Economics for the IB Diploma

Microeconomics

Chapter 6

The theory of the firm I:
Production, costs, revenues
and profit

Higher level topic

This chapter and the next are concerned with the behaviour of firms. Much of firm behaviour depends on the
type of market structure within which the firm operates, which will be studied in Chapter 7. The present chapter
introduces the fundamental concepts necessary to analysing firm behaviour: production, costs, revenues and profit.

6.1 Production in the short run: the • The long run is a time period when all inputs
law of diminishing returns can be changed. Using the example above, in this
time period the firm can build new buildings and
All firms use inputs (or resources, or factors of factories and buy more heavy machinery; it can
production) to produce output. The quantities of change all of its inputs. In the long run the firm has
inputs needed to produce output is determined by a no fixed inputs; we say all inputs are variable.
technical relationship explaining why firms behave the
way they do. This technical relationship depends on a Note that the short run and the long run do not
distinction between the short run and the long run. correspond to any particular length of time. Some
industries may require months to change their fixed
The short run and the long run inputs while others may require years.

Distinguish between the short run and long run in the Total product, marginal product and
context of production. average product

The difference between the short and long run is the Define total product, average product and marginal
following: product, and construct diagrams to show their relationship.

• The short run is a time period during which at Understanding and illustrating total,
least one input is fixed and cannot be changed marginal and average product curves
by the firm. For example, if a firm wants to increase In this section, we will study the relationship between
output, it can hire more labour and increase inputs and output in the short run. Since we are
materials, tools and equipment, but it cannot studying the short run, we know the firm has both
quickly change the size of its buildings, factories fixed and variable inputs. For simplicity, let’s consider a
and heavy machinery. As long as these inputs are hypothetical firm that uses only two inputs, land and
fixed, the firm is operating in the short run. labour, where land is the fixed input and labour is the

Chapter 6 The theory of the firm I 139

variable input; we can think of this firm as a simple farm. (9 − 5) 4
The only way the farm can increase the quantity of its = =4
output in the short run is by increasing the quantity of
labour it uses. We can now distinguish between: (3 − 2) 1

• Total product (TP) is the total quantity of output the marginal product of the sixth worker is
produced by a firm.
(21 − 18) = 3 = 3
• Marginal product (MP) is the extra or additional (6 − 5) 1
output resulting from one additional unit of the
variable input, labour; it tells us by how much To find average product, we take the total product
output increases as labour increases by one worker. and divide it by the units of labour that produce that
Marginal product is given by: amount of product. For example, the average product
of the third worker is
Δ TP
MP = 9 = 3; of the sixth worker it is 21 = 3.5
36
Δ units of labour
The total, marginal and average products of
• Average product (AP) is the total quantity of output Table 6.1 are drawn in Figure 6.1. Part (a) plots the
per unit of variable input, or labour; this tells us total product data of column 2 of the table, while
how much output each unit of labour (each worker) part (b) plots the marginal and average product
produces on average. Average product is given by: data of columns 3 and 4. The vertical axis in both
figures measures units of output, and the horizontal
TP axis measures units of the variable input (labour).
AP = Note that the scale of variable input units on the
horizontal axis is identical in both parts, so the MP
units of labour and AP curves in part (b) correspond to the TP curve
in part (a). Both (a) and (b) are divided into three
Table 6.1 shows an example of the total product that parts:
results as the number of units of labour working
on the fixed land (the farm) increases. Once we are • Increasing marginal product. When labour
given the information in columns 1 and 2, we can units are between 0 and 4, the marginal product
easily calculate marginal and average product. To find of labour is increasing, as we see in part (b): the
marginal product, we take an increase in TP and divide addition to total product made by each unit of
it by the increase in the units of labour. For example,
the marginal product of the third worker is

(1) (2) (3) (4)
Units of variable input Total product
(units of output) = TP Marginal product Average product
(labour)
(units of output) = MP (units of output) = AP

MP = Δ Δ TP AP = units TP
units of labour of labour

0 0 − −
1 2
2 5 2 2
3 9
4 14 3 2.5
5 18
6 21 4 3
7 23
8 24 5 3.5
9 24
10 23 4 3.6
11 21
3 3.5
Table 6.1 Total, marginal and average products
2 3.3
140 Section 1: Microeconomics
1 3

0 2.7

−1 2.3

−2 1.9

(a) Total product curve based on data of Table 6.1units of output units of output(c) Total product curve
25
20 TP TP
15
10 0
5 units of variable input (labour)

0 1 2 3 4 5 6 7 8 9 10 11
units of variable input (labour)

units of outputincreasing decreasing negative units of output
6 marginal marginal marginal
5 product product product AP
4 0 MP
3
2 units of variable input (labour)
1 AP
0 (d) Marginal and average product curves
-1 1 2 3 4 5 6 7 8 9 10 11
-2 units of variable input MP
-3 (labour)

(b) Marginal and average product curves based on data of Table 6.1

Figure 6.1 Total, marginal and average products

labour gets bigger and bigger. When 4 workers are the tenth and eleventh workers that we see in
employed, marginal product, equal to five units of part (b).1
output, is maximum.
The relationship between the marginal
• Decreasing marginal product. When labour units and average product curves
are between 4 and 9, the marginal product of labour Average product also rises at first and then falls
is decreasing (and positive, or greater than zero), (see Figure 6.1(b)). Note the relationship between
as we see in part (b). Here, the addition to total the average and marginal product curves: when the
product made by successive units of labour becomes marginal product curve lies above the average product
smaller and smaller. curve (MP > AP), average product is increasing; and
when the marginal product curve lies below the average
• Negative marginal product. At 8 and 9 units of product curve (MP < AP), average product is decreasing.
labour, total product is maximum, as we see in This means the marginal product curve always intersects
part (a), and the ninth unit of labour adds zero the average product curve when this is at its maximum. The
units of output; the marginal product of the ninth reason lies in the mathematical relationship between
unit of labour is zero, shown in part (b). Beyond the average and marginal values of any variable.
9 units of labour, total product begins to fall and
corresponds to the negative marginal product of

1 The mathematically inclined student will note that the marginal Therefore, with increasing marginal product, MP increases (Figure
product, measuring the change in total product arising from an 6.1(b)) because the slope of the TP curve is increasing (Figure 6.1(a)).
additional unit of labour, is the slope of the total product curve. (The With decreasing marginal product, MP falls because the slope of the TP
slope is here interpreted in the mathematically correct way, referring to curve decreases. When 9 units of labour are employed, the slope of the
the change in the vertical axis divided by the change in the horizontal TP curve is 0 (i.e. the marginal product of the ninth worker is zero) and
axis; see ‘Quantitative techniques’ chapter on the CD-ROM, page 19.) beyond that the MP, or the slope of the TP curve, becomes negative.

Chapter 6 The theory of the firm I 141

Consider a simple example involving test scores. Say With four workers, marginal product is the greatest it
you have an average of 80 in your tests and you would can be; when the fifth worker is added, marginal product
like to increase your average. If your next text score (the begins to fall, and falls continuously thereafter. This
‘marginal’ score) is greater than your average of 80, your is the point at which diminishing returns begin. Why
average will increase. If your next test score is lower does this happen? On the farm, it happens because of
than your average of 80, then your average will fall. overcrowding: each additional worker has less and less
This relationship between average and marginal test land to work with, and so produces less and less output.
scores is exactly the same as the relationship between Eventually, the conditions on the farm become so
average and marginal products. crowded that the ninth worker adds zero extra output;
with the addition of the tenth worker the marginal
Generalised product curves product is negative and total product begins to fall.
Figures 6.1 (c) and (d) show the total, marginal and
average product curves that result in the general More generally, marginal product will begin to
case when a variable input is added to a fixed input. fall at some point not just on a farm with a fixed
These curves show the technical relationship between piece of land, but whenever more and more units of
inputs and output that we need to understand to a variable input are added to a fixed input (provided
study firm behaviour in the short run. We turn to this the technology of production is unchanging).
relationship next. For example, in the case of a factory where more and
more workers are hired, each worker will have fewer
Law of diminishing returns and fewer machines and equipment to work with, and
so will add less and less output.
Explain the law of diminishing returns.
Imagine what would happen if diminishing returns
In the short run, the technical relationship between did not exist. Using our farm example, it would be
inputs and output is provided by the law of possible for food production to increase indefinitely
diminishing returns. just by continuously adding variable inputs to a fixed
piece of land – a clear impossibility!
According to the law of diminishing returns
(also known as the law of diminishing marginal Real world focus
product), as more and more units of a variable input
(such as labour) are added to one or more fixed David Ricardo and
inputs (such as land), the marginal product of the the end of agricultural
variable input at first increases, but there comes a output growth
point when it begins to decrease. This relationship
presupposes that that the fixed input(s) remain fixed, David Ricardo, a famous English economist of the 19th
and that the technology of production is also fixed. century, believed that agricultural output would eventually
stop growing, because as more and more labour and capital
The law of diminishing returns is reflected in the data inputs were added to land that was fixed in quantity, the
of Table 6.1 and the curves of Figure 6.1. When there additional output of labour and capital would become
are zero workers on the land, there is no output at all; smaller and smaller until it would no longer be possible for
it is equal to zero. When one worker is hired, there total output to increase further.
will be some output and so total product is two units.
Marginal product is also equal to two units. But one Applying your skills
worker alone on the farm must do all the ploughing,
planting, harvesting, and so on, and so output is quite 1 Explain the law that describes the process
low. When a second worker is hired, the two workers Ricardo was referring to.
share the work, and total product increases to five units,
indicating that the output produced by the two together 2 Do you think Ricardo’s fears were justified?
is more than double the output of the first working 3 How can you explain the growth of agricultural
alone. The additional (or marginal) product due to
the second worker (three units) is greater than that of output in the real world in spite of a fixed
the first (two units). This process is repeated with the quantity of land?
addition of the third and fourth workers, and marginal
product increases with the addition of each one.

142 Section 1: Microeconomics

Calculating total, average and marginal input; and from TP we then calculate marginal
product product as well. If we are given marginal product,
we find total product by adding up the successive
Calculate total, average and marginal product from a set of marginal products of each additional unit of labour.
data and/or diagrams. The example in Table 6.2 shows the calculations made
to find total product from marginal product.
If we are given data on the total product of a firm, it
is a simple matter to calculate average and marginal To calculate TP, AP or MP from a diagram, we
product; we simply apply the formulae shown on page simply read off the information appearing in the
140. If we are given data on average product, we can graph, and apply exactly the same principles as in
find total product by using TP = AP × units of variable Table 6.2 to calculate the variable or variables we are
interested in.

Units of labour 12 3 4 5
(variable input)
20 25 20 15 10
Marginal product (MP)
20 45 65 80 90
Total product (TP)

(= 25 + 20) (= 20 + 25 + 20) (= 15 + 20 + 25 + 20) (= 10 + 15 + 20 + 25 + 20)

Table 6.2 Calculating total product

Test your understanding 6.1 (b) Define the law demonstrated by the pattern
shown by the marginal product and average
1 Distinguish between the short run and the long product figures and curves.
run in relation to production.
(c) Why does this law only hold in the short run?
2 Define (a) total product, (b) marginal product,
and (c) average product. (d) With how many units of the variable input
do we see the beginning of diminishing
3 Why does marginal product reach a point when returns (diminishing marginal product)?
it begins to decrease? Show this in your diagram.

4 What happens to average product when (e) With how many units of the variable
MP > AP? When MP < AP? input do we see the beginning of negative
returns? Show this in your diagram.
5 Copy the following table, then fill in the missing
figures to show production in the short run. (f) Explain the relationship between the average
product and marginal product curves.
Units of Total product Marginal Average
variable product product 7 Copy the following table, then fill in the missing
input (labour) figures to show production in the short run.

00 Units of Total product Marginal Average
1 10 variable product product
2 22 input (labour)
3 35 –
4 46 0 3
5 54 5
6 59 1
7 61
8 60 2

6 Using the information in question 5: 34
43
(a) Plot the total product, marginal product 52
and average product curves. 60
7 –1
8 –3

Chapter 6 The theory of the firm I 143

8 Using the data in question 7, (a) plot the resource, which is an opportunity cost. Therefore
total product, marginal product and average all production costs are opportunity costs, and are
product curves. (b) With how many units of known as economic costs.
the variable input do we see the beginning of
diminishing returns (diminishing marginal In economics, because of the condition of
product)? Show this in your diagram. (c) With scarcity, economic costs, which include all costs of
how many units of the variable input do we see production, are opportunity costs of all resources
the beginning of negative returns? Show this in used in production.
your diagram.
Explicit, implicit costs and
9 Copy the following table, then fill in the economic costs
missing figures to show production in the
short run. Distinguish between explicit costs and implicit costs as the
two components of economic costs.
Units of Total product Marginal Average
product We can distinguish between two kinds of economic
variable product costs (opportunity costs), depending on who
owns the resources used by the firm. Resources
input (labour) are either owned by the firm itself, or are owned
by outsiders to the firm from whom the firm
0– buys them.

1 4.00 Explicit costs
When the firm uses resources it does not own, it
2 5.00 buys them from outsiders and makes payments
of money to the resource suppliers. For example,
3 4.33 a firm hires labour and pays a wage; it purchases
materials and pays the price to the seller; it uses
4 3.75 electricity and pays the electricity supplier, and
so on.
5 3.20
Payments made by a firm to outsiders to acquire
6 2.50 resources for use in production are explicit costs.

6.2 Introduction to costs of The opportunity cost of using resources not owned
production: economic costs by the firm is equal to the amount paid to acquire
them; these payments could have been made to
Costs of production as opportunity costs buy something else instead, which is now being
sacrificed.
Explain the meaning of economic costs as the opportunity
cost of all resources employed by the firm (including Implicit costs
entrepreneurship). The firm may own some of the resources that it uses
for its production, such as, for example, an office
When firms use resources to produce, they incur building. In this case, the firm does not make a
costs of production, which include money money payment to acquire the resource. There is still
payments to buy resources plus anything else a cost involved in the use of the self-owned resource,
given up by a firm for the use of resources. which is the sacrifice of income that would have been
The resources include land, labour, capital and earned if the resource had been employed in its best
entrepreneurship (see Chapter 1, page 3). Because alternative use.
of scarcity, the use of any resource by a firm
involves a sacrifice of the best alterative use of that

144 Section 1: Microeconomics

The sacrificed income arising from the use of self- Economic costs (= total opportunity costs)
owned resources by a firm is an implicit cost. £109 000 (implicit costs)
+ £ 50 000 (accounting costs)
In the case of the office building owned and £159 000
used by the firm, the opportunity cost is the
rental income that could have been earned if the Test your understanding 6.2
building were rented out. The hours of work a firm
owner puts into his or her own business have an 1 Explain (a) explicit costs, and (b) implicit costs.
opportunity cost equal to what the firm owner could Provide examples of each.
have earned if s/he had worked elsewhere. The
entrepreneurial abilities the firm owner puts into the 2 Why do both explicit costs and implicit costs
business (risk-taking, innovative, organisational and represent opportunity costs to the firm?
managerial abilities) entail a further opportunity
cost equal to what these abilities could have 3 Why are economic costs greater than explicit
earned elsewhere. costs?

Economic costs 4 Explain the meaning of economic cost, using the
Adding together explicit and implicit costs, we get the concepts of explicit, implicit and opportunity
firm’s economic costs. costs.

Economic costs are the sum of explicit and 6.3 Costs of production in the
implicit costs, or total opportunity costs incurred by short run
a firm for its use of resources, whether purchased or
self-owned. When economists refer to ‘costs’ they Short-run costs
mean ‘economic costs’.
We can put together the concepts we learned above to
Suppose you had a job with a salary of £60 000 a year, study costs of production in the short run.
which you decided to quit to open your own business.
You estimate that your entrepreneurial talent you are Fixed, variable and total costs in the
putting into your business is worth £45 000 a year. short run and long run
You set up your office in a spare room of your house
that you used to rent out for £4000 a year. Further, Explain the distinction between the short run and
you borrow £30 000, for which you are paying interest the long run, with reference to fixed costs and variable
of £2000 a year, and use the borrowed amount to costs.
buy supplies and materials. You also hire an assistant
whom you pay £18 000 a year. Your explicit, implicit The distinction between fixed inputs and variable
and economic costs are: inputs discussed on page 139 in connection with the
short and long run leads us to a distinction between
Implicit costs fixed and variable costs:
£60 000 (opportunity cost of your foregone
• Fixed costs arise from the use of fixed inputs.
salary) Fixed costs are costs that do not change as output
+£45 000 (opportunity cost of your changes. Examples of fixed costs include rental
payments, property taxes, insurance premiums
entrepreneurial talent) and interest on loans. They do not increase if the
+£ 4 000 (opportunity cost of foregone rental firm produces more output, and do not decrease if
it produces less. Even if there is zero output, these
income from your spare room) payments still have to be made in the short run.
£109 000 Fixed costs arise only in the short run, as in the long
run there are no fixed inputs.
Explicit costs
£ 2 000 (interest on your loan) • Variable costs arise from the use of variable inputs.
These are costs that vary (change) as output
+£30 000 (purchase of supplies and materials) increases or decreases, therefore they are ‘variable’.
+ £18 000 (assistant’s salary) An example is the wage cost of labour. To produce
more output, the firm hires more labour, and has
£50 000

Chapter 6 The theory of the firm I 145

increased wage costs. The more variable inputs a are equivalent is that fixed costs are constant (do not
firm uses, the greater the variable costs. change) as output increases or decreases. Marginal cost
• Total costs are the sum of fixed and variable is given by:
costs.
MC = Δ TC Δ TVC
In the short run, a firm’s total costs are the sum of =
fixed and variable costs. In the long run there are no ΔQ ΔQ
fixed costs, therefore a firm’s total costs are equal to
its variable costs. where the Greek letter Δ stands for ‘change in’.

