Theory of the Firm

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What is a Firm?• Firm is a unit of organization that transforms

inputs into outputs.*Produces homogeneous commodity

*Technology is represented by a production function.

• Neoclassical Theory: Firm as a collection of Resources that is transformed into products demanded by the consumers.

• Cost of Production: Governed by available Technology

• Output Produced and Selling Price are determined by Market Structure

• Aim of firm: Maximize Profit

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House-Holds

ProductMarkets

FactorMarkets

Firms

Money spent

Goods Demanded

Money Earned

Goods

Supplier

Money Costs

Input

DemandedInput

Supplied

Money Incomes

Circular Flow of Economic Activity

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Rational of Existence of Firm

Why cannot we offer separate contract for each function of a firm?Ex (1): Car Manufacturing through individual contracts and

Coordinated through Prices.Ex (2): A Shoe Manufacture contacts a COBBLER to make the Shoe Cobbler has bilateral transaction with TANNER to get Tanned Leather Tanner Transacts with BUTCHER Finally SHOES is sold in the Market

Outcome: High Transaction cost Multilateral Contract or complex set of contracts would be costly to negotiate.

Cost can be reduced through BILATERAL CONTRACTS

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Rationale for the firm

• In the absence of firm, Cost of Producing any rate of output would be higher. – High Transaction Cost: Cost of a firm entering into

contract with other entities.• Cost of obtaining information on prices, cost of negotiating, cost of having

separate contracts for each step of the production Process, Cost of Enforcement of contract and Coordinating Transaction.

Transaction Costs are influenced by Uncertainty (inability to know future outcome with accuracy) Hence not feasible to include all contingencies in a contract especially Long term Contract

What is the Way Out:Trade-off between External Transaction Costs and Costs of Internal Operations

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Firm’s existence……..Choose to Allocate the resources between External Transactions and

Internal Operations to ensure MINIMUM TOTAL COST

External Transaction: Outsourcing/Off shoring• Outsourcing peripheral activities noticed earlier

• Outsourcing Core Activities-Recent Phenomenon

• Off shoring (firm source its product in another Country)

– Ex. 80 per cent of Kodak’s reloadable Cameras and all of its digital Cameras are outsourced in ASIA (Keat & Young: 2006)

Compaq Computer (prior to merger with Hewlett-Packard) made only about 10 per cent of the computers sold to consumers

Use Third Party for Recruitment of Employees(Ex: Corporate Sector in India)

Transfer of White-Collar Jobs to Foreign Countries where salaries and Wages are Low

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Transaction Cost …….*Opening of Call Centres

Wave of Outsourcing of highly Technical Jobs (production of Software)

India: one of the largest supplier of these services. How (Large pool of Well-Educated Labour Force and low Salary as compared to

US and other Western Countries)

– Government Interference leads to INCREASE in Cost of ProductionEx: Sales Tax applies to transaction among firms not within

firmsReal Estate/Construction Company: Pay Tax for buying

Furniture. No tax if it is done internally by hiring a person

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Large Firm vis-à-vis Small FirmIF COST OF PRODUCTION DECLINES in a FIRM then Why can’t there be a Large

ONE Firm like Hindustan Lever, Proctor & Gamble so on (which produce variety of goods and Services)?

Cost of Organizing Transactions increases with increase in Size of Firm

Sometimes Internal Transaction Cost is equal to Transacting in the Market

Ex: SHOULD AUTOMOBILE PRODUCERS (General Motors) BUY TYRE from MRF, GOODYEAR or Build Plant to Produce Own Tyre .

Cost of Developing New Management Skill for a Different Type of Production (TYRE) can be Higher.

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Rationale of having Small Firm• Limitations of Entrepreneur’s Organizational Skill:

If firm size exceeds the manager’s ability to control the operation then resources may not be efficiently allocated in the firm.

Production cost Per unit of Output tends to rise as firms grow larger because of limited managerial ability-Known as DIMINSHING RETURNS TO MANAGEMENT

The Way out: Decentralize by Establishing number of separate divisions or profit centre

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Why do firms Exist…….?• Ronald Coase (1937): Production is organised in firm rather

than through series of Individual contracts. Why?

– To reduce Transaction Cost

– Higher Productivity under Team Work(Group production can offer Benefit of Specialization)

Drawbacks: ‘Shirking’ and ‘Free-riding’ in Group Production Difficult to Assess Contribution of Each Employee

The Way Out: Hire Monitor to Discipline the Team.

