is increasing; and
labour, total product is maximum, as we see in when the marginal product curve lies below the average
part (a), and the ninth unit of labour adds zero product curve (MP < AP), average product is decreasing.
units of output; the marginal product of the ninth This means the marginal product curve always intersects
unit of labour is zero, shown in part (b). Beyond the average product curve when this is at its maximum. The
9 units of labour, total product begins to fall and reason lies in the mathematical relationship between
corresponds to the negative marginal product of the average and marginal values of any variable.

1 The mathematically inclined student will note that the marginal Therefore, with increasing marginal product, MP increases (Figure
product, measuring the change in total product arising from an 6.1(b)) because the slope of the TP curve is increasing (Figure 6.1(a)).
additional unit of labour, is the slope of the total product curve. (The With decreasing marginal product, MP falls because the slope of the TP
slope is here interpreted in the mathematically correct way, referring to curve decreases. When 9 units of labour are employed, the slope of the
the change in the vertical axis divided by the change in the horizontal TP curve is 0 (i.e. the marginal product of the ninth worker is zero) and
axis; see ‘Quantitative techniques’ chapter on the CD-ROM, page 19.) beyond that the MP, or the slope of the TP curve, becomes negative.

Chapter 6 The theory of the firm I 141

Consider a simple example involving test scores. Say With four workers, marginal product is the greatest it
you have an average of 80 in your tests and you would can be; when the fifth worker is added, marginal product
like to increase your average. If your next text score (the begins to fall, and falls continuously thereafter. This
‘marginal’ score) is greater than your average of 80, your is the point at which diminishing returns begin. Why
average will increase. If your next test score is lower does this happen? On the farm, it happens because of
than your average of 80, then your average will fall. overcrowding: each additional worker has less and less
This relationship between average and marginal test land to work with, and so produces less and less output.
scores is exactly the same as the relationship between Eventually, the conditions on the farm become so
average and marginal products. crowded that the ninth worker adds zero extra output;
with the addition of the tenth worker the marginal
Generalised product curves product is negative and total product begins to fall.
Figures 6.1 (c) and (d) show the total, marginal and More generally, marginal product will begin to
average product curves that result in the general fall at some point not just on a farm with a fixed
case when a variable input is added to a fixed input. piece of land, but whenever more and more units of
These curves show the technical relationship between a variable input are added to a fixed input (provided
inputs and output that we need to understand to the technology of production is unchanging).
study firm behaviour in the short run. We turn to this For example, in the case of a factory where more and
relationship next. more workers are hired, each worker will have fewer
and fewer machines and equipment to work with, and
Law of diminishing returns so will add less and less output.
Imagine what would happen if diminishing returns
! Explain the law of diminishing returns. did not exist. Using our farm example, it would be
possible for food production to increase indefinitely
In the short run, the technical relationship between just by continuously adding variable inputs to a fixed
inputs and output is provided by the law of piece of land – a clear impossibility!
diminishing returns.

According to the law of diminishing returns

(also known as the law of diminishing marginal
Real world focus
product), as more and more units of a variable input
(such as labour) are added to one or more fixed
inputs (such as land), the marginal product of the
variable input at first increases, but there comes a
David Ricardo and
point when it begins to decrease. This relationship
presupposes that that the fixed input(s) remain fixed,
the end of agricultural
and that the technology of production is also fixed. output growth
The law of diminishing returns is reflected in the data David Ricardo, a famous English economist of the 19th
of Table 6.1 and the curves of Figure 6.1. When there century, believed that agricultural output would eventually
are zero workers on the land, there is no output at all; stop growing, because as more and more labour and capital
it is equal to zero. When one worker is hired, there inputs were added to land that was fixed in quantity, the
additional output of labour and capital would become
will be some output and so total product is two units.
smaller and smaller until it would no longer be possible for
Marginal product is also equal to two units. But one
total output to increase further.
worker alone on the farm must do all the ploughing,
planting, harvesting, and so on, and so output is quite
low. When a second worker is hired, the two workers
share the work, and total product increases to five units, Applying your skills
indicating that the output produced by the two together 1 Explain the law that describes the process
is more than double the output of the first working Ricardo was referring to.
alone. The additional (or marginal) product due to 2 Do you think Ricardo’s fears were justified?
the second worker (three units) is greater than that of 3 How can you explain the growth of agricultural
the first (two units). This process is repeated with the output in the real world in spite of a fixed
addition of the third and fourth workers, and marginal quantity of land?
product increases with the addition of each one.

142 Section 1: Microeconomics

Calculating total, average and marginal input; and from TP we then calculate marginal
product product as well. If we are given marginal product,
we find total product by adding up the successive
! Calculate total, average and marginal product from a set of
marginal products of each additional unit of labour.
data and/or diagrams.
The example in Table 6.2 shows the calculations made
to find total product from marginal product.
If we are given data on the total product of a firm, it To calculate TP, AP or MP from a diagram, we
is a simple matter to calculate average and marginal simply read off the information appearing in the
product; we simply apply the formulae shown on page graph, and apply exactly the same principles as in
140. If we are given data on average product, we can Table 6.2 to calculate the variable or variables we are
find total product by using TP = AP × units of variable interested in.

Units of labour 1 2 3 4 5
(variable input)

Marginal product (MP) 20 25 20 15 10

Total product (TP) 20 45 65 80 90

(= 25 + 20) (= 20 + 25 + 20) (= 15 + 20 + 25 + 20) (= 10 + 15 + 20 + 25 + 20)

Table 6.2 Calculating total product

(b) Define the law demonstrated by the pattern

Test your understanding 6.1 shown by the marginal product and average
1 Distinguish between the short run and the long product figures and curves.
run in relation to production. (c) Why does this law only hold in the short run?

2 Define (a) total product, (b) marginal product, (d) With how many units of the variable input
and (c) average product. do we see the beginning of diminishing
returns (diminishing marginal product)?
3 Why does marginal product reach a point when
Show this in your diagram.
it begins to decrease?
(e) With how many units of the variable
4 What happens to average product when
input do we see the beginning of negative
MP > AP? When MP < AP?
returns? Show this in your diagram.
5 Copy the following table, then fill in the missing
(f) Explain the relationship between the average
figures to show production in the short run.
product and marginal product curves.
Units of Total product Marginal Average 7 Copy the following table, then fill in the missing
variable product product figures to show production in the short run.
input (labour)
0 0 Units of Total product Marginal Average
variable product product
1 10 input (labour)
2 22
0 –
3 35
1 3
4 46
2 5
5 54
6 59 3 4
7 61 4 3
8 60 5 2
6 Using the information in question 5: 6 0
(a) Plot the total product, marginal product 7 –1
and average product curves. 8 –3

Chapter 6 The theory of the firm I 143

 8 Using the data in question 7, (a) plot the resource, which is an opportunity cost. Therefore
total product, marginal product and average all production costs are opportunity costs, and are
product curves. (b) With how many units of known as economic costs.
the variable input do we see the beginning of
diminishing returns (diminishing marginal In economics, because of the condition of
product)? Show this in your diagram. (c) With scarcity, economic costs, which include all costs of
how many units of the variable input do we see production, are opportunity costs of all resources
the beginning of negative returns? Show this in used in production.
your diagram.
9 Copy the following table, then fill in the
missing figures to show production in the Explicit, implicit costs and
short run. economic costs

Units of Total product Marginal Average ! Distinguish between explicit costs and implicit costs as the
variable product product
two components of economic costs.
input (labour)

0 – We can distinguish between two kinds of economic

costs (opportunity costs), depending on who
1 4.00 owns the resources used by the firm. Resources
are either owned by the firm itself, or are owned
2 5.00
by outsiders to the firm from whom the firm
buys them.
3 4.33

4 3.75 Explicit costs

When the firm uses resources it does not own, it
5 3.20 buys them from outsiders and makes payments
of money to the resource suppliers. For example,
6 2.50 a firm hires labour and pays a wage; it purchases
materials and pays the price to the seller; it uses
electricity and pays the electricity supplier, and
so on.

Payments made by a firm to outsiders to acquire

6.2 Introduction to costs of resources for use in production are explicit costs.
production: economic costs
The opportunity cost of using resources not owned
Costs of production as opportunity costs by the firm is equal to the amount paid to acquire
them; these payments could have been made to
! Explain the meaning of economic costs as the opportunity buy something else instead, which is now being
cost of all resources employed by the firm (including sacrificed.
entrepreneurship).
Implicit costs
When firms use resources to produce, they incur The firm may own some of the resources that it uses
costs of production, which include money for its production, such as, for example, an office
payments to buy resources plus anything else building. In this case, the firm does not make a
given up by a firm for the use of resources. money payment to acquire the resource. There is still
The resources include land, labour, capital and a cost involved in the use of the self-owned resource,
entrepreneurship (see Chapter 1, page 3). Because which is the sacrifice of income that would have been
of scarcity, the use of any resource by a firm earned if the resource had been employed in its best
involves a sacrifice of the best alterative use of that alternative use.

