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1. Theory of the Firm

2. 4/18/2016 2
What is a Firm?
• Firm is a unit of organization that transforms
inputs into outputs.
*Produces homogeneous commodity
*Technology is represented by a production
function.
• Neoclassical Theory: Firm as a collection of Resources that
is transformed into products demanded by the consumers.
• Cost of Production: Governed by available Technology
• Output Produced and Selling Price are determined by Market
Structure
• Aim of firm: Maximize Profit

3. 4/18/2016 3
House-
Holds
Product
Markets
Factor
Markets
Firms
Money spent
Goods
Demanded
Money Earned
Goods
Supplier
Money
Costs
Input
Demanded
Input
Supplied
Money Incomes
Circular Flow of
Economic Activity

4. 4/18/2016 4
Rational of Existence of Firm
Why cannot we offer separate contract for each
function of a firm?
Ex (1): Car Manufacturing through individual contracts and
Coordinated through Prices.
Ex (2): A Shoe Manufacture contacts a COBBLER to make the Shoe
Cobbler has bilateral transaction with TANNER to get Tanned Leather
Tanner Transacts with BUTCHER
Finally SHOES is sold in the Market
Outcome: High Transaction cost
Multilateral Contract or complex set of contracts would be costly to
negotiate.
Cost can be reduced through BILATERAL CONTRACTS

5. 4/18/2016 5
Rationale for the firm
• In the absence of firm, Cost of Producing any rate of output
would be higher.
– High Transaction Cost: Cost of a firm entering
into contract with other entities.
• Cost of obtaining information on prices, cost of negotiating, cost of
having separate contracts for each step of the production Process, Cost
of Enforcement of contract and Coordinating Transaction.
Transaction Costs are influenced by Uncertainty
(inability to know future outcome with accuracy)
Hence not feasible to include all contingencies in a
contract especially Long term Contract
What is the Way Out:
Trade-off between External Transaction Costs and Costs of Internal
Operations

6. 4/18/2016 6
Firm’s existence……..
Choose to Allocate the resources between External Transactions and
Internal Operations to ensure MINIMUM TOTAL COST
External Transaction: Outsourcing/Off shoring
• Outsourcing peripheral activities noticed earlier
• Outsourcing Core Activities-Recent Phenomenon
• Off shoring (firm source its product in another Country)
– Ex. 80 per cent of Kodak’s reloadable Cameras and all of its digital Cameras are
outsourced in ASIA (Keat & Young: 2006)
Compaq Computer (prior to merger with Hewlett-Packard) made only about 10 per
cent of the computers sold to consumers
Use Third Party for Recruitment of Employees
(Ex: Corporate Sector in India)
Transfer of White-Collar Jobs to Foreign Countries where salaries and Wages
are Low

7. 4/18/2016 7
Transaction Cost …….
*Opening of Call Centres
Wave of Outsourcing of highly Technical Jobs (production of
Software)
India: one of the largest supplier of these services. How
(Large pool of Well-Educated Labour Force and low Salary as compared to
US and other Western Countries)
– Government Interference leads to INCREASE in Cost of
Production
Ex: Sales Tax applies to transaction among firms not within
firms
Real Estate/Construction Company: Pay Tax for buying Furniture.
No tax if it is done internally by hiring a person

8. 4/18/2016 8
Large Firm vis-à-vis Small Firm
IF COST OF PRODUCTION DECLINES in a FIRM then Why can’t there be a Large
ONE Firm like Hindustan Lever, Proctor & Gamble so on (which produce
variety of goods and Services)?
Cost of Organizing Transactions increases with increase in Size of Firm
Sometimes Internal Transaction Cost is equal to Transacting in the Market
Ex: SHOULD AUTOMOBILE PRODUCERS (General Motors) BUY TYRE from MRF,
GOODYEAR or Build Plant to Produce Own Tyre .
Cost of Developing New Management Skill for a Different Type of Production
(TYRE) can be Higher.

