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Theory of the Firm (Product, Cost, Revenue, Profit)

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Following this presentation you will:
- Understand what the Theory of The Firm means
- Explain the firm behavior to minimise cost
- Understand the firm behavior to increase productivity and economics efficiency.
- Explain the firms behavior to maximise profit.
- Understand the concept of Economy of Scale.

Publicado en: Economía y finanzas
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Theory of the Firm (Product, Cost, Revenue, Profit)

  1. 1. Microeconomics by: Shadi A. Razak 1 Theory of Firm
  2. 2. Objectives • Understand what the Theory of The Firm means • Explain the firm behaviour to minimise cost • Understand the firm behaviour to increase productivity and economics efficiency. • Explain the firms behaviour to maximise profit • Understand the concept of Economy of Scale by: Shadi A. Razak 2
  3. 3. Structure • Introduction • Theory of Firm • Production Function • Cost Theory • Revenue Theory • Profit Theory by: Shadi A. Razak 3
  4. 4. Tale of a Firm • 2010 : $63.5 Billion Revenue Year • 2015 : $58 Billion Revenue for Q2 only by: Shadi A. Razak 4 INTRODUCTION HL
  5. 5. Tale of a Firm • 2010 : Filling for bankruptcy • 2015 : $2.5 Billion Revenue in Q2 by: Shadi A. Razak 5 INTRODUCTION HL
  6. 6. Tale of a firm by: Shadi A. Razak 6 INTRODUCTION HL
  7. 7. Critical Questions by: Shadi A. Razak 7 INTRODUCTION How should the firm use resources to make a profit? How should the firm reduce costs, be efficient and maximize profits? What is the best price to obtain the most revenue? How many units should the firm produce to make the most revenue? How should the firm plan for the future in terms of price and quantity? What are the advantages and risks of the firms market environment? How can the firm respond to the business cycle? HL
  8. 8. Theory of Firm by: Shadi A. Razak 8 INTRODUCTIONTHEORY OF FIRM Theories about a firm’s behavior in the market place, the nature of that market place and how they produce and price their goods. Production Function Cost Theory Revenue Theory Profit Theory HL
  9. 9. Theory of Firm by: Shadi A. Razak 9 INTRODUCTIONTHEORY OF FIRM • Help us identify: – Best level of output – Best price to sell at – Best price to breakeven – The price to shutdown – Optimum level of profit HL
  10. 10. Theory of Firm by: Shadi A. Razak 10 INTRODUCTIONTHEORY OF FIRM • Firms are analysed in: – Short run: some factors fixed and cannot be increased/reduced – Long run: time taken to vary all factors of production HL
  11. 11. Production Function by: Shadi A. Razak 11 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTION Output Process (Product or service generated and value added) Input (Land, Labour, and Capital) HL
  12. 12. Production Measurements by: Shadi A. Razak 12 INTRODUCTIONTHEORY OF FIRM • Total Product (TP)= total output of a firm • Average Product (AP) = TP/V (Units of the Variable Factor) • Marginal Product (MP) = Change in TP/Change in V (Units of the Variable Factor) PRODUCTION FUNCTION HL
  13. 13. Production Measurements by: Shadi A. Razak 13 INTRODUCTIONTHEORY OF FIRM • Total Product (TP)= total output of a firm • Average Product (AP) = TP/V (Units of the Variable Factor) • Marginal Product (MP) = Change in TP/Change in V (Units of the Variable Factor) PRODUCTION FUNCTION HL
  14. 14. Production Measurements by: Shadi A. Razak 14 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTION HL
  15. 15. Total Product Curve by: Shadi A. Razak 15 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTION
  16. 16. Average and Marginal Product Curve by: Shadi A. Razak 16 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTION Diminishing Average Value (Returns) As extra units of a VF are added to a given quantity of a FF, the output per unit of the VF will eventually diminish. Diminishing Marginal Value (Returns) As extra units of a VF are added to a given quantity of a FF, the output from each additional unit of the VF will eventually diminish.