144 Section 1: Microeconomics

 Economic costs (= total opportunity costs)
The sacrificed income arising from the use of self-
£109 000 (implicit costs)
owned resources by a firm is an implicit cost.
+ £ 50 000 (accounting costs)
£159 000
In the case of the office building owned and
used by the firm, the opportunity cost is the
rental income that could have been earned if the Test your understanding 6.2
building were rented out. The hours of work a firm
1 Explain (a) explicit costs, and (b) implicit costs.
owner puts into his or her own business have an
Provide examples of each.
opportunity cost equal to what the firm owner could
have earned if s/he had worked elsewhere. The 2 Why do both explicit costs and implicit costs
entrepreneurial abilities the firm owner puts into the represent opportunity costs to the firm?
business (risk-taking, innovative, organisational and 3 Why are economic costs greater than explicit
managerial abilities) entail a further opportunity costs?
cost equal to what these abilities could have 4 Explain the meaning of economic cost, using the
earned elsewhere. concepts of explicit, implicit and opportunity
costs.
Economic costs
Adding together explicit and implicit costs, we get the
firm’s economic costs. 6.3 Costs of production in the
Economic costs are the sum of explicit and short run
implicit costs, or total opportunity costs incurred by
a firm for its use of resources, whether purchased or Short-run costs
self-owned. When economists refer to ‘costs’ they We can put together the concepts we learned above to
mean ‘economic costs’. study costs of production in the short run.

Suppose you had a job with a salary of £60 000 a year, Fixed, variable and total costs in the
which you decided to quit to open your own business. short run and long run
You estimate that your entrepreneurial talent you are
putting into your business is worth £45 000 a year. ! Explain the distinction between the short run and
You set up your office in a spare room of your house the long run, with reference to fixed costs and variable
that you used to rent out for £4000 a year. Further, costs.
you borrow £30 000, for which you are paying interest
of £2000 a year, and use the borrowed amount to The distinction between fixed inputs and variable
buy supplies and materials. You also hire an assistant inputs discussed on page 139 in connection with the
whom you pay £18 000 a year. Your explicit, implicit short and long run leads us to a distinction between
and economic costs are: fixed and variable costs:

Implicit costs • Fixed costs arise from the use of fixed inputs.
£60 000 (opportunity cost of your foregone Fixed costs are costs that do not change as output
salary) changes. Examples of fixed costs include rental
+£45 000 (opportunity cost of your payments, property taxes, insurance premiums
entrepreneurial talent) and interest on loans. They do not increase if the
+£ 4 000 (opportunity cost of foregone rental firm produces more output, and do not decrease if
income from your spare room) it produces less. Even if there is zero output, these
£109 000 payments still have to be made in the short run.
Fixed costs arise only in the short run, as in the long
Explicit costs run there are no fixed inputs.
£ 2 000 (interest on your loan) • Variable costs arise from the use of variable inputs.
+£30 000 (purchase of supplies and materials) These are costs that vary (change) as output
+ £18 000 (assistant’s salary) increases or decreases, therefore they are ‘variable’.
£50 000 An example is the wage cost of labour. To produce
more output, the firm hires more labour, and has

Chapter 6 The theory of the firm I 145

 increased wage costs. The more variable inputs a are equivalent is that fixed costs are constant (do not
firm uses, the greater the variable costs. change) as output increases or decreases. Marginal cost
• Total costs are the sum of fixed and variable is given by:
costs. ∆ TC ∆ TVC
MC = =
In the short run, a firm’s total costs are the sum of ∆Q ∆Q
fixed and variable costs. In the long run there are no where the Greek letter ∆ stands for ‘change in’.
fixed costs, therefore a firm’s total costs are equal to
its variable costs.
Test your understanding 6.3
Total, average and marginal costs
1 Define (a) fixed costs, (b) variable costs, and (c)
total costs, and explain how they are related to
! Distinguish between total costs, marginal costs and average the distinction between the short run and the
costs. long run.
2 Which of the following are fixed and which are
Average costs variable costs:
Average costs are costs per unit of output, or total (a) insurance premiums on the value of the
cost divided by the number of units of output. They property owned by a business
tell us how much each unit of output produced costs (b) interest payments on a loan taken out by a
on average. From our definitions above, we have three business
total costs, each one corresponding to an average cost:
(c) wage payments to the workers that are
hired by a business
Total costs Average costs
total fixed costs average fixed costs (d) payments for the purchase of seeds and
(TFC) (AFC) fertiliser by a farmer.
total variable costs average variable costs 3 (a) Define the three kinds of average costs,
(TVC) (AVC) and explain how they are derived from the
total costs average total costs three kinds of total cost. (b) How are the
(TC) (ATC) three kinds of average costs related to each
other?
To calculate average costs, we simply divide each of 4 Define marginal cost, and explain how it is
the totals by the units of output (Q) that the firm related to total cost and total variable cost.
produces:
TFC TVC TC
AFC =
Q
AVC =
Q
ATC =
Q
Costs curves and product curves
It was noted above that total cost is the sum of fixed ! Draw diagrams illustrating the relationship between
costs plus variable costs: marginal costs and average costs, and explain the
connection with production in the short run.
TC = TFC + TVC

Similarly, average total costs are the sum of average Drawing the short-run cost curves
fixed costs plus average variable costs: In this section, we will draw diagrams of a firm’s total,
ATC = AFC + AVC average and marginal costs. Let’s continue with our
example of the data in Table 6.1 (page 140), and assume
Marginal costs that the farm incurs fixed costs of €200 per week (for
Marginal cost (MC) is the extra or additional cost of rent for the land), and that the cost of labour is €100
producing one more unit of output. It tells us by how per worker (per unit of labour) per week. We now have
much total costs increase if there is an increase in all the information we need to calculate the firm’s
output by one unit. It is calculated by considering the short-run production costs, which appear in Table 6.3:
change in total cost (TC) resulting from a change in
output. In addition, it can be calculated by considering • Columns 1 and 2 contain the same data on total
the change in total variable cost (TVC) that results product and corresponding labour input that appear
from a change in output. The reason why the two in Table 6.1.

146 Section 1: Microeconomics

 (1) (2) (3) (4) (5) (6) (7) (8) (9)
Total Labour Total fixed Total Total cost Average Average Average Marginal
product (units of cost variable = TC fixed cost variable total cost cost
= TP or Q labour) = TFC cost TC = = AFC cost = ATC = MC
(units) (€) = TVC TFC + TVC = AVC TC
AFC = TFC ATC = MC =
∆ TC
(€) (€) Q Q ∆Q
TVC
(€) AVC = or ATC =
Q ∆ TVC
(€) AFC + AVC MC =
(€) ∆Q
(€)
0 0 200 0 200 − − −
2 1 200 100 300 100 50 150 50
5 2 200 200 400 40 40 80 33.3
9 3 200 300 500 22.2 33.3 55.5 25
14 4 200 400 600 14.3 28.6 42.9 20
18 5 200 500 700 11.1 27.8 38.9 25
21 6 200 600 800 9.5 28.6 38.1 33.3
23 7 200 700 900 8.7 30.4 39.1 50
24 8 200 800 1000 8.3 33.3 41.6 100

Table 6.3 Total, average and marginal costs

• Column 3 shows the farm’s total fixed cost (TFC) of ∆TVC = ∆TC. (You can confirm this by comparing
€200; this payment has to be made even when total the figures in column 4 with those in column 5.)
product is zero.
• Column 4 shows the farm’s total variable cost, All the cost information of Table 6.3 is shown
which is the number of workers (from column 2) graphically in Figure 6.2 (a) and (b). (Parts (c) and
times €100 per worker. (d) show cost curves in the general case for a firm
in the short run.) Both parts (a) and (b) measure costs on
• Column 5 calculates total cost, which is the sum of
the vertical axis, and units of output on the horizontal
total fixed cost (column 3) plus total variable cost
axis. Part (a) illustrates the three total cost curves (TFC,
(column 4).
TVC, TC), and part (b) the three average cost curves
• Column 6 shows average fixed cost, obtained by (AFC, AVC, ATC) and the marginal cost (MC) curve.
dividing total fixed cost (column 3) by the number
of units of output (column 1). In part (a):
• Column 7 calculates average variable cost, obtained
by dividing total variable cost (column 4) by the • The TFC curve is parallel to the horizontal axis, as
number of units of output (column 1). it represents a fixed amount of costs that do not
change as output changes.
• Column 8 shows average total cost, obtained by
dividing total cost (column 5) by the number of • The TVC curve shows that TVC increases as output
units of output (column 1): alternatively, average increases. However, it does not increase at a constant
total cost is the sum of AFC plus AVC. rate; this is due to the law of diminishing marginal returns.
• Column 9 shows marginal cost, obtained by • The TC curve is the vertical sum of TFC and TVC,
dividing the change in total cost (from column 5) by and so the vertical difference between TC and TVC
the change in the number of units of output (from is equal to TFC.
column 1); for example, when total cost increases
from €200 to €300, so that ∆TC = 100, TP increases In part (b):
from 0 to 2 units of output, so that ∆Q = 2. Dividing • The AFC curve indicates that AFC falls continuously
100 by 2, we obtain MC = 50. Marginal cost can also as output increases, because it represents the
be calculated as the change in total variable cost amount of fixed costs (TFC) divided by an ever
divided by the change in total product, because growing quantity of output.

