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Chapter 3A: Firms' objectives + costs of production - Coggle Diagram
Chapter 3A: Firms' objectives + costs of production
Traditional objectives
Profit maximisation through TT=TR-TC, where firms aim to increase TR while reducing TC
TR>TC ➡ supernormal profit
TR=TC ➡ normal profit (min amt needed to continue operations)
TR<TC ➡ subnormal profit (will exit industry if it continues to make subnormal profit in LR)
TR-TC approach
TR ➡ PXQ
TC ➡ implicit + explicit costs
implicit (opp) costs ➡ no direct payment (e.g unused buildings)
explicit (opp) costs ➡ using resources not already owned by firm
Marginalist Principle: producing until MR=MC (before then, MR>MC)
MR ➡ addition to TR for one additional unit of G/S produced
MC ➡ addition to TC from production of additional unit of G/S
Costs of production (Short Run, where at least one FOP is fixed)
Law of Diminishing Returns (assuming existence of one fixed factor)
When increasing amounts of variable factor are used, there will come a point where each extra unit of VF will produce
less extra output than the prev unit
At some point of time, the
fixed factor will constrain productivity
of the variable factor (limiting; NOT due to less effective variable factor)
Factors/Inputs
Fixed: quantity cannot be changed irrespective of level of output (e.g factory buildings)
Variable: quantities can e changed such that more of the factor can be employed, increasing output.
Total Fixed Costs, Total Variable Costs and Total Cost
TFC: do NOT vary with level of output. (e.g even if factory is not working, TFC will still be there due to depreciation of machinery)
TVC:
vary
with level of output of firm (e.g costs of raw materials + wages)
TC: sum of TFC and TVC at a specific level of output.
Average FC, VC and C (pg 13)
AFC: fixed costs per unit of output.
Declines over time
as TFC is being spread out over a larger output.
AVC: variable costs of unit per output
AC: cost per unit of output
MC: additional cost of producing one more unit
MC curve cuts AVC and SRAC curve at minimum point. This is because adding an additional unit above/below AC pulls up/drags down MC.
Costs of production (LR, when all factors of production are variable)
Productive efficiency: least cost combination to produce any given output level
Returns to Scale: when
all
FOP are increased/decreased simultaneously in the same ratio
Increasing RTS: % increase in all inputs by same proportion leads to larger % increase in output
Constant RTS: % in all inputs by same proportion leads to same % increase in output
Decreasing RTS: % increase in all inputs by same proportion leads to smaller % increase in output
Economies and Diseconomies to Scale
Internal (point in LRAC)
Economies: reduction in LRAC of production for an
individual firm
(movement downwards in LRAC; shifted points)
Technical: when the firm expands its plant size (divided vs not)
Specialisation and Division of labour: processes to be broken down into simpler processes. Specialised labour becomes skilled ➡ less time lost switching from one task to another + scaled down training costs.
Indivisibilities: firms producing on larger scale can utilise indivisible capital equipment ➡ spread cost over larger output levels ➡ lower AC
Firm: having a large-scale organisation + management
Marketing economies: buying raw materials in bulk
Financial economies: offering loans/extending credit to bigger firms (cost savings)
Organisational: indiv admin departments specialising in particular functions
Managerial: Dividing labour to raise productivity
Risk-bearing: Large firms diversifying risks due to scale of operations
Diseconomies: LRAC moves upward.