Solution: Compare Benefit of Greater Productivity under group Production with Cost of Monitoring

Offer Incentives (BONUS, PERKS) etc to IMPROVE PRODUCTIVITY

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Firm and Industry: A Comparison

Industry: A group of firms producing the SAME product or SIMILAR product.

Exp: Sugar & Automobile Industry

Number of firms selling cheese, butter, milk are part of Dairy Industry (Nandini, Amul, Indore Dairy….)

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Market and Industry

• Market consists of buyers and Sellers that communicate with each other for voluntary exchange

Market and Industry do not convey the same Meaning always

Exp: Footwear Market consists of products that are supplied by more than one industry

(leather, rubber and so on)Packaging Material supplied by other industries

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Market vis-à-vis Industry

An industry’s product cater to the needs of more than one marketExp: Aluminum Industry meets demand for Utensils, Electricity wire and so on)

Difference between Market for Electricity and Electricity Industry

Electricity Industry consists of Sellers only (State Electricity Board, GRIDCO) while Electricity Market consists of Buyers (Households, Industry) and Sellers.

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Objectives of Firm• Profit Maximization (Max. Market Share)-

Major Goal

• Subsidiary Goals: Large volumes of sales/ Company Image

• But can a firm afford to Maximize profit always by compromising on Ethical Issues?

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Profit = Revenue - Cost

• Total Profit = Total Revenue – Total Cost

• Total Profit will be maximum at that level of output where vertical distance between TR and TC curves is maximum (TR exceeds TC with high margin)

• Total profit is maximum at that point where slopes of both TR and TC curves are the same, i.e.,

•

0

0.5

1

1.5

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2.5

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3.5

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4.5

5

0 5 10 15 20 25 30 35

-2

-1.5

-1

-0.5

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STC

TR

Tp

MCMR

$

$Q

Q

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Marginal Revenue = Marginal Cost• Marginal Revenue

-0.1

0

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-0.5

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MCMRM pMR

MC Marginal Cost

Mp

Marginal Profit M

Maximum Profit

M: Marginal Profit- Rate of change in total profit of firm w.r.t changes in level of output=(∆T / ∆T Q)= (T 2-T1)/Q2-Q1.

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Profit Maximization….

• For profit Maximization, profit to be gained by producing additional unit of output (marginal profit), must be zero (M =0).

• Or Slope of TOTAL PROFIT curve is zero at that point

• M =0 implies MR= MC ( at the profit maximizing level of output, additional revenue to be generated from one unit of output must be equal to additional cost the firms incur by producing it).

• Total Profit is not maximized at the point where Marginal Profit is maximum rather at zero Marginal Profit.

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How to Maximize Profit?• Total Profit (T )= Total Revenue- Total Cost

= TR-TC

• Total Revenue: Total amount of money that the firm receives by selling a given quantity of output

(In fact, sales of a firm are equal to current year’s production plus opening stock minus the closing stock of finished goods, but let us assume that total sales volume of a firm is equal to the level of output produced).

Profit Maximization Condition of a firm

Equilibrium Condition (Firm)Necessary Condition (a) MC= MR

Output will be expanded to the point where Marginal Cost is equal to Marginal Revenue

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Profit Maximization…..

Sufficient Condition (b)

Slope of MR curve < Slope of MC curve(MC cuts MR from Below)

When MR > MC, If firm expands output then it will add more to revenue than to costs.It is rational to expand production of output and add more profit.

If MR < MC, then expansion of output will add more to costs than to the output- Reduce Profit

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Level of Output and Profit of a Firm

Q P TR=P*Q TC Profit MR MC         (TR-TC)    1 2 3(=2*1) 4 5(=3-4) 6 70 10 0 12 -12 - -

1 10 10 14 -4 10 2

2 10 20 15 5 10 1

3 10 30 17 13 10 2

4 10 40 20 20 10 3

5 10 50 25 25 10 5

6 10 60 35 25 10 107 10 70 50 20 10 15

8 10 80 81 -1 10 31

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When does a firm Stop Production?Breakeven Analysis (Volume-Cost- Profit Analysis)

• Used in Actual Business Situations for understanding Effect of a change in Quantity of a Product on Profit of the Firm

• Investigates the relationship between Quantity of the Product, the Cost to Produce this quantity, and the Profit (Keat & Young: 2006)

Popularly known as VOLUME-COST-PROFIT Analysis

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Breakeven Analysis ………

• Break-even point: Output level at which Total Revenue of a firm equals to Total Cost implying Total Profits equal to zero.

