Objectives of Firms

• The short run is defined as a period over which at least one factor input is fixed. Production can only be varied by changing the quantity of variable factors.
• Production is the process by which factor inputs are transformed into output of goods and services, where the transforming agent is the firm.
• The long run is defined as a period over which all factors used in the production process are variable.
• The time duration that distinguishes short run and long run differs from firm to firm and from industry to industry, depending on the time needed to change the inputs to production.
• While a firm's production decision is subjected to a fixed maximum capacity in the short run, production in the long run is not constrained by any fixed factor.
• The long run encompasses enough time for existing firms to leave for new firms to enter the industry.
• Total cost is the sum of both:

  • Explicit costs
  • Implicit costs
• Explicit costs are the costs of using factor inputs that arise when a firm makes actual cash payments for the factor inputs purchased.
• Implicit costs are the opportunity costs of using factor inputs that are owned and do not involve a direct payment of money. These include self-owned and self-employed factor inputs.
• Fixed factors are inputs to the production process that cannot be altered in quantity over a given period of time.
• Variable factors are inputs to the production process which firms can alter the quantity over a given period of time.
• Total cost is the sum of all costs incurred by a firm producing a certain level of output, where

  Total Cost = Total Fixed Cost + Total Variable Cost
• Total Fixed Cost is the part of the production cost that is independent of the level of output.
• Total Variable Cost is the part of the production cost that is dependent of the level of output.
• Marginal Cost is the change in total cost that arises from producing one additional unit of output. It is entirely attributed to the change in variable cost.
• Marginal Cost = Change in Total Variable Cost / Change in Quantity
• Average Fixed Cost is the fixed cost per unit of output.
• Average Fixed Cost = Total Fixed Cost / Quantity of Output
• Average Variable Cost is the variable cost per unit of output.
• Average Variable Cost = Total Variable Cost / Quantity of Output
• Average Cost is the cost per unit of output.
• Average Cost = Total Cost / Quantity of Output
• Average Cost = ( Total Fixed Cost + Total Variable Cost ) / Quantity of Output
• Average Cost = Average Fixed Cost + Average Variable Cost
• This is a short-run cost curve:

  A) MC

  B) AC

  C) AVC

  D) AFC

  
• In a short-run cost curve, MC cuts the minimum point of both the AVC and AC curves.
• Optimum capacity is defined as the level of output that represents the lowest attainable unit cost for a given capacity or plant size. In the short-run, it is the minimum point of the AC curve.
• This is a long-run cost curve:

  A) LRMC

  B) LRAC

  
• In the long-run, the minimum efficient scale is at the minimum point of the AC curve.
• The LRAC curve provides a boundary between attainable and unattainable levels of cost, where points above the curve are attainable but productively inefficient, and points below the curve are unattainable.
• Internal economies of scale refer to the cost savings arising from the increase in scale of production of the firm. This is represented by a movement along the downward sloping portion of the LRAC curve.
• Internal diseconomies of scale refers to the situation where a firm experiences rising average cost as a result of increasing its scale of production. This is represented by a movement along the upward sloping portion of the LRAC curve.
• External economies of scale refers to the reduction in unit cost arising from industry expansion. This is represented by a downward shift of the LRAC curve.
• External diseconomies of scale refers to the increase in unit cost arising from an industry's expansion. This is represented by an upward shift of the LRAC curve.
• Economic profit = Total Revenue - Total Economic Costs
• Total Economic Costs = Explicit Costs + Implicit Costs
• Principal-Agent Problem arises due to:

  • Separation between ownership and management
  • Interests of managers conflict with that of the shareholders
  • Information asymmetry and high cost of monitoring
• A profit-maximising firm would produce at the level of output where MR = MC, and where MC cuts MR from below.
• A revenue-maximising firm would produce at the level of output where MR = 0.
• Reasons for sales revenue maximisation:

  • A sign of healthy growth of a normal firm
  • Managers prefer steady performance
  • Large sales, which grow over time, gives prestige to managers
  • Investors are more willing to invest in firms with large and growing sales