Total, average and marginal costs Test your understanding 6.3

Distinguish between total costs, marginal costs and average 1 Define (a) fixed costs, (b) variable costs, and (c)
costs. total costs, and explain how they are related to
the distinction between the short run and the
Average costs long run.
Average costs are costs per unit of output, or total
cost divided by the number of units of output. They 2 Which of the following are fixed and which are
tell us how much each unit of output produced costs variable costs:
on average. From our definitions above, we have three (a) insurance premiums on the value of the
total costs, each one corresponding to an average cost: property owned by a business
(b) interest payments on a loan taken out by a
Total costs Average costs business
total fixed costs average fixed costs (c) wage payments to the workers that are
(TFC) (AFC) hired by a business
total variable costs average variable costs (d) payments for the purchase of seeds and
(TVC) (AVC) fertiliser by a farmer.
total costs average total costs
(TC) (ATC) 3 (a) Define the three kinds of average costs,
and explain how they are derived from the
To calculate average costs, we simply divide each of three kinds of total cost. (b) How are the
the totals by the units of output (Q) that the firm three kinds of average costs related to each
produces: other?

TFC TVC TC 4 Define marginal cost, and explain how it is
AFC = AVC = ATC = related to total cost and total variable cost.

Q Q Q Costs curves and product curves

It was noted above that total cost is the sum of fixed Draw diagrams illustrating the relationship between
costs plus variable costs: marginal costs and average costs, and explain the
connection with production in the short run.
TC = TFC + TVC
Drawing the short-run cost curves
Similarly, average total costs are the sum of average In this section, we will draw diagrams of a firm’s total,
fixed costs plus average variable costs: average and marginal costs. Let’s continue with our
example of the data in Table 6.1 (page 140), and assume
ATC = AFC + AVC that the farm incurs fixed costs of €200 per week (for
rent for the land), and that the cost of labour is €100
Marginal costs per worker (per unit of labour) per week. We now have
Marginal cost (MC) is the extra or additional cost of all the information we need to calculate the firm’s
producing one more unit of output. It tells us by how short-run production costs, which appear in Table 6.3:
much total costs increase if there is an increase in
output by one unit. It is calculated by considering the • Columns 1 and 2 contain the same data on total
change in total cost (TC) resulting from a change in product and corresponding labour input that appear
output. In addition, it can be calculated by considering in Table 6.1.
the change in total variable cost (TVC) that results
from a change in output. The reason why the two

146 Section 1: Microeconomics

(1) (2) (3) (4) (5) (6) (7) (8) (9)
Total Labour Total fixed Total Total cost Average Average Average Marginal
product (units of variable fixed cost variable total cost
= TP or Q labour) cost cost = TC = AFC = ATC cost
(units) = TFC = TVC TC = cost ATC = TC = MC
TFC + TVC AFC = TFC = AVC
(€) (€) (€) Q Q MC = Δ TC
or ATC = ΔQ
0 200 (€) AVC = TVC AFC + AVC
100 300 Q Δ TVC
200 400 (€) (€) MC = ΔQ
300 500
400 600 150 (€)
500 700 80
0 0 200 600 800 − − −
2 1 200 700 900 100 50 55.5
5 2 200 800 1000 40 40 42.9 50
38.9
9 3 200 22.2 33.3 38.1 33.3
14 4 200 14.3 28.6 39.1
18 5 200 11.1 27.8 41.6 25
21 6 200 9.5 28.6 20
23 7 200 8.7 30.4 25
24 8 200 8.3 33.3 33.3
50
Table 6.3 Total, average and marginal costs 100

• Column 3 shows the farm’s total fixed cost (TFC) of ΔTVC = ΔTC. (You can confirm this by comparing
€200; this payment has to be made even when total the figures in column 4 with those in column 5.)
product is zero.
All the cost information of Table 6.3 is shown
• Column 4 shows the farm’s total variable cost, graphically in Figure 6.2 (a) and (b). (Parts (c) and
which is the number of workers (from column 2) (d) show cost curves in the general case for a firm
times €100 per worker. in the short run.) Both parts (a) and (b) measure costs on
the vertical axis, and units of output on the horizontal
• Column 5 calculates total cost, which is the sum of axis. Part (a) illustrates the three total cost curves (TFC,
total fixed cost (column 3) plus total variable cost TVC, TC), and part (b) the three average cost curves
(column 4). (AFC, AVC, ATC) and the marginal cost (MC) curve.

• Column 6 shows average fixed cost, obtained by In part (a):
dividing total fixed cost (column 3) by the number
of units of output (column 1). • The TFC curve is parallel to the horizontal axis, as
it represents a fixed amount of costs that do not
• Column 7 calculates average variable cost, obtained change as output changes.
by dividing total variable cost (column 4) by the
number of units of output (column 1). • The TVC curve shows that TVC increases as output
increases. However, it does not increase at a constant
• Column 8 shows average total cost, obtained by rate; this is due to the law of diminishing marginal returns.
dividing total cost (column 5) by the number of
units of output (column 1): alternatively, average • The TC curve is the vertical sum of TFC and TVC,
total cost is the sum of AFC plus AVC. and so the vertical difference between TC and TVC
is equal to TFC.
• Column 9 shows marginal cost, obtained by
dividing the change in total cost (from column 5) by In part (b):
the change in the number of units of output (from • The AFC curve indicates that AFC falls continuously
column 1); for example, when total cost increases
from €200 to €300, so that ΔTC = 100, TP increases as output increases, because it represents the
from 0 to 2 units of output, so that ΔQ = 2. Dividing amount of fixed costs (TFC) divided by an ever
100 by 2, we obtain MC = 50. Marginal cost can also growing quantity of output.
be calculated as the change in total variable cost
divided by the change in total product, because

Chapter 6 The theory of the firm I 147

(a) Total cost, total variable cost and total fixed cost curves (c) Total cost, total variable cost and total
based on the data of Table 6.3 fixed cost curves

costs1200 TC costs TC
1000 TVC TVC
800
600 TFC TFC
400 0 output, Q
200
MC
0 2 4 6 8 10 12 14 16 18 20 22 24
output, Q ATC
AVC
160
AFC
150 0 output, Q
(d) Average cost and marginal cost curves
140

130
120 MC

110

100 costs

costs 90

80

70

60 ATC
50

40 AVC
30

20

10 AFC

0 2 4 6 8 10 12 14 16 18 20 22 24

output, Q

(b) Average cost and marginal cost curves based on the data
of Table 6.3

Figure 6.2 Total, average and marginal cost curves test scores, which applies equally well here). When
marginal cost is below average variable cost (MC <
• The three remaining curves, AVC, ATC and MC, AVC), average variable cost is falling; when marginal
though they are different from each other, all follow cost is above average variable cost (MC > AVC), then
the same general pattern: at first they fall, they average variable cost is rising. The same applies to
reach a minimum, and then they begin to rise.2 the relationship between marginal cost and average
total cost: when MC < ATC, ATC is falling, and when
• The ATC curve is the vertical sum of AFC and AVC, MC > ATC, ATC is rising.
and so the vertical difference between the ATC and
the AVC curves at any level of output is equal to AFC. The U-shapes of the AVC, ATC and MC curves are due
to the law of diminishing returns. We will discover
• The MC curve intersects both the AVC and ATC curves why in the next section.
at their minimum points. The reason is the same
as in the case of marginal and average products, (page 141), the slope is interpreted in the mathematically correct way; see
discussed on page 141 above (recall the example of footnote 1.)

2 The mathematically inclined student may note that marginal cost (MC )
represents the slope of the total cost (TC ) curve. (Again, as with MP and TP

148 Section 1: Microeconomics

Relating the cost and product curves: the Decreasing marginal product, on the other hand, means
law of diminishing returns that the additional output of each unit of labour is
falling, and so the additional cost of each extra unit of
Explain the relationship between the product curves output (marginal cost) must be increasing. In Table 6.1
(average product and marginal product) and the cost curves we saw that maximum marginal product occurs when
(average variable cost and marginal cost), with reference to four units of labour are hired; this is also when marginal
the law of diminishing returns. cost is minimum (see Table 6.3). In other words, when
the additional output produced by an extra worker is the
The law of diminishing marginal returns is very
important in determining the shape of the cost curves. most it can be, then the extra labour cost of producing an
Figure 6.3 shows that the product curves (MP and
AP) are mirror images of the cost curves (MC and additional unit of output is the least it can be.
AVC). The MC curve mirrors the MP curve, and the
AVC curve mirrors the AP curve. (Note the labelling The explanation for the shape of the average variable
of the axes of the product and cost curves, which are cost curve can also be found in the law of diminishing
different from each other.) How can we explain this returns. When average product is increasing, this means
interesting pattern? that each additional unit of output can be produced
with fewer and fewer units of labour; therefore, the
Remember that at low levels of output, the labour cost of each unit of output (average variable cost)
marginal product of labour increases, meaning falls. But when average product is falling, additional
that the extra output produced by each additional unit units of output require more and more units of labour,
of labour rises. When this happens, the additional cost and so the labour cost of each unit of output, or average
of one more unit of output, or marginal cost, falls. variable cost, begins to increase.3 Note from Table 6.1
that when five units of labour are hired, average product
units of output (AP, MP) is maximum; this is the point of production where
average variable cost is minimum (see Table 6.3). This
happens because when workers on average produce the
most they can produce, the labour cost of producing
each unit of output is the lowest it can be.

costs (AVC, MC) AP The U-shape of the AVC, ATC and MC curves is due
MP to the law of diminishing returns. This law also
0 explains why the AVC and MC curves are mirror
units of variable input (labour) images of the AP and MP curves.

MC Shifts in the cost curves (supplementary
AVC material)
The cost curves shift in response to two factors:
0 output, Q changes in resource prices, or changes in technology.
Figure 6.3 Product curves and cost curves are mirror images due to the If resource prices increase, an increase in costs of
production results. Which particular curves are affected
law of diminishing returns depends on whether the price increases involve fixed
or variable costs. If there is an increase in a fixed cost
3 Another way to see this numerically is to consider the average product of production, this affects TFC and TC, as well as AFC
figures in Table 6.1. We know that each unit of labour costs €100, i.e. €100 = and ATC, all of which shift upward. Variable costs and
cost per unit of labour. If we divide 100 by average product, we have: marginal cost remain unaffected. This is shown in
Figure 6.4(a), where we see AFC and ATC curves shifting
cost per unit of labour upward to the dotted lines, while AVC and MC remain
= variable cost per unit of output, unchanged. If, on the other hand, there is an increase
in variable costs (say, because of an increase in wages),
output per unit of labour TVC and TC, as well as AVC, ATC and MC, will increase.
This can be seen in Figure 6.4(b), where AVC, ATC and

which is average variable cost. When the units of labour are few, AVC is
high; as the labour units increase AVC falls, and after reaching a minimum,
AVC begins to rise, thus resulting in the U-shaped curve.

Chapter 6 The theory of the firm I 149

(a) Increase in FC (b) Increase in VC

ATC1 MC1 ATC1
MC ATC MC

ATC

cost AVC1
cost AVC
AVC
AFC
AFC1 0
AFC
0 output
output

Figure 6.4 Shifts in the cost curves 2 Using the data of question 1, (a) plot TFC,
TVC and TC, and (b) in a different diagram
MC have shifted upward to the dotted lines. If resource plot AFC, AVC, ATC and MC.
prices fall, leading to decreases in costs of production,
the corresponding curves shift downward. 3 Why does the average fixed cost curve decline
continuously throughout its range?
Changes in technology also impact upon costs of
production because they increase the amount of output 4 What accounts for the U-shape of the average
that can be produced by a given level of inputs. An variable cost curve and the average total cost
improved technology would therefore shift the product curve?
curves of Figure 6.1 (TP, AP and MP) upwards, and this
would correspond to a downward shift in the cost curves. 5 In your diagram for question 2(a), explain
what is represented by (a) the vertical distance
Calculating costs between the TC and TFC curves, and (b) the
vertical distance between the TC and TVC
Calculate total fixed costs, total variable costs, total costs, curves.
average fixed costs, average variable costs, average total
costs and marginal costs from a set of data and/or diagrams. 6 In your diagram for question 2(b), explain
what is represented by (a) the vertical
To calculate costs, it is only necessary to remember distance between ATC and AFC, and
and understand the relationships between the various (b) the vertical distance between ATC
cost concepts we have studied above: TC = TFC + TVC; and AVC.
dividing through by Q we obtain average costs, where
ATC = AFC + AVC. Finally, marginal cost is ΔTC/ΔQ, 7 How does the law of diminishing marginal
or ΔTVC/ΔQ. You will have several opportunities to product affect the shape of the marginal cost
calculate costs both in this chapter and the next. curve?

To calculate costs from a diagram, we simply 8 Why does marginal cost intersect both average
read off the information appearing in the variable cost and average total cost at their
graph, and apply the same principles as above minimum points?
to calculate the cost variable or variables we are
interested in. 9 Draw two diagrams showing the relationships
between the AP and MP curves, and the AVC
Test your understanding 6.4 and MC curves. How are the product curves
related to the cost curves? What accounts for
1 For question 5 of Test your understanding 6.1, this relationship?
suppose that the price of labour is $2000 a
month per worker and fixed costs are $1500 10 (Optional) Using diagrams, show how (a) a
a month. Calculate TFC, TVC, TC, AFC, AVC, fall in insurance premiums, and (b) a fall in
ATC and MC up to the point of maximum wage rates would affect the positions of the
total product (61 units of output). AFC, AVC, ATC and MC curves of a firm.

150 Section 1: Microeconomics

6.4 Production and costs in the It seems logical to think that if a firm doubles
long run all its inputs, then output should also double;
there should be constant returns to scale. Why
Production in the long run: returns to scale does it happen that output can sometimes increase
more than or less than in proportion to the
Distinguish between increasing returns to scale, decreasing increase in inputs? We will discover the answer
returns to scale and constant returns to scale. when we consider costs of production in the long
run below. For now, it is important that you do
Let’s examine the long-run relationship between not confuse decreasing returns to scale, discussed
inputs and output. An important point to bear in here, with diminishing returns (page 142).
mind is that in the long run, there are no fixed inputs. Diminishing returns occur only in the short
All inputs are variable. We are interested in seeing run, because they show what happens to output as
what happens to output when the firm changes all of a variable input is added to a fixed input. Decreasing
its inputs. There are three possibilities, explained using returns to scale can occur only in the long run,
the example in Table 6.4: showing what happens to output when all inputs are
variable.
Constant returns to scale
Suppose a firm doubles all of its inputs. In Table 6.4, Costs of production in the long run
both land and labour double in quantity. With constant
returns to scale, output also doubles. Constant Long-run average total cost curve in
returns to scale means that output increases in the same relation to short-run average total cost
proportion as all inputs: given a percentage change in all curves
inputs, output increases by the same percentage.
Outline the relationship between short-run average costs
Increasing returns to scale and long-run average costs.
If a firm doubles all inputs and there are increasing
returns to scale, output more than doubles. In the Remember that in the long run there are no fixed
example, as land and labour double in quantity, the inputs and therefore no fixed costs; all inputs are
quantity of output increases from 100 to 250 units, variable. When a firm varies inputs that were fixed in
which is more than double. Increasing returns to the short run, it changes its size or scale.
scale means that output increases more than in proportion
to the increase in all inputs: given a percentage increase in It is convenient to think of the long run as the
all inputs, output increases by a larger percentage. firm’s planning horizon. If a firm wants to expand
production, it must think in terms of increasing its
Decreasing returns to scale fixed inputs, otherwise its production will run into
If a firm doubles all its inputs and there are decreasing diminishing returns. As the firm plans its future
returns to scale, there results a less than double activities in the long run, it can select any size or
increase in output. In the example, land and labour scale of operation depending on the quantity of
have doubled in quantity, but output has increased output it is aiming for. The particular size it selects
only from 100 to 150 units. Decreasing returns to will be the one that minimises costs for that level of
scale means that output increases less than in proportion output.
to the increase in all inputs: given a percentage increase in
all inputs, output increases by a smaller percentage. Let’s consider our farmer who produces with two
inputs, land and labour. The farmer wants to expand
production and considers the long-run options.
Suppose, too, that there are only four possible

Land (1st input) Labour (2nd input) Output with constant Output with increasing Output with decreasing

1 acre 5 workers returns to scale returns to scale returns to scale
2 acres 10 workers
100 units of output 100 units of output 100 units of output
200 units of output 250 units of output 150 units of output

Table 6.4 Constant, increasing and decreasing returns to scale

Chapter 6 The theory of the firm I 151

farm sizes. Each one is represented by a different Initially, the farmer produces output Q1 on SRATC1,
short-run average total cost curve (SRATC), shown in but then decides to increase production. Which SRATC
Figure 6.5(a). should the farmer select? The answer depends on how
much output the farmer wants to produce, and which
(a) Four short-run ATC curves SRATC will minimise cost for that level of output. In
the short run, it is possible to increase output to Q2,
costs a SRATC1 SRATC2 SRATC4 without changing farm size, by remaining on SRATC1.
Yet a larger farm size, corresponding to SRATC2, can
b cSRATC3 produce output Q2 at a lower average cost. In the short
run, it is possible to produce at the lowest possible cost
LRATC on SRATC1 only up to point a; beyond this the farmer
should consider increasing farm size (going into the
0 Q1 Q2 Q3 long run) and moving onto SRATC2. Once the farmer is
on SRATC2, output can increase at the lowest possible
output, Q cost until point b is reached, where the farmer once
again should consider increasing farm size (going into
(b) Long-run average total cost curve in relation to the long run again) and switching to SRATC3. We can
short-run average total cost curves see then that points like a, b and c represent output
levels at which the farmer should increase the farm
a SRATC1 LRATC size in order to continue to minimise average costs as
b SRATC2 output increases. It follows that the farmer’s planning
horizon is made up of the bold-face portions of the short-
costs SRATCm run average cost curves in Figure 6.5(a), connecting all
possible points of intersection between SRATC curves.
0 Q1 Q2
In practice, it is likely that there will not only be
output, Q four possible firm sizes as in our example, but many
more, shown in Figure 6.5(b). In this case, the long-
(c) Economies and diseconomies of scale run average total curve is the curve that just touches
(i.e. is tangent to) each of the short-run cost curves.
economies diseconomies Long run average total costs represent the lowest
of scale of scale LRATC possible average cost, or cost per unit of output, for
every level of output, when all resources are variable.
costs When the firm plans its activities over the long run, it
can choose where on the long-run curve it wishes to
0 output, Q be; it will then end up on the SRATC curve at the point
Figure 6.5 The long-run average total cost curve where this just touches the long-run curve (i.e. the
point of tangency between the two).4

The long-run average total cost curve
(LRATC) is defined as a curve that shows the lowest
possible average cost that can be attained by a firm
for any level of output when all of the firm’s inputs
are variable. It is a curve that just touches (is tangent
to) each of many short-run average total cost curves.
It is also known as a planning curve.

