Intro to firmsslide 1 THEORIES OF THE FIRM Theories of the firm try to explain supply.

Intro to firmsslide 2 BACKGROUND TERMS Theories of the firm are organized around the different kinds of market forms in which firms can operate. In this course, the market forms are grouped this way: Perfect competition Monopoly Monopolistic competition, and Oligopoly

Intro to firmsslide 3 Perfect Competition A market form with these characteristics: 1) Large number of firms. 2) Homogeneous product. 3) Easy entry and exit of firms. Some economists add to this list that consumers and firms also have cheap, accurate information about prices.

Intro to firmsslide 4 What the assumptions boil down to is that each firm in perfect competition is a price taker. NO FIRM HAS ANY CONTROL OVER MARKET PRICE. This means that the demand curve the firm sees for its product is infinitely elastic.

Intro to firmsslide 5 Infinitely elastic demand curve of a perfectly competitive producer of soybeans in Mason, Michigan: price quantity (hundred bushels) P0P0 P 0 is the current market price.

Intro to firmsslide 6 WARNING! The market demand curve is still negatively sloped: price quantity (hundred bushels) P0P0 price P0P0 quantity (million bushels) D MARKET FIRM S

Intro to firmsslide 7 In competitive markets, market price is determined by supply and demand. If a firm were to raise its price above market price it would lose all its sales. It would never be silly enough to charge less because it can sell all it wants at the going market price.

Intro to firmsslide 8 OTHER MARKET FORMS DEFINED MONOPOLY: a market with only one seller of a product for which there are no close substitutes. MONOPOLISTIC COMPETITION: a market with many firms, easy entry, and product differentiation. (Each firm produces a slightly different version of the product.) OLIGOPOLY: a market with a small number of firms.

Intro to firmsslide 9 PROFIT Profit is the difference between total revenue and total cost, or Profit = TR - TC. In economics class cost means OPPORTUNITY cost. Because opportunity cost is often different from accounting cost, economic profit has a very special meaning and significance.

Intro to firmsslide 10 TWO EXAMPLES SHOWING THE DIFFERENCE BETWEEN OPPORTUNITY (a.k.a. ECONOMIC OR FULL) COSTS, AND ACCOUNTING COSTS.

Intro to firmsslide 11 Jim’s H&H Mobil -- A Proprietorship Annual costs and revenues Receipts from sales$200,000 Costs Employees’ labor$100,000 Rent 25,000 Gas, oil, parts, etc. 30,000 Total explicit costs $155,000 Accounting “profit” = 200, ,000=45,000 Cost of Jim’s labor resources & effort = Value of Jim’s labor in next best use (an implicit cost) = $35,000 ECONOMIC PROFIT = $10,000

Intro to firmsslide 12 BugOff Software, Inc. -- A Corporation Receipts $400,000 Costs Employees’ Labor$100,000 Disks, computers, advertising, etc. 100,000 Before tax accounting profit 200,000 Profit taxes 50,000 After tax profit 150,000 Dividends100,000 Retained earnings 50,000 Opportunity cost of capital = $125,000 ECONOMIC PROFIT = 25,000

Intro to firmsslide 13 The smallest amount of money that must be paid to shareholders to keep them investing in the company is sometimes called “normal” profit. “Normal” profit is a cost. It is part of opportunity costs.

Intro to firmsslide 14 SHORT-RUN VS. LONG-RUN Short-run : a time period over which the firm has some inputs it can’t change. (Short-run implies at least one fixed input. In the short-run firms can’t enter or leave an industry.) Reasons: Long-run : a time period over which the firm can choose the amounts of all of its inputs. (Long-run implies no fixed inputs. In the long-run firms can enter or leave an industry.)