Theory of Firm

Topics: Supply and demand / Pages: 14 (3347 words) / Published: Apr 12th, 2013
The Theory of the Firm

The firm's goal is to maximize profits, !. In order to do this it must decide what quantity of a good to produce given costs, technology and demand. A competitive firm is assumed to be able to sell as much as it wants at the market price without affecting price. So it takes price as exogenous (beyond it's control) and does not worry about demand. In addition, for our purpose we’ll assume the firm operates efficiently, that is, whatever the level of production that the firm chooses, that level of production will always be produced at the minimum possible cost. Profit is defined by the difference between total revenue (TR) and total cost (TC). Both TC and TR are functions of quantity. TR is defined as: (price per unit of the good)*(quantity of the good sold). It is a linear function, TR=Pq, where P equals the price of the good, q the quantity sold. The slope of the TR line is P and the price is the amount the firm receives if it produces and sells one more unit of the good. Marginal revenue (MR) is the additional revenue the firm gets from selling one more unit, given a particular level of sales. Therefore, marginal revenue is equal to P. The slope of the TR line is P, equal to MR. Because the firm takes price as given, our TR line has a constant slope. Total cost, TC, on the other hand, is a more complicated function of quantity. It may vary at different rates with different quantities, as we shall soon see. Marginal cost (MC) is the increase in cost from producing one more unit of the good given the amount you are already producing. The marginal cost to produce your first ton of steel, in a certain time period, is probably higher than the MC of the hundred and first ton in that same period. To produce the first ton you must build a plant, buy equipment, train labor and pay for all of the fixed costs associated with opening a steel plant. The hundred and first ton involves only the cost of the ore, the energy, the man hours and other

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