4 While a decision to produce a particular level of output in the long run in the long run. When the long-run curve is downward sloping, there will

involves selection of the firm scale that minimises costs for that level of always be a larger firm size that can achieve lower average costs than the

output, the firm will not necessarily be operating at the lowest possible short-run minimum (i.e. SRATC2 achieves lower average costs than point b
on SRATC1); and when the long-run curve is upward sloping, there will
cost on the SRATC curve of its choice. In Figure 4.5(b), say a firm wants to always be a smaller firm size that can achieve lower average costs than

produce output Q1; it will then choose to be on SRATC1 at point a, which the short-run minimum. There is only one SRATC curve whose minimum
is the point where SRATC1 just touches the long-run curve, corresponding
to output level Q1. But the point of minimum average cost on SRATC1 is coincides with the long-run minimum, and that is SRATCm, shown in bold
point b, representing output Q2, not point a. Therefore, minimum average in Figure 6.5(b).
cost in the short run is not necessarily the same as minimum average cost

152 Section 1: Microeconomics

The shape of the LRATC curve: economies • Efficiency of capital equipment. Large
and diseconomies of scale machines are sometimes more efficient than
smaller ones; for example, a large power generator
Explain, using a diagram, the reason for the shape of the is more efficient than a small one (it can produce
long-run average total cost curve. more output per unit of inputs). However, a small
firm with a small volume of output cannot make
As we can see in Figure 6.5 (b) and (c), the long-run effective use of large machines, and so is forced to
average total cost curve (LRATC) has a U-shape. use smaller, less efficient ones.

The reasons for the U-shape of the long-run average • Indivisibilities of capital equipment. Some
total cost (LRATC) curve have nothing whatever to machines are only available in large sizes that
do with diminishing returns, which are a feature require large volumes of output in order to be used
only of short-run production and costs. The U-shape effectively. They cannot be divided up into smaller
of the LRATC curve can be found in economies and pieces of equipment.
diseconomies of scale, in turn related to increasing and
decreasing returns to scale. • Indivisibilities of efficient processes. Some
production processes, such as mass production
Economies of scale assembly lines, require large volumes of output in
order to be used efficiently. Even if all inputs are used
Describe factors giving rise to economies of scale, in proportionately smaller quantities, it may not be
including specialisation, efficiency, marketing and possible to achieve the same degree of efficiency.
indivisibilities.
• Spreading of certain costs, such as
Economies of scale are decreases in the average marketing, over larger volumes of output.
costs of production over the long run as a firm Costs of certain activities such as marketing and
increases all its inputs. Economies of scale explain advertising, design, research and development result
the downward-sloping portion of the LRATC curve: in lower average costs if they can be spread over
as output increases, and a firm increases all inputs, large volumes of output.
average cost, or cost per unit of output, falls.
Diseconomies of scale
Falling average costs as output increases mean the
firm is experiencing increasing returns to scale (page Describe factors giving rise to diseconomies of scale,
151). To see this, consider that if input prices are including problems of co-ordination and communication.
constant and inputs double, this means that costs
also double (since costs of inputs = price of inputs x Diseconomies of scale are increases in the average
quantity of inputs), but when there are increasing costs of production as a firm increases its output by
returns to scale, as inputs double, output will more increasing all its inputs. Diseconomies of scale are
than double. This means that costs per unit of output responsible for the upward-sloping part of the LRATC
(or average costs) must be falling.5 curve: as a firm increases its scale of production, costs
per unit of output increase.
There are several reasons why this can occur:
Increasing average costs as output increases mean
• Specialisation of labour. As the scale of that the firm is experiencing decreasing returns to scale
production increases, more workers must (page 151). If input prices are constant, and inputs
be employed, allowing for greater labour double, costs also double (again, costs of inputs = price of
specialisation. Each worker specialises in inputs x quantity of inputs), but when inputs double, the
performing tasks that make use of skills, interests increase in output will be less than double when there
and talents, thus increasing efficiency and allowing are decreasing returns to scale. This means that costs per
output to be produced at a lower average cost. unit of output (or average costs) must be increasing.

• Specialisation of management. Larger scales of Reasons for diseconomies of scale can include the
production allow for more managers to be employed, following:
each of whom can be specialised in a particular area
(such as production, sales, finance, and so on), again • Co-ordination and monitoring difficulties.
resulting in greater efficiency and lower average cost. As a firm grows larger and larger, there may come a
point where its management runs into difficulties

5 It may be noted that economies of scale actually have a broader meaning input proportions are fixed, whereas in economies of scale it is possible to
than increasing returns to scale. The reason is that in returns to scale, have varying input proportions.

Chapter 6 The theory of the firm I 153

of co-ordination, organisation, co-operation downward-sloping and the upward-sloping portions.
and monitoring. The result involves growing Constant returns to scale involve constant long-run
inefficiencies causing average costs to increase as average costs over a certain range of output. In this
the firm expands. range, as output increases (with all inputs increasing),
average costs do not change, i.e. the firm does not
• Communication difficulties. A larger firm size encounter economies or diseconomies of scale.
may lead to difficulties in communication between
various component parts of the firm, again resulting Firms are generally eager to take advantage of
in inefficiencies and higher average costs. economies of scale, and try to avoid diseconomies of
scale. Empirical studies agree that firms can achieve
• Poor worker motivation. If workers begin to substantial economies of scale by increasing their
lose their motivation, to feel bored and to care little size, but there is some debate over whether firms
about their work, they become less efficient, with the experience diseconomies. Some studies suggest that after
result that costs per unit of output start to increase. exhausting economies of scale, many firms exhibit constant
returns to scale, and do not run into diseconomies of scale
Constant returns to scale even as size becomes very large.
Constant returns to scale may appear in some long-
run average total cost curves as in Figure 6.6(a), where Real world focus
there is a horizontal segment of the curve between the

(a) Varying firm sizes

average total cost economies diseconomies Economies of scale in the
of scale of scale tourism industry

constant returns LRATC Travelplanet.pl and Invia are two Polish online tourism
to scale companies that are planning to merge. A merger takes
place when two (or more) companies join together and
0 Qmes Q1 Q2 Q3 Q4 form a single company. The aim of the merger is to
output, Q obtain economies of scale through their co-operative
interactions. The merger will result in the biggest online
(b) Few large firms tourism company in Central Eastern Europe.

average total cost LRATC Source: Adapted from ‘Travelplanet.pl closer to merging with
Invia’ in Polish News Bulletin, 1 April 2010.
0 Q1 output, QQmes
Applying your skills
(c) Natural monopoly
1 Using a diagram, show how a merger of two
companies can result in economies of scale.

2 Explain the possible sources of economies of
scale arising from the merger.

average total cost LRATC The minimum efficient scale and the
structure of industries (supplementary
0 output, Q Qmes material)
There is a point on the long-run average total cost
Figure 6.6 Minimum efficient scale and the structure of industries curve that represents the lowest level of output at
which the lowest long-run total average costs are
154 Section 1: Microeconomics achieved, called the minimum efficient scale (MES). In
Figure 6.6 this is represented by Qmes. The minimum
efficient scale is the level of output at which

economies of scale are exhausted; beyond that Test your understanding 6.5
level of output average costs will either be constant or
they will begin to increase. When there are constant 1 Using a numerical example, distinguish between
returns to scale, the minimum efficient scale can be increasing, constant and decreasing returns to
achieved by firms of varying sizes, producing any scale.
output ranging from Qmes to Q4 in Figure 6.6(a).
2 (a) Define the long-run average total cost
The importance of the concept of minimum (LRATC) curve. (b) Why do you think this curve
efficient scale lies in the information it can reveal is also referred to as a ‘planning curve’? (c) How
about the structure of industries, such as whether it is the LRATC curve related to short-run average
is likely that an industry will consist of many firms, cost curves?
some of which are smaller and some larger, as opposed
to a small number of large firms, or at the extreme a 3 Describe some factors that can cause (a)
single very large firm providing for the entire market. economies of scale, and (b) diseconomies of scale.
Each of these possibilities is illustrated in Figure 6.6.
4 (a) Using a diagram, show the relationship
The LRATC curve in Figure 6.6(a) indicates that between economies and diseconomies of scale
the firm reaches the minimum efficient scale at a low and the shape of the LRATC. (b) What do
level of output, shown as Qmes, and then begins to constant returns to scale signify?
experience constant returns to scale. If this level of
output, Qmes, is a small fraction of the total market, 5 What is the relationship between (a) increasing
then there are likely to be many firms of varying returns to scale and economies of scale, and
sizes in the industry; examples include clothing and (b) decreasing returns to scale and diseconomies
shoe manufacturing, other light manufacturing such of scale?
as furniture and wood products, food processing,
retailing and banking. These tend to be industries 6 If, as many economists suggest, a firm is unlikely
that fall under the market structure of monopolistic to run into diseconomies of scale after achieving
competition (see Chapter 7, page 195). all possible economies of scale, what would its
long-run average total cost curve look like?
Figure 6.6(b) shows the LRATC curve of a firm that
experiences economies of scale over a very large range 7 (Optional) Explain the concept of minimum
of output. It is only at the very large level of output efficient scale.
of Qmes that the minimum efficient scale is achieved,
at which point the firm runs into either diseconomies 6.5 Revenues
of scale or constant returns to scale (shown by the
dotted lines). Here, Qmes represents a large fraction of Total revenue, marginal revenue and
the market. This means that there can only be a small average revenue
number of large firms in this industry. If smaller firms
tried to enter this industry, they would have difficulty Distinguishing between total, marginal
competing with the larger firms because of their higher and average revenue
average costs. (Compare the average total costs of a firm
producing output Q1 with the average costs of a firm Distinguish between total revenue, average revenue and
producing at Qmes.) Examples of such industries include marginal revenue.
car and refrigerator manufacturers, heavy industries Illustrate, using diagrams, the relationship between total
such as aluminium and steel, and pharmaceutical revenue, average revenue and marginal revenue.
industries. These tend to be industries that fall under the
market structure of oligopoly (see Chapter 7, page 201). Revenues are the payments firms receive when they
sell the goods and services they produce over a given
In Figure 6.6(c), the minimum efficient scale occurs at time period. We make a distinction between three
a level of output, Qmes, so large that if the firm expands fundamental revenue concepts: total, marginal and
to that point where it exhausts all economies of scale, it average revenue.
will be supplying the entire market. Such a firm is called
a natural monopoly (see Chapter 7, page 187). The firm’s total revenue (TR) is obtained by
multiplying the price at which a good is sold (P) by
(It may be noted that the U-shaped long-run average the number of units of the good sold (Q):
total cost curve does not cover firms under perfect
competition (see page 168). This is because firms under TR = P × Q
perfect competition do not experience economies and
diseconomies of scale, as we will see in Chapter 7.)

Chapter 6 The theory of the firm I 155

The firm’s marginal revenue (MR) is the additional (1) (2) (3) (4) (5)
revenue arising from the sale of an additional unit of Units of Product
output:6 output Total Marginal Average
price
MR = Δ TR (Q) (P) revenue revenue revenue
ΔQ (€)
0 TR = P × Q MR = Δ TR MR = TR
The firm’s average revenue (AR) is revenue per unit 1 10 (€) ΔQ Q
of output sold: 2 10
3 10 (€) (€)
TR 4 10
AR = 5 10 -- -
6 10 10 10 10
Q 7 10 20 10 10
10 30 10 10
Note that AR is always equal to P, or the price of the 40 10 10
TR 50 10 10
60 10 10
product. The reason is that since AR = , it follows 70 10 10
Q
Table 6.5 Calculating total, marginal and average revenue when price is
that TR = AR × Q, but since TR = P × Q, this means that constant (the firm has no control over price)
AR = P.
(a) Total revenue
Whereas the definitions of revenues given above
apply to all firms, the analysis of revenues is not the TR
same for all firms, because this depends on whether or TR
not the firm has any control over the price at which
it sells its product. In Chapter 2, page 20, it was noted 70
that firms under highly competitive conditions have 60
no ability to influence price. Firms operating under 50
less competitive conditions do have varying degrees 40
of control over price, depending on their degree 30
of market power (see page 20 for a review of these 20
concepts). We will study these differences under the 10
topics of market structures in Chapter 7. For now, we
will make a distinction between situations where: 0 1234567Q

• the firm has no control over price, and price is (b) Marginal and average revenue
constant as output varies P, MR, AR

• the firm has some degree of control over price, and 40
price varies with output.
30
Revenue curves where the firm has no
control over price 20
Table 6.5 shows how we calculate total, marginal
and average revenue from information on the price 10
and quantity of the good in situations where a firm P = MR = AR
has no control over price. Columns 3, 4 and 5 are
calculated from the information in columns 1 and 2, 0 1234567Q
using the definitions of total, marginal and average
revenue given above. Note that the price at which the Figure 6.7 Total, marginal and average revenue curves when price is
good is sold does not change; this occurs only under constant (the firm has no control over price)
perfect competition, where the firm has no control
over the price at which it sells its product. Figure 6.7
plots the data of Table 6.5. We will examine these
revenue curves, their meaning and implications in
detail in Chapter 7, page 169.

6 The mathematically inclined student will note that MR is the slope of the
TR curve (where slope is interpreted in the mathematically correct way; see
footnotes 1 and 2).

156 Section 1: Microeconomics

(1) (2) (3) (4) (5) Revenue curves where the firm has some
Units of Product Marginal Average control over price
output Total revenue revenue Table 6.6 shows how we calculate total, marginal
price and revenue from price and quantity information in
(Q) (P) revenue Δ TR TR the case where the firm has some control over price.
(€) (TR = Q × P) MR = Δ Q AR = Q The method of calculation is exactly the same as
in the competitive case above, where columns 3–5
(€) (€) (€) are calculated using the information of the first two
columns. The difference is in the price data, appearing
0−− − − in column 2, showing that the price at which the good
is sold changes as the quantity of output changes. This
1 12 12 12 12 occurs under all market models that we will study in
Chapter 7 other than perfect competition. Figure 6.8
2 11 22 10 11 plots the data of Table 6.6. These revenue curves, their
meaning and implications will be examined in detail
3 10 30 8 10 in Chapter 7, page 184.

4 9 36 6 9

5 8 40 4 8

6 7 42 2 7

7 6 42 0 6

8 5 40 −2 5

9 4 36 −4 4 Calculating revenues

10 3 30 −6 3

Table 6.6 Calculating total, marginal and average revenue when price Calculate total revenue, average revenue and marginal
varies (the firm has some control over price) revenue from a set of data and/or diagrams.

To calculate revenues, it is only necessary to remember

(a) Total revenue and understand the relationships between the various
revenue concepts, beginning with the idea that
40
35 TR = P × Q. If you are given data on P and Q, you can
30
25 TR find TR, and from there you can calculate AR = TR
20
15 Δ TR Q
10
total revenue ( )5 and MR = . You can also work backwards to find
ΔQ
0 1 2 3 4 5 6 7 8 9 10 11
TR and MR if you know AR and Q, or to find TR and
(b) Marginal and average revenue
AR if you know MR and Q. Remember also that AR = P

in all cases, so that if you know AR, you also know the

price of the product.

To calculate revenues from a diagram, we simply

Q read off the information appearing in the graph, and
apply exactly the same principles as above to calculate

the revenue variable or variables we are interested in.

15 Test your understanding 6.6

price, revenue ( ) 10 1 Define (a) total revenue, (b) marginal revenue,
and (c) average revenue.
5
2 Given the following price and quantity data
P = AR = D for a product, calculate total revenue, marginal
revenue and average revenue.

