Theory of the Firm: Costs, Revenue, Profit and Market Structures
What the exam tests
Theory of the firm tests cost and revenue curves, profit maximisation, market structures and HL extensions such as game theory, price discrimination and contestability. Expect calculations, diagram-based reasoning and evaluation of efficiency.
Core rules
- TC = TFC + TVC; MC = change in TC / change in Q; ATC = TC/Q; AVC = TVC/Q. The law of diminishing returns explains rising short-run MC; economies of scale explain falling long-run LRAC.
- Profit maximisation occurs where MR = MC and MC is rising. Normal profit is included in economic cost; supernormal profit is profit above normal.
- Short-run shutdown occurs if price falls below minimum AVC; in the long run, firms exit if price is below minimum ATC.
- Perfect competition has many firms, homogeneous output, free entry and normal profit in long-run equilibrium. Monopoly has barriers, price-setting power and deadweight loss. Oligopoly features interdependence, strategic behaviour and possible collusion.
- Contestable markets may constrain incumbents even with few firms; sunk costs determine contestability.
Worked example
A firm has TC = 100 + 10Q + Q squared, so MC = 10 + 2Q. If it is a price taker facing P = 50, then MR = 50. Set 50 = 