9. 4/18/2016 9
Rationale of having Small Firm
• Limitations of Entrepreneur’s Organizational Skill:
If firm size exceeds the manager’s ability to control the
operation then resources may not be efficiently allocated in
the firm.
Production cost Per unit of Output tends to rise as firms grow
larger because of limited managerial ability-Known as
DIMINSHING RETURNS TO MANAGEMENT
The Way out: Decentralize by Establishing number of
separate divisions or profit centre

10. 4/18/2016 10
Why do firms Exist…….?
• Ronald Coase (1937): Production is organised in firm rather
than through series of Individual contracts. Why?
– To reduce Transaction Cost
– Higher Productivity under Team Work
(Group production can offer Benefit of Specialization)
Drawbacks: ‘Shirking’ and ‘Free-riding’ in Group Production
Difficult to Assess Contribution of Each Employee
The Way Out: Hire Monitor to Discipline the Team.
Solution: Compare Benefit of Greater Productivity under group
Production with Cost of Monitoring
Offer Incentives (BONUS, PERKS) etc to IMPROVE PRODUCTIVITY

11. 4/18/2016 11
Firm and Industry: A Comparison
Industry: A group of firms producing the SAME
product or SIMILAR product.
Exp: Sugar & Automobile Industry
Number of firms selling cheese, butter, milk are
part of Dairy Industry
(Nandini, Amul, Indore Dairy….)

12. 4/18/2016 12
Market and Industry
• Market consists of buyers and Sellers
that communicate with each other for
voluntary exchange
Market and Industry do not convey the same Meaning always
Exp: Footwear Market consists of products that are supplied by
more than one industry
(leather, rubber and so on)
Packaging Material supplied by other industries

13. 4/18/2016 13
Market vis-à-vis Industry
An industry’s product cater to the needs of
more than one market
Exp: Aluminum Industry meets demand for Utensils,
Electricity wire and so on)
Difference between Market for Electricity and
Electricity Industry
Electricity Industry consists of Sellers only (State Electricity
Board, GRIDCO) while Electricity Market consists of Buyers
(Households, Industry) and Sellers.

14. 4/18/2016 14
Objectives of Firm
• Profit Maximization (Max. Market Share)-
Major Goal
• Subsidiary Goals: Large volumes of sales/
Company Image
• But can a firm afford to Maximize profit
always by compromising on Ethical Issues?

15. 4/18/2016 15
Profit = Revenue - Cost
• Total Profit = Total Revenue – Total
Cost
• Total Profit will be maximum at that
level of output where vertical
distance between TR and TC curves
is maximum (TR exceeds TC with
high margin)
• Total profit is maximum at that
point where slopes of both TR and
TC curves are the same, i.e.,
•
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
0 5 10 15 20 25 30 35
-2
-1.5
-1
-0.5
0
0.5
1
0 5 10 15 20 25 30 35
STC
TR
Tp
MCMR 
$
$
Q
Q

16. 4/18/2016 16
Marginal Revenue = Marginal Cost
• Marginal Revenue
-0.1
0
0.1
0.2
0.3
0.4
0.5
0 5 10 15 20 25 30 35
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0 5 10 15 20 25 30 35
MCMRM p
MR
MC
 Marginal Cost
Mp
 Marginal Profit M
Maximum
Profit
M: Marginal Profit- Rate of
change in total profit of firm w.r.t
changes in level of output
=(∆T / ∆T Q)
= (T 2-T1)/Q2-Q1.

17. 4/18/2016 17
Profit Maximization….
• For profit Maximization, profit to be gained by producing additional unit of
output (marginal profit), must be zero (M =0).
• Or Slope of TOTAL PROFIT curve is zero at that point
• M =0 implies MR= MC ( at the profit maximizing level of output,
additional revenue to be generated from one unit of output must be equal
to additional cost the firms incur by producing it).
• Total Profit is not maximized at the point where Marginal Profit is
maximum rather at zero Marginal Profit.