0 Q Price ($) 55555
1 2 3 4 5 6 7 8 9 10 11

-5 Quantity (thousand units) 0 1 2 3 4
MR
3 Plot the data for total, marginal and average
Figure 6.8 Total, marginal and average revenue curves when price revenue you calculated in question 2.
varies (the firm has some control over price)

Chapter 6 The theory of the firm I 157

4 Given the following price and quantity data this chapter (page 144) we made a distinction between
for a product, calculate total revenue, marginal explicit costs, implicit costs and economic costs or total
revenue and average revenue. opportunity costs (the sum of explicit plus implicit
costs). In economics, economic profit is defined as:
Price ($) 87 65 43 2
economic profit = total revenue – economic costs
Quantity 23 45 67 8 = total revenue – the sum of
explicit costs + implicit costs
(thousand units)
In economics, even when we use the term ‘profit’ on
5 Plot the data for total, marginal and average its own, we mean ‘economic profit’, indicating that
revenue you calculated in question 4. we have taken all costs (explicit plus implicit) into
consideration.
6 (a) Explain why the shapes of the curves
for total, marginal and average revenue you Normal profit
graphed for question 3 differ from those of
question 5. (b) What can you conclude about Describe normal profit as the amount of revenue needed
how price changes (or does not change) for to cover the costs of employing self-owned resources
each unit of output sold in questions 3 and 5? (implicit costs, including entrepreneurship) or the amount
(c) What is the relationship between price and of revenue needed to just keep the firm in business.
average revenue?
When economic profit is equal to zero, and total
7 Given the following data, calculate total revenue revenue is equal to total economic costs, the firm is
and marginal revenue for each level of output. said to be making normal profit.
What is the price at each level of output?
Normal profit can be defined as the minimum
Quantity 1 2 3 4 56 amount of revenue that the firm must receive so
that it will keep the business running (as opposed to
(thousand units) shutting down). It can also be defined as the amount
of revenue that covers all implicit costs (including
Average revenue € 20 18 16 14 12 10 the payment for entrepreneurship, which is itself an
implicit cost). This presupposes that total revenues
8 Given the following data, calculate total revenue are just enough to cover both explicit and implicit
and average revenue for each level of output. costs. Therefore, a firm earns normal profit when total
What is the price at each level of output? revenue = economic costs, and economic profit =
zero. This is called the break-even point of the firm.
Quantity 1 23456
(thousand units) These apparently different definitions are in fact
consistent: the minimum amount of revenue the firm
Marginal revenue (£) 14 12 10 8 6 4 must receive to make it worthwhile to stay in business
and keep all its resources employed in the firm is equal
6.6 Profit to the revenue that covers the firm’s implicit costs,
after revenues have also covered explicit costs.
Distinguishing between economic and
normal profit It should be stressed that normal profit also includes
the payment for entrepreneurship. Entrepreneurship,
Economic profit you will remember, includes the talents to organise
and manage a business and take risks (page 4).
Describe economic profit as the case where total revenue Entrepreneurship receives a payment just as all other
exceeds economic cost.7 factors of production do, and this payment is included
in normal profit. In fact, if we think of normal profit
In a general sense, profit equals total revenue minus total as consisting of payment for the entrepreneur’s
costs. The precise meaning of the term ‘profit’ in this
expression depends on the meaning of ‘costs’. Earlier in

7 ‘Economic profit’ in this learning outcome actually refers to positive
economic profit as opposed to negative economic profit (i.e. a loss).

158 Section 1: Microeconomics

entrepreneurial and risk-taking functions, as well as the (a) Positive economic profit
opportunity costs of employing self-owned resources,
we can see that normal profit is not ‘profit’ in the economic profit
customary sense, but is actually a cost of production. (supernormal,
abnormal profit)
Why a firm continues to operate even
when earning zero economic profit (£21 000)

Explain why a firm will continue to operate even when it implicit costs total
earns zero economic profit. (including revenue
(£180 000)
It was noted above that the firm earns normal profit payment for
when economic profit is zero, meaning that total economic costs = entrepreneurship)
revenue is just equal to total economic costs. It follows opportunity costs
that when we say a firm is ‘earning normal profit’, the (£109 000)
firm is earning just the necessary revenues to cover
payment for entrepreneurship (a cost) and all other explicit costs
implicit costs of self-owned resources, after revenues (£50 000)
have also covered explicit costs. Therefore, when a
firm is earning normal profit, it has covered all its (b) Zero economic profit
opportunity costs, and will continue to operate.
economic costs = implicit costs normal
Positive and negative economic profit opportunity costs (including profit

Explain that economic profit is profit over and above payment for total
normal profit, and that the firm earns normal profit when entrepreneurship) revenue
economic profit is zero.8 (£159 000)
Explain the meaning of loss as negative economic profit (£109 000)
arising when total revenue is less than total cost. loss
explicit costs (£19 000)
Economic profit can be positive, zero or negative. (£50 000)
Positive economic profit is also known as supernormal total
profit, or abnormal profit, because it involves profit (c) Negative economic profit (loss) revenue
over and above normal profit. If economic profit is zero, (£140 000)
the firm is earning normal profit. And if economic profit economic costs = implicit costs
is negative, the firm is making a loss. To summarise: opportunity costs (including
payment for
Economic profit can be positive, zero or negative.
entrepreneurship)
Positive economic profit: TR > economic cost; the (£109 000)
firm earns supernormal profit (or abnormal profit).
explicit costs
Zero economic profit: TR = economic cost; the firm (£50 000)
earns normal profit.
Figure 6.9 Illustrating economic profit (positive and negative) and
Negative economic profit: TR < economic cost; the normal profit
firm makes a loss.
Figure 6.9(b) shows a firm making zero economic
We can see these relationships in Figure 6.9. In profit. The firm’s total revenue has fallen to £159 000,
Figure 6.9(a) the firm’s total revenue is £180 000. which is equal to its economic costs; therefore, the
Implicit costs = £109 000, explicit costs = £50 000, firm is earning normal profit. The firm in this situation
and the sum is economic costs of £159 000. Economic will not shut down even though it is earning zero
profit is therefore £21 000 (= £180 000 − £159 000). economic profit, because it is earning normal profit;
its revenue is enough to cover all opportunity costs
(including entrepreneurship).

In Figure 6.9(c) the firm is earning negative economic
profit (loss). Total revenue has fallen to £140000, of
which £50000 is used to cover explicit costs, and there
are £90000 left over to go toward covering implicit
costs. However, this is not enough, as implicit costs are
£109000. Therefore, the firm is making an economic loss
of £19000, and will shut down (go out of business) as
soon as it is able to do so (we will see how in Chapter 7).

Table 6.7 summarises the cost, product, revenue and
profit concepts we have studied.

8 Profit over and above normal profit is positive economic profit, since
negative economic profit refers to loss. See also footnote 7.

Chapter 6 The theory of the firm I 159

Table 6.7 Summary of cost, product, revenue and profit concepts

Cost concepts Definition Equation
Explicit cost
The monetary payment made by a firm to an outsider to acquire TC = TFC + TVC
Implicit cost an input.
Economic cost AFC = TFC
The income sacrificed by a firm that uses a resource it owns. Q
Total fixed cost (TFC)
The sum of explicit and implicit costs, also equal to the firm’s
Total variable cost (TVC) total opportunity costs.

Total cost (TC) Costs that do not change as output changes; arise from the use
Average fixed cost (AFC) of fixed inputs.

Costs that vary (change) as output changes; arise from the use of
variable inputs.

The sum of fixed and variable costs.

Fixed cost per unit of output.

Average variable cost (AVC) Variable cost per unit of output. AVC = TVC
Q

Average total cost (ATC) Total cost per unit of output. ATC = AFC + AVC
Marginal cost (MC) The change in cost arising from one additional unit of output.
MC = Δ TC = Δ TVC
ΔQ ΔQ

Long-run average total cost A curve showing the lowest possible average cost that can be
(LRATC) curve attained for any level of output when all of the firm’s inputs are
variable.

Product concepts

Total product (TP or Q) The total amount of product (output) produced by a firm. MP = ΔTP
Marginal product (MP) variable
The additional product produced by one additional unit of
variable input. Δ units of input

Average product (AP) Product per unit of variable input. AP = TP
units of variable input

Revenue concepts

Total revenue The total earnings of a firm from the sale of its output. TR = P × Q
Marginal revenue
The additional revenue of a firm arising from the sale of an MR = Δ TR
additional unit of output. ΔQ

Average revenue Revenue per unit of output. AR = TR
Q

Profit concepts

Economic profit Total revenue minus economic costs (or total opportunity costs,
or the sum of explicit plus implicit costs).

Normal profit The minimum amount of revenue required by a firm so that it
will be induced to keep running, which is that part of revenue
that covers implicit costs, including entrepreneurship (after all
explicit costs have been covered).

160 Section 1: Microeconomics

Test your understanding 6.7 but until it decides to shut down, it will be interested
in producing the quantity of output that will make
1 Define economic profit and normal profit, and its loss as small as possible. Therefore, the theory of
explain the difference between them. the firm is also concerned with how much output a
loss-making firm should produce in order to minimise
2 Why do you think positive economic profit is its loss.
also called ‘supernormal’ profit or ‘abnormal’
profit? There are two approaches to analysing profit
maximisation (or loss minimisation): one involves
3 What is the relationship between earning use of the total revenue and total cost concepts, and
normal profit and the break-even point of a the other involves use of marginal revenues and
firm? costs. Both these approaches yield the same results
for the profit-maximising (or loss-minimising) level of
4 Explain why economic profit can be positive, output, though the second approach is more relevant
zero or negative. to analysing market structures (as we will see in
Chapter 7).
5 A firm earns zero economic profit, and yet it
does not shut down. Explain why. Profit maximisation based on the total
revenue and cost approach
6 A firm had implicit costs of $35 000 per year This approach is based on the simple principle that
and explicit costs of $75 000 per year, which
remained constant for each year between profit = total revenue (TR) − total cost (TC)
2009 and 2011. In 2009 its total revenues
were $150 000, in 2010 they were $110 000, where profit refers to economic profit and TC is
and in 2011 they were $95 000. (a) In which the firm’s economic or opportunity costs (explicit plus
year did the firm earn normal profit? (b) In implicit costs).
which year did the firm consider shutting
down? Why? (c) In which year did the The firm’s profit-maximisation rule is to produce the
firm earn supernormal profit? How much level of output where TR − TC (= economic profit) is
supernormal profit did it earn? (d) How as large as possible.
much economic profit did it make each year
(remember, economic profit may be positive, The amount of profit made by the firm is equal to
zero or negative). (e) What was the break- the numerical difference between TR and TC. If this
even point of the firm? difference is positive, the firm is making a profit
(supernormal profit); if it is negative, the firm is
6.7 Goals of firms making a loss; if it is zero, the firm is earning normal
profit.
Profit maximisation
Calculating different profit levels
Explain the goal of profit maximisation where the We can see how economic profit is calculated based
difference between total revenue and total cost is on the total revenue and total cost approach using
maximised or where marginal revenue equals marginal cost. the information in Figure 6.9. In part (a), TR > TC,
Calculate different profit levels from a set of data and/or and the firm makes an economic profit of £21 000
diagrams. (= TR – TC). In part (b), TR = TC, therefore the firm
is making zero economic profit, though it is earning
Standard economic theory of the firm assumes normal profit which allows it to stay in business. In
that firm behaviour is guided by the firm’s goal to part (c), TR < TC, and so the firm is making a loss of
maximise profit. Profit maximisation involves £19 000 (= TR – TC = –£19 000), and will eventually
determining the level of output that the firm should go out of business.
produce to make profit as large as possible.
Figure 6.10 puts together TR and TC curves we
Yet firms do not always make a profit; in some have already studied. It shows the total revenue curve
cases their total revenue is not sufficient to cover of a firm with no ability to influence price (as in
all costs, in which case they make a loss. If a firm is Figure 6.7), and a total cost curve (as in Figure 6.2(c)).
making a loss, it may eventually go out of business, In part (a), we look at levels of output where TR
lies above TC, and find the Q where the difference

Chapter 6 The theory of the firm I 161

(a) Profit-maximising firm produces at Q2 (b) Profit-maximising firm produces at (c) The loss-minimising firm produces at
and makes economic profit: TR – TC = Q2 and makes zero economic profit: Q2 (if it produces) and makes a loss =
TR – TC = 0 (it earns normal profit) TC – TR = a – b (negative economic
c–d profit since TR < TC )
TC
TC TR TC
TR a TR
a
costs, revenues e b
costs, revenuesc
costs, revenuesaf

d
b

0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q

Figure 6.10 Profit maximisation using the total revenue and total cost approach when the firm has no control over price

between TR and TC is largest. This occurs at Q 2, where difference between total revenue and total cost is
profit is the vertical distance between points c and d. largest. Part (a) shows the case of a profit-making
(You can see that profit levels a – b and e – f are smaller). firm; profit is maximised at output level Qπmax. At
In part (b), the firm produces at Q2 where TR = TC, points a and b where the TC curve intersects the
indicating zero economic profit (the firm earns normal TR curve, economic profit is zero (the firm would
profit). At all other levels of output, TC > TR. In part (c) be earning normal profit). In part (b) there is no
there is no Q where TR > TC, therefore we look for the level of output where TR > TC; therefore, this firm
Q where the difference between TC and TR is smallest. can only make a loss. Loss is minimum at output
This is at Q2, where the firm makes a loss (negative level Qlmin.
economic profit) of a – b.
In the event that you are asked to find the profit-
Figure 6.11 illustrates the case of a firm that does maximising level of output and the amount of
have control over price, showing its total revenue profit (or loss) made by a firm based on data on
curve (as in Figure 6.8(a)), together with a total cost total costs and revenues, you must first calculate the
curve (as in Figure 6.2(c)). The method of finding amount of profit (or loss) that results at each level
the firm’s maximum profit is exactly the same as of output (using the profit = TR – TC principle), and
above. We look for the level of output where the then determine which profit level is largest or which

(a) Profit maximisation TC (b) Loss minimisation TC
TC, b
TR TR TC,
TR
a

0 Q max Q TR
0 Q1min Q

Figure 6.11 Profit maximisation using the total revenue and total cost approach when the firm has control over price

162 Section 1: Microeconomics

loss level is smallest. The corresponding output will In Figure 6.12, both parts (a) and (b) show the
be the profit-maximising or loss-minimising one. standard MC curve that we studied earlier (page 148).
You will be given the opportunity to perform such There are two kinds of marginal revenue curves,
calculations in Test your understanding 6.8. depending on whether or not the firm has control
over the price of its output (pages 156–7). Part (a)
Profit maximisation based on the shows the MR curve of the firm with no control
marginal revenue and cost approach over price. Part (b) shows the MR curve of the firm
Profit maximisation using this approach is based on a with some control over price. Both parts (a) and
comparison of marginal revenue (MR) with marginal (b) illustrate the identical principle about profit
cost (MC) to determine the profit-maximising level of maximisation.
output.
According to the profit-maximising rule, MC = MR,
The firm’s profit-maximisation rule is to choose to the point of intersection between the MC and MR
produce the level of output where MC = MR. The curves determines the profit-maximising level
same rule is used by the firm that is interested in of output; this is Qπmax in Figure 6.12 (a) and
minimising its loss. (b). Why is this so? Consider a firm producing
output Q1 in both parts (a) and (b), where MR > MC.
(a) Price constant If this firm increases its output by one unit, the
additional revenue it would receive (MR) will
MC be greater than its additional cost (MC). It is
therefore in the firm’s interests to increase its level
MC, MR MR of output until it reaches Qπmax where MR = MC.
If it continues to increase output beyond Qπmax,
0 Q1 Q max Q2 Q say to Q2, where MR < MC, the additional revenue
it would receive for an extra unit of output is
(b) Price varies with output less than the additional cost, and so it should cut
back on its Q. There is only one point where the firm
can do nothing to improve its position, and that is
Qπmax, where MR = MC, and profit is the greatest it
can be.

When we are given data for MC and MR (and no
information on total costs and total revenues), all
we can do is find the profit-maximising level of output
(where MC = MR), but we cannot find the amount of
profit (or loss) unless we have more information. We
will see how this is done in Chapter 7. You will be
given the opportunity to find the profit-maximising
level of output using the MC = MR rule in the
exercises below.

MC

MC, MR Test your understanding 6.8

0 Q1 Q max Q2 Q 1 (a) What are the two approaches to profit
MR maximisation by firms? (b) What is the profit-
maximising rule of firms in each of the two
Figure 6.12 Profit maximisation using the marginal revenue and marginal approaches?
cost approach
2 (a) Say a firm is producing a level of output
Q where MC > MR. What should it do to
increase its profit (or reduce its loss)? (b) If
it is producing Q where MC < MR, what should
it do?

Chapter 6 The theory of the firm I 163

3 Assume that a firm that has no control over its Additional goals of firms
price sells its output at $5 per unit. (a) Given
the following data, use the total revenue and Describe alternative goals of firms, including revenue
total cost approach to determine the level of maximisation, growth maximisation, satisficing and
output at which the firm will maximise profit. corporate social responsibility.
(b) How much profit will it make? (c) Graph
TR and TC and find the profit-maximising Q Over the years, economists have developed many
and profit on your graph; do they match your theories about firm behaviour. The following is a brief
calculations? (d) Calculate the amount of profit survey of some of the more important ones.
(or loss) when Q = 3, Q = 6, Q = 10 and find
these on your graph. Do your results match? Revenue maximisation
In one theory of firm behaviour, it is argued that
Units of output (Q) 1 2 3 4 5 6 7 8 9 10 the separation of firm management from firm
ownership, which increasingly dominates business
Total cost ($) 15 18 20 21 23 26 30 35 41 48 organisation, has meant that firms’ objectives have
changed. Whereas profit maximisation may be the
4 Given the data in question 3, (a) determine the dominant motive of the traditional owner-managed
level of output at which the firm will maximise firm, firm managers who are hired by the owners to
profit using the marginal revenue (MR) and perform management tasks may be more interested
marginal cost (MC) approach. (Hint: you must in increasing sales and maximising the revenues that
use the information in the question to find arise from larger quantities sold. This goal of firms is
MR and MC.) (b) Graph the resulting MR and referred to as revenue maximisation.9 Increasing
MC curves. (c) Did you find the same profit- sales and maximising revenues may be more useful
maximising level of output as in question 3?* to a firm than profit maximisation for the following
reasons:
5 Suppose that a firm with some control over price
faces the costs and prices per unit of output shown • Sales can be identified and measured more easily
in the table below. (a) Use the total revenue and over the short run than profits, and increased sales
total cost approach to determine the level of targets can be used to motivate employees.
output at which the firm will maximise profit.
(b) How much profit will it make? (c) Graph TR • Rewards for managers and employees are often
and TC and find the profit-maximising Q and profit linked to increased sales rather than increased
on your graph; do they match your calculations? profits.
(d) Calculate the amount of profit (or loss) when
Q = 2, Q = 3, Q = 8 and find these on your graph. • It is often assumed that revenue from more sales
Do your results match your calculations? will increase more rapidly than costs; if this is the
case, profit (= TR − TC) will also increase.
Units of output (Q) 1 2345678
Total cost ($) 15 18 20 21 23 26 30 35 • Increased sales give rise to a feeling of success,
Price ($) 10 9 8 7 6 5 4 3 whereas declining sales create a feeling of failure.