Chapter 6 The theory of the firm I 147

 (a) Total cost, total variable cost and total fixed cost curves (c) Total cost, total variable cost and total
based on the data of Table 6.3 fixed cost curves

1200
TC TC
1000
TVC TVC
800

costs
costs

600

400

200 TFC TFC

0 2 4 6 8 10 12 14 16 18 20 22 24 0 output, Q
output, Q

160
150 MC
140
130
120 MC
110 ATC
100
90 costs
costs

80 AVC
70
60 ATC
50
40 AVC
30
20
10 AFC AFC
0 2 4 6 8 10 12 14 16 18 20 22 24 0 output, Q
output, Q
(b) Average cost and marginal cost curves based on the data (d) Average cost and marginal cost curves
of Table 6.3

Figure 6.2 Total, average and marginal cost curves

• The three remaining curves, AVC, ATC and MC, test scores, which applies equally well here). When
though they are different from each other, all follow marginal cost is below average variable cost (MC <
the same general pattern: at first they fall, they AVC), average variable cost is falling; when marginal
reach a minimum, and then they begin to rise.2 cost is above average variable cost (MC > AVC), then
average variable cost is rising. The same applies to
• The ATC curve is the vertical sum of AFC and AVC,
the relationship between marginal cost and average
and so the vertical difference between the ATC and
total cost: when MC < ATC, ATC is falling, and when
the AVC curves at any level of output is equal to AFC.
MC > ATC, ATC is rising.
• The MC curve intersects both the AVC and ATC curves
at their minimum points. The reason is the same
The U-shapes of the AVC, ATC and MC curves are due
as in the case of marginal and average products,
to the law of diminishing returns. We will discover
discussed on page 141 above (recall the example of
why in the next section.
2The mathematically inclined student may note that marginal cost (MC ) (page 141), the slope is interpreted in the mathematically correct way; see
represents the slope of the total cost (TC ) curve. (Again, as with MP and TP footnote 1.)

148 Section 1: Microeconomics

Relating the cost and product curves: the Decreasing marginal product, on the other hand, means
law of diminishing returns that the additional output of each unit of labour is
falling, and so the additional cost of each extra unit of
! Explain the relationship between the product curves output (marginal cost) must be increasing. In Table 6.1
(average product and marginal product) and the cost curves we saw that maximum marginal product occurs when
(average variable cost and marginal cost), with reference to four units of labour are hired; this is also when marginal
the law of diminishing returns. cost is minimum (see Table 6.3). In other words, when
the additional output produced by an extra worker is the
The law of diminishing marginal returns is very most it can be, then the extra labour cost of producing an
important in determining the shape of the cost curves. additional unit of output is the least it can be.
Figure 6.3 shows that the product curves (MP and The explanation for the shape of the average variable
AP) are mirror images of the cost curves (MC and cost curve can also be found in the law of diminishing
AVC). The MC curve mirrors the MP curve, and the returns. When average product is increasing, this means
AVC curve mirrors the AP curve. (Note the labelling that each additional unit of output can be produced
of the axes of the product and cost curves, which are with fewer and fewer units of labour; therefore, the
different from each other.) How can we explain this labour cost of each unit of output (average variable cost)
interesting pattern? falls. But when average product is falling, additional
Remember that at low levels of output, the units of output require more and more units of labour,
marginal product of labour increases, meaning and so the labour cost of each unit of output, or average
that the extra output produced by each additional unit variable cost, begins to increase.3 Note from Table 6.1
of labour rises. When this happens, the additional cost that when five units of labour are hired, average product
of one more unit of output, or marginal cost, falls. is maximum; this is the point of production where
average variable cost is minimum (see Table 6.3). This
happens because when workers on average produce the
most they can produce, the labour cost of producing
units of output (AP, MP)

each unit of output is the lowest it can be.

The U-shape of the AVC, ATC and MC curves is due

to the law of diminishing returns. This law also
explains why the AVC and MC curves are mirror
AP images of the AP and MP curves.

MP
0 Shifts in the cost curves (supplementary
units of variable input (labour)
material)
The cost curves shift in response to two factors:
changes in resource prices, or changes in technology.
If resource prices increase, an increase in costs of
MC
costs (AVC, MC)

production results. Which particular curves are affected

depends on whether the price increases involve fixed
AVC or variable costs. If there is an increase in a fixed cost
of production, this affects TFC and TC, as well as AFC
and ATC, all of which shift upward. Variable costs and
marginal cost remain unaffected. This is shown in
Figure 6.4(a), where we see AFC and ATC curves shifting
upward to the dotted lines, while AVC and MC remain
0
output, Q unchanged. If, on the other hand, there is an increase
in variable costs (say, because of an increase in wages),
Figure 6.3 Product curves and cost curves are mirror images due to the TVC and TC, as well as AVC, ATC and MC, will increase.
law of diminishing returns This can be seen in Figure 6.4(b), where AVC, ATC and

3 Another which is average variable cost. When the units of labour are few, AVC is
way to see this numerically is to consider the average product
figures in Table 6.1. We know that each unit of labour costs €100, i.e. €100 = high; as the labour units increase AVC falls, and after reaching a minimum,
cost per unit of labour. If we divide 100 by average product, we have: AVC begins to rise, thus resulting in the U-shaped curve.
cost per unit of labour
= variable cost per unit of output,
output per unit of labour

Chapter 6 The theory of the firm I 149

 (a) Increase in FC (b) Increase in VC
ATC1 MC1
ATC ATC1
MC MC
ATC
cost

cost
AVC1
AVC AVC

AFC1
AFC AFC
0 0
output output

Figure 6.4 Shifts in the cost curves

MC have shifted upward to the dotted lines. If resource

prices fall, leading to decreases in costs of production, 2 Using the data of question 1, (a) plot TFC,
the corresponding curves shift downward. TVC and TC, and (b) in a different diagram
Changes in technology also impact upon costs of plot AFC, AVC, ATC and MC.
production because they increase the amount of output
3 Why does the average fixed cost curve decline
that can be produced by a given level of inputs. An
continuously throughout its range?
improved technology would therefore shift the product
curves of Figure 6.1 (TP, AP and MP) upwards, and this 4 What accounts for the U-shape of the average
would correspond to a downward shift in the cost curves. variable cost curve and the average total cost
curve?
Calculating costs 5 In your diagram for question 2(a), explain
what is represented by (a) the vertical distance
! Calculate total fixed costs, total variable costs, total costs, between the TC and TFC curves, and (b) the
average fixed costs, average variable costs, average total vertical distance between the TC and TVC
costs and marginal costs from a set of data and/or diagrams. curves.

To calculate costs, it is only necessary to remember 6 In your diagram for question 2(b), explain
and understand the relationships between the various what is represented by (a) the vertical
cost concepts we have studied above: TC = TFC + TVC; distance between ATC and AFC, and
dividing through by Q we obtain average costs, where (b) the vertical distance between ATC
ATC = AFC + AVC. Finally, marginal cost is ∆TC/∆Q, and AVC.
or ∆TVC/∆Q. You will have several opportunities to 7 How does the law of diminishing marginal
calculate costs both in this chapter and the next. product affect the shape of the marginal cost
To calculate costs from a diagram, we simply curve?
read off the information appearing in the
8 Why does marginal cost intersect both average
graph, and apply the same principles as above
variable cost and average total cost at their
to calculate the cost variable or variables we are
minimum points?
interested in.
9 Draw two diagrams showing the relationships
between the AP and MP curves, and the AVC
Test your understanding 6.4 and MC curves. How are the product curves
related to the cost curves? What accounts for
1 For question 5 of Test your understanding 6.1,
this relationship?
suppose that the price of labour is $2000 a
month per worker and fixed costs are $1500 10 (Optional) Using diagrams, show how (a) a
a month. Calculate TFC, TVC, TC, AFC, AVC, fall in insurance premiums, and (b) a fall in
ATC and MC up to the point of maximum wage rates would affect the positions of the
total product (61 units of output). AFC, AVC, ATC and MC curves of a firm.

150 Section 1: Microeconomics

6.4 Production and costs in the It seems logical to think that if a firm doubles

long run all its inputs, then output should also double;
there should be constant returns to scale. Why
does it happen that output can sometimes increase
Production in the long run: returns to scale more than or less than in proportion to the
increase in inputs? We will discover the answer
! Distinguish between increasing returns to scale, decreasing when we consider costs of production in the long
returns to scale and constant returns to scale. run below. For now, it is important that you do
not confuse decreasing returns to scale, discussed
Let’s examine the long-run relationship between here, with diminishing returns (page 142).
inputs and output. An important point to bear in Diminishing returns occur only in the short
mind is that in the long run, there are no fixed inputs. run, because they show what happens to output as
All inputs are variable. We are interested in seeing a variable input is added to a fixed input. Decreasing
what happens to output when the firm changes all of returns to scale can occur only in the long run,
its inputs. There are three possibilities, explained using showing what happens to output when all inputs are
the example in Table 6.4: variable.

