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THEORIES OF THE FIRM

THEORIES OF THE FIRM. Theories of the firm try to explain supply. BACKGROUND TERMS. Theories of the firm are organized around the different kinds of market forms in which firms can operate. In this course, the market forms are grouped this way: Perfect competition Monopoly

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THEORIES OF THE FIRM

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  1. THEORIES OF THE FIRM • Theories of the firm try to explain supply. Intro to firms

  2. BACKGROUND TERMS • Theories of the firm are organized around the different kinds of market forms in which firms can operate. • In this course, the market forms are grouped this way: • Perfect competition • Monopoly • Monopolistic competition, and • Oligopoly Intro to firms

  3. Perfect Competition • A market form with these characteristics: • 1) Large number of firms. • 2) Homogeneous product. • 3) Easy entry and exit of firms. • Some economists add to this list that consumers and firms also have cheap, accurate information about prices. Intro to firms

  4. What the assumptions boil down to is that each firm in perfect competition is a price taker. • NO FIRM HAS ANY CONTROL OVER MARKET PRICE. • This means that the demand curve the firm sees for its product is infinitely elastic. Intro to firms

  5. Infinitely elastic demand curve of a perfectly competitive producer of soybeans in Mason, Michigan: price P0 is the current market price. P0 quantity (hundred bushels) Intro to firms

  6. WARNING! • The market demand curve is still negatively sloped: MARKET FIRM S price price P0 P0 D quantity (million bushels) quantity (hundred bushels) Intro to firms

  7. In competitive markets, market price is determined by supply and demand. • If a firm were to raise its price above market price it would lose all its sales. It would never be silly enough to charge less because it can sell all it wants at the going market price. Intro to firms

  8. OTHER MARKET FORMS DEFINED • MONOPOLY: a market with only one seller of a product for which there are no close substitutes. • MONOPOLISTIC COMPETITION: a market with many firms, easy entry, and product differentiation. (Each firm produces a slightly different version of the product.) • OLIGOPOLY: a market with a small number of firms. Intro to firms

  9. PROFIT • Profit is the difference between total revenue and total cost, or Profit = TR - TC. • In economics class cost means OPPORTUNITY cost. • Because opportunity cost is often different from accounting cost, economic profit has a very special meaning and significance. Intro to firms

  10. TWO EXAMPLES SHOWING THE DIFFERENCE BETWEEN OPPORTUNITY (a.k.a. ECONOMIC OR FULL) COSTS, AND ACCOUNTING COSTS. Intro to firms

  11. Jim’s H&H Mobil -- A Proprietorship • Annual costs and revenues • Receipts from sales $200,000 • Costs • Employees’ labor $100,000 • Rent 25,000 • Gas, oil, parts, etc. 30,000 • Total explicit costs $155,000 • Accounting “profit” = 200,000-155,000=45,000 • Cost of Jim’s labor resources & effort = Value of Jim’s labor in next best use (an implicit cost) = $35,000 • ECONOMIC PROFIT = $10,000 Intro to firms

  12. BugOff Software, Inc. -- A Corporation • Receipts $400,000 • Costs • Employees’ Labor $100,000 • Disks, computers, • advertising, etc. 100,000 • Before tax accounting profit 200,000 • Profit taxes 50,000 • After tax profit 150,000 • Dividends 100,000 • Retained earnings 50,000 • Opportunity cost of capital = $125,000 • ECONOMIC PROFIT = 25,000 Intro to firms

  13. The smallest amount of money that must be paid to shareholders to keep them investing in the company is sometimes called “normal” profit. “Normal” profit is a cost. It is part of opportunity costs. Intro to firms

  14. SHORT-RUN VS. LONG-RUN • Short-run: a time period over which the firm has some inputs it can’t change. (Short-run implies at least one fixed input. In the short-run firms can’t enter or leave an industry.) • Reasons: • Long-run: a time period over which the firm can choose the amounts of all of its inputs. (Long-run implies no fixed inputs. In the long-run firms can enter or leave an industry.) Intro to firms

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