6 Given the data in question 5, (a) determine the Growth maximisation
level of output at which the firm will maximise In other approaches it is assumed that firms may be
profit using the marginal revenue (MR) and interested in maximising their growth rather than
marginal cost (MC) approach. (Hint: you must their profits.10 Growth maximisation can be
use the information in the question to find attractive for the following reasons:
MR and MC.) (b) Graph the resulting MR and
MC curves. (c) Did you find the same profit- • A growing firm can achieve economies of scale and
maximising level of output as in question 5?* lower its average costs.

* When using the TR and TC approach your results give two profit- • As a firm grows it can diversify into production
maximising levels of output, whereas the MR and MC approach of different products and markets and reduce its
gives only one. This is because the MR and MC approach is actually dependence on a single product or market.
more precise than the TR and TC approach. It is good idea to use the
larger of the two values of output that you get by using the TR and • A larger firm has greater market power and
TC approach. increased ability to influence prices.

9 The revenue-maximisation goal of firms was described by W. J. Baumol 10 This is based on the work of R. Marris and others.
in 1959.

164 Section 1: Microeconomics

• A larger firm reduces its risks because it may be less consumers would consider to be ethically unacceptable,
affected in an economic downturn and is less likely such as the practice in many developing countries of
to be taken over (bought) by another firm. employing children who are extremely poorly paid
and forced to work long hours, or employing labour
• The objective of growth maximisation reconciles that is forced to work under unhealthy or dangerous
the interests of both owners and managers, because conditions. These situations may arise in countries
both groups have much to gain from a growing where there is widespread poverty, and government
firm (other maximisation objectives pit firm legislation protecting the rights of children and workers
owners against firm managers; for example, profit is either non-existent or poorly enforced.
maximisation is favoured by owners while revenue
maximisation is favoured by managers). However, many firms are increasingly recognising
that the pursuit of self-interest need not necessarily
Managerial utility maximisation conflict with ethical and environmentally responsible
In this view, when firm management is separated from behaviour. A negative image of the firm held by
firm ownership, managers develop their own objectives workers and customers (buyers of the product) can
that revolve around the maximisation of their own cut deeply into the firm’s revenues and profits by
utility (satisfaction).11 Managerial utility can be derived lowering worker productivity and the firm’s sales.
from increased salaries, larger fringe benefits (such as Further, socially irresponsible firm behaviour may
company cars and expense accounts), employment of lead to government regulation of the firm intended
more staff that gives rise to a feeling of importance, and to minimise the negative consequences of the firm’s
investments in the managers’ favourite projects. The actions for society, whereas socially responsible
result of all these activities may be to cut into profits behaviour could instead result in avoidance of
and make these lower than they would otherwise be. government regulation. Therefore, firms face
strong incentives to display corporate social
Satisficing responsibility by engaging in socially beneficial
All of the above objectives assume that the firm tries to activities. These can take many forms, including:
maximise some variable, whether it is profit, revenue,
growth or managerial utility. H. Simon, a Nobel • avoidance of polluting activities
Prize-winning economist, has argued that the large
modern enterprise cannot be looked upon as a single • engaging in environmentally sound practices
entity with a single maximising objective; instead
it is composed of many separate groups within the • support for human rights, such as avoiding
firm, each with its own objectives which may overlap exploitation of child labour and labour in general in
or may conflict. This multiplicity of objectives does less developed countries, or avoiding investments in
not allow the firm to pursue any kind of maximising countries with politically oppressive regimes
behaviour. Firms therefore try to establish processes
through which they can make compromises and • art and athletics sponsorships
reconcile conflicts to arrive at agreements, the result of
which is the pursuit of many objectives that are placed • donations to charities.
in a hierarchy. This behaviour was termed satisficing
by Simon, referring to the idea that firms try to achieve Many of these practices are the result of increased
satisfactory rather than optimal or ‘best’ results. consumer awareness of social and environmental
issues, growing consumer concern over ethical and
Ethical and environmental concerns: environmental aspects of business practices, and
corporate social responsibility even consumer activism that results in boycotts of
The self-interested behaviour of firms often leads to offending firms. One indication of the influence and
negative consequences for society. Many of these were concern of consumers is the rapidly growing interest
examined in Chapter 5 under the topic of market in investments in companies (through stock markets)
failure and negative production externalities. It is often that meet certain social, ethical and ecological criteria.
the case that the well-being of firms is not consistent
with the welfare of society. A prime example is the Economists used to think that ethical and
self-interested firm that pollutes the environment. environmentally responsible behaviour of firms would
In addition, firms can engage in actions that most reduce their profits. This was based on considering
only the cost aspect of profits; for example, firms using
11 This is based on the work of O. E. Williamson in 1963. cheap child labour face lower costs, and hence will
make higher profits than firms avoiding such practices.
Yet profits depend not only on costs, but also on
revenues. If consumers avoid buying the products

Chapter 6 The theory of the firm I 165

of offending firms, revenues will decline and profits The behaviour of firms themselves, however, suggests
will go down in spite of the lower costs. The same that they often do not want to risk consumer
arguments also apply to firms that may be pursuing displeasure.
some strategy other than profit maximisation, such as
revenue maximisation. Test your understanding 6.9

A number of studies have attempted to measure Discuss some possible goals of firms other than
the effects of socially responsible behaviour on the profit maximisation that may influence their
profits of firms. Does ethical and environmentally behaviour.
responsible behaviour lower or increase firms’ profits?
The results of these studies have been inconclusive.

Theory of knowledge

How realistic is profit maximisation as the firm’s main goal?

Standard economic theory assumes that profit Milton Friedman, an American Nobel Prize-winning
maximisation is the most important goal of firms. As we economist, argued in a famous book12 that it does not matter
will see in the next chapter, the theory of the firm is based if the assumptions of a theory are unrealistic, as long as the
very heavily on the assumption of profit maximisation. Yet theory has predictive powers. In fact, good theories are often
this assumption is criticised for several reasons: based on unrealistic assumptions that do not accurately
describe the real world, because the role of assumptions is
• The use of marginal concepts (MR and MC) in the to portray only the important aspects of a process that is
theory is unrealistic; firms cannot easily identify modelled or theorised about, ignoring the irrelevant details.
marginal revenues and marginal costs, and do not even
try to do so; therefore, this theory does not accurately Paul Samuelson, another American Nobel Prize-winning
describe methods actually used by firms to determine economist, fundamentally disagreed. Samuelson argued
price and output. that the predictions of a theory can only be as empirically
valid as the theory itself, and as the assumptions on which
• The model is based on the assumption that firms have the theory rests. If the assumptions are unrealistic or
perfect information at their disposal, whereas in fact invalid, then the theory and its predictions will similarly be
the information on which they base their decisions is invalid; it is not possible to have a theory with predictive
highly fragmentary and uncertain; firms do not know powers if its assumptions are unrealistic. If the predictions
what demand curves they face for their products and of a theory are empirically valid, so is the theory and its
they do not know how competitor firms will behave in assumptions. Logically, then, it is not possible to separate
response to their actions. the predictions of a theory from the assumptions of the
theory; they all stand or fall together.
• Short run profit maximisation may be unrealistic;
firms may not try to maximise profits in the short run, 12 Milton Friedman (1953) ‘The Methodology of Positive
as they might prefer lower profits in the short run in Economics’ in Essays in Positive Economics, University of Chicago
exchange for larger profits over the long run. Press.

• The factors determining demand and supply for Thinking points
products and resources are continuously changing,
with demand and supply curves continuously shifting, • Remember that a theory tries to explain real-
so that any profit-maximising decisions regarding world events. Does it matter if a theory is based on
prices and output made today under current unrealistic assumptions?
conditions may be irrelevant by the time the output is
produced and ready for sale in the market. • As you read through Chapter 7, you may want to keep
these issues in mind, as we will encounter further
• There is real-world evidence suggesting that firm unrealistic assumptions in some market models
behaviour may be motivated by a variety of objectives discussed in that chapter (see also the Theory of
other than profit maximisation, which were discussed knowledge feature on page 211).
on pages 164–6.

166 Section 1: Microeconomics

Assessment

The Student’s CD-ROM at the back of this book
provides practice of examination questions based on
the material you have studied in this chapter.
Higher level
• Exam practice: Paper 1, Chapter 6

HL topics (questions 6.1–6.8)
• Exam practice: Paper 3, Chapter 6

HL topics (questions 13–15)

Chapter 6 The theory of the firm I 167

Microeconomics

Chapter 7

The theory of the firm II:
Market structures

Higher level topic

This chapter continues our study of firm behaviour. We will use the general principles outlined in Chapter 6 to
study how firms behave within the market structure in which they operate.

Introduction to market structures The model of perfect competition is based on the
following assumptions:
A firm (or business) is an organisation that employs
factors of production to produce and sell a good or • There is a large number of firms. The large
service. A group of one or more firms producing identical number means that each firm’s output is small in
or similar products is called an industry. For example, the relation to the size of the market. Also, it means that
car industry consists of firms that are car manufacturers firms act independently of each other and the actions
(Ford, Honda, Mercedes, etc.); the shoe industry consists of each one do not affect the actions of the others.
of firms that are shoe manufacturers; and so on. There
are many kinds of industries with various characteristics, • All firms produce identical, or homogeneous
which economists analyse by use of models called products. The products produced by the firms in
market structures. A market structure describes the each industry are identical, and are referred to as
characteristics of market organisation that influence the homogeneous. It is not possible to distinguish the
behaviour of firms within an industry. There are four product of one producer from that of another.
market structures identified by economists:
• There is free entry and exit. Any firm that
• perfect competition wishes to enter an industry can do so freely as there is
• monopoly nothing to prevent it from doing so; similarly, it can
• monopolistic competition also leave the industry freely. In other words, there are
• oligopoly. no barriers to entry into and exit from the industry.

7.1 Perfect competition • There is perfect (complete) information. Perfect
information means that all firms and all consumers
Assumptions of the model have complete information regarding products, prices,
resources and methods of production. This ensures
Describe, using examples, the assumed characteristics that no firm has access to information not available to
of perfect competition: a large number of firms; a others that would allow it to produce at a lower cost
homogeneous product; freedom of entry and exit; perfect compared to its competitors. Also, it ensures that all
information; perfect resource mobility. consumers are aware of the market-determined price,
and would therefore not be willing to pay a higher
168 Section 1: Microeconomics price for the product.

• There is perfect resource mobility. Resources
bought by the firms for production are completely

mobile. This means that they can easily and The individual firm, being small, can do nothing to
without any cost be transferred from one firm to influence this price; it must accept Pe and sell whatever
another, or from one industry to another. output will maximise profit. The firm is therefore a
price-taker. If the firm raises its price above Pe, it
Although these assumptions are rarely if ever fully met will not sell any output because buyers will buy the
in the real world, some industries are described more product elsewhere at the lower price Pe. On the other
accurately by the model of perfect competition than by hand, since it can sell all it wants at price Pe, it would
any other: some agricultural commodities (wheat, corn, have nothing to gain and something to lose (some
livestock), other commodities (silver and gold), and the revenue) if it dropped its price below Pe. Therefore, the
foreign exchange market (where currencies are bought firm sells all its output at Pe.
and sold). In spite of its limited applicability to real-world
industries, this model is studied because it offers important The demand curve for a good facing the perfectly
insights into the workings of the market, studied in competitive firm is perfectly elastic (horizontal) at
Chapter 2. Also, as we will learn in this chapter, it serves the price determined in the market for that good.
as a standard used by economists to assess the degree of This means the firm is a price-taker, as it accepts the
efficiency achieved in the other market structures. price determined in the market.

Demand and revenue curves The firm’s revenue curves
The firm we are considering is the one studied in
Explain, using a diagram, the shape of the perfectly Chapter 6, page 156, when we introduced revenue data
competitive firm’s average revenue and marginal revenue and curves for the firm that is unable to control price.
curves, indicating that the assumptions of perfect Let’s consider once again the example used in Table 6.5
competition imply that each firm is a price taker. and Figure 6.7 (page 156). Assume that a perfectly
Explain, using a diagram, that the perfectly competitive competitive firm sells a good at €10 per unit. We can
firm’s average revenue and marginal revenue curves are now calculate the firm’s total revenue, marginal revenue
derived from market equilibrium for the industry. and average revenue, and see what happens to these as
output increases. The data are shown again in Table 7.1.
The demand curve (average revenue curve) Column 3 shows total revenue, calculated by multiplying
facing the firm units of output in column 1 by price shown in column
Consider a market or industry (these terms are used 2. Column 4 calculates marginal revenue, by taking the
interchangeably) for a product produced under perfect change in total revenue and dividing it by the change in
competition. Figure 7.1(a) shows standard market output. Column 5 shows average revenue, obtained by
demand and supply curves for this product, which dividing total revenue by quantity of output. The data in
determine the equilibrium price, Pe. Figure 7.1(b) the table reveal an interesting pattern:
shows the demand curve for the product as it appears
to the individual firm. It is perfectly elastic, appearing No matter how much output the perfectly competitive
as a horizontal line at Pe determined in the market. A firm sells, P = MR = AR and these are constant at the level
perfectly elastic demand curve has a price elasticity of of the horizontal demand curve. This follows from the fact
demand (PED) equal to infinity throughout its range (see that price is constant regardless of the level of output sold.
Chapter 3, page 49). What does this mean for the firm?

PP
S

Pe Pe D

0 D 0 Q
(a) Individual firm Q (b) Market/industry

Figure 7.1 Market (industry) demand and supply determine demand faced by the perfectly competitive firm

Chapter 7 The theory of the firm II 169

(1) (2) (3) (4) (5) at a constant rate, i.e. it is a straight line. Part (b)
Units of Product Total Marginal shows that since price is constant at €10, P = MR
output revenue revenue Average = AR, and they all coincide with the horizontal
price TR = P × Q MR = Δ TR demand curve.
(Q) (P) (€) revenue
ΔQ Test your understanding 7.1
(€) (€) MR = TR
Q 1 What are the assumptions defining the perfectly
competitive market model?
(€)
2 (a) Explain why the perfectly competitive
0 10 - - - firm is a price-taker. (b) What would
10 10 happen if this firm tried to raise its price
1 10 10 10 10 above the market price? (c) What would
10 10 happen if it lowered its price below the market
2 10 20 10 10 price?
10 10
3 10 30 10 10 3 How is the demand curve facing the perfectly
10 10 competitive firm related to the industry/market
4 10 40 equilibrium?

5 10 50 4 (a) Using a diagram, explain the relationship
between the firm’s average revenue (AR)
6 10 60 and marginal revenue (MR) in perfect
competition. (b) How are they related to
7 10 70 product price? (c) How are they related to the
demand curve facing the firm? (d) How are
Table 7.1 Total, marginal and average revenue when price is constant they related to the principle that each firm is a
price-taker?
This result holds only for firms operating under perfect
competition, because these are the only firms that have Profit maximisation in the short run
no control over price and are forced to sell all their
output at the single price determined in the market. Explain, using diagrams, that it is possible for a perfectly
competitive firm to make economic profit (supernormal
The data of Table 7.1 are plotted in Figure 7.2, profit), normal profit or negative economic profit in the
where we see in part (a) that total revenue increases short run based on the marginal cost and marginal revenue
profit maximisation rule.
TR Distinguish between the short-run shut-down price and
TR the break-even price.
Explain, using a diagram, when a loss-making firm would
70 shut down in the short run.
60
50 Remember, the short run is the period when the
40 firm has at least one fixed input. You should bear
30 in mind that this means the number of firms in the
20 industry is also fixed. To enter or leave an industry,
10 a firm must be able to vary all its inputs. Since this
cannot be done in the short run, firms cannot enter
0 1234567Q or leave the industry (until they move into the
long run).
(a) Total revenue

P, MR, AR

40

30

20

10
D = P = MR = AR

0 1234567Q
(b) Marginal and average revenue

Figure 7.2 Revenue curves under perfect competition

170 Section 1: Microeconomics

When a firm wants to maximise profit in the short At the profit-maximising level of output Q:
run, what must it do? Since it is a price-taker, it cannot
influence its selling price. It can only make a choice • If P > ATC, the firm makes supernormal profit
on how much quantity of output it should produce. (positive economic profit).
We will see how the firm does this using the marginal
revenue and marginal cost rule (introduced in • If P = ATC, the firm breaks even, making zero
Chapter 6, page 163). economic profit, though it is earning normal profit.