• Assuming a Constant Price, Constant Average Variable cost and specific level of fixed costs, decision has to be taken about the level of output for the firm to cover its Total Costs.

• Or firm has to decide the level of output to be produced so as to cover its total costs and achieve target level of income.

• TO BREAK EVEN, A FIRM’S REVENUE MUST BE EQUAL TO COST

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TFC

TC

TR

TVC

Qb: Break-Even Output

Cost , Revenue

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Break-Even Analysis• At the Break-even point TR = TC

TFCTVCTR

TFCAVCPorQTFCQAVCQorP

TFCQAVCQP

)()()(

)()(

AVCPTFCQBEP

or

therefore:

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Break even….• (P - AVC) is known as the UNIT CONTRIBUTION

MARGIN.

• (P-AVC) indicates the contribution that each unit sold will make towards covering fixed cost and eventually generating profit.

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Units of Output Fixed Cost Variable Cost Total Cost Total Revenue Profit

('000s) (Rs in '000) (Rs in '000) (Rs in '000) (Rs in '000) (Rs in '000)

1 2 3 4(=2+3) 5 6(=5-6)0 20 0 20 0 -20

5 20 15 35 25 -10

10 20 30 50 50 015 20 45 65 75 10

20 20 60 80 100 20

25 20 75 95 125 3030 20 90 110 150 40

35 20 105 125 175 50

40 20 120 140 200 60Source: Keat & Young (2006) Break-Even: Total Revenue=Total Cost Production of Quantity beyond

10,000 units will result in Profit. Drops in quantity below 10,000

leads to Loss.

Break-Even Analysis

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Application of Break- Even: Restaurant in Indore

Rs

Fixed Cost (per month) 60,000Avg. Price of Soft drinks, sandwich etc 6

Average Variable Cost (per unit) 3.6

How much quantity to sell per month to BREAK-EVEN?

QBEP= (60,000)/(6-3.6)

= 25,000

To make a Target income of Rs 24,000 per month

how much quantity (no. of units) to serve (sell)

Q= (60000+24000)/2.40

= 35000 (units)

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Break-Even Analysis Example

• Product Cost (Avg Variable) is Rs 3.60 • Product Price is Rs 6.00 per unit• Total Fixed Costs are

Rs60,000/month.

0

50

100

150

200

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Q(1000's)

Rs(1

000's

)

TFC

TVC Total Variable Cost

TC

Total Cost

TR

Total Revenue

BEP Break-even point at 25,000 products / month

PROFIT

Profit at higher sales volumes grows without bound

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Issues in Break-Even Analysis

• Break-Even Point when one or more variables Changes?– Increase in AVC…..Increase in Slope of Total cost

curve……Increase in Break-Even Point– Change in Unit Price of Commodity….Change in

Slope of Total Revenue cure. Price Increase will decrease Break-Even Point.

– Change in Fixed Cost. Increase in FC….. Parallel Shift in Cost Curve….Increase in Break-Even Point

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Shutdown Point• Firm Maximizes profit by producing the output where MC=MR as

long as PRICE is GREATER than or EQUAL to AVERAGE VARIABLE COST.

If a firm makes loss in the SHORT RUN then is it rational to STOP Production?

• Loss implies Total Cost > Total Revenue

• In the short run: At least one FIXED factor and other VARIABLE Factors

• The firm has to bear FIXED INPUT COST in the SHORT RUN irrespective of its decision to Produce or not?

Variable Cost depends on level of output Produced

• Again, it is Difficult to EXIT the industry in the short run. WHY?

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Decision Issue:• MANAGER has to DECIDE

First: Whether to Produce or SHUT DOWN (Produce zero output and hire none of the variable inputs)

Second: If go for production, Choose the Optimal Level of OUPUT that MINIMIZES LOSS to the firm

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The Way Out…

• COMPARE LOSS to be incurred for SHUTTING DOWN production with loss from DECIDING to PRODUCE

CHOOSE The OPTION that MINIMIZES COST

• Case I: If TR> TVC or P > AVC then it can produce. Why?