Constant returns to scale Costs of production in the long run

Suppose a firm doubles all of its inputs. In Table 6.4,
both land and labour double in quantity. With constant Long-run average total cost curve in
returns to scale, output also doubles. Constant relation to short-run average total cost
returns to scale means that output increases in the same curves
proportion as all inputs: given a percentage change in all
inputs, output increases by the same percentage. ! Outline the relationship between short-run average costs
and long-run average costs.
Increasing returns to scale
If a firm doubles all inputs and there are increasing Remember that in the long run there are no fixed
returns to scale, output more than doubles. In the inputs and therefore no fixed costs; all inputs are
example, as land and labour double in quantity, the variable. When a firm varies inputs that were fixed in
quantity of output increases from 100 to 250 units, the short run, it changes its size or scale.
which is more than double. Increasing returns to It is convenient to think of the long run as the
scale means that output increases more than in proportion firm’s planning horizon. If a firm wants to expand
to the increase in all inputs: given a percentage increase in production, it must think in terms of increasing its
all inputs, output increases by a larger percentage. fixed inputs, otherwise its production will run into
diminishing returns. As the firm plans its future
Decreasing returns to scale activities in the long run, it can select any size or
If a firm doubles all its inputs and there are decreasing scale of operation depending on the quantity of
returns to scale, there results a less than double output it is aiming for. The particular size it selects
increase in output. In the example, land and labour will be the one that minimises costs for that level of
have doubled in quantity, but output has increased output.
only from 100 to 150 units. Decreasing returns to Let’s consider our farmer who produces with two
scale means that output increases less than in proportion inputs, land and labour. The farmer wants to expand
to the increase in all inputs: given a percentage increase in production and considers the long-run options.
all inputs, output increases by a smaller percentage. Suppose, too, that there are only four possible

Land (1st input) Labour (2nd input) Output with constant Output with increasing Output with decreasing
returns to scale returns to scale returns to scale

1 acre 5 workers 100 units of output 100 units of output 100 units of output
2 acres 10 workers 200 units of output 250 units of output 150 units of output

Table 6.4 Constant, increasing and decreasing returns to scale

Chapter 6 The theory of the firm I 151

farm sizes. Each one is represented by a different Initially, the farmer produces output Q1 on SRATC1,
short-run average total cost curve (SRATC), shown in but then decides to increase production. Which SRATC
Figure 6.5(a). should the farmer select? The answer depends on how
much output the farmer wants to produce, and which
(a) Four short-run ATC curves SRATC will minimise cost for that level of output. In
the short run, it is possible to increase output to Q2,
without changing farm size, by remaining on SRATC1.
Yet a larger farm size, corresponding to SRATC2, can
SRATC4
SRATC1 produce output Q2 at a lower average cost. In the short
a SRATC2 SRATC3 run, it is possible to produce at the lowest possible cost
costs

b c on SRATC1 only up to point a; beyond this the farmer

LRATC should consider increasing farm size (going into the
long run) and moving onto SRATC2. Once the farmer is
on SRATC2, output can increase at the lowest possible
cost until point b is reached, where the farmer once
0 Q1 Q2 Q3 again should consider increasing farm size (going into
output, Q the long run again) and switching to SRATC3. We can
see then that points like a, b and c represent output
levels at which the farmer should increase the farm
(b) Long-run average total cost curve in relation to
size in order to continue to minimise average costs as
short-run average total cost curves
output increases. It follows that the farmer’s planning
horizon is made up of the bold-face portions of the short-
a LRATC run average cost curves in Figure 6.5(a), connecting all
b SRATC1
SRATC2
possible points of intersection between SRATC curves.
SRATCm In practice, it is likely that there will not only be
costs

four possible firm sizes as in our example, but many

more, shown in Figure 6.5(b). In this case, the long-
run average total curve is the curve that just touches
(i.e. is tangent to) each of the short-run cost curves.
Long run average total costs represent the lowest
0 Q1 Q2 possible average cost, or cost per unit of output, for
output, Q every level of output, when all resources are variable.
When the firm plans its activities over the long run, it
can choose where on the long-run curve it wishes to
(c) Economies and diseconomies of scale be; it will then end up on the SRATC curve at the point
where this just touches the long-run curve (i.e. the
point of tangency between the two).4
economies diseconomies
of scale of scale
LRATC
costs

The long-run average total cost curve

(LRATC) is defined as a curve that shows the lowest
possible average cost that can be attained by a firm
for any level of output when all of the firm’s inputs
0 are variable. It is a curve that just touches (is tangent
output, Q to) each of many short-run average total cost curves.
It is also known as a planning curve.
Figure 6.5 The long-run average total cost curve

4 in the long run. When the long-run curve is downward sloping, there will
While a decision to produce a particular level of output in the long run
involves selection of the firm scale that minimises costs for that level of always be a larger firm size that can achieve lower average costs than the
output, the firm will not necessarily be operating at the lowest possible short-run minimum (i.e. SRATC2 achieves lower average costs than point b
cost on the SRATC curve of its choice. In Figure 4.5(b), say a firm wants to on SRATC1); and when the long-run curve is upward sloping, there will
produce output Q1; it will then choose to be on SRATC1 at point a, which always be a smaller firm size that can achieve lower average costs than
is the point where SRATC1 just touches the long-run curve, corresponding the short-run minimum. There is only one SRATC curve whose minimum
to output level Q1. But the point of minimum average cost on SRATC1 is coincides with the long-run minimum, and that is SRATCm, shown in bold
point b, representing output Q2, not point a. Therefore, minimum average in Figure 6.5(b).
cost in the short run is not necessarily the same as minimum average cost

152 Section 1: Microeconomics

 • Efficiency of capital equipment. Large
The shape of the LRATC curve: economies machines are sometimes more efficient than
and diseconomies of scale smaller ones; for example, a large power generator
is more efficient than a small one (it can produce
! Explain, using a diagram, the reason for the shape of the more output per unit of inputs). However, a small
long-run average total cost curve. firm with a small volume of output cannot make
effective use of large machines, and so is forced to
As we can see in Figure 6.5 (b) and (c), the long-run use smaller, less efficient ones.
average total cost curve (LRATC) has a U-shape.
• Indivisibilities of capital equipment. Some
The reasons for the U-shape of the long-run average
machines are only available in large sizes that
total cost (LRATC) curve have nothing whatever to
require large volumes of output in order to be used
do with diminishing returns, which are a feature
effectively. They cannot be divided up into smaller
only of short-run production and costs. The U-shape
pieces of equipment.
of the LRATC curve can be found in economies and
diseconomies of scale, in turn related to increasing and • Indivisibilities of efficient processes. Some
decreasing returns to scale. production processes, such as mass production
assembly lines, require large volumes of output in
Economies of scale order to be used efficiently. Even if all inputs are used
in proportionately smaller quantities, it may not be
! Describe factors giving rise to economies of scale, possible to achieve the same degree of efficiency.
including specialisation, efficiency, marketing and • Spreading of certain costs, such as
indivisibilities. marketing, over larger volumes of output.
Costs of certain activities such as marketing and
Economies of scale are decreases in the average advertising, design, research and development result
costs of production over the long run as a firm in lower average costs if they can be spread over
increases all its inputs. Economies of scale explain large volumes of output.
the downward-sloping portion of the LRATC curve:
as output increases, and a firm increases all inputs, Diseconomies of scale
average cost, or cost per unit of output, falls.
Falling average costs as output increases mean the ! Describe factors giving rise to diseconomies of scale,
firm is experiencing increasing returns to scale (page including problems of co-ordination and communication.
151). To see this, consider that if input prices are
constant and inputs double, this means that costs Diseconomies of scale are increases in the average
also double (since costs of inputs = price of inputs x costs of production as a firm increases its output by
quantity of inputs), but when there are increasing increasing all its inputs. Diseconomies of scale are
returns to scale, as inputs double, output will more responsible for the upward-sloping part of the LRATC
than double. This means that costs per unit of output curve: as a firm increases its scale of production, costs
(or average costs) must be falling.5 per unit of output increase.
There are several reasons why this can occur: Increasing average costs as output increases mean
that the firm is experiencing decreasing returns to scale
• Specialisation of labour. As the scale of
(page 151). If input prices are constant, and inputs
production increases, more workers must
double, costs also double (again, costs of inputs = price of
be employed, allowing for greater labour
inputs x quantity of inputs), but when inputs double, the
specialisation. Each worker specialises in
increase in output will be less than double when there
performing tasks that make use of skills, interests
are decreasing returns to scale. This means that costs per
and talents, thus increasing efficiency and allowing
unit of output (or average costs) must be increasing.
output to be produced at a lower average cost.
Reasons for diseconomies of scale can include the
• Specialisation of management. Larger scales of following:
production allow for more managers to be employed,
each of whom can be specialised in a particular area • Co-ordination and monitoring difficulties.
(such as production, sales, finance, and so on), again As a firm grows larger and larger, there may come a
resulting in greater efficiency and lower average cost. point where its management runs into difficulties

5It may be noted that economies of scale actually have a broader meaning input proportions are fixed, whereas in economies of scale it is possible to
than increasing returns to scale. The reason is that in returns to scale, have varying input proportions.

Chapter 6 The theory of the firm I 153

 of co-ordination, organisation, co-operation downward-sloping and the upward-sloping portions.
and monitoring. The result involves growing Constant returns to scale involve constant long-run
inefficiencies causing average costs to increase as average costs over a certain range of output. In this
the firm expands. range, as output increases (with all inputs increasing),
• Communication difficulties. A larger firm size average costs do not change, i.e. the firm does not
may lead to difficulties in communication between encounter economies or diseconomies of scale.
various component parts of the firm, again resulting Firms are generally eager to take advantage of
in inefficiencies and higher average costs. economies of scale, and try to avoid diseconomies of
scale. Empirical studies agree that firms can achieve
• Poor worker motivation. If workers begin to
substantial economies of scale by increasing their
lose their motivation, to feel bored and to care little
size, but there is some debate over whether firms
about their work, they become less efficient, with the
experience diseconomies. Some studies suggest that after
result that costs per unit of output start to increase.
exhausting economies of scale, many firms exhibit constant
Constant returns to scale returns to scale, and do not run into diseconomies of scale
Constant returns to scale may appear in some long- even as size becomes very large.
run average total cost curves as in Figure 6.6(a), where
there is a horizontal segment of the curve between the
Real world focus
(a) Varying firm sizes

Economies of scale in the

average total cost

economies diseconomies
of scale of scale

constant returns
to scale
LRATC tourism industry
Travelplanet.pl and Invia are two Polish online tourism
companies that are planning to merge. A merger takes
place when two (or more) companies join together and
form a single company. The aim of the merger is to
0 Qmes Q1 Q2 Q3 Q4 obtain economies of scale through their co-operative
output, Q interactions. The merger will result in the biggest online
tourism company in Central Eastern Europe.
(b) Few large firms
Source: Adapted from ‘Travelplanet.pl closer to merging with
average total cost

Invia’ in Polish News Bulletin, 1 April 2010.