Short-run profit maximisation based • If P < ATC, the firm makes a loss (negative
on the marginal revenue and marginal economic profit).
cost rule
Making economic profit, breaking even
The analysis consists of three steps: and shutting down in the short run
Using the above three-step approach, we will examine
(i) Compare marginal revenue with the behaviour of the perfectly competitive firm in the
marginal cost to determine profit- short run, making use of the diagrams in Figure 7.3.
maximising (or loss-minimising) Each of these diagrams contains identical cost curves
level of output. As we know from (AVC, ATC and MC; note that MC always intersects
Chapter 6, a firm interested in maximising AVC and ATC at their minimum points). What differs
profit (or minimising loss) produces output between the diagrams is the position of the perfectly
where MR = MC. This can be seen in elastic demand curve, showing different possible prices
Figure 6.12(a), page 163, where Qπmax was that the firm, being a price-taker, must accept.
shown to be the profit-maximising level of
output. Figure 7.3(a): profit maximisation and
economic profit in the short run
(ii) Compare average revenue (or price) When market price is P1, P1 = MR1 = AR1 = D1 represent
and average total cost to determine the the demand curve facing the firm. Using the rule
amount of profit (or loss) per unit of
output. A comparison of average revenue (which MR = MC, the intersection of the MR and MC curves
is equal to price) with average cost shows the
amount of profit (or loss) per unit of output. determines the firm’s profit-maximising level of
We know profit = T R− TC. If we divide this
throughout by output, Q, we get an expression for output, Q1 (simply draw a line from the point of
profit per unit of output, in other words, in terms intersection to the horizontal axis). We then compare
of averages:
P1 with ATC along this same vertical line at the level
profit TR TC of output Q1. Since P1 > ATC, we conclude the firm is
=− making profit per unit equal to P1 − ATC, represented
by the vertical distance between points a and b. To
Q QQ
find total profit, we multiply profit per unit times the

total number of units produced; this is given by

Alternatively, profit = profit ×Q
profit
= AR – ATC Q
Q
and is represented by the shaded area in the diagram.
(since AR = TR, and ATC = TC Note that all profit measures in our discussion refer to
). economic profit (supernormal profit).
QQ

Moreover, since P = AR (shown in Table 7.1 and When P>ATC at the level of output where MC = MR, the
Figure 7.2(b)), it follows that firm earns positive economic profit (supernormal profit).

profit Figure 7.3(b): zero economic profit (normal
= P – ATC profit) in the short run and the break-even
price
Q
The market-determined price falls to P2,
This is the key to calculating the size of the corresponding to demand curve D2. Applying again
firm’s profit or loss per unit of output. the MR = MC rule, we find the profit-maximising

(iii) Find total profit (or total loss). To do this, level of output Q2. Comparing P2 with ATC at
we multiply profit by Q (or loss by Q). output Q2, we see they are equal to each other;
QQ

Chapter 7 The theory of the firm II 171

(a) Economic profit therefore, profit per unit is P2 − ATC = 0. Therefore,
economic profit is zero and the firm is earning
price, revenue, costs P1 total profit MC ATC AVC normal profit. When economic profit is zero, price
0 a P1 = MR1 = AR1 = D1 equals minimum ATC: this is a break-even price,
meaning that at this price the firm breaks even, so
b profit that its total revenues are equal to its total economic
Q costs (implicit plus explicit).1
Q1
Q The price P = minimum ATC is the firm’s break-even
price. At this price the firm is breaking even: it is
(b) Zero economic profit (normal profit) making zero economic profit, but is earning normal
profit.

price, revenue, costs MC Figure 7.3(c): loss minimisation in
ATC
AVC

P2 the short run

P2 = MR2 = AR2 = D2 If the market price falls below minimum ATC, such as

= break-even price P3, corresponding to demand curve D3, the firm does
(break-even point) not earn enough revenue to cover all its costs. Using

0 Q2 Q the MC = MR rule, we see that the profit-maximising

(c) Economic loss: the firm continues to produce or loss-minimising level of output is Q3, at which P3 <
ATC, indicating the firm is making a negative profit, or

price, revenue, costs MC loss. Therefore, Q3 is the firm’s loss-minimising output.
ATC ATC – P3, or the difference between points c and d,
AVC represents the firm’s loss per unit of output, or loss.

c P3 = MR3 = AR3 = D3 Q
loss If we multiply this vertical distance by Q3, we get the
P3 total loss d firm’s total loss, given by the shaded area.
0
Q What should this firm do? Should it continue

Q3 Q producing at a loss or should it stop producing

(d) Loss in the short run and the shut-down price and shut down? To answer this question, we must
remember that the firm is in the short run. This

price, revenue, costs MC means if it stops producing, it will have zero revenue
ATC AVC and zero variable costs (it will have fired all its
workers, and will not be purchasing any other variable
e inputs), but since it will still have some fixed inputs it

total loss f P4 = MR4 = AR4 = D4 will have some fixed costs (such as interest payments
= short-run on loans, insurance payments and rental payments).
P4 loss = AFC shut-down price The fixed costs are costs that must be paid even
Q
0
Q4 Q though the firm has zero output. Therefore, with zero

(e) The loss-making firm that will not produce revenues and zero variable costs, the firm that does
not produce in the short run will have a loss equal to

price, revenue, costs MC ATC AVC its fixed costs.
g Remember, the firm’s objective is to make its

loss as small as possible. What if by producing
some output the firm can receive enough revenue

P5 h P5 = MR5 = AR5 = D5 to cover all its variable costs plus a portion of its
0 Q5 Q fixed costs? If the firm can do this, it will be better
off producing, because then its loss will be smaller
than its fixed costs. This answers the loss-making

firm’s question: it is better to produce rather than
Figure 7.3 Short-run equilibrium positions of the perfectly competitive firm

1 The break-even price is any price at which the firm breaks even, even price is of special significance because it corresponds to the
i.e. makes zero economic profit. A price that is equal to minimum perfectly competitive firm’s profit-maximising level of output.
ATC is just one possible break-even price. This particular break-

172 Section 1: Microeconomics

shut down, as long as the loss it makes by producing Figure 7.3(e): the loss-making firm that will
is less than its total fixed cost. In terms of our per not produce
unit analysis, the firm should produce as long as the If the price falls below the shut-down price, or
loss per unit incurred by producing is less than its below minimum AVC, the firm should shut down
average fixed cost (AFC). (stop producing). As part (e) shows, if the firm were
to produce, it would produce Q5 units of output,
This is illustrated in part (c). The vertical difference where MC = MR. But at Q5 the loss per unit is equal
between ATC and AVC is equal to AFC (since to the distance between points g and h, which is
AFC + AVC = ATC). Therefore, loss per unit, given by greater than AFC. Therefore, the firm is better off not
ATC − P3 at output level Q3 (the distance between c and producing at all, and its loss will equal its fixed costs.
d), is smaller than AFC. Therefore, this firm should not
shut down in the short run; it should produce its loss- When price falls below the shut-down price, so that
minimising output. P < minimum AVC, the firm should shut down in the
short run, and will make a loss equal to its fixed costs.
When ATC>P>AVC at the level of output where
MC = MR, the firm is making a loss but should continue The firm’s short-run decisions on how much to produce
producing because its loss is smaller than its fixed cost. and whether or not it should produce are summarised
Graphically, this occurs when the demand curve lies in Figure 7.4. The cost curves, prices and demand curves
below minimum ATC and above minimum AVC. are the same as those in Figure 7.3 (a)–(e).

Figure 7.3(d): loss in the short run and In perfect competition in the short run:
the short-run shut-down price
The price P = minimum AVC is called the shut- • When P > ATC, the firm makes economic profit.
down price, and is P4 in part (d), corresponding to
demand curve D4. At this price, the firm’s loss per • When P = minimum ATC, the firm makes zero
unit of output is exactly equal to AFC, or ATC − AVC economic profit but earns normal profit; this P is a
(the vertical difference between points e and f). At break-even price of the firm (at the break-even point).
the shut-down price, the firm is indifferent between
producing Q4, determined by MC = MR, and not • When ATC > P > AVC, the firm produces at a loss,
producing at all, because either way it will have a loss but its loss is less than fixed costs; therefore, it
equal to fixed costs. continues to produce.

The price P = minimum AVC is the firm’s shut-down • When P = minimum AVC, the firm’s loss = fixed
price in the short run. At this price, the firm’s total costs; this P is the firm’s short-run shut-down price.
loss is equal to its total fixed cost.
• When P < AVC, i.e. when price falls below the
shut-down price, the firm shuts down (stops
producing); its loss will then be equal to its fixed
costs.

price, MC ATC
revenue, 1 AVC
costs

P = minimum ATC = break-even price P > ATC P1 2
firm makes normal profit, firm makes economic
or zero economic profit (supernormal) profit P2 3

P = minimum AVC = shut-down price ATC > P > AVC P3 4
firm is indifferent between producing firm makes loss but P4 5
continues to produce P5
at a loss or not producing 0 Q5 Q4 Q3 Q2 Q1
P < AVC output, Q
firm makes loss
and shuts down

Figure 7.4 Summary of the perfectly competitive firm’s short-run decisions, and the firm’s short-run supply curve

Chapter 7 The theory of the firm II 173

Calculating economic profit or loss technology of production, etc.), the firms in the
industry will go on producing the output levels shown
Calculate different profit levels from a set of data and/or in Figure 7.3, earning economic profit, or normal
diagrams. profit, or making a loss.

We can use the above principles to calculate Test your understanding 7.2
the firm’s supernormal profit or loss, or
determine if the firm is earning normal profit. 1 We know from Chapter 6 that the profit-
Remember that total profit is equal to profit maximising (loss-minimising) rule using the
per unit (P – ATC) multiplied by the number of marginal revenue and cost approach is MC =
units produced, while total loss is loss per unit MR. Yet in perfect competition, the firm will
(ATC – P) multiplied by the number of units maximise profit (minimise loss) where MC = P.
produced (assuming the firm produces). Test your How is this possible?
understanding 7.2 includes some exercises that will
allow you to practise such calculations. 2 Using diagrams, show when a firm (a) earns
economic profit (you must show profit per unit
The firm’s short-run supply curve and total profit), (b) earns normal profit, and
The MC curves in Figures 7.3 and 7.4 represent the (c) earns negative economic profit (a loss) (you
various quantities that a firm is willing and able must show loss per unit and total loss).
to supply in a market at different possible prices.
This is none other than the definition of the firm’s 3 (a) Using a diagram, explain what it means
supply curve, which we studied in Chapter 2, page for a firm to be earning zero economic profit.
26. However, as we now know, the firm will not offer (b) What is the price called, at which the firm’s
any supply if the price falls below minimum AVC. economic profit is zero?
Therefore, in Figure 7.4, the firm’s short-run supply
curve is the bold face segment of the MC curve 4 Suppose a firm in the short run is making a
which begins at P = minimum AVC. As we know from loss. (a) Use diagrams to show how it makes
Chapter 2, page 27, the industry (market) supply a decision between continuing to produce
curve is obtained by adding up all the individual in the short run or shutting down. (b) What
firm supplies; therefore, the industry supply curve is the largest possible loss it will be prepared
is the sum of all individual firm MC curves above to accept before shutting down? (c) Using a
minimum AVC. diagram, show the lowest possible price it will
be prepared to accept before shutting down.
The short-run supply curve of the perfectly (d) What is this price called?
competitive firm is the portion of its marginal cost
curve that lies above the point of minimum AVC. 5 For each of the following profit-maximising
(loss-minimising) situations, explain whether
Short-run equilibrium under perfect a perfectly competitive firm will continue to
competition operate or will shut down in the short run,
Parts (a)–(e) of Figure 7.3 each represent a short- noting whether it is making positive economic
run equilibrium position for an individual firm in (supernormal) profit, normal profit or negative
a perfectly competitive market structure. Each firm economic profit (loss).
equilibrium corresponds to an equilibrium in the
market as well, where market demand and supply (a) Q = 200 units; AFC = $2, AVC = $6, P = $9
determine the market price each firm accepts. These (b) Q = 250 units; AFC = $3, AVC = $12, P = $13
short-run firm equilibrium positions for the firm and (c) Q = 150 units; AFC = $5, AVC = $12, P = $17
for the market hold and will continue to hold, ceteris
paribus. As long as everything that could cause a 6 For each of the parts in question 5, calculate
change is held constant, and as long as firms remain supernormal profit or loss per unit of output,
in the short run, these equilibrium positions continue and then calculate total supernormal profit or
indefinitely. The reason is that firms in the short run loss.
cannot change their fixed resources, and so if nothing
else changes (market demand, resource prices, the 7 Given the information in the table below,
(a) if price = €6, explain if the profit-maximising
(loss-minimising) firm will produce, how much
it will produce and how much profit or loss
it will make; (b) if price = €4, explain if the
profit-maximising (loss-minimising) firm will

174 Section 1: Microeconomics

produce, how much it will produce and how Normal profit in the long run
much profit or loss it will make; (c) explain
what the firm will do if price = €2. (d) Graph Explain, using a diagram, why, in the long run, a perfectly
the curves corresponding to the data in the competitive firm will make normal profit.
table and identify the break-even price and
shut-down price. In the long-run equilibrium of the perfectly
competitive market structure, all firms earn zero
Total Average Average Average Marginal economic profits (they earn normal profit). The
product fixed variable total cost (€) reason behind this principle is that if firms earn
(units of cost (€) supernormal profit or make losses in the short run,
output) cost (€) cost (€) the profits and losses lead to a process of entry and
8.00 exit of firms that makes the short-run profits or losses
1 6.00 5.50 14.00 4 tend to zero.
2 3.00 4.33 8.50 3
3 2.00 3.50 6.33 2 The long-run equilibrium position of the firm and
4 1.50 3.20 5.00 1 the industry under perfect competition is shown in
5 1.20 3.17 4.40 2 Figure 7.5. As a result of entry or exit, the market settles
6 1.00 3.28 4.17 3 at the price Pe, which is just equal to the firm’s short-run
7 0.86 3.50 4.14 4 and long-run minimum ATC, where each firm is earning
8 0.75 3.77 4.25 5 normal profit. Each firm in the industry produces
9 0.67 4.10 4.44 6 output Qf, and the industry as a whole produces output
10 0.60 4.70 7 Qi (equal to the sum of all the firms’ outputs).

Profit maximisation in the long run In perfectly competitive long-run equilibrium, firms’
economic profits and losses are eliminated, and
In the long run, all the firm’s resources are variable; revenues are just enough to cover all economic costs
therefore, the number of firms in the industry is no so that every firm earns normal profit.
longer unchanging. New firms can enter the industry,
existing firms can change their size (increase or We will now see how firms and the industry arrive at
decrease their fixed resources), or firms can sell their this long-run equilibrium position.
fixed resources and business and leave the industry
altogether. There is therefore free entry and exit of Moving from short-run equilibrium to
firms in an industry, one of the characteristics of this long-run equilibrium
market structure (see page 168), which is the key to
understanding the long run. Explain, using a diagram, how a perfectly competitive
market will move from short-run equilibrium to long-run
equilibrium.

(a) The firmprice, costs, revenue MC (b) The industry S
Pe LRATC P

SRATC Pe
D = MR

0 Qf Q 0 Qi D
Q

Figure 7.5 The firm and industry long-run equilibrium position in perfect competition

Chapter 7 The theory of the firm II 175

Economic (supernormal) profit in the short to fall to P2. At P2, the economic profits of the firms have
run to normal profit in the long run fallen to zero, and all firms are earning normal profit
Assume that a perfectly competitive industry is in (where P = minimum ATC). This is the break-even price,
short-run equilibrium where each firm in the industry which is the same for the short run and the long run.
is earning economic (supernormal) profit (as in
Figure 7.3(a)). Economic loss in the short run to normal
profit in the long run
The initial industry equilibrium is shown in We now assume that firms begin from a short-run
Figure 7.6(b), with D and S1 determining price equilibrium position where they are making losses.
P1. Figure 7.6(a) shows the corresponding firm The firm and industry positions are shown in
equilibrium. P1 is the price accepted by each firm, Figure 7.6 (c) and (d). The demand curve D and
equal to the firm’s MR, and by the MC = MR rule, firms supply curve S1 determine P1 that firms accept and
produce output Q1 and earn economic (supernormal) which represents their MR. By the MC = MR rule,
profit equal to a – b per unit of output. firms minimise losses by producing Q1. Loss per
unit is equal to a – b. In the short run, because they
As long as the firms are in the short run, they have at have at least one fixed input, they are unable to exit
least one fixed input and will remain in the short run, the industry. (They may or may not be producing
but once they move into the long run, they can vary all depending on whether P1 is above or below
their inputs; this is where the assumption of free entry minimum AVC.)
and exit comes into play. In the long run, the economic
profit realised by firms in the industry leads to the Once they go into the long run and have no more
entry of new firms attracted by the prospect of making fixed inputs, the firms are free to leave the industry.
economic (supernormal) profits. As new firms enter, As some firms begin to exit, the industry supply curve
the industry supply curve S1 in Figure 7.6(b) begins to begins to shift to the left from S1 in Figure 7.6(d),
shift to the right, and shifts until it reaches S2, causing and shifts until it reaches S2, determining price P2. As
industry output to increase to Q2 and the market price

(a) The firm From economic (supernormal) profit to normal profit
(b) The industry
P1
P2 P S1

costs, revenue, P MC ATC S2
2
a P1 1
b D
P2

0 Q2 Q1 Q 0 Q1 Q2 Q

(c) The firm From loss to normal profit
(d) The industry

costs, revenue, P MC ATC P

a S2
P1
P2 2 S1
P2 b
P1 1

0 Q1 Q2 Q D
0 Q2 Q1 Q

Figure 7.6 From short-run equilibrium to long-run equilibrium

176 Section 1: Microeconomics

the supply curve shifts and price rises, the remaining Changes in technology or resource prices
firms’ losses get smaller and smaller until at P2 the If there is an improvement in the technology of
firms are no longer making losses. P2 represents production, or if resource prices change, these will be
the firms’ new MR, and by the MC = MR rule, firms reflected in the firm’s cost curves and in the industry
produce output Q2 and earn normal profit (where supply curve. Both an improvement in technology
P = minimum ATC). and a fall in resource prices mean lower costs for the
firm, and appear as a downward shift in the firm’s
When the loss-making firm exits cost curves. Firms that were previously earning
the market in the long run only normal profit (at the long-run equilibrium)
will now be earning supernormal profit, leading to
Explain, using a diagram, when a loss-making firm would new entrants into the industry, a rightward shift of
shut down and exit the market in the long run. the industry supply curve and a fall in price until
it is equal to the new, lower minimum ATC curve.
We have just seen that the price P2 is again the Industry output increases, the final market price is
break-even price, but note that P2 is also the shut- lower, and all firms are earning normal profit once
down price in the long run. In other words, in the again. If resource prices were to increase, there would
long run, the break-even price and the shut-down result an upward shift in the firm’s cost curves, and
price are the same. The reason is that in the long the final equilibrium for the industry would involve
run, any loss-making firm facing a price lower a lower quantity of output produced and a higher
than minimum ATC will shut down and leave the equilibrium price.
industry.
Test your understanding 7.3
In the long run, a loss-making firm shuts down and
exits the market when price falls below minimum 1 How would you use the assumption of free
ATC. entry and exit in a perfectly competitive
industry to distinguish between the short run
Explaining the appearance of short-run and the long run?
profits and losses
Once an industry and its firms find themselves in a 2 Consider an industry where firms are earning
position of long-run equilibrium, they will remain economic profits in the short run. Using
there indefinitely until something from outside the diagrams, explain what will happen in the long
system causes a disturbance. If a disturbance occurs, run to (a) the number of firms in the industry,
firms find themselves in situations making economic (b) industry supply, (c) the market price,
profits or losses, as portrayed in Figure 7.6 (a) and (c). (d) the economic profits of the firms, and
What factors could cause disturbances? (e) the industry’s quantity of output.

