Supply and Firms, Theory of the Firm

1/44
4008AFE The Economics Environment of Business
Week 3: Supply and Firms, Theory of the Firm
Dr Alban Asllani
Lecture Outline
1 Introduction
2 Supply
3 Firm Theory
4 The Supply Decision
5 Short-Run Costs
6 Costs in the Long-run
7 Profit
8 Conclusion
2/44
Intended Learning Outcomes
3/44
Today wetake the second step towards understanding how markets
work.
After this lecture you should be able to understand and analyse:
How the behaviour of firms and their economic interactions
form supply.
How the supply side of the economy works.
Firm Theory and the Supply Curve.
The law of Supply
Law of Supply
The law of supply states a positive relationship between price
and quantity supplied. A higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied.
Supply refers to the amount of some good or service firms are
willing and able to supply at each price.
Supplycurves(graphs) and supplyschedules(tables) are
tools used to summarize the relationship between quantity
supplied and price.
4/44
Supply curves and schedules
5/44
The supply curve and the supply schedule are different
representations of the same thing.
The supply equation
QS = a+ b P
Where Qs is the quantity supplied, P is the price of the good,
ais the intercept and b is the slope parameter
Supply curves and schedules
P O
Q
S
7/44
Supply curves and schedules
P O
Q
S
7/44

Price Quantity
£1 3
£2 6
£3 9
£4 12
£5 15
£6 18

Table: Supply schedule
Factors that influence supply
8/44
Any change in price level represents a movement along the same
supply curve. The supply curve will shift if any other factor that
affects supply changes.
Cost of the factors of production (land, labour, capital).
Technology.
External shocks, such as weather, war etc.
Number of producers. As the number of firms producing a
product increases, wewould expect more supply to be
available.

Supply and Technology
(0,0) Q
Q
0 Q1
P Advance in Technology
S
S
,
P
D,
D
9/44
How is the supply curve derived?
10/44
What determines the shape of the supply curve?
How do firms decide about their supply?
What is the relationship between input and output?
How do costs vary with output?
How do wemeasure profit, and how do wemaximize it?
Profit
Profit
Profit is the main economic goal of any company. Every firm
wants to maximize profits.
It is computed by deducting total cost from total revenue.
Formula
π = TR TC
So how do the firms determine at what level to produce?
11/44
Firm and Production
12/44
Firms use inputs to produce their goods (output)
This process, the transformation of inputs to output, is
described by the
production function
In other words, the production function (PF) will tell us, how
much wecan produce if wechange the ”mixture” of inputs we
allocate.
In a simple form the PF looks like this: Q = f (K ,L), where K
is capital and L is labour.
So, wecan adjust our inputs to find the ”perfect mixture” for
our desired output level.

Firm and Production
13/44
We can calculate how much an additional factor of production
will add to our output using the function:
MP =f ∆∆QQf
where Q is the output and Qfis the amount of factor
(remember ∆ denotes”change”).
As a result, wecan calculate the marginal product of labour
which is the increase in product from an additional unit of
labour:
MPL = ∆∆QL
However, all units of labour do not contribute the same in
production.

Diminishing Marginal Product
14/44
Consider a fixed field of land of about 100m2where cotton is
planted.
Without any workers to harvest the initial production is 0.
When we add the first worker the production increases from 0
to 50 kg of cotton. Because he is alone, some of the cotton is
wasted in theprocess.
Hiring a second worker increases production from 50 to 90
and the third one from 90 to 120 and then with the 4
th
worker weget 140kg.
Diminishing Marginal Product
15/44
You can see from the above that with every additional worker
our total product is increasing. But it does so in a decreasing
way.The marginal product of labour from 50 went down to
40, to 30 and so on…
If wego to an extreme example of adding an additional 20
workers, while our field remains at 100
m2, meaning that
everyone is bumping on each other making it very hard to do
their job or the equipment is not enough for everyone, we
could see a production of a total of 80 kg of cotton!

Diminishing Marginal Product
16/44
This phenomenon is observed in almost all productive
activities and is called
diminishingmarginal product.
This plays a significant role in the decision making process of
the firm as every input costs money. So adding extra workers
to the production, not only increases the production, but also
the cost of producing.

Total Cost
Total cost consists of:
TotalFixedCost(TFC ), that are not dependent on the level
of goods or services produced by the firm, such as rents or
labour not associated with production.
TotalVariableCost(TVC ), costs associated with producing
a good or service that change in direct proportion to the
quantity produced or provided, such as raw materials,
packaging or labour directly associated with production.
Total Cost
TC = TFC +TVC
17/44
Factors of Production
18/44
Rent
Wages
Interest
Profit
Factors of production:
Land
Labour
Capital
Entrepreneurship
Fixed or Variable factors ?

Example: Factors of Production
19/44
Bakery
Fixed factors: cannot be
increased in supply within a
given time period
The building that the
bakery rents
Capital, such as ovens used
to bake goods
Variable factors: can be
increased in supply within a
given time period
Flour and other raw
materials
Utility bills depend on the
quantity produced, e.g.
ovens use electricity.