LRATC
Applying your skills
1 Using a diagram, show how a merger of two
0 Q1 Qmes companies can result in economies of scale.
output, Q
2 Explain the possible sources of economies of
scale arising from the merger.
(c) Natural monopoly
average total cost

The minimum efficient scale and the

structure of industries (supplementary
LRATC material)
There is a point on the long-run average total cost
0 Qmes curve that represents the lowest level of output at
output, Q which the lowest long-run total average costs are
achieved, called the minimum efficient scale (MES). In
Figure 6.6 this is represented by Qmes. The minimum
Figure 6.6 Minimum efficient scale and the structure of industries efficient scale is the level of output at which

154 Section 1: Microeconomics

economies of scale are exhausted; beyond that
Test your understanding 6.5
level of output average costs will either be constant or
they will begin to increase. When there are constant 1 Using a numerical example, distinguish between
returns to scale, the minimum efficient scale can be increasing, constant and decreasing returns to
achieved by firms of varying sizes, producing any scale.
output ranging from Qmes to Q4 in Figure 6.6(a).
2 (a) Define the long-run average total cost
The importance of the concept of minimum
(LRATC) curve. (b) Why do you think this curve
efficient scale lies in the information it can reveal
is also referred to as a ‘planning curve’? (c) How
about the structure of industries, such as whether it
is the LRATC curve related to short-run average
is likely that an industry will consist of many firms,
cost curves?
some of which are smaller and some larger, as opposed
to a small number of large firms, or at the extreme a 3 Describe some factors that can cause (a)
single very large firm providing for the entire market. economies of scale, and (b) diseconomies of scale.
Each of these possibilities is illustrated in Figure 6.6. 4 (a) Using a diagram, show the relationship
The LRATC curve in Figure 6.6(a) indicates that between economies and diseconomies of scale
the firm reaches the minimum efficient scale at a low and the shape of the LRATC. (b) What do
level of output, shown as Qmes, and then begins to constant returns to scale signify?
experience constant returns to scale. If this level of 5 What is the relationship between (a) increasing
output, Qmes, is a small fraction of the total market, returns to scale and economies of scale, and
then there are likely to be many firms of varying (b) decreasing returns to scale and diseconomies
sizes in the industry; examples include clothing and of scale?
shoe manufacturing, other light manufacturing such
6 If, as many economists suggest, a firm is unlikely
as furniture and wood products, food processing,
to run into diseconomies of scale after achieving
retailing and banking. These tend to be industries
all possible economies of scale, what would its
that fall under the market structure of monopolistic
long-run average total cost curve look like?
competition (see Chapter 7, page 195).
Figure 6.6(b) shows the LRATC curve of a firm that 7 (Optional) Explain the concept of minimum
experiences economies of scale over a very large range efficient scale.
of output. It is only at the very large level of output
of Qmes that the minimum efficient scale is achieved,
at which point the firm runs into either diseconomies
of scale or constant returns to scale (shown by the 6.5 Revenues
dotted lines). Here, Qmes represents a large fraction of
the market. This means that there can only be a small Total revenue, marginal revenue and
number of large firms in this industry. If smaller firms average revenue
tried to enter this industry, they would have difficulty
competing with the larger firms because of their higher Distinguishing between total, marginal
average costs. (Compare the average total costs of a firm and average revenue
producing output Q1 with the average costs of a firm
producing at Qmes.) Examples of such industries include ! Distinguish between total revenue, average revenue and
car and refrigerator manufacturers, heavy industries marginal revenue.
such as aluminium and steel, and pharmaceutical ! Illustrate, using diagrams, the relationship between total
industries. These tend to be industries that fall under the revenue, average revenue and marginal revenue.
market structure of oligopoly (see Chapter 7, page 201).
In Figure 6.6(c), the minimum efficient scale occurs at Revenues are the payments firms receive when they
a level of output, Qmes, so large that if the firm expands sell the goods and services they produce over a given
to that point where it exhausts all economies of scale, it time period. We make a distinction between three
will be supplying the entire market. Such a firm is called fundamental revenue concepts: total, marginal and
a natural monopoly (see Chapter 7, page 187). average revenue.
(It may be noted that the U-shaped long-run average The firm’s total revenue (TR) is obtained by
total cost curve does not cover firms under perfect multiplying the price at which a good is sold (P) by
competition (see page 168). This is because firms under the number of units of the good sold (Q):
perfect competition do not experience economies and
diseconomies of scale, as we will see in Chapter 7.) TR = P × Q

Chapter 6 The theory of the firm I 155

The firm’s marginal revenue (MR) is the additional
(1) (2) (3) (4) (5)
revenue arising from the sale of an additional unit of Units of Product Total Marginal Average
output:6 output price revenue revenue revenue
∆ TR (Q) (P) TR = P × Q ∆ TR TR
MR = MR = MR =
∆Q (€) (€) ∆Q Q
(€) (€)
The firm’s average revenue (AR) is revenue per unit 0 10 - - -
of output sold: 1 10 10 10 10
2 10 20 10 10
TR
AR = 3 10 30 10 10
Q
4 10 40 10 10
Note that AR is always equal to P, or the price of the 5 10 50 10 10
TR 6 10 60 10 10
product. The reason is that since AR = , it follows 7 10 70 10 10
Q
that TR = AR × Q, but since TR = P × Q, this means that
Table 6.5 Calculating total, marginal and average revenue when price is
AR = P. constant (the firm has no control over price)
Whereas the definitions of revenues given above
apply to all firms, the analysis of revenues is not the
same for all firms, because this depends on whether or (a) Total revenue
not the firm has any control over the price at which
it sells its product. In Chapter 2, page 20, it was noted
that firms under highly competitive conditions have TR
no ability to influence price. Firms operating under TR
less competitive conditions do have varying degrees 70
of control over price, depending on their degree 60
of market power (see page 20 for a review of these 50
concepts). We will study these differences under the 40
topics of market structures in Chapter 7. For now, we 30
will make a distinction between situations where: 20
10
• the firm has no control over price, and price is
constant as output varies 0 1 2 3 4 5 6 7 Q
• the firm has some degree of control over price, and
price varies with output.
(b) Marginal and average revenue
Revenue curves where the firm has no P, MR, AR
control over price
Table 6.5 shows how we calculate total, marginal 40
and average revenue from information on the price
and quantity of the good in situations where a firm 30
has no control over price. Columns 3, 4 and 5 are
calculated from the information in columns 1 and 2, 20
using the definitions of total, marginal and average
revenue given above. Note that the price at which the 10
good is sold does not change; this occurs only under P = MR = AR
perfect competition, where the firm has no control
over the price at which it sells its product. Figure 6.7 0 1 2 3 4 5 6 7 Q
plots the data of Table 6.5. We will examine these
revenue curves, their meaning and implications in Figure 6.7 Total, marginal and average revenue curves when price is
detail in Chapter 7, page 169. constant (the firm has no control over price)
6
The mathematically inclined student will note that MR is the slope of the
TR curve (where slope is interpreted in the mathematically correct way; see
footnotes 1 and 2).

156 Section 1: Microeconomics

 (1) (2) (3) (4) (5)
Units of Product Total Marginal Average
Revenue curves where the firm has some
output price revenue revenue revenue control over price
(Q) (P) (TR = Q × P) ∆ TR TR Table 6.6 shows how we calculate total, marginal
(€) (€) MR = AR = and revenue from price and quantity information in
∆Q Q
(€) (€) the case where the firm has some control over price.
0 − − − − The method of calculation is exactly the same as
in the competitive case above, where columns 3–5
1 12 12 12 12
are calculated using the information of the first two
2 11 22 10 11 columns. The difference is in the price data, appearing
3 10 30 8 10 in column 2, showing that the price at which the good
4 9 36 6 9 is sold changes as the quantity of output changes. This
occurs under all market models that we will study in
5 8 40 4 8
Chapter 7 other than perfect competition. Figure 6.8
6 7 42 2 7 plots the data of Table 6.6. These revenue curves, their
7 6 42 0 6 meaning and implications will be examined in detail
8 5 40 −2 5 in Chapter 7, page 184.
9 4 36 −4 4
10 3 30 −6 3
Calculating revenues
Table 6.6 Calculating total, marginal and average revenue when price ! Calculate total revenue, average revenue and marginal
varies (the firm has some control over price) revenue from a set of data and/or diagrams.

