An introduction to the theory

1. (An introduction to)
The Theory of the Firm
A theory (or collection of theories) which attempts to
explain how firms behave under different market
conditions.
Three market structures are considered:
(i) Perfect Competition
(ii) Oligopoly
(iii) Monopoly
The theory of the firm includes:
The theory suggests that 
Production theory
firms behave differently 
Cost theory
in different markets. 
Revenue theory

Profit maximisation in different types of market

An evaluation of the market structures against
efficiency and welfare criteria

2. Underlying concepts
To understand the theory of the
firm you must firstly understand
some basic concepts
underpinning the theory...
1. What is a firm?
A firm is a business enterprise
which produces, or trades in,
goods and/or services.
A firm can be privately or state
owned (i.e. by individuals or
government).

3. Concepts continued...
2. Profit Maximisation
PROFIT
Firms aim to make as much profit
Revenue
as possible i.e. produce at the
Costs
level of output at which the gap
between revenue and
production costs is greatest.
3. Production
Factors of Production
A firm 'adds value' by combining a
range of factors of production PRODUCT
into a finished product or
service. This process is known
as production.

4. Concepts continued
4. Productive efficiency
The production process incurs costs. Firms will attempt to minimise
costs to maximise profit. A firm will be productively efficient is costs
are minimised.
100 units 200 units 300 units 400 units
Total Cost £500 £900 £1200 £1800
Unit cost
What level of output is the most productively efficient?

5. Concepts continued
4. Productive efficiency
The production process incurs costs. Firms will attempt to minimise
costs to maximise profit. A firm will be productively efficient is costs
are minimised.
100 units 200 units 300 units 400 units
Total Cost £500 £900 £1200 £1800
Unit cost £5 £4.50 £4 £4.50
What level of output is the most productively efficient?

6. Concepts continued
5. Revenue maximisation
Firms receive revenue for selling their product or service. The amount
of revenue is determined by the price charged and the level of sales.
100 units 200 units 300 units 400 units
Price £10 £6 £3 £2
Revenue
What level of price generates the most revenue?

7. Concepts continued
5. Revenue maximisation
Firms receive revenue for selling their product or service. The amount
of revenue is determined by the price charged and the level of sales.
100 units 200 units 300 units 400 units
Price £10 £6 £3 £2
Revenue £1000 £1200 £900 £800
What level of price generates the most revenue?

8. Concepts continued
6. Market structure
Put these UK markets in
order according to the The behaviour of a firm will vary
number of firms according to the nature of the
operating in them. market it is in. An important
factor is the number of firms in

Car market the market.

Hairdressers 
Monopoly = 1 firm

Banks

Nuclear power plants 
Oligopoly = a few firms

Supermarkets

Website designers

Perfect competition = many
firms

9. Concepts continued
And...
7. Short run 8. Long run
Revenue and costs in the short Revenue and costs are not
run are influenced by the restricted by factors of
factors of production available. production in the long run.
'Short-run' is defined as a 'Long run' is defined as a period
period within which at least one over which all the factors of
factor of production is fixed. production can change.
Consider the
This isn't a output achievable
'short run'. The with one factory
finish line keeps compared to as
moving! many factories as
you can build.

10. And finally...
9. Welfare and efficiency
What is the best market structure?
We can judge this by the extent
to which they deliver economic
welfare and efficiency. Economic
efficiency
Output per
Jobs Max out worker
Economic for min in
welfare
Best use of
resources
Consumer
Producer surplus
surplus (utility)
(profit)

11. Summary
Evaluating market structures using efficiency and welfare criteria
Imperfect Competition
Model of Perfect Model of Monopoly
Competition
Model of
Oligopoly
PRODUCTION THEORY
Short-run production Long-run production Revenue theory (for
theory (the law of theory (returns to each market structure)
diminishing returns) scale)
Short-run cost theory Long-run cost theory

12. Application of the theory
Understanding the Theory of the Firm will help
you answer questions like these...

Why is Tesco's starting a price war?

Should the Post Office be privatised?

Will making schools more competitive help
improve standards?

Why are Honda cutting wages?

What makes Facebook the market leaders in
social networking?