Presentation on theme: "An Introduction to the Theory of the Firm. Answering the How to Produce? Question In a command economy the government decides In a market economy the."— Presentation transcript:
Answering the How to Produce? Question In a command economy the government decides In a market economy the producers decide (based on actions of consumers) Canada – a mixed economy –Some govt. decisions (minimum wage, environmental laws, zoning) –But mostly market driven
The Wizard of Id Page 140 of the text Which product would you choose to produce if the king gave you the option? Why?
Motivating factor Well call it accounting profit Total revenues – total costs = profit
Why are profits important? Incentive/reward Least expensive source of money for expansion Compare performance with competitors Dividends for shareholders Message about what to produce (and therefore related to efficiency) Benefit to pension funds, mutual funds, insurance companies, etc.
The Theory of the Firm Explains the relationship between costs, revenues and profits in influencing the output decisions of producers
Total Revenue Total Revenue = Price x Quantity sold Knowledge about demand is therefore extremely important to producers
Total Costs Costs of all the factors of production (land, labour, capital) Two types: Fixed costs Variable costs
Fixed costs Remain the same whether one unit or 1000 units or 1 000 000 units are produced Examples include rent, property taxes, interest on loans (any cost that does not change as the level of output changes) (Think about if the cost would be incurred even if no units were produced. If so it is a fixed cost.)
Variable costs Changes with a change in the level of output Examples include labour, raw materials, fuel Total costs = variable + fixed costs
Long vs Short-run Costs Short-run is the time period in which only variable costs can be changed Long-run is the time period in fixed costs can be changed (in other words all costs are variable) Different for different types of industries
How much to Produce? Produce where profit is maximized (difference between costs and revenue is the greatest) Detailed analysis is required to discover this Small changes consider (produce one more unit or not?) Called thinking at the margin Review p. 146 and 147 (fig 7.4 & 7.5)
The most important rule!! Continue to increase production until: –Marginal Revenue = Marginal Cost –Expressed as MR=MC –In other words increase production as long as the additional revenue generated by one more unit is greater than the additional cost (see board notes for proof)
Homework You can review some of what we addressed by reading pages 141 to 148. Try and answer page 152 #1, 3 and 4 to test your understanding. Read page 152 to 157and answer page 160 #1 to 6