To calculate revenues, it is only necessary to remember

and understand the relationships between the various
revenue concepts, beginning with the idea that
(a) Total revenue
TR = P × Q. If you are given data on P and Q, you can
TR
40 find TR, and from there you can calculate AR =
Q
35 ∆ TR
total revenue ( )

and MR = . You can also work backwards to find

30 ∆Q
25 TR TR and MR if you know AR and Q, or to find TR and
20 AR if you know MR and Q. Remember also that AR = P
15 in all cases, so that if you know AR, you also know the
10 price of the product.
5 To calculate revenues from a diagram, we simply
read off the information appearing in the graph, and
0 1 2 3 4 5 6 7 8 9 10 11 Q apply exactly the same principles as above to calculate
the revenue variable or variables we are interested in.
(b) Marginal and average revenue

Test your understanding 6.6

15
1 Define (a) total revenue, (b) marginal revenue,
and (c) average revenue.
price, revenue ( )

10
2 Given the following price and quantity data
5 for a product, calculate total revenue, marginal
P = AR = D revenue and average revenue.
0
1 2 3 4 5 6 7 8 9 10 11 Q Price ($) 5 5 5 5 5
-5 Quantity (thousand units) 0 1 2 3 4
MR
3 Plot the data for total, marginal and average
Figure 6.8 Total, marginal and average revenue curves when price revenue you calculated in question 2.
varies (the firm has some control over price)

Chapter 6 The theory of the firm I 157

 4 Given the following price and quantity data this chapter (page 144) we made a distinction between
for a product, calculate total revenue, marginal explicit costs, implicit costs and economic costs or total
revenue and average revenue. opportunity costs (the sum of explicit plus implicit
costs). In economics, economic profit is defined as:
Price ($) 8 7 6 5 4 3 2
economic profit = total revenue – economic costs
Quantity 2 3 4 5 6 7 8
= total revenue – the sum of
(thousand units)
explicit costs + implicit costs
5 Plot the data for total, marginal and average
revenue you calculated in question 4.
In economics, even when we use the term ‘profit’ on
6 (a) Explain why the shapes of the curves its own, we mean ‘economic profit’, indicating that
for total, marginal and average revenue you we have taken all costs (explicit plus implicit) into
graphed for question 3 differ from those of consideration.
question 5. (b) What can you conclude about
how price changes (or does not change) for Normal profit
each unit of output sold in questions 3 and 5?
(c) What is the relationship between price and ! Describe normal profit as the amount of revenue needed
average revenue? to cover the costs of employing self-owned resources
7 Given the following data, calculate total revenue (implicit costs, including entrepreneurship) or the amount
and marginal revenue for each level of output. of revenue needed to just keep the firm in business.
What is the price at each level of output?
When economic profit is equal to zero, and total
Quantity 1 2 3 4 5 6 revenue is equal to total economic costs, the firm is
(thousand units) said to be making normal profit.

Average revenue € 20 18 16 14 12 10 Normal profit can be defined as the minimum

amount of revenue that the firm must receive so
8 Given the following data, calculate total revenue
that it will keep the business running (as opposed to
and average revenue for each level of output.
shutting down). It can also be defined as the amount
What is the price at each level of output?
of revenue that covers all implicit costs (including
the payment for entrepreneurship, which is itself an
Quantity 1 2 3 4 5 6
implicit cost). This presupposes that total revenues
(thousand units)
are just enough to cover both explicit and implicit
Marginal revenue (£) 14 12 10 8 6 4 costs. Therefore, a firm earns normal profit when total
revenue = economic costs, and economic profit =
zero. This is called the break-even point of the firm.

6.6 Profit These apparently different definitions are in fact

consistent: the minimum amount of revenue the firm
Distinguishing between economic and must receive to make it worthwhile to stay in business
normal profit and keep all its resources employed in the firm is equal
to the revenue that covers the firm’s implicit costs,
after revenues have also covered explicit costs.
Economic profit It should be stressed that normal profit also includes
the payment for entrepreneurship. Entrepreneurship,
! Describe economic profit as the case where total revenue you will remember, includes the talents to organise
exceeds economic cost.7 and manage a business and take risks (page 4).
Entrepreneurship receives a payment just as all other
In a general sense, profit equals total revenue minus total factors of production do, and this payment is included
costs. The precise meaning of the term ‘profit’ in this in normal profit. In fact, if we think of normal profit
expression depends on the meaning of ‘costs’. Earlier in as consisting of payment for the entrepreneur’s

7‘Economic profit’ in this learning outcome actually refers to positive

economic profit as opposed to negative economic profit (i.e. a loss).

158 Section 1: Microeconomics

entrepreneurial and risk-taking functions, as well as the (a) Positive economic profit
opportunity costs of employing self-owned resources, economic profit
we can see that normal profit is not ‘profit’ in the (supernormal,
customary sense, but is actually a cost of production. abnormal profit)
(£21 000)
Why a firm continues to operate even implicit costs total
(including revenue
when earning zero economic profit
payment for (£180 000)
economic costs = entrepreneurship)
! Explain why a firm will continue to operate even when it
opportunity costs (£109 000)
earns zero economic profit.
explicit costs
It was noted above that the firm earns normal profit (£50 000)
when economic profit is zero, meaning that total
revenue is just equal to total economic costs. It follows (b) Zero economic profit
that when we say a firm is ‘earning normal profit’, the normal
implicit costs profit
firm is earning just the necessary revenues to cover (including
payment for entrepreneurship (a cost) and all other payment for
implicit costs of self-owned resources, after revenues entrepreneurship) total
economic costs =
have also covered explicit costs. Therefore, when a (£109 000) revenue
opportunity costs
(£159 000)
firm is earning normal profit, it has covered all its explicit costs
opportunity costs, and will continue to operate. (£50 000)

Positive and negative economic profit (c) Negative economic profit (loss)
implicit costs loss
! Explain that economic profit is profit over and above (including (£19 000)
normal profit, and that the firm earns normal profit when payment for
economic profit is zero.8 economic costs = entrepreneurship)
opportunity costs (£109 000) total
! Explain the meaning of loss as negative economic profit revenue
arising when total revenue is less than total cost. explicit costs
(£140 000)
(£50 000)
Economic profit can be positive, zero or negative.
Positive economic profit is also known as supernormal Figure 6.9 Illustrating economic profit (positive and negative) and
profit, or abnormal profit, because it involves profit normal profit
over and above normal profit. If economic profit is zero,
the firm is earning normal profit. And if economic profit Figure 6.9(b) shows a firm making zero economic
is negative, the firm is making a loss. To summarise: profit. The firm’s total revenue has fallen to £159 000,
which is equal to its economic costs; therefore, the
Economic profit can be positive, zero or negative. firm is earning normal profit. The firm in this situation
will not shut down even though it is earning zero
Positive economic profit: TR > economic cost; the economic profit, because it is earning normal profit;
firm earns supernormal profit (or abnormal profit). its revenue is enough to cover all opportunity costs
Zero economic profit: TR = economic cost; the firm (including entrepreneurship).
earns normal profit. In Figure 6.9(c) the firm is earning negative economic
profit (loss). Total revenue has fallen to £140 000, of
Negative economic profit: TR < economic cost; the which £50 000 is used to cover explicit costs, and there
firm makes a loss. are £90 000 left over to go toward covering implicit
costs. However, this is not enough, as implicit costs are
We can see these relationships in Figure 6.9. In £109 000. Therefore, the firm is making an economic loss
Figure 6.9(a) the firm’s total revenue is £180 000. of £19 000, and will shut down (go out of business) as
Implicit costs = £109 000, explicit costs = £50 000, soon as it is able to do so (we will see how in Chapter 7).
and the sum is economic costs of £159 000. Economic Table 6.7 summarises the cost, product, revenue and
profit is therefore £21 000 (= £180 000 − £159 000). profit concepts we have studied.

8
Profit over and above normal profit is positive economic profit, since
negative economic profit refers to loss. See also footnote 7.

Chapter 6 The theory of the firm I 159

Table 6.7 Summary of cost, product, revenue and profit concepts

Cost concepts Definition Equation

Explicit cost The monetary payment made by a firm to an outsider to acquire
an input.

Implicit cost The income sacrificed by a firm that uses a resource it owns.

Economic cost The sum of explicit and implicit costs, also equal to the firm’s
total opportunity costs.

Total fixed cost (TFC) Costs that do not change as output changes; arise from the use
of fixed inputs.

Total variable cost (TVC) Costs that vary (change) as output changes; arise from the use of
variable inputs.

Total cost (TC) The sum of fixed and variable costs. TC = TFC + TVC

Average fixed cost (AFC) Fixed cost per unit of output. TFC
AFC =
Q

Average variable cost (AVC) Variable cost per unit of output. TVC
AVC =
Q

Average total cost (ATC) Total cost per unit of output. ATC = AFC + AVC

Marginal cost (MC) The change in cost arising from one additional unit of output. ∆ TC ∆ TVC
MC = =
∆Q ∆Q

Long-run average total cost A curve showing the lowest possible average cost that can be
(LRATC) curve attained for any level of output when all of the firm’s inputs are
variable.

Product concepts

Total product (TP or Q) The total amount of product (output) produced by a firm.

Marginal product (MP) The additional product produced by one additional unit of ∆TP
MP =
variable input. ∆ units of variable input

Average product (AP) Product per unit of variable input. TP

AP =
units of variable input

Revenue concepts

Total revenue The total earnings of a firm from the sale of its output. TR = P × Q

Marginal revenue The additional revenue of a firm arising from the sale of an ∆ TR
MR =
additional unit of output. ∆Q

Average revenue Revenue per unit of output. TR

AR =
Q

Profit concepts

Economic profit Total revenue minus economic costs (or total opportunity costs,
or the sum of explicit plus implicit costs).

Normal profit The minimum amount of revenue required by a firm so that it

will be induced to keep running, which is that part of revenue
that covers implicit costs, including entrepreneurship (after all
explicit costs have been covered).

