Theory of the Firm: Production, Costs, Revenue and Market Structures
Candidates must connect short-run production to cost curves, derive profit-maximising output, and compare competition with monopoly and oligopoly. Numerical profit-maximisation questions are common.
Production
- The short run has at least one fixed factor, so the law of diminishing returns applies: marginal product eventually falls.
- Marginal product cuts average product at the maximum of average product. Rational producers operate where marginal product is positive and falling.
- In the long run all factors vary and returns to scale apply: increasing, constant or decreasing.
Costs
- Fixed costs do not vary with output; variable costs do. Marginal cost is the change in total cost from one more unit.
- Marginal cost cuts both average variable cost and average cost at their minimum points, because it pulls the average in the direction it is moving.
- Long-run average cost is the envelope of short-run curves; economies of scale explain its falling section, diseconomies of scale its rising section.
Revenue and profit
- Average revenue equals price. Under perfect competition marginal revenue equals price; under monopoly the firm must cut price to sell more, so marginal revenue lies below average revenue.
- Profit is maximised where marginal revenue equals marginal cost, not where revenue is greatest. In the short run a firm continues if price covers average variable cost; otherwise it shuts down.
Market structures
- Perfect competition: many firms, homogeneous product, free entry, price taker, normal profit in long-run equilibrium, allocatively and productively efficient.
- Monopoly: barriers to entry, price maker, deadweight loss, but a natural monopoly may have lower average costs.
- Monopolistic competition: differentiated products, some price-setting power, non-price competition, excess capacity in the long run.
- Oligopoly: interdependence, kinked demand curve, collusion and game-theoretic behaviour.
Worked example
A firm faces total cost of 200 + 10Q + Q squared and sells at a fixed price of 50 XAF, so price equals marginal revenue.
- Marginal cost = 10 + 2Q.
- Setting 50 = 10 + 2Q gives Q = 20.
- Total revenue = 1,000; total cost = 200 + 200 + 400 = 800; profit = 200 XAF.
- Average cost at Q = 20 is 40, below price, so the firm produces rather than shuts down.
Traps that cost marks
- Choosing output where marginal revenue is zero, which maximises revenue, not profit.
- Saying a monopolist charges the highest possible price rather than the profit-maximising one.
- Confusing normal profit, which is a cost, with zero or negative profit.
- Drawing marginal cost crossing average cost at the maximum rather than the minimum.
- Assuming perfect competition means every firm earns supernormal profit; in long-run equilibrium entry removes it.