Booklet 7- Theory of the Firm

• Economies of scale - The reduction in average costs as output increases
• Diseconomies of scale - An increase in average cost as output increases.
• Internal economies of scale - Cost savings that arise from within the firm, such as specialisation or increased efficiency due to larger size.
• External economies of scale - Cost savings that arise outside the firm, such as lower transport costs when suppliers are closer together.
• Minimum efficient scale (MES) - The minimum level of output at which all possible internal economies have been achieved.
• Long run average cost curve - Shows how long run average costs change with changes in output.
• Barriers to entry - Any factor which makes it difficult for new firms to enter an industry.
• Monopoly - Where there is only one supplier of a good or service.
• U shape LRAC curve - Occurs where there is an MES and increasing returns to scale up to this point followed by decreasing returns to scale beyond it.
• Increasing returns to scale - When a percentage rise in inputs leads to more than a proportionate rise in outputs.
• Industry structure - The way an industry is organised with regards to its number of firms, market share and barriers to entry.
• Economic profit = Total revenue – total opportunity cost
• Perfect competition - An industry where many small firms produce identical products and sell them on a competitive market.
• Oligopoly - An industry dominated by a few large firms who compete against each other.
• Decreasing returns to scale - When a percentage rise in inputs leads to less than a proportionate rise in outputs.
• Constant returns to scale - When a percentage rise in inputs leads to exactly the same proportionate rise in outputs.
• Market power - Ability of firm/industry to influence price above marginal cost.
• Examples of internal economies of scale:

  1. Risk bearing
  2. Financial
  3. Managerial
  4. Technical
  5. Marketing
  6. Purchasing
• Examples of External economies of scale

  1. better transport infrastructure
  2. component suppliers move closer
  3. research and development firms move closer
• Examples of diseconomies of scale in a firm:

  1. Control
  2. Communication
  3. Coordination
  4. Motivation
• Diminishing Returns

  The concept that as more units of a variable input are added to a production process while holding other inputs constant, the marginal output will eventually decrease.
• Price Taker


  A firm that has no influence on the market price of its product. The firm has to accept the market price for its product.
• Price Maker


  A business or firm that can influence the market price of a good or service.
• Perfect Competition

  A market structure where many firms produce a homogeneous product with free entry and exit, perfect information, and no barriers to entry or exit
• Imperfect competition


  A market structure where there are multiple firms producing differentiated products, with barriers to entry.
• Differentiated products


  Products that are unique or have distinctive features, allowing firms to differentiate themselves from others.
• Barriers to entry

  Obstacles that prevent new firms from entering the market, creating a limit to the number of firms that can produce goods and services.
• Agency Problem


  A situation where the objectives of the owner (shareholders) and the manager (agent) of a firm may not align, leading to a conflict of interest.
• Monitoring and Control

  Measures taken by shareholders, Board of Directors, and external auditors to ensure managers act in the company's best interests.
• Incentivization


  Methods to motivate managers to act in the company's best interests, such as performance-based bonuses or stock options.
• Limit Pricing


  A strategic pricing approach where a firm sets a price lower than its minimum average cost to deter new entrants from entering the market.
• Natural Monopoly


  A market situation where one firm can supply the entire market at a lower average cost than two or more firms could, usually due to economies of scale.
• First Mover Advantage


  The benefits gained by being the first company to introduce a new product, service, or innovation in a market.
• Complex Monopoly


  A market structure where a single firm has a monopoly on a product or service due to technological advancements or regulatory changes, but still faces competition in other areas.
• Revenue Maximization

  A goal of a firm where it tries to earn the highest possible revenue by setting the optimal price and quantity, considering market demand and production costs.
• Dynamic Efficiency


  The ability of a market economy to adapt and innovate over time, leading to the production of new goods and services, and the improvement of existing ones.
• Perfect Price Discrimination


  Theoretically, a firm can differentiate its products or services and charge a unique price for each individual customer, maximizing its profits if it has full information about each customer's willingness to pay.
• Duopoly


  A market structure where only 2 firms produce a product or service
• Price Fixing


  An illegal agreement between firms to set prices
• Consumer Surplus


  The difference between the maximum amount a buyer is willing to pay (reservation price) and the market price of a good or service.