160 Section 1: Microeconomics

 but until it decides to shut down, it will be interested
Test your understanding 6.7 in producing the quantity of output that will make
1 Define economic profit and normal profit, and its loss as small as possible. Therefore, the theory of
explain the difference between them. the firm is also concerned with how much output a
loss-making firm should produce in order to minimise
2 Why do you think positive economic profit is
its loss.
also called ‘supernormal’ profit or ‘abnormal’
There are two approaches to analysing profit
profit?
maximisation (or loss minimisation): one involves
3 What is the relationship between earning use of the total revenue and total cost concepts, and
normal profit and the break-even point of a the other involves use of marginal revenues and
firm? costs. Both these approaches yield the same results
4 Explain why economic profit can be positive, for the profit-maximising (or loss-minimising) level of
zero or negative. output, though the second approach is more relevant
5 A firm earns zero economic profit, and yet it to analysing market structures (as we will see in
does not shut down. Explain why. Chapter 7).
6 A firm had implicit costs of $35 000 per year
Profit maximisation based on the total
and explicit costs of $75 000 per year, which
revenue and cost approach
remained constant for each year between
This approach is based on the simple principle that
2009 and 2011. In 2009 its total revenues
were $150 000, in 2010 they were $110 000, profit = total revenue (TR) − total cost (TC)
and in 2011 they were $95 000. (a) In which
where profit refers to economic profit and TC is
year did the firm earn normal profit? (b) In
the firm’s economic or opportunity costs (explicit plus
which year did the firm consider shutting
implicit costs).
down? Why? (c) In which year did the
firm earn supernormal profit? How much
supernormal profit did it earn? (d) How The firm’s profit-maximisation rule is to produce the
much economic profit did it make each year level of output where TR − TC (= economic profit) is
(remember, economic profit may be positive, as large as possible.
zero or negative). (e) What was the break-
even point of the firm?
The amount of profit made by the firm is equal to
the numerical difference between TR and TC. If this
difference is positive, the firm is making a profit
(supernormal profit); if it is negative, the firm is
6.7 Goals of firms making a loss; if it is zero, the firm is earning normal
profit.
Profit maximisation
Calculating different profit levels
! Explain the goal of profit maximisation where the We can see how economic profit is calculated based
difference between total revenue and total cost is on the total revenue and total cost approach using
maximised or where marginal revenue equals marginal cost. the information in Figure 6.9. In part (a), TR > TC,
! Calculate different profit levels from a set of data and/or and the firm makes an economic profit of £21 000
diagrams. (= TR – TC). In part (b), TR = TC, therefore the firm
is making zero economic profit, though it is earning
normal profit which allows it to stay in business. In
Standard economic theory of the firm assumes part (c), TR < TC, and so the firm is making a loss of
that firm behaviour is guided by the firm’s goal to £19 000 (= TR – TC = –£19 000), and will eventually
maximise profit. Profit maximisation involves go out of business.
determining the level of output that the firm should Figure 6.10 puts together TR and TC curves we
produce to make profit as large as possible. have already studied. It shows the total revenue curve
Yet firms do not always make a profit; in some of a firm with no ability to influence price (as in
cases their total revenue is not sufficient to cover Figure 6.7), and a total cost curve (as in Figure 6.2(c)).
all costs, in which case they make a loss. If a firm is In part (a), we look at levels of output where TR
making a loss, it may eventually go out of business, lies above TC, and find the Q where the difference

Chapter 6 The theory of the firm I 161

 (a) Profit-maximising firm produces at Q2 (b) Profit-maximising firm produces at (c) The loss-minimising firm produces at
and makes economic profit: TR – TC = Q2 and makes zero economic profit: Q2 (if it produces) and makes a loss =
c–d TR – TC = 0 (it earns normal profit) TC – TR = a – b (negative economic
profit since TR < TC )
TC
TR TC TC
e
costs, revenues

costs, revenues

costs, revenues
c TR a
a TR
f a
d b
b

0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q

Figure 6.10 Profit maximisation using the total revenue and total cost approach when the firm has no control over price

between TR and TC is largest. This occurs at Q 2, where difference between total revenue and total cost is
profit is the vertical distance between points c and d. largest. Part (a) shows the case of a profit-making
(You can see that profit levels a – b and e – f are smaller). firm; profit is maximised at output level Qπmax. At
In part (b), the firm produces at Q2 where TR = TC, points a and b where the TC curve intersects the
indicating zero economic profit (the firm earns normal TR curve, economic profit is zero (the firm would
profit). At all other levels of output, TC > TR. In part (c) be earning normal profit). In part (b) there is no
there is no Q where TR > TC, therefore we look for the level of output where TR > TC; therefore, this firm
Q where the difference between TC and TR is smallest. can only make a loss. Loss is minimum at output
This is at Q2, where the firm makes a loss (negative level Qlmin.
economic profit) of a – b. In the event that you are asked to find the profit-
Figure 6.11 illustrates the case of a firm that does maximising level of output and the amount of
have control over price, showing its total revenue profit (or loss) made by a firm based on data on
curve (as in Figure 6.8(a)), together with a total cost total costs and revenues, you must first calculate the
curve (as in Figure 6.2(c)). The method of finding amount of profit (or loss) that results at each level
the firm’s maximum profit is exactly the same as of output (using the profit = TR – TC principle), and
above. We look for the level of output where the then determine which profit level is largest or which

(a) Profit maximisation (b) Loss minimisation

TC, TC TC, TC
TR TR
b
TR
a
TR

0 Q max Q 0 Q1min Q

Figure 6.11 Profit maximisation using the total revenue and total cost approach when the firm has control over price

162 Section 1: Microeconomics

loss level is smallest. The corresponding output will In Figure 6.12, both parts (a) and (b) show the
be the profit-maximising or loss-minimising one. standard MC curve that we studied earlier (page 148).
You will be given the opportunity to perform such There are two kinds of marginal revenue curves,
calculations in Test your understanding 6.8. depending on whether or not the firm has control
over the price of its output (pages 156–7). Part (a)
Profit maximisation based on the shows the MR curve of the firm with no control
marginal revenue and cost approach over price. Part (b) shows the MR curve of the firm
Profit maximisation using this approach is based on a with some control over price. Both parts (a) and
comparison of marginal revenue (MR) with marginal (b) illustrate the identical principle about profit
cost (MC) to determine the profit-maximising level of maximisation.
output. According to the profit-maximising rule, MC = MR,
the point of intersection between the MC and MR
The firm’s profit-maximisation rule is to choose to curves determines the profit-maximising level
produce the level of output where MC = MR. The of output; this is Qπmax in Figure 6.12 (a) and
same rule is used by the firm that is interested in (b). Why is this so? Consider a firm producing
minimising its loss. output Q1 in both parts (a) and (b), where MR > MC.
If this firm increases its output by one unit, the
additional revenue it would receive (MR) will
be greater than its additional cost (MC). It is
therefore in the firm’s interests to increase its level
(a) Price constant of output until it reaches Qπmax where MR = MC.
If it continues to increase output beyond Qπmax,
MC say to Q2, where MR < MC, the additional revenue
it would receive for an extra unit of output is
less than the additional cost, and so it should cut
back on its Q. There is only one point where the firm
MC, MR

can do nothing to improve its position, and that is

MR Qπmax, where MR = MC, and profit is the greatest it
can be.
When we are given data for MC and MR (and no
information on total costs and total revenues), all
we can do is find the profit-maximising level of output
0 Q1 Q max Q2 Q (where MC = MR), but we cannot find the amount of
profit (or loss) unless we have more information. We
will see how this is done in Chapter 7. You will be
given the opportunity to find the profit-maximising
level of output using the MC = MR rule in the
(b) Price varies with output
exercises below.

MC

Test your understanding 6.8

MC, MR

1 (a) What are the two approaches to profit

maximisation by firms? (b) What is the profit-
maximising rule of firms in each of the two
approaches?

Q1 Q 2 (a) Say a firm is producing a level of output

0 max Q2 Q
MR Q where MC > MR. What should it do to
increase its profit (or reduce its loss)? (b) If
it is producing Q where MC < MR, what should
Figure 6.12 Profit maximisation using the marginal revenue and marginal it do?
cost approach