  17. 17. Cost and Product by: Shadi A. Razak 17 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Product Fixed Costs Variable Costs Variable Costs (VC) are the focus as Fixed Costs (FC)cannot change in the short term.
  18. 18. Types of Cost by: Shadi A. Razak 18 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY • Economic cost = Explicit cost + Implicit Cost – Explicit cost represent the business accounting cost, which consist of: • Fixed cost • Variable cost – Implicit cost represent indirect costs: • Entrepreneurship skills • Time spent running the business • Ideas
  19. 19. Total Cost by: Shadi A. Razak 19 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Total Costs (TC) = total cost to produce a certain output. TC = TFC + TVC Total Variable Costs (TVC) = total cost of the variable assets that a firm uses in a given period of time. Total Fixed Costs (TFC) = total cost of fixed assets used in a given time period. HL
  20. 20. Average Cost by: Shadi A. Razak 20 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) HL
  21. 21. Marginal Cost by: Shadi A. Razak 21 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Marginal Cost (MC) = increase in TC of producing an extra unit of output HL
  22. 22. Total Cost Curve by: Shadi A. Razak 22 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY HL
  23. 23. Average Cost Curves by: Shadi A. Razak 23 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY HL
  24. 24. Average Cost (Long Run) by: Shadi A. Razak 24 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY HL
  25. 25. Economies & Diseconomies of Scale by: Shadi A. Razak 25 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Economies of scale LRAC  as Output constant Diseconomies of scale LRAC  as Output constant Constant returns to scale LRAC is constant as Output  HL
  26. 26. Economies & Diseconomies of Scale by: Shadi A. Razak 26 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY HL
  27. 27. Economies of Scale Means by: Shadi A. Razak 27 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Economies of Scale Specialization Bulk Buying of Inputs Financial Savings Transport Savings Technology Advertising and promotion HL
  28. 28. Diseconomies of Scale Cause by: Shadi A. Razak 28 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORY Diseconomies of Scale Loss Control and Communication Workforce Alienation and dissatisfaction HL
  29. 29. Total Revenue by: Shadi A. Razak 29 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORY Quantity Sold Sales Price Total Revenue X = HL
  30. 30. Marginal Revenue by: Shadi A. Razak 30 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORY Change in Revenue Change in Quantity Marginal Revenue ÷ = HL
  31. 31. Revenue Curves by: Shadi A. Razak 31 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORY P Price Output D=AR=MR DemandinPerfectElasticity PED=Infinity HL
  32. 32. Revenue Curves by: Shadi A. Razak 32 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORY TR rises then falls. At first firm gains extra revenue by lowering price because more are sold but eventually this is outweighed by the loss in revenue from the units that were being sold at a higher price but must now be sold at a lower price. MR falls at a steeper rate & becomes negative when a loss of revenue caused by lowering price MR below AR because the firm, in order to sell more products, has to lower the price and thus revenue is lost on the products that could have been sold at a higher price. In this way the firm will get more revenue from increased sales. AR = Price This falls as output increases as the price will be lowered in order to sell more products. HL
  33. 33. Types of Profit by: Shadi A. Razak 33 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Accountant Profit: Total Profit = Total Revenue – Total Costs (variable and fixed) • Economic Profit: Total Profit = Total Revenue – Total Costs (variable, fixed & opportunity) HL
  34. 34. Profit and Loss by: Shadi A. Razak 34 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Which firm is making a Profit, which is making and Profit and which is making a loss? Firm A Firm B Firm C TR 200,000 200,000 200,000 TFC 40,000 40,000 40,000 TVC 80,000 100,000 120,000 Opportunity Cost 60,000 60,000 60,000 TC 180,000 200000 220,000 HL
