Foundations of Firm Economics: Production, Costs, and Market Structures
Firm Fundamentals: Core Economic Concepts
Key Economic Definitions
- Enterprise: An institute that hires and organizes productive resources to produce and sell goods and services.
- Opportunity Cost: The highest-value alternative forgone when making a choice.
- Explicit Costs: Direct monetary payments for resources. The amount paid could have been spent on something else.
- Implicit Costs: Costs incurred when a company forgoes an alternative action without making a direct monetary payment.
- Economic Benefit: Equal to total revenue minus opportunity cost.
Strategic Decisions for a Company
A company must make five basic decisions:
- What goods and services to produce, and in what quantities.
- How to produce, i.e., which technology to use.
- How to organize and pay their workers.
- How to market and price their products.
- Whether to produce components internally or buy from other companies.
Types of Constraints
- Technological constraints
- Information constraints
- Market constraints
Understanding Production and Cost Structures
Cost Concepts and Efficiencies
- Transaction Costs: Costs incurred when trying to find someone to do business, reach agreement on price and other aspects of the exchange, and ensure the conditions of the agreement are met.
- Economies of Scale: Occur when the unit cost of producing a good decreases as the production rate increases.
- Economies of Scope: Occur when a company uses specialized resources to produce a range of goods and services more efficiently.
- Team Production: A production process where individuals specialize in tasks that support each other.
Production Function
The Production Function describes the relationship between the quantity of inputs required and the amount of output that can be obtained.
Market Structures and Time Horizons
Types of Market Structures
- Perfect Competition: Many companies, homogeneous product, no entry/exit restrictions.
- Monopolistic Competition: Many companies, differentiated but similar products.
- Oligopoly: A few large firms competing.
- Monopoly: A single firm produces a good or service with no close substitutes.
- Four-Firm Concentration Ratio: The percentage of total industry sales accounted for by the four largest firms.
Time Horizons and Factors of Production
- Short Run: A period of time during which a firm cannot alter the use of certain factors of production (fixed inputs).
- Long Run: A period of time long enough for a firm to alter all factors of production; all inputs are variable.
- Variable Factor: An input that can be adjusted even in the short run (e.g., number of employees, hours worked, raw materials).
- Fixed Factor: An input that cannot be adjusted in the short run but is changeable in the long run (e.g., machinery, equipment, plant size, infrastructure).
Revenue, Cost, and Profit
- Total Revenue: The total amount received by a firm from the sale of its production.
- Total Cost: The market value of all factors of production a firm uses.
- Profit: Total Revenue minus Total Costs.
Production and Cost Metrics
Key Production Metrics
- Total Product (TP): The total quantity of output produced.
- Marginal Product (MP): The change in total product resulting from a one-unit increase in a variable input.
- Average Product (AP): Total product divided by the number of employees (or variable input).
- Law of Diminishing Marginal Returns: Occurs when the marginal product of an additional worker is less than the marginal product of the previous worker.
Cost Metrics
- Variable Cost (VC): Costs that vary with the level of production.
- Marginal Cost (MC): The increase in total cost resulting from a one-unit increase in production.
- Fixed Cost (FC): Costs that do not depend on the quantity produced in the short run.
- Total Cost (TC): The cost of all productive resources a firm uses.
Essential Formulas in Firm Economics
Production Formulas
- T: Number of Workers (Labor)
- PT: Total Product
- AP: Average Product = PT / T
- MP: Marginal Product = ΔPT / ΔT (Change in Total Product / Change in Labor)
Cost Formulas
- VC: Variable Cost = T × Wage Rate
- FC: Fixed Cost (given)
- TC: Total Cost = VC + FC
- MC: Marginal Cost = ΔTC / ΔQ (Change in Total Cost / Change in Quantity)
- ATC: Average Total Cost = TC / Q (or PT)