Chapter 6 The theory of the firm I 163

 3 Assume that a firm that has no control over its
Additional goals of firms
price sells its output at $5 per unit. (a) Given
! Describe alternative goals of firms, including revenue
the following data, use the total revenue and
maximisation, growth maximisation, satisficing and
total cost approach to determine the level of
corporate social responsibility.
output at which the firm will maximise profit.
(b) How much profit will it make? (c) Graph
TR and TC and find the profit-maximising Q Over the years, economists have developed many
and profit on your graph; do they match your theories about firm behaviour. The following is a brief
calculations? (d) Calculate the amount of profit survey of some of the more important ones.
(or loss) when Q = 3, Q = 6, Q = 10 and find
these on your graph. Do your results match? Revenue maximisation
In one theory of firm behaviour, it is argued that
Units of output (Q) 1 2 3 4 5 6 7 8 9 10
the separation of firm management from firm
Total cost ($) 15 18 20 21 23 26 30 35 41 48 ownership, which increasingly dominates business
4 Given the data in question 3, (a) determine the organisation, has meant that firms’ objectives have
level of output at which the firm will maximise changed. Whereas profit maximisation may be the
profit using the marginal revenue (MR) and dominant motive of the traditional owner-managed
marginal cost (MC) approach. (Hint: you must firm, firm managers who are hired by the owners to
use the information in the question to find perform management tasks may be more interested
MR and MC.) (b) Graph the resulting MR and in increasing sales and maximising the revenues that
MC curves. (c) Did you find the same profit- arise from larger quantities sold. This goal of firms is
maximising level of output as in question 3?* referred to as revenue maximisation.9 Increasing
5 Suppose that a firm with some control over price sales and maximising revenues may be more useful
faces the costs and prices per unit of output shown to a firm than profit maximisation for the following
in the table below. (a) Use the total revenue and reasons:
total cost approach to determine the level of • Sales can be identified and measured more easily
output at which the firm will maximise profit. over the short run than profits, and increased sales
(b) How much profit will it make? (c) Graph TR targets can be used to motivate employees.
and TC and find the profit-maximising Q and profit
• Rewards for managers and employees are often
on your graph; do they match your calculations?
linked to increased sales rather than increased
(d) Calculate the amount of profit (or loss) when
profits.
Q = 2, Q = 3, Q = 8 and find these on your graph.
Do your results match your calculations? • It is often assumed that revenue from more sales
will increase more rapidly than costs; if this is the
Units of output (Q) 1 2 3 4 5 6 7 8 case, profit (= TR − TC) will also increase.
Total cost ($) 15 18 20 21 23 26 30 35 • Increased sales give rise to a feeling of success,
Price ($) 10 9 8 7 6 5 4 3 whereas declining sales create a feeling of failure.
6 Given the data in question 5, (a) determine the
level of output at which the firm will maximise
Growth maximisation
profit using the marginal revenue (MR) and
In other approaches it is assumed that firms may be
marginal cost (MC) approach. (Hint: you must
interested in maximising their growth rather than
use the information in the question to find
their profits.10 Growth maximisation can be
MR and MC.) (b) Graph the resulting MR and
attractive for the following reasons:
MC curves. (c) Did you find the same profit-
maximising level of output as in question 5?* • A growing firm can achieve economies of scale and
lower its average costs.
* When using the TR and TC approach your results give two profit- • As a firm grows it can diversify into production
maximising levels of output, whereas the MR and MC approach
gives only one. This is because the MR and MC approach is actually of different products and markets and reduce its
more precise than the TR and TC approach. It is good idea to use the dependence on a single product or market.
larger of the two values of output that you get by using the TR and
TC approach. • A larger firm has greater market power and
increased ability to influence prices.
9 10
The revenue-maximisation goal of firms was described by W. J. Baumol This is based on the work of R. Marris and others.
in 1959.

164 Section 1: Microeconomics

• A larger firm reduces its risks because it may be less
consumers would consider to be ethically unacceptable,
affected in an economic downturn and is less likely
such as the practice in many developing countries of
to be taken over (bought) by another firm.
employing children who are extremely poorly paid
• The objective of growth maximisation reconciles and forced to work long hours, or employing labour
the interests of both owners and managers, because that is forced to work under unhealthy or dangerous
both groups have much to gain from a growing conditions. These situations may arise in countries
firm (other maximisation objectives pit firm where there is widespread poverty, and government
owners against firm managers; for example, profit legislation protecting the rights of children and workers
maximisation is favoured by owners while revenue is either non-existent or poorly enforced.
maximisation is favoured by managers). However, many firms are increasingly recognising
that the pursuit of self-interest need not necessarily
Managerial utility maximisation conflict with ethical and environmentally responsible
In this view, when firm management is separated from behaviour. A negative image of the firm held by
firm ownership, managers develop their own objectives workers and customers (buyers of the product) can
that revolve around the maximisation of their own cut deeply into the firm’s revenues and profits by
utility (satisfaction).11 Managerial utility can be derived lowering worker productivity and the firm’s sales.
from increased salaries, larger fringe benefits (such as Further, socially irresponsible firm behaviour may
company cars and expense accounts), employment of lead to government regulation of the firm intended
more staff that gives rise to a feeling of importance, and to minimise the negative consequences of the firm’s
investments in the managers’ favourite projects. The actions for society, whereas socially responsible
result of all these activities may be to cut into profits behaviour could instead result in avoidance of
and make these lower than they would otherwise be. government regulation. Therefore, firms face
strong incentives to display corporate social
Satisficing responsibility by engaging in socially beneficial
All of the above objectives assume that the firm tries to activities. These can take many forms, including:
maximise some variable, whether it is profit, revenue, • avoidance of polluting activities
growth or managerial utility. H. Simon, a Nobel
• engaging in environmentally sound practices
Prize-winning economist, has argued that the large
modern enterprise cannot be looked upon as a single • support for human rights, such as avoiding
entity with a single maximising objective; instead exploitation of child labour and labour in general in
it is composed of many separate groups within the less developed countries, or avoiding investments in
firm, each with its own objectives which may overlap countries with politically oppressive regimes
or may conflict. This multiplicity of objectives does • art and athletics sponsorships
not allow the firm to pursue any kind of maximising • donations to charities.
behaviour. Firms therefore try to establish processes
through which they can make compromises and Many of these practices are the result of increased
reconcile conflicts to arrive at agreements, the result of consumer awareness of social and environmental
which is the pursuit of many objectives that are placed issues, growing consumer concern over ethical and
in a hierarchy. This behaviour was termed satisficing environmental aspects of business practices, and
by Simon, referring to the idea that firms try to achieve even consumer activism that results in boycotts of
satisfactory rather than optimal or ‘best’ results. offending firms. One indication of the influence and
concern of consumers is the rapidly growing interest
Ethical and environmental concerns: in investments in companies (through stock markets)
corporate social responsibility that meet certain social, ethical and ecological criteria.
The self-interested behaviour of firms often leads to Economists used to think that ethical and
negative consequences for society. Many of these were environmentally responsible behaviour of firms would
examined in Chapter 5 under the topic of market reduce their profits. This was based on considering
failure and negative production externalities. It is often only the cost aspect of profits; for example, firms using
the case that the well-being of firms is not consistent cheap child labour face lower costs, and hence will
with the welfare of society. A prime example is the make higher profits than firms avoiding such practices.
self-interested firm that pollutes the environment. Yet profits depend not only on costs, but also on
In addition, firms can engage in actions that most revenues. If consumers avoid buying the products

11 This is based on the work of O. E. Williamson in 1963.

Chapter 6 The theory of the firm I 165

of offending firms, revenues will decline and profits The behaviour of firms themselves, however, suggests
will go down in spite of the lower costs. The same that they often do not want to risk consumer
arguments also apply to firms that may be pursuing displeasure.
some strategy other than profit maximisation, such as
revenue maximisation. Test your understanding 6.9
A number of studies have attempted to measure
the effects of socially responsible behaviour on the Discuss some possible goals of firms other than
profits of firms. Does ethical and environmentally profit maximisation that may influence their
responsible behaviour lower or increase firms’ profits? behaviour.
The results of these studies have been inconclusive.

Theory of knowledge

How realistic is profit maximisation as the firm’s main goal?

Standard economic theory assumes that profit Milton Friedman, an American Nobel Prize-winning
maximisation is the most important goal of firms. As we economist, argued in a famous book12 that it does not matter
will see in the next chapter, the theory of the firm is based if the assumptions of a theory are unrealistic, as long as the
very heavily on the assumption of profit maximisation. Yet theory has predictive powers. In fact, good theories are often
this assumption is criticised for several reasons: based on unrealistic assumptions that do not accurately
describe the real world, because the role of assumptions is
• The use of marginal concepts (MR and MC) in the
to portray only the important aspects of a process that is
theory is unrealistic; firms cannot easily identify
modelled or theorised about, ignoring the irrelevant details.
marginal revenues and marginal costs, and do not even
Paul Samuelson, another American Nobel Prize-winning
try to do so; therefore, this theory does not accurately
economist, fundamentally disagreed. Samuelson argued
describe methods actually used by firms to determine
that the predictions of a theory can only be as empirically
price and output.
valid as the theory itself, and as the assumptions on which
• The model is based on the assumption that firms have the theory rests. If the assumptions are unrealistic or
perfect information at their disposal, whereas in fact invalid, then the theory and its predictions will similarly be
the information on which they base their decisions is invalid; it is not possible to have a theory with predictive
highly fragmentary and uncertain; firms do not know powers if its assumptions are unrealistic. If the predictions
what demand curves they face for their products and of a theory are empirically valid, so is the theory and its
they do not know how competitor firms will behave in assumptions. Logically, then, it is not possible to separate
response to their actions. the predictions of a theory from the assumptions of the
• Short run profit maximisation may be unrealistic; theory; they all stand or fall together.
firms may not try to maximise profits in the short run,
as they might prefer lower profits in the short run in 12Milton Friedman (1953) ‘The Methodology of Positive
exchange for larger profits over the long run. Economics’ in Essays in Positive Economics, University of Chicago
Press.
• The factors determining demand and supply for
products and resources are continuously changing,
with demand and supply curves continuously shifting,
Thinking points
so that any profit-maximising decisions regarding • Remember that a theory tries to explain real-
prices and output made today under current world events. Does it matter if a theory is based on
conditions may be irrelevant by the time the output is unrealistic assumptions?
produced and ready for sale in the market. • As you read through Chapter 7, you may want to keep
• There is real-world evidence suggesting that firm these issues in mind, as we will encounter further
behaviour may be motivated by a variety of objectives unrealistic assumptions in some market models
other than profit maximisation, which were discussed discussed in that chapter (see also the Theory of
on pages 164–6. knowledge feature on page 211).

166 Section 1: Microeconomics

Assessment
The Student’s CD-ROM at the back of this book
provides practice of examination questions based on
the material you have studied in this chapter.

Higher level
• Exam practice: Paper 1, Chapter 6
" HL topics (questions 6.1–6.8)

• Exam practice: Paper 3, Chapter 6

" HL topics (questions 13–15)

Chapter 6 The theory of the firm I 167