18. 4/18/2016 18
How to Maximize Profit?
• Total Profit (T )= Total Revenue- Total Cost
= TR-TC
• Total Revenue: Total amount of money that the firm receives by selling a
given quantity of output
(In fact, sales of a firm are equal to current year’s production plus opening stock minus the closing
stock of finished goods, but let us assume that total sales volume of a firm is equal to the level of
output produced).
Profit Maximization Condition of a firm
Equilibrium Condition (Firm)
Necessary Condition
(a) MC= MR
Output will be expanded to the point where Marginal
Cost is equal to Marginal Revenue

19. 4/18/2016 19
Profit Maximization…..
Sufficient Condition (b)
Slope of MR curve < Slope of MC curve
(MC cuts MR from Below)
When MR > MC, If firm expands output then it will add more to
revenue than to costs.
It is rational to expand production of output and add more profit.
If MR < MC, then expansion of output will add more to costs
than to the output- Reduce Profit

20. 4/18/2016 20
Level of Output and Profit of a
Firm
Q P TR=P*Q TC Profit MR MC
(TR-TC)
1 2 3(=2*1) 4 5(=3-4) 6 7
0 10 0 12 -12 - -
1 10 10 14 -4 10 2
2 10 20 15 5 10 1
3 10 30 17 13 10 2
4 10 40 20 20 10 3
5 10 50 25 25 10 5
6 10 60 35 25 10 10
7 10 70 50 20 10 15
8 10 80 81 -1 10 31

21. 4/18/2016 21
When does a firm Stop Production?
Breakeven Analysis (Volume-Cost- Profit Analysis)
• Used in Actual Business Situations for understanding Effect of a
change in Quantity of a Product on Profit of the Firm
• Investigates the relationship between Quantity
of the Product, the Cost to Produce this
quantity, and the Profit (Keat & Young: 2006)
Popularly known as VOLUME-COST-PROFIT Analysis

22. 4/18/2016 22
Breakeven Analysis ………
• Break-even point:
Output level at which Total Revenue of a firm equals to
Total Cost implying Total Profits equal to zero.
• Assuming a Constant Price, Constant Average Variable cost and specific level
of fixed costs, decision has to be taken about the level of output for the firm
to cover its Total Costs.
• Or firm has to decide the level of output to be produced so as to
cover its total costs and achieve target level of income.
• TO BREAK EVEN, A FIRM’S REVENUE MUST BE EQUAL TO COST

23. 4/18/2016 23
TFC
TC
TR
TVC
Qb: Break-Even Output
Cost , Revenue

24. 4/18/2016 24
Break-Even Analysis
• At the Break-even point TR = TC
TFCTVCTR 
TFCAVCPorQ
TFCQAVCQorP
TFCQAVCQP



)(
)()(
)()(
AVCP
TFC
QBEP


or
therefore:


25. 4/18/2016 25
Break even….
• (P - AVC) is known as the UNIT CONTRIBUTION
MARGIN.
• (P-AVC) indicates the contribution that each
unit sold will make towards covering fixed cost
and eventually generating profit.

26. 4/18/2016 26
Units of Output Fixed Cost Variable Cost Total Cost Total Revenue Profit
('000s) (Rs in '000) (Rs in '000) (Rs in '000) (Rs in '000) (Rs in '000)
1 2 3 4(=2+3) 5 6(=5-6)
0 20 0 20 0 -20
5 20 15 35 25 -10
10 20 30 50 50 0
15 20 45 65 75 10
20 20 60 80 100 20
25 20 75 95 125 30
30 20 90 110 150 40
35 20 105 125 175 50
40 20 120 140 200 60
Source: Keat & Young (2006)
Break-Even: Total Revenue=Total Cost
Production of Quantity beyond
10,000 units will result in Profit.
Drops in quantity below 10,000
leads to Loss.
Break-Even Analysis