  35. 35. Profit and Loss by: Shadi A. Razak 35 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Which firm is making a Profit, which is making and Profit and which is making a loss? Firm A Firm B Firm C TR 200,000 200,000 200,000 TFC 40,000 40,000 40,000 TVC 80,000 100,000 120,000 Opportunity Cost 60,000 60,000 60,000 TC 180,000 200000 220,000 Abnormal Profit Normal Profit Loss HL
  36. 36. Normal Profit by: Shadi A. Razak 36 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Normal profit is the minimum level of profit needed for a company to remain competitive in the market. • Normal Profit takes place when TR = TC (fixed, variable and opportunity) • AC is the key for a firm to avoid loss and do better than normal profits to achieve abnormal profits. HL
  37. 37. Normal Profit by: Shadi A. Razak 37 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Normal Demand: HL
  38. 38. Abnormal Profit by: Shadi A. Razak 38 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Normal Demand: HL
  39. 39. Loss Profit by: Shadi A. Razak 39 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Normal Demand: HL
  40. 40. Shutdown and Breakeven by: Shadi A. Razak 40 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • What advice would you give these firms? Firm X Firm Y Firm Z TR 80,000 120,000 150,000 TFC (including OC) 100,000 100,000 100,000 TVC 100,000 120,000 140,000 TC 200,000 220,000 240,000 Loss 120,000 100,000 90,000 HL
  41. 41. Shutdown and Breakeven by: Shadi A. Razak 41 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Firm X should shut down as TR <TVC and TFC Firm X Firm Y Firm Z TR 80,000 120,000 150,000 TFC (including OC) 100,000 100,000 100,000 TVC 100,000 120,000 140,000 TC 200,000 220,000 240,000 Loss 120,000 100,000 90,000 HL
  42. 42. Shutdown and Breakeven by: Shadi A. Razak 42 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Firm Y should continue production as TR ≥TVC Firm X Firm Y Firm Z TR 80,000 120,000 150,000 TFC (including OC) 100,000 100,000 100,000 TVC 100,000 120,000 140,000 TC 200,000 220,000 240,000 Loss 120,000 100,000 90,000 HL
  43. 43. Shutdown and Breakeven by: Shadi A. Razak 43 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Firm Z should continue production as TR >TVC Firm X Firm Y Firm Z TR 80,000 120,000 150,000 TFC (including OC) 100,000 100,000 100,000 TVC 100,000 120,000 140,000 TC 200,000 220,000 240,000 Loss 120,000 100,000 90,000 HL
  44. 44. Shutdown and Breakeven by: Shadi A. Razak 44 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY Shut Down Price = AVC Break Even Price = ATC HL
  45. 45. Shutdown and Breakeven by: Shadi A. Razak 45 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY HL
  46. 46. Profit Maximizing by: Shadi A. Razak 46 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • If a firm wishes to maximize profits, it should produce at the level of output where MC cuts MR from below When MR > MC then a firm should increase production until MC = MR HL
  47. 47. Profit Maximizing by: Shadi A. Razak 47 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Perfect Elastic Demand HL
  48. 48. Profit Maximizing by: Shadi A. Razak 48 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Perfect Elastic Demand HL
  49. 49. Profit Maximizing by: Shadi A. Razak 49 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Normal Demand HL
  50. 50. Profit Maximizing by: Shadi A. Razak 50 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Normal Demand HL
  51. 51. Profit Maximizing by: Shadi A. Razak 51 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • With Normal Demand Therefore P = AR at q – AC at q X Quantity (q) The profit per unit of output must be the difference between the AR and the AC. HL
  52. 52. Its Not Always About Profit by: Shadi A. Razak 52 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Maximize sales and revenue • Maximize resources use • Shareholder satisfaction • Environmental goals HL
  53. 53. Revenue Maximizing by: Shadi A. Razak 53 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY HL
  54. 54. Sales Maximizing by: Shadi A. Razak 54 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY HL
  55. 55. Summary by: Shadi A. Razak 55 INTRODUCTIONTHEORY OF FIRMPRODUCTION FUNCTIONCOST THEORYREVENUE THEORYPROFIT THEORY • Explained what is meant by ‘Theory of Firm’ • Differentiated between the firm different behaviours to maximise profit and minimise cost • Identified the break-even and shut down price • Explained the concept of Economies and diseconomies of Scale

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