Changes in demand 3 Consider an industry where firms are making
Any change in demand will cause a movement losses in the short run. Using diagrams, explain
to a new long-run equilibrium. Suppose there is a what will happen in the long run to (a) the
change in consumer tastes in favour of the product; number of firms in the industry, (b) industry
the industry demand curve shifts to the right, price supply, (c) the market price, (d) the losses of
increases, firms begin to make positive economic the firms, and (e) the industry’s quantity of
(supernormal) profits, as in Figure 7.6(a), and the output.
process continues as described above: new firms are
attracted into the industry, the supply curve shifts to 4 (a) Use diagrams to show an individual firm’s
the right, and price falls until the firms are earning and the market’s equilibrium position in the
normal profits again. long run. (b) What is the relationship between
price, ATC and MC for the individual firm when
If market demand falls, the market demand curve it is in long-run equilibrium? (c) Does the firm
shifts to the left, price falls and firms begin to make earn any economic profit when it is in long-run
losses, as in Figure 7.6(c). The long-run response is for equilibrium?
firms to leave the industry, the industry supply curve
shifts to the left, and price increases until firms are 5 Explain when the firm will shut down and leave
making normal profits again. the market in the long run.

Chapter 7 The theory of the firm II 177

6 Consider a perfectly competitive market in • The short-run shut-down price is P = minimum
long-run equilibrium. Using diagrams, explain AVC: the firm shuts down (stops producing) when
the adjustment to a new long-run equilibrium price falls below minimum AVC.
in the event that there is (a) a change in
consumer preferences in favour of the product • The long-run shut-down price is P = minimum
(market demand increases), and (b) a change ATC: the firm shuts down (leaves the industry)
in consumer preferences against the product when price falls below minimum ATC.
(market demand decreases).
The break-even price
The shut-down price and the The break-even price, or the price at which total
break-even price revenues are exactly equal to total costs, occurs at the
firm’s break-even point (see page 172). It is the same for
Shutting down in the short run and both the short run and the long run, and is where P
the long run: the shut-down price = minimum ATC. This is the price at which the firm
We have seen that shutting down in the short run earns normal profit (zero economic profit). As we have
is different from shutting down in the long run. already seen, in the long run, the break-even price is
In the short run, the firm continues to produce as the same as the shut-down price. If price falls below
long as the price is greater than minimum AVC, this level, the firm is no longer covering all its costs,
even though it may be making a loss. It stops and will therefore shut down in the sense that it will
producing and ‘shuts down’ when price falls below exit the industry.
minimum AVC. In the long run, the firm stops
producing and shuts down when price falls below Calculating short-run shut-down and
minimum ATC. break-even prices

Imagine you are running a dry-cleaning Calculate the short-run shut-down price and the break-
business, and you are renting the premises. Suppose even price from a set of data.
that in the short run the price of your services has
fallen below your minimum AVC, as in Figure 7.3(e). To calculate the short-run shut-down price, you must
You ‘shut down’ in the sense that you stop providing remember that it is the price (equal to AR and MR) that
dry-cleaning services. However, you still have to go is equal to minimum AVC. Therefore, if you are given
on paying the rent (your fixed costs) until your rental cost data, you must calculate AVC and find its smallest
contract expires. Even though you are not producing, value; that is the shut-down price.
you cannot exit the industry. It is only when your
rental contract expires and you no longer have any To calculate the break-even price, you should
fixed costs, that you can go into the long run and remember it is the price (equal to AR and MR) that is
leave the industry altogether. equal to minimum ATC. Therefore, given cost data,
you calculate ATC and find its smallest value; that is
But suppose that the price of your dry-cleaning the break-even price.
services had not fallen so low, and that instead it
was above minimum AVC, though it was below Test your understanding 7.4
minimum ATC, as in Figure 7.3(c). In this case, you
would not shut down in the short run, even though 1 Using diagrams, explain the meaning of the
you would be making a loss. However, since you are perfectly competitive firm’s break-even point.
making a loss, you do not want to stay in the dry-
cleaning business forever. As soon as your rental 2 Using diagrams, explain the difference between
contract expires and you can move into the long the shut-down price and the break-even price
run, you will choose to ‘shut down’ in the sense that for a perfectly competitive firm operating in the
you will sell your business and leave the industry short run.
completely. Once you are in the long run, you
will make this decision for any price that is below 3 (a) Why is there a difference between a firm
minimum ATC, as P = minimum ATC is the lowest that shuts down in the short run and one that
price you would be willing to accept in order to shuts down in the long run? (b) Use diagrams
remain in the business. to show the difference.

178 Section 1: Microeconomics

4 Given the cost data below, find the perfectly opportunity cost, of the resources used to produce one
competitive firm’s shut-down price and break- extra unit of the good. When price is equal to marginal
even price in the short run. (Hint: you must first cost, there is equality between what consumers are
calculate total cost, and average costs from the prepared to pay to get one more unit and what it costs
totals.) to produce it.

Quantity 1 23456789 What would happen if P and MC were not equal
(units of 6 9 11 12 14 17 21 26 32 to each other? If P > MC, an additional unit of the
output) 444444444 good is worth more to consumers than its costs to
produce. There is an underallocation of resources to
Total its production, and consumers would be better off if
variable more of it were produced. If P < MC, an additional unit
cost ($) of the good costs more to produce than it is worth
to consumers; there is an overallocation of resources
Total fixed to the good, and consumers would be better off if
cost ($) output were reduced. In both these cases, allocative
inefficiency results. Therefore, resources are allocated
Allocative and productive (technical) efficiently only when the price of a good is equal to
efficiency the marginal cost of producing it.

In Chapter 2, page 44, we saw that competitive Productive (technical) efficiency
markets achieve allocative and productive efficiency,
because equilibrium is determined by MB = MC, where Explain the meaning of the term ‘productive/technical
consumer and producer (social) surplus is maximum. efficiency’.
This discussion focused on efficiency at the level of the Explain that the condition for productive efficiency is that
market, or industry. We now want to see how efficiency production takes place at minimum average total cost.
can be analysed also at the level of the individual firm.
Productive (also known as technical) efficiency occurs
Allocative efficiency when production takes place at the lowest possible
cost. The condition is the following:
Explain the meaning of the term ‘allocative efficiency’.
Explain that the condition for allocative efficiency is Productive efficiency is achieved when production
P = MC (or, with externalities, MSB = MSC). occurs at minimum ATC.

Allocative efficiency occurs when firms produce the When production is at minimum ATC, this means
particular combination of goods and services that that resources are being used economically and are not
consumers mostly prefer. The condition is the being wasted. Production of the good uses up the least
following: amount of resources possible.

Allocative efficiency is achieved when P = MC. Efficiency and perfect competition

The reason is that allocative efficiency is achieved when Explain, using a diagram, why a perfectly competitive
MB = MC; but since MB = P, it follows there is allocative market leads to allocative efficiency in both the short run
efficiency when P = MC. Note that this condition holds and the long run.
only when there are no externalities, in which case Explain, using a diagram, why a perfectly competitive firm
it is also true that MSB = MSC (this was our condition will be productively efficient in the long run, though not
for the achievement of allocative efficiency when we necessarily in the short run.
considered externalities in Chapter 5).
Efficiency and perfect competition in the
The price, P, paid by consumers to acquire a long run
good reflects the marginal benefit they derive from Figure 7.7 shows the long-run equilibrium position
consumption of one more unit of the good and shows of a firm and industry in perfect competition.
the amount of money they are willing to pay to buy one Part (a) shows the firm to be earning normal profit,
more unit. Marginal cost, MC, measures the value, or and indicates that in long-run equilibrium, the

Chapter 7 The theory of the firm II 179

P S = MC
MC

costs, revenue, P ATC consumer

surplus

Pe P = MR = Pe Pe

producer

surplus

0 Qe Q0 D = MB
(a) The firm Qe Q

(b) The market/industry

Figure 7.7 Productive and allocative efficiency in perfect competition in the long run

perfectly competitive firm achieves both allocative is because this short-run equilibrium is identical to
and productive efficiency. At the profit-maximising long-run equilibrium.
level of output, Qe, P = MC, and ATC is minimum.
Part (b) shows the industry to be achieving allocative In the short run, the perfectly competitive firm
efficiency (MB = MC and social surplus is maximum). achieves allocative efficiency but is unlikely to
It illustrates how the efficiency at the level of the firm achieve productive efficiency.
corresponds to efficiency at the level of the industry.
Evaluating perfect competition
In long-run equilibrium under perfect competition,
the firm achieves both allocative efficiency Perfect competition, though not a very realistic
(P = MC) and allocative efficiency (production market structure, offers a number of insights into the
at minimum ATC). At the level of the industry, workings of competitive markets, as described below.
social surplus (consumer plus producer surplus) is
maximum, and MB = MC. Insights provided by the model

The achievement of allocative and productive • Allocative efficiency. Perfect competition leads
efficiency in long-run equilibrium is an important to the best or ‘optimal’ allocation of resources based
result, because perfect competition is the only market on the mix of goods and services that consumers
structure where this occurs. mostly want, achieved through P = MC in long-run
equilibrium.
Efficiency and perfect competition in the
short run • Productive efficiency. Perfect competition also
Figures 7.3 (a) and (c) illustrated the firm’s short- leads to production at the lowest possible cost,
run equilibrium when it is making economic profits avoiding waste in the use of resources, achieved
and losses, respectively (page 172). When the firm is through production at minimum ATC.
earning an economic profit, as in part (a), the firm
achieves allocative efficiency, since P = MC at the • Low prices for consumers. Consumers benefit
profit-maximising level of output. The same is true from low prices, due to (a) production at the lowest
for the loss-making firm at its loss-minimising level of possible cost (achievement of productive efficiency),
output, shown in part (c). and (b) absence of economic profits, which would
have led to a higher price. You can check this by
However, neither the profit-making nor the loss- comparing Figure 7.3 (a) and (b), showing that the
making firm achieves productive efficiency in the price when the firm earns economic profit is higher
short run, because ATC is higher than minimum at than the price in long-run equilibrium, where the
the level of output where they produce. Only if the firm earns only normal profit.
firm happens to be in a short-run equilibrium such
as in Figure 7.3(b), where it earns normal profit (zero • Competition leads to the closing down
economic profit), will it be productively efficient. This of inefficient producers. Inefficient firms
are those that produce at higher than necessary
180 Section 1: Microeconomics costs. Inefficiency could be due to factors like
less productive labour, or the use of outdated

technologies, or poor entrepreneurship. The Test your understanding 7.5
revenues of inefficient firms are insufficient to cover
all costs, leading to losses that force these firms to 1 Why do we study the perfectly competitive
leave the industry in the long run. market model extensively when this model is
based on so many unrealistic assumptions?
• The market responds to consumer tastes.
Changes in consumer tastes are reflected in changes 2 Explain the meaning of and state the conditions
in market demand and therefore market price. By for (a) productive efficiency, and (b) allocative
creating short-run economic profits or losses, price efficiency. (c) Using diagrams, show how
changes result in long-run adjustments that make the perfectly competitive firm achieves both
the quantity of output produced by the industry productive and allocative efficiency in long-
respond to consumer tastes. run equilibrium. (d) Using a diagram, show
which of these two conditions is unlikely to be
• The market responds to changes in achieved in the short run. (e) How would you
technology or resource prices. If there is an show the achievement of allocative efficiency
improvement in the technology of production, or for the perfectly competitive industry?
a change in resource prices, the cost curves will
shift upward or downward, leading to economic 3 Evaluate the perfectly competitive market model
profits or losses, once again leading to new long-run by referring to the insights it offers and its
equilibria that accommodate the changes. limitations.

Limitations of the model 7.2 Monopoly

• Unrealistic assumptions. The model rests on Assumptions of the model
strict and unrealistic assumptions that are rarely
met in the real world. Describe, using examples, the assumed characteristics of
a monopoly: a single or dominant firm in the market; no
• Limited possibilities to take advantage of close substitutes; significant barriers to entry.
economies of scale. Economies of scale (studied in
Chapter 6, page 153) lead to lower average costs as a The model of monopoly rests on the following
firm grows larger and larger. In perfect competition assumptions:
the requirement that the firms are many and small
prevents them from growing to a size large enough • There is a single seller or dominant firm
to take advantage of economies of scale. in the market. The term ‘monopoly’ is derived
from the Greek word μοvοπω′ λιο meaning ‘single
• Lack of product variety. All firms within an seller’. When there is a single firm producing a good
industry produce identical or undifferentiated or service for the entire market, it is called a pure
products. This is a disadvantage for consumers, who monopoly. The firm is therefore the entire industry.
prefer product variety. In the real world, a monopolistic industry may
consist of one firm that dominates the market with
• Waste of resources in the process of long-run a very large market share. For example, DeBeers
adjustment. It is possible that the continuous Company of South Africa controls over 80% of
opening and closing of firms as the industry diamond sales, and is considered to be a monopoly.
responds to changes in demand, resource prices and
technology in the long run may lead to a waste of • There are no close substitutes. If substitute
resources (the model unrealistically assumes there goods existed, then consumers could easily switch
are no costs of adjustment). to buying a substitute good, in which case there
would no longer be a monopoly for the good in
• Limited ability to engage in research and question. Therefore, the monopolist produces a
development. The lack of economic profits in the good or service that has no close substitutes.
long run does not offer firms the necessary funds to
pursue research and development.

• Market failure. Even if it were possible to meet
all of the assumptions of the perfectly competitive
market model, there are numerous real-world
situations where resources are allocated inefficiently
because of market failures (see Chapter 5).

Chapter 7 The theory of the firm II 181

• There are significant barriers to entry. The SRATC2
monopolist owes its dominance in the market
and the absence of competitor firms partly to costs SRATC1 LRATC
the inability of other firms to enter the industry.
Anything that prevents other firms from entering 0 Q
the industry is called a barrier to entry. Figure 7.8 Economies of scale as a barrier to entry

Monopoly lies at the opposite extreme of market Branding
structures to perfect competition. As a single seller, Branding involves the creation by a firm of a unique
the monopolist faces no competition from other firms image and name of a product. It works through
and it has substantial market power (the ability to advertising campaigns that try to influence consumer
control price). Yet a pure monopoly is quite rare in tastes in favour of the product, attempting to
the real world. Like perfect competition, it is studied establish consumer loyalty. If branding of a product
because of the insights it offers into the ability of firms is successful, many consumers will be convinced of
to exercise market power, also known as monopoly the product’s superiority, and will be unwilling to
power. Monopoly power arises whenever a firm faces switch to substitute products, even though these may
a demand curve that is downward-sloping. As we will be qualitatively very similar. Branding may work as a
see throughout the rest of this chapter, firms in all barrier to entry by making it difficult for new firms to
market structures except perfect competition face a enter a market that is dominated by a successful brand.
downward-sloping demand curve, and therefore have Note that branding need not lead to a monopoly (it is
varying degrees of monopoly power, or the ability to a method used by firms in monopolistic competition
influence the price at which they sell their output. and oligopoly, as we will discover below), but it
does have the effect of limiting the number of new
Barriers to entry competitor firms that enter a market. Examples of
branding include brand-name items (such as NIKE®,
Describe, using examples, barriers to entry, including Adidas®, CocaCola®, etc.)
economies of scale, branding and legal barriers.
Legal barriers
There are several kinds of barriers to entry. These are Legal barriers include the following:
described below.
• Patents are rights given by the government to a
Economies of scale firm that has developed a new product or invention
Economies of scale result in the downward-sloping to be its sole producer for a specified period of
portion of a firm’s long-run average total cost curve time. For that period, the firm producing the
(LRATC), permitting lower average costs to be achieved patented product has a monopoly on the product.
as the firm increases its size (see page 153). A barrier Examples include patents on new pharmaceutical
to entry exists when economies of scale are extensive products, Polaroid and instant cameras, Intel and
and the LRATC curve declines over a very large range microprocessor chips used by IBM computers.
of output. In Figure 7.8 the average total costs of a
large firm on SRATC1 are substantially lower than the • Licences are granted by governments for particular
average costs faced by a smaller firm on SRATC2. The professions or particular industries. Licences may be
large firm can charge a lower price than the smaller required, for example, to operate radio or television
firm, and can force the smaller firm into a situation stations, or to enter a particular profession (such
where it will not be able to cover its costs. Therefore, as medicine, dentistry, architecture, law and
if new firms try to enter the industry on a small scale others). Such licences do not usually result in a
they will be unable to compete with the larger one. monopoly, but they do have the impact of limiting
competition.
On the other hand, a new firm attempting to enter
the market on a very large scale so as to be able to
take advantage of economies of scale would encounter
huge start-up costs, and would be unlikely to take the
risk involved. Economies of scale form a significant
barrier to entry in the case not only of monopolies but
also of oligopolies (see page 201).