• Whether a firm produce or not, it has to bear fixed cost.

• By continuing production, if it can cover variable cost (and something left to cover fixed cost) then it justifies decision to produce.

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Shut-down….• Firm Maximizes profit where MC=MR as long as Price

(P) is greater than or equal to Average Variable Cost (AVC).

Discontinue Production if PRICE falls Below AVERAGE VARIABLE COST.

If P < AVC; firm will not produce at all.

• This only works for the short-run.

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Does Firm wish to Max Profit?• Herbert Simon: ‘Firm with many divisions and with vibrant intra-firm

rivalries (between divisions), would be BETTER OFF if it sets its ASPIRATION levels between Unsatisfactory and Maximum Level of Profit, rather than at the Maximum Level of Profit’

• Non-Profit Organisation do not have objective of Profit Maximization– Ex: Hospitals, Rotary Clubs, Co-operatives…– (Operate with funds received from External Agencies/sources-

Donations).

• Public Sector Organisations owned by Govt. and operate where Pvt. Sector may not be keen to Enter do not aim at PROFIT MAXIMIZATION– Provision of Public Good: Defense, Light House

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Summary and Conclusion……

• Major goals of firm: Maximization of profit, sales max., growth maximisation

• Firm’s Short run Profit is maximized when MC=MR and MC cuts MR from below.

• Break-even point: the output level at which firm’s TR is equal to TC, implying zero profit.

• Shut-down point: output level at which Price is equal to Average Variable Cost and losses equal to Total Fixed Cost (irrespective of opting for production or not).

• Based on these criteria Manager has to take appropriate decision.

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Market Structure

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Market Structure: Imperfect Competition

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Factors Influencing Structure of the Market

(A) No of Independent Buyers and Sellers(Large no. of Sellers ……. Total supply controlled by individual firm is less….. Seller cannot influence the price by its own action)

Exp: Perfect Competition (Agricultural Output)

(B) Degree of Seller-ConcentrationPower to influence Market Price depends on Proportion of total output Controlled by Individual firm)

Exp: Electricity Supply-Duopoly (Tata, Reliance)

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Factors Influencing Structure of Market

© Product DifferentiationI. Product Identical (homogeneous)-Ex: Toilet soaps (Lux, Cynthol, Mysore sandal soap- Not perfectly substitute)If price increase marginally some buyers will opt for other competing brands

II. Perfectly Substitute (Exp. Potato, eggs etc.)Marginal increase in price of product in one firm- Reduce demand to zero for the Product

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(D) Degree of substitutability of product: Power to influence price depends on substitutability of products of competing firms

Depends on Cross Elasticity of Demand

(E) Condition of Entry:Barriers to Entry is high or lowEx: Monopoly- Barriers to Entry High

Free Entry: No of sellers will be large and degree of concentration will be lowEx: Perfect Competition

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Different forms of Market: An Overview• Perfect Competition:

A form of Market structure characterized by COMPLETE ABSENCE of RIVALRY among the individual firms.

• Exp: Agriculture (closely approximating), construction industry

Monopoly: (Mono: one, Poly: Seller) Form of Market Organization in which a single firm sells a product for which there are no close substitutes.

It can either set the price and sell the quantity or it can choose the quantity to sell and set the maximum price indicated by the demand curve, not both.

Exp: Production of defense equipment by Government of India, Dominance of Public sector in Electricity, Indian Railways, Indian Post

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Oligopoly & Monopolistic Competition

Oligopoly: Few sellers of a homogeneous or differentiated product. Action of each seller will affect other sellers.

Exp: Telecom Sector, Aviation Industry

Monopolistic competition: Market organization in which there are MANY FIRMS selling CLOSELY RELATED but not identical commodities. Entry into and exit from the industry is rather easy in the long run.

Exp: Different Toothpaste available in the market (Close up, Pepsodent etc

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Classifications of Different Markets

Types of MarketNumber of Sellers Entry Barriers to

SellersNature of Product

Perfect Competition

Many, small, Independent

None Homogeneous

Monopoly One Insurmountable Homogeneous

Monopolistic Competition

Many, small, virtually

independent

None Differentiated

Oligopoly Few, interdependent

Substantial Homogeneous or differentiated

Source: Madala, G S (2005): Microeconomics, Theory and Applications, Tata McGraw Hill, New Delhi.

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Thanks a Lot