Short-run vs long-run
20/44
Howisthe operatingperioddefined?
Short-run
Period of time over which at least one factor is fixed
Fixed cost is ashort-run concept
Long-run
Period of time over which all factors are variable
All costs arevariable in thelong-run
Short-run cost categories
21/44
Totalcost(TC ) = TFC + TVC
Total fixed costs(TFC ), do not vary with amount of output
produced
Total variable costs(TVC ), do vary with amount of output
produced
Marginal cost: The cost of producing one more unit.
MC = TC
Q
Average total cost: Total cost per unit of output. ATC = TC Q
Fixed Cost Curve
12
11
10
9
TC
TFC
0
0 1 2 3 4
Q
5 6 7
22/44
TVC Curve
80
60
40
20
TC
TVC
TFC
0
0 1 2 3 4
Q
5 6 7
23/44
TVC Curve
80
100
60
40
20
0
0 1 2 3 4 5 6 7
Q
TC
TVC
TFC
TC
24/44
Costs in the Short-run
25/44
Table: Total, Marginal and Average Costs.
Output TFC TVC TC MC AFC
0 12 0 12

1 12 10 22 10 12
2 12 16 28 6 6
3 12 21 33 5 4
4 12 28 40 7 3
5 12 40 52 12 2.4
6 12 60 72 20 2
7 12 91 103 31 1.7

Average Fixed Cost and Quantity
2 4 6
0
0
12
10
8 6 4 2
Q
TC
AFC
26/44
Consider a firm that produces
only one unit. This unit will bear
the full fixed cost. But as
production increases, the TFC is
shared amongst more units.
AFC falls rapidly at first,
reaching very low levels as
production increases.

Marginal and Average Costs
The MC line crosses
the
AVCline at its
lowest point (y)
MC = AVC
At point x the MC is
minimized and AVC is
decreasing.
At point z AVCis
increasing and
MC >AVC
27/44
Marginal and Average Costs
28/44
ATC = AFC + AVC
The ATC is the sum of the AFCand the AVC
The ATC is U-shaped. At first it falls and then starts
increasing.
At first, it falls because the TFC is shared between more units
and MC is decreasing due to division of labour.
Then, it rises due to diminishing marginal returns.
Economies and diseconomies of scale
29/44
Increasing returns to scale, or economies of scale: An increase
in a firm’s scale of production leads to lower costs per unit
produced.
Constant returns to scale: An increase in a firm’s scale of
production has no effect on costs per unit produced.
Decreasing returns to scale, or diseconomies of scale: An
increase in a firm’s scale of production leads to higher costs
per unit produced.

Deriving the LRAC
Factories of fixed size.
Additional factories
increase the average
cost in the market as
the quantity
increases.
30/44
Deriving the LRAC
31/44
Deriving the LRAC
32/44
Firm’s Revenue
33/44
Total revenue: total amount a firm earns from its sales in a
given time period.
TR = P Q
Average revenue: total revenue per unit. AR = TR Q, i.e.
AR = P. The AR curve will be the same as the demand curve
for the firm’s product.
Marginal revenue: extra revenue earned from the sale of one
more unit per time period.
(
MR) = ∆TR
Q
Firm’s Profit
34/44
Total cost: is the cost that the firm faces when producing a
certain level of output.
TC = TFC +TVC
Total revenue: total amount a firm earns from its sales in a
given time period.
TR = P Q
Profit is the difference of the two.
π = TR TC
Profit Maximization
Every firm wants to maximize profits.
max
π = TR TC
Step 1:
∂π
= 0
Q
Step 2:
MR MC = 0 MR = MC
35/44
Profit Maximization
36/44
The profit maximizing quantity is the one that yields
MR = MC
the firm’s marginalbenefitis its marginalrevenue: the
addition to revenue from producing one moreunit
Marginalcost:addition to cost from producing one moreunit
Profit Maximization
37/44
Intuition
If MR > MC , you are not profit maximizing, producing more
will add more to your revenue than your cost (i.e. profit);
If MR < MC , you are not profit maximizing, producing less
will add to your profit
Therefore, you can only profit maximized when MR = MC
Profit Maximizing – Graph
2 6 8
0
0
5
10
15
20
4
Q
Cost and
Revenue
MC
38/44
Profit Maximizing – Graph

1 2 3 5 6 7
Qmax
a
Q
Cost and Revenue

8
3
21
18
15
12
9 6 3
MC
MR
39/44
Profit Maximization
40/44
Normal profit and Supernormal profit
Normalprofitis:
an economic condition occurring when the difference between
a firm’s total revenue and total cost is equal to zero.
it is the minimum level of profit needed for a company to
remain competitive in the market.
Supernormalprofitis:
Any excess profit over normal profit.
What We Learned Today
41/44
How the Supply curve is determined
Short-run costs (TC,TFC,TVC,ATC,AFC,AVC,MC)
Deriving the long-run cost
Profit Maximization
Conclusion
42/44
Review today’s lesson.
Read the relevant chapters in the book (Ch.3, pg.38-42 and
Ch.6, including all boxes and case studies)
Search online for more sources.
Ask questions in seminar if anything is unclear.
Do self-test questions at the end of the chapter and online.
Thank youfor your attention.
Questions?
43/44
44/44