27. 4/18/2016 27
Application of Break- Even:
Restaurant in Indore
Rs
Fixed Cost (per month) 60,000
Avg. Price of Soft
drinks, sandwich etc 6
Average Variable Cost (per unit) 3.6
How much quantity to sell per month to BREAK-EVEN?
QBEP= (60,000)/(6-3.6)
= 25,000
To make a Target income of Rs 24,000 per month
how much quantity (no. of units) to serve (sell)
Q= (60000+24000)/2.40
= 35000 (units)

28. 4/18/2016 28
Break-Even Analysis Example
• Product Cost (Avg Variable) is Rs 3.60
• Product Price is Rs 6.00 per unit
• Total Fixed Costs are Rs60,000/month.
0
50
100
150
200
0 10 20 30 40
Q(1000's)
Rs(1000's)
TFC
TVC
 Total Variable Cost
TC
 Total Cost
TR
 Total Revenue
BEP
 Break-even point at 25,000
products / month
PROFIT
 Profit at higher sales
volumes grows without bound

29. 4/18/2016 29
Issues in Break-Even Analysis
• Break-Even Point when one or more variables
Changes?
– Increase in AVC…..Increase in Slope of Total cost
curve……Increase in Break-Even Point
– Change in Unit Price of Commodity….Change in
Slope of Total Revenue cure. Price Increase will
decrease Break-Even Point.
– Change in Fixed Cost. Increase in FC….. Parallel Shift
in Cost Curve….Increase in Break-Even Point

30. 4/18/2016 30
Shutdown Point
• Firm Maximizes profit by producing the output where MC=MR as
long as PRICE is GREATER than or EQUAL to AVERAGE
VARIABLE COST.
If a firm makes loss in the SHORT RUN then is it rational to STOP Production?
• Loss implies Total Cost > Total Revenue
• In the short run: At least one FIXED factor and other VARIABLE Factors
• The firm has to bear FIXED INPUT COST in the SHORT RUN irrespective of its
decision to Produce or not?
Variable Cost depends on level of output Produced
• Again, it is Difficult to EXIT the industry in the short run. WHY?

31. 4/18/2016 31
Decision Issue:
• MANAGER has to DECIDE
First: Whether to Produce or SHUT DOWN
(Produce zero output and hire none of the
variable inputs)
Second: If go for production, Choose the
Optimal Level of OUPUT that MINIMIZES LOSS
to the firm

32. 4/18/2016 32
The Way Out…
•
COMPARE LOSS to be incurred for SHUTTING DOWN production
with loss from DECIDING to PRODUCE
CHOOSE The OPTION that MINIMIZES COST
• Case I: If TR> TVC or P > AVC then it can produce. Why?
• Whether a firm produce or not, it has to bear fixed cost.
• By continuing production, if it can cover variable cost (and
something left to cover fixed cost) then it justifies decision to
produce.

33. 4/18/2016 33
Shut-down….
• Firm Maximizes profit where MC=MR as long as Price
(P) is greater than or equal to Average Variable Cost (AVC).
Discontinue Production if PRICE falls Below AVERAGE VARIABLE
COST.
If P < AVC; firm will not produce at all.
• This only works for the short-run.

34. 4/18/2016 34
Does Firm wish to Max Profit?
• Herbert Simon: ‘Firm with many divisions and with vibrant intra-firm
rivalries (between divisions), would be BETTER OFF if it sets its ASPIRATION
levels between Unsatisfactory and Maximum Level of Profit, rather than at
the Maximum Level of Profit’
• Non-Profit Organisation do not have objective of Profit Maximization
– Ex: Hospitals, Rotary Clubs, Co-operatives…
– (Operate with funds received from External Agencies/sources-
Donations).
• Public Sector Organisations owned by Govt. and operate where Pvt. Sector
may not be keen to Enter do not aim at PROFIT MAXIMIZATION
– Provision of Public Good: Defense, Light House