Loss of control: difficult to monitor work performance ➡ some may be overworked
Lack of coordination and comms: inefficiency ➡ higher AC of production
Min Eff Scale (MES): lowest level of output where LRAC is at its minimum. Indicates firm size + type of market structure
External (whole LRAC shift)
Economies: downwards
shift
of LRAC
Concentration
Trained workforce: no need to provide additional training as prerequisite skills are already there ➡ lower AC
Better industry infrastructure: lower operation costs ➡ lower AC (e.g Silicon valley, where there is a concentration of high-tech firms)
Information: sharing cost of research and development instead of doing so individually
Disintegration: splitting up the production process, spawning
auxiliary firms
to support the main firms in production process (producing intermediate products, at a much lower cost)
Diseconomies: upwards shift of LRAC
Higher factor prices: higher input prices for e.g skilled input of specific raw materials ➡ a need to bid up prices ➡ increase in AC
Increased strain on infrastructure: increased congestion due to expansion and concentration of industry
Growth of Firms:
Size of firms are determined by:
Legal formation (how many people own the firm)
Number of shareholders (more SH, larger firm)
Capital asset size
Number of employees
Sales revenue
Market share
Types of firm growth
Internal expansion: making more of its existing product or extending its range
External expansion
Growth by mergers
Vertical merger: two firms in the same industry, but at different production stages (w/ earlier stages: secure supplies. w/ later: control distribution channels)
Conglomerate merger: two firms in different industries (provides
risk diversification, so risks are spread out
)
Horizontal merger: two firms in the same industry in the same stage of production (makes firm more competitive)
Joint ventures/alliances: joining two firms to pursue a common objective. Firms benefit from collab work by reaching a strategic target (e.g joint-research projects)
Why do firms want to grow?
Cost motives: achieving IEoS. (pg36)
Monopoly power motive (revenue advantage): reduce competition, gain profits. Increased pricing power due to product being less price elastic. Can engage in price discrimination
Gain access to
special resources
Reduce
uncertainty
Factors affecting size of firms:
Demand
Limited market size: expansion may not be economically efficient if size of demand is small (e.g a farm in a remote village ➡ no incentive to increase scale unless demand increases)
Consumer preferences: Small firms cater better to the specialised/non-standardised needs of consumers. (e.g haircuts, mani/pedi services)
Subcontracting relationships: Small firms help to support the larger firms in the industry by manufacturing parts/components to sell the final product. These firms do not need to be big to capture market share.
Tech disruptions in industry. Change in demand due to sig advancements in tech: Disruptive tech replacing systems due to being superior e.g online news sites/GPS (usually only in LR)
Supply
Industries w/ predominantly small firms: having
personalised service
➡ cannot always introduce standardisation and mass production.
Expansion may lead to IDoS at a low level of output, causing LRAC to rise. MES is obtained at a low level, hence efficient firms are small.
Industries w/ predominantly large firms: Through expansion they can spread fixed costs and enjoy lower AC. IEoS can be reaped at a high level of output. This can only support a few large firms (Oligopoly) or a firm (Monopoly)
Small firms cannot produce this output, thus not being able to have the AC advantage.
Industries where both types of firms exist: MES is reached quickly.
Small firms are less vulnerable to econ downturns, and can respond faster to changing market conditions. They may also be unable to expand due to lack of capital ➡ limited opps
Small firm advantages
Adaptability and flexibility: more adaptable to changes in market conditions. Small ➡ decisions can be made quicker as fewer people are involved.
During times of recession, smaller firms can adopt cost cutting measures and reduce cost.
Niche markets: SF able to cater better to niche markets which have a smaller consumer base. More price inelastic demand ➡increasing profit without decreasing market share.
Personalised services: better able to cater to individual needs and preferences.
Cost management: small size and flexibility ➡ less liable to DoS by larger firms. It is easier to extend SF worker's hours, while large firms must go through many procedures
Personnel management: better able to maintain good working relations due to stronger bonding and sense of identity
Government Financial Support: assistance schemes. There are grants for SMEs to develop capability/go into overseas markets.
Alternative objectives of firms
Market share dominance: Setting price below AC/MC ➡ chasing out rival firms due to predatory pricing ➡ market dominance by increasing market share and market power.
Revenue maximisation: increasing the level of production to the point where MR=0 and setting a price lower than at MR=MC
Growth maximisation: profits not maximised, but scale of production will increase. Sacrifice of profits in short term as costs of acquiring businesses may exceed revenue in SR.
Profit satisficing objective: As firms do not know perfect info bout MR/MC. Deciding against profit-maximising decisions, and falling below prof-max level,
enjoying other benefits
like less stress
Managerial Utility Maximisation: Once satisfactory level of profit is reached, managers can choose what policies to pursue, and may seek to maximise their own utility.