How Firm is The Firm?The firm is a business activity that is organized as:a) A depository for capital (Marx)b) A reservoir of labor (Ricardo)c) An incomplete transaction awaiting a buyer

(Robinson)d) An instrument of public policy (Keynes)

The firm is the basis for the private sector economy and the theory of the firm sets up the nature of supply in the free market. It is governed by the forces of supply and demand (Smith) and it is governed in turn by the nature of competition. Its objective is to earn a profit which is determined in turn by its cost structure.

Forms of Competition determine the nature of the Firm.

• Perfect competition is a market form in which no single supplier can affect the market price.

• Monopoly is a form in which the supplier sets the market price.

• Oligopoly is a form in which a few suppliers set the market price either by collusion (illegal) or market reactions (legal).

• Monopolistic Competition is a form in which few suppliers set the market price through contesting market share directly but who face a downward sloping demand curve and therefore can practice price discrimination, market chain domination, and or vertical integration but who inevitably face a competitive result in the market.

How Costs Determine Profit• Profit is the residual of total revenue less total costs and as

costs are determined outside of any particular market and demand is also dictated outside of the control of the firm, it is costs that the firm attempts to control in any number of ways:– by using market structures in other markets to control final costs which

may include buying up suppliers (Vertical Integration) or by buying out competitors (Horizontal Integration)

– by investing in cost reducing technology through design of products, marketing of products (warehousing and distribution) , and financing of products

– by standardizing unit variable costs through supplier specifications (detailed requirements), organization of delivery, and unionization formal or informal.

Firms maximize profits when costs are predictable and stablized.

Cost StructuresCosts are either fixed or variable. Fixed costs are the same

regardless of output while variable costs increase as output increases.

Costs include opportunity costs which include all other potential ways of making money that are given up to undertake the enterprise.

Sunk costs are those that have been spent in the past and are no longer of value to the firm except that they may earn a place in a market because of them. Sunk costs are capitalized and are therefore fully depreciated.

Average costs are costs per unit of output for total costs, variable costs and fixed costs.

Marginal costs are costs associated with last unit of output produced. This will cut the average variable cost and the average total costs curves at their lowest point for an constant returns to scale technology.

Marginal revenues are revenues associated with the last unit of output produced and will be less steep than the demand curve.

When Marginal Cost is equal to Marginal Revenue the profit will be maximized.

Cost StructuresProfit is Maximized when Marginal Revenue is equal to Marginal Cost. (Price Received minus Cost Incurred )

times Quantity Sold is Profit Earned. A is market exit point because revenue would not cover fixed costs. B is plant shut down point because revenue would not cover variable costs. C is profit minimization point because marginal revenue would be equal to average total cost.

Demand

Marginal Cost

Marginal Revenue

Average Total Cost

Average Variable Costs

Average Fixed Costs

Price

Quantity

Price Received

Cost Incurred

Quantity Sold

A

B

C

Perfect Competition

• Complete knowledge of the market.• Homogeneous product throughout.• Ease of entry and exit from the market

usually characterized by a singular planning point in time or space.

• Ability to carry over product from one time period to the next at minimal active cost

• No Profit available.

Perfect Competition Analytics• There is no profit in perfect competition [total costs include opportunity costs].

Price

Quantity

Average Total Cost

Demand = Marginal Revenue

Marginal Cost

Quantity Sold

Price Received = Costs Incurred

Imperfect Competition

• Complete knowledge of the market is known only to the firm.

• Non-homogeneous product throughout.• No ease of entry and exit from the market

usually characterized by continuous planning points in time or space.

• No Ability to carry over product from one time period to the next without major active costs.

• Profit available.

Imperfect Competition Analytics Monopoly

• Imperfect Competition leads to a deadweight loss [A:D:E:C] because in the perfectly competitive case average total cost would have been equal to average revenue [demand] and we would have produced more quantity but profit would be given up.

Price

Quantity

Average Total Cost

Marginal Cost

Demand

Marginal Revenue

Price Received

Cost Incurred

Quantity Sold

A

B C

Quantity that could have been sold

Perfectly Competitive [Price Received = Cost Incurred]

DE

Deadweight Loss Issues• If we have deadweight loss issues because of imperfect competition it may be

possible to compensate and improve welfare.• If the deadweight loss is significant and wasteful the government has remedies that

can compete with the monopolist, open up the market to competition, regulate conduct of the monopolist or tax the profits away.

• Not all monopolies are ‘bad’ and the government may accept some welfare loss :– Natural monopolies come about due to single sources of product or geographic

necessity.– Policy monopolies come about due to government efforts to encourage research

[patent monopolies] , to preserve local industries [tariff monopolies] , to encourage investment [offset monopolies] or to establish cultural, health , safety and environmental standards.

– Structural monopolies exist because of business preferences for single service provision which minimize transactions costs.

Competition Policy• Competition is encouraged by governments in order to maximize welfare by

minimizing deadweight losses due to monopoly.• Competition is welcomed by consumers and valued by business but relative losses

have tended to favor business over consumer surpluses.• Competition policy is civil law in Canada based on tort laws.• The remedies include:

– Competition with the monopoly and pricing at the competitive solution thereby dragging down the market to the welfare maximizing position (automobile insurance)

– Opening up the market to competition by funding alternative options with grants and subsidies in order to expand options on a regional or functional basis (food retailing)

– Regulating the conduct of the monopolist through licensing and compliance rules (securities and exchange regulations)

– Taxing the profits away with targeted taxation based on the relative balance between tax revenues and deadweight losses.

The Organization of the Firm• The Organization of the firm is the key to its stability because it minimizes the

business risks that the firm is exposed to:– A sole proprietorship is the business that is owned by an individual. It has the “status” of a person under

the law. This is typical for consulting companies and holding companies and is found in professional services.

– A partnership is a firm organized with a formal agreement between a number of people who provide funds according to a set plan and agree upon initiation and also dissolution of the company. This is typical of clinics.

– A limited partnership is similar but is registered, usually with a professional society that is self regulating and therefore sets standards amongst it members on matters of conduct. This is typical of professional agencies that have large public liability exposure.

– A corporation that is incorporated under the laws of a province or country and has set prescriptions regarding the nature of the affairs that the company can undertake and limits corporation liabilities to the capital invested in the company. This is usually identified as an “incorporated” firm and usually has ownership distributed through shares and funding derived from bonds that are regulated under securities legislation. The corporation may be public or private . Going from private to public involves an IPO [Initial Public Offering] and going from public to private involves the exercise of executive share options.

Firming Firms• The more stable the structure of business, the greater is the reliability of the

market for the company in terms of planning, marketing and finance.• The stability of the firm is reflected in price stability and efficient market

information in which prices are publicly posted.• The parameters of the market are stable when the boundaries of who

supplies to the market and how can be set and projected into investments.• The projection of markets allows for anticipation of research and

development needs and the further stability of government planning and policy management.

• The more stable the firm the more stable the economy.