182 Section 1: Microeconomics

• Copyrights guarantee that an author (or an located some distance from any other stores may be a
author’s appointed person) has the sole rights to local monopoly.
print, publish and sell copyrighted works.
Aggressive tactics
• Public franchises are granted by the government If a monopolist is confronted with the possibility of
to a firm which is to produce or supply a particular a new entrant into the industry, it can create entry
good or service. barriers by cutting its price, advertising aggressively,
threatening a takeover of the potential entrant, or any
• Tariffs, quotas and other trade restrictions other behaviour that can dissuade a new firm from
limit the quantities of a good that can be imported entering the market.
into a country, thus reducing competition.
Demand and revenue curves under
Not all of these legal barriers lead to monopoly, but monopoly
they all have the effect of limiting competition,
thus contributing to the creation of some degree of Explain that the average revenue curve for a monopolist
monopoly power. is the market demand curve, which will be downward
sloping.
Control of essential resources Explain, using a diagram, the relationship between
Monopolies can arise from ownership or control of an demand, average revenue and marginal revenue in a
essential resource. A classic example of an international monopoly.
monopoly is DeBeers, the South African diamond
firm, that mines roughly 50% of the world’s diamonds The demand curve facing the monopolist
and purchases about 80% of diamonds sold on open
markets. Whereas it is not the sole diamond supplier, Since the pure monopolist is the entire industry,
its large market share allows it to have a significant the demand curve it faces is the industry or market
control over the price of diamonds. On a national demand curve, which is downward-sloping. This
level, an example is Alcoa (the Aluminum Company of is the most important difference between the
America), which, following the expiration of patents in monopolist and the perfectly competitive firm,
1909, was able to maintain its monopoly position on which faces perfectly elastic demand at the price
the production of aluminium within the United States level determined in the market.
until the Second World War, because of its control of
almost all the bauxite resources within the country. On The two demand curves shown in Figure 7.9 indicate
a local level, professional sports leagues create a local that the perfectly competitive firm is a price-taker with
monopoly by signing long-term contracts with the best zero market power, while the monopolist is a price-
players and securing exclusive use of sports stadiums. A maker with a significant degree of market power.
local monopoly is a single producer/supplier within a
particular geographical area. Local monopolies appear
more commonly than national or international ones.
For example, a local grocery store in a residential area

(a) Facing the perfectly competitive firm (b) Facing the monopolist a
P P
P2
D = AR

P1

D = AR

0 Q 0 Q2 Q1 Q
Figure 7.9 Demand curves

Chapter 7 The theory of the firm II 183

All firms under market structures other than perfect (1) (2) (3) (4) (5)
competition are to varying degrees price-makers, Units of
as they all face downward-sloping demand curves. output Product Total Marginal Average
Of these, the monopolist has the greatest degree of
market power, or the ability to influence price, because (Q) price revenue revenue revenue
it is the sole or dominant firm in the industry. TR
0 (P) (TR = P × Q) MR = Δ TR AR = Q
However, whereas the monopolist has a large 1 ΔQ
control over price, this control is limited by the 2 (€) (€) (€) (€)
position of the market demand curve. Given the 3
demand curve in Figure 7.9(b), when it chooses how 4 −− − −
much output to produce, say Q1, it simultaneously 5
determines the price at which the good can be sold, 6 12 12 12 12
or P1. It could not possibly sell output Q1 at a price 7
such as P2, since the price–quantity combination P2 8 11 22 10 11
and Q1 is at a point a lying off the demand curve. The 9
monopolist can sell its output at price P2 if it wants 10 10 30 8 10
to, but will only be able to sell quantity Q2 at that
price. In other words, the monopolist cannot make 9 36 6 9
independent decisions on both price and quantity; it
can only choose price–quantity combinations that are 8 40 4 8
on the market demand curve.
7 42 2 7
The monopolist’s revenue curves
In perfect competition where the firm is a price-taker, 6 42 0 6
the market-determined price is constant for all output,
leading to the perfectly elastic (horizontal) demand 5 40 −2 5
curve. But when a firm faces a downward-sloping
demand curve, price is no longer constant for all 4 36 −4 4
output: more output can only be sold at a lower price.
Let’s consider once again the example used in Table 3 30 −6 3
6.6 and Figure 6.8 in Chapter 6 (page 157), when we
introduced revenue data and curves for the firm that Table 7.2 Total, marginal and average revenue when price varies with output
has some ability to control price. Table 7.2 provides
the same data for a monopolist’s total, marginal and total revenue ( )(a) Total revenue
average revenues, and the diagrams in Figure 7.10 plot
these data. 40 Q
35
Looking at Table 7.2 and Figure 7.10, we may note 30
the following: 25 TR
20
• As price (P) falls, output (Q) increases because of the 15
downward-sloping demand curve). Total revenue 10
(TR), obtained by Q × P, at first increases, reaches 5
a maximum at six and seven units of output, and
then begins to fall. 0 1 2 3 4 5 6 7 8 9 10 11

• Marginal revenue, showing the change in total (b) Marginal and average revenue
revenue resulting from a change in output, falls
continuously; MR is equal to zero when total 15 PED > 1 PED = 1
revenue is at its maximum (at seven units of output), (unit elastic demand)
and becomes negative when total revenue falls.2 (price-elastic

• Average revenue (column 5 of Table 7.2) is equal demand)
to price (see column 2):
price, revenue ( ) 10 PED < 1
(price-inelastic

demand)

5

P = AR = D

0 Q
1 2 3 4 5 6 7 8 9 10 11

-5
MR

Figure 7.10 Revenue curves in monopoly

2 Marginal revenue represents the slope of the total revenue
curve (just as marginal cost is the slope of the total cost curve).

184 Section 1: Microeconomics

Since TR = P × Q, and AR = TR, it follows that P is In Figure 7.10(b), the monopolist will not produce any
Q output greater than seven units, which is where TR is
equal to AR. maximum and MR = 0. If it did, its total revenue would
fall and marginal revenue would be negative.
• The AR and P curves represent the demand curve facing
the firm. Test your understanding 7.6

• The MR curve lies below the demand curve. The reason 1 What are the assumptions defining the market
is that, unlike in perfect competition, where MR = P, model of monopoly?
here the firm must lower its price in order to sell
more output. The lower price is charged not only 2 Using a diagram, explain how economies
for the last unit of output but all the previous units of scale can result in a monopolistic market
of output sold. Marginal revenue, or the extra structure by posing barriers to entry.
revenue from selling an additional unit of output,
is therefore equal to the amount of the price of the 3 How can branding and legal factors provide
last unit sold minus what is lost by selling all the barriers to entry into an industry? Provide some
other units of output at the now lower price.3 examples.

The monopolist’s output and price 4 (a) Compare and contrast the demand curve
elasticity of demand facing the perfectly competitive firm and
that facing the monopolist. (b) What is the
Explain why a monopolist will never choose to operate on relationship between market power and the
the inelastic portion of its average revenue curve. differences between the two demand curves?
(c) Why is one firm a price-taker and the other a
In Table 7.2 and Figure 7.10, in the range of output price-maker?
where total revenue is increasing and marginal
revenue is positive, the demand curve facing the firm 5 (a) Explain the relationship between the
(represented by P = AR) is price elastic (PED > 1); in monopolist’s average revenue (AR) and marginal
the range of output where total revenue is falling and revenue (MR). (b) How are they related to
marginal revenue is therefore negative, the demand product price? (c) How are they related to the
curve is price inelastic (PED < 1). (The reason can be demand curve facing the firm?
found in Chapter 3, page 50, where we discussed the
changing PED along a straight-line demand curve.) 6 Explain why the average revenue curve is the
Figure 7.10 shows the relationship between PED demand curve facing the monopolist. Why is
and total revenue. When demand is elastic, price this curve downward-sloping?
and total revenue change in opposite directions: in
part (b) as price falls from €12 to €6 along the elastic 7 Why will the monopolist avoid producing in
portion of the demand curve, we see total revenue the inelastic portion of its demand curve? Use
increasing in part (a). When demand is inelastic, diagrams to support your answer.
price and total revenue change in the same direction:
as price falls beyond €6 (along the inelastic portion 8 What is the maximum level of output that a
of the demand curve in part (b), we see total revenue monopolist would consider producing? What
falling in part (a). Total revenue is maximum, and would the monopolist be maximising at this
MR = 0 where PED = 1. level of output? Use a diagram to support your
answer.
These observations have important implications for
the level of output produced by the monopolist. Profit maximisation by the monopolist

The monopolist will not produce any output in the Explain, using a diagram, the short- and long-run
inelastic portion of its demand curve (which is also equilibrium output and pricing decision of a profit-
its average revenue curve). maximising (loss-minimising) monopolist, identifying the
firm’s economic profit (or losses).
Explain the role of barriers to entry in permitting the firm
to earn economic profit.

3 To understand this, consider the following numerical example. for each of the initial 3 units of output that previously were selling
Say output increases from 3 to 4 units. Marginal revenue will be for €10 and must now sell for €9, equal to €3. Marginal revenue is
the result of a gain and a loss. The gain is €9, obtained from selling equal to the gain minus the loss, or 9 − 3 = 6.
the fourth unit of output at the price of €9. The loss is equal to €1

Chapter 7 The theory of the firm II 185

Profit maximisation based on the • To find total profit, we multiply profit per unit
marginal revenue and cost approach times the total number of units produced, which is
The monopolist interested in maximising profit (or
minimising loss) follows the same three-step approach profit = profit ×Q
used by the perfectly competitive firm:
Q
(i) The monopolist determines the profit-maximising
(or loss-minimising) level output using the MC = and is represented by the shaded area.
MR rule.
The monopolist need not always make profits; it may
(ii) For that level of output, it determines profit per
unit or loss per unit by using make losses if price cannot cover ATC. This is shown

profit in Figure 7.11(b), where the monopolist is minimising
= P − ATC
loss. At the level of output Qlmin, determined by MR =
Q MC, the monopolist’s loss is minimised. The price that

If P > ATC, the monopolist is making a profit; will be charged is given by Pe, found by extending a
if P = ATC it is earning normal profit (zero line upward to the demand curve at output level Qlmin.
economic profit); Loss per unit of output
if P < ATC it is making a loss.
( )loss is given by ATC − P (the distance c – d), and total
(iii) The firm multiplies profit by Q to determine total Q
Q
loss is given by the shaded area, found by multiplying
profit, or loss by Q to determine total loss. loss per unit of output by the total number of units
Q produced.

Figure 7.11 (a) and (b) show the standard ATC and Just as in perfect competition, the loss-making
MC curves (derived in Chapter 6, page 148). On these monopolist continues to produce in the short run
cost curves, the monopolist’s demand and marginal as long as its losses are smaller than its fixed costs
revenue curves are added. Consider first part (a). (P > minimum AVC). In the long run (when all
resources are variable), the loss-making monopolist
• We first find where MR = MC, which determines the is likely to shut down or move its resources to
profit-maximising level of output, Qπmax. another more profitable industry. However, the
distinction between the short run and the long
• At Qπmax, we draw a vertical line upward to the run is not as important in monopoly as it is in
AR (or demand) curve (point a) and from there perfect competition. In perfect competition, the
extend a horizontal line leftward to the vertical distinction between the short and long runs is of
axis; this will determine the price, Pe, at which the crucial importance because as firms enter and exit an
monopolist sells output Qπmax. industry in the long run, economic (supernormal)
profits and losses disappear, and firms are left with
• For output Qπmax, we find profit per unit normal profits in their long-run equilibrium. This
is not possible in monopoly, due to the presence of
( )profit barriers to entry.
Q , given by P − ATC; this is the vertical
distance between the average revenue (demand)
and ATC curves, or between points a and b.

(a) price, costs, revenue MC (b) MC
price, costs, revenuea ATCPe lossc ATC
Pe d
profit b

MR D = AR MR D = AR
0 Qlmin Q
0 Q max Q

Figure 7.11 Profit maximisation and loss minimisation in monopoly: marginal revenue and cost approach

186 Section 1: Microeconomics

Under monopoly, high barriers to entry prevent price, costs, revenue MC
potential competitor firms from entering a profit-
making industry, and the monopolist can therefore Pπ
continue making economic (supernormal) profits Pr
indefinitely in the long run.
D = AR
Revenue maximisation by the
monopolist 0 Qπ Qr Q
MR
Comparing revenue-maximisation with
profit maximisation

Explain, using a diagram, the output and pricing decision Figure 7.12 Comparison of profit maximisation and revenue
of a revenue-maximising monopoly firm. maximisation by the monopolist
Compare and contrast, using a diagram, the equilibrium
positions of a profit-maximising monopoly firm and a When given data, we similarly find the revenue-
revenue-maximising monopoly firm. maximising level of output by finding the quantity
that corresponds to MR = 0. Therefore, in Table 7.2,
In Chapter 6, page 164, we saw that according to an we see that the quantity of output where revenue is
alternative theory, firms try to maximise revenue rather maximised is 7, which corresponds to MR = 0.
than profit. How does the output and price of such a
firm compare with those of the profit maximiser? Natural monopoly

The answer to this question can be seen in With reference to economies of scale, and using examples,
Figure 7.10. In part (a), total revenue (TR) is maximum explain the meaning of the term ‘natural monopoly’.
when seven units of output are produced. This Draw a diagram illustrating a natural monopoly.
corresponds to the point where marginal revenue (MR)
is equal to zero in part (b). Therefore, the revenue- A natural monopoly is a firm that has economies of
maximising monopolist produces that level of output scale so large that it is possible for the single firm
where MR = 0. alone to supply the entire market at a lower average
cost than two or more firms. A natural monopoly is
Comparing the profit-maximising firm with the illustrated in Figure 7.13.
revenue-maximising firm shows that the revenue
maximiser produces a larger quantity of output and If the market demand for a product is within the range
sells it at a lower price than the profit maximiser. of falling LRATC, this means that a single large firm
This can be seen in Figure 7.12. The profit maximiser can produce for the entire market at a lower average
equates MC with MR, and produces quantity Qπ which total cost than two or more smaller firms. When this
it sells at price Pπ. The revenue maximiser produces occurs, the firm is called a natural monopoly.
quantity Qr which it sells at price Pr.

Calculating the revenue-maximising
level of output

Calculate from a set of data and/or diagrams the revenue- costs
maximising level of output. LRATC

Bearing in mind that revenue maximisation involves D
choosing the level of output where MR = 0, it is a 0Q
simple matter to find the corresponding level of
output. In a diagram, it is simply the level of output minimum efficient
where the MR curve intersects the horizontal axis. For scale
example, in Figure 7.10, we can see immediately that
the level of output where revenue is maximised is Figure 7.13 Natural monopoly
where Q = 7 units of output.
Chapter 7 The theory of the firm II 187

There are two factors at work making for a natural 3 Using diagrams, show the case where a
monopoly: costs and market demand. In Figure 7.13, monopolist (a) earns economic profit (show
at the point where market demand, D, intersects the profit per unit and total profit), (b) earns normal
LRATC curve, LRATC is still declining, meaning that profit, and (c) incurs losses (show loss per unit
economies of scale have not yet been fully exhausted and total loss).
and the minimum efficient scale occurs at a higher
level of output. (The minimum efficient scale is the 4 (a) What is the difference, if any, between
lowest level of output at which lowest average total the short-run and long-run equilibrium of
costs are achieved; see page 154.) As output increases, a monopolist? (b) Why can a monopolist
average costs fall, and keep on falling even beyond continue to earn economic profits in the
the point where the entire market demand for the long run?
product is satisfied. A market like this cannot support
more than one firm. In fact, natural monopoly acts 5 The data in the table below show the demand
as a strong barrier to entry of new firms into the curve and costs (ATC and MC) facing a
industry because potential entrants realise that it monopolist. (a) Calculate the monopolist’s
would be extremely difficult to attain the low costs total revenue and marginal revenue for each
of the already existing firm. Examples of natural level of output. (b) What is this monopolist’s
monopolies include water, gas and electricity profit-maximising level of output? (c) At what
distribution, cable television, fire protection and price will this level of output be sold? (d)
postal services. The falling average costs over a Find the monopolist’s profit per unit and total
very large range of output often occur because of profit. (e) Plot the demand curve, marginal
very large capital costs (such as laying pipes for revenue curve, average total cost curve and
water distribution, or laying cables for electricity marginal cost curve, and confirm your results
distribution, or putting a satellite into orbit). for parts (b)–(d).

A natural monopoly may stop being ‘natural’ if Units of Price Average Marginal
changing technologies create conditions that allow output ($) total cost cost
new competitor firms to enter the industry and
begin production at a relatively low cost. Once this 1 10 ($) ($)
happens and technological changes result in lower 2 9 14.0 4.0
costs for firms, it may no longer be the case that a 3 8 8.5 3.0
single firm exhausts economies of scale. This has 4 7 6.3 2.0
happened in recent years with technological change 5 6 5.0 1.0
in telecommunications, forcing telephone companies 6 5 4.4 2.0
that previously were natural companies to compete 7 4 4.2 3.0
with new entrants into the market. 8 3
4.1 4.0
Test your understanding 7.7 4.3 5.0

1 Do the profit-maximising rules used by the 6 (a) Using diagrams illustrating total revenue
monopolist differ from those used by the and marginal revenue of a monopolist,
perfectly competitive firm? show the revenue-maximising level of output.
(b) Using the data of question 5, find the
2 How does the profit-making monopolist level of output (Q) and price (P) of a revenue-
determine (a) the price at which output will maximizing monopolist. (c) How do these
be sold, and (b) whether the firm is earning results compare with the P and Q of the profit-
economic (supernormal) profit, normal profit, maximizing monopolist?
or incurring a loss? (c) Is there any difference in
the method used by the perfectly competitive 7 Can a perfectly competitive firm maximise
firm and the monopolist to determine profits or revenue? Why or why not?
losses?

188 Section 1: Microeconomics