35. 4/18/2016 35
Summary and Conclusion……
• Major goals of firm: Maximization of profit, sales max., growth maximisation
• Firm’s Short run Profit is maximized when MC=MR and MC cuts MR from
below.
• Break-even point: the output level at which firm’s TR is equal to TC, implying
zero profit.
• Shut-down point: output level at which Price is equal to Average Variable Cost
and losses equal to Total Fixed Cost (irrespective of opting for production or
not).
• Based on these criteria Manager has to take appropriate decision.

36. 4/18/2016 36
Market Structure
Market
Perfect Competition
(Many sellers)
Monopoly
(One seller)
Imperfect Competition
(Few Sellers)

37. 4/18/2016 37
Market Structure: Imperfect Competition
Imperfect Competition
Duopoly Oligopoly
Monopolistic
Competition

38. 4/18/2016 38
Factors Influencing Structure of the Market
(A) No of Independent Buyers and Sellers
(Large no. of Sellers ……. Total supply controlled by individual firm is less…..
Seller cannot influence the price by its own action)
Exp: Perfect Competition (Agricultural Output)
(B) Degree of Seller-Concentration
Power to influence Market Price depends on Proportion of total output
Controlled by Individual firm)
Exp: Electricity Supply-Duopoly (Tata, Reliance)

39. 4/18/2016 39
Factors Influencing Structure of Market
© Product Differentiation
I. Product Identical (homogeneous)-
Ex: Toilet soaps (Lux, Cynthol, Mysore sandal
soap- Not perfectly substitute)
If price increase marginally some buyers will
opt for other competing brands
II. Perfectly Substitute (Exp. Potato, eggs etc.)
Marginal increase in price of product in one
firm- Reduce demand to zero for the Product

40. 4/18/2016 40
(D) Degree of substitutability of product:
Power to influence price depends on substitutability
of products of competing firms
Depends on Cross Elasticity of Demand
(E) Condition of Entry:
Barriers to Entry is high or low
Ex: Monopoly- Barriers to Entry High
Free Entry: No of sellers will be large and degree of
concentration will be low
Ex: Perfect Competition

41. 4/18/2016 41
Different forms of Market: An Overview
• Perfect Competition:
A form of Market structure characterized by COMPLETE ABSENCE
of RIVALRY among the individual firms.
• Exp: Agriculture (closely approximating), construction industry
Monopoly: (Mono: one, Poly: Seller)
Form of Market Organization in which a single firm sells a product for which
there are no close substitutes.
It can either set the price and sell the quantity or it can choose the quantity
to sell and set the maximum price indicated by the demand curve, not both.
Exp: Production of defense equipment by Government of India,
Dominance of Public sector in Electricity,
Indian Railways, Indian Post

42. 4/18/2016 42
Oligopoly & Monopolistic Competition
Oligopoly:
Few sellers of a homogeneous or differentiated product. Action
of each seller will affect other sellers.
Exp: Telecom Sector, Aviation Industry
Monopolistic competition:
Market organization in which there are MANY FIRMS selling CLOSELY
RELATED but not identical commodities.
Entry into and exit from the industry is rather easy in the long run.
Exp: Different Toothpaste available in the market (Close up, Pepsodent etc

43. 4/18/2016 43
Classifications of Different Markets
Types of Market
Number of Sellers Entry Barriers to
Sellers
Nature of Product
Perfect
Competition
Many, small,
Independent
None Homogeneous
Monopoly One Insurmountable Homogeneous
Monopolistic
Competition
Many, small,
virtually
independent
None Differentiated
Oligopoly Few,
interdependent
Substantial Homogeneous or
differentiated
Source: Madala, G S (2005): Microeconomics, Theory and
Applications, Tata McGraw Hill, New Delhi.

44. 4/18/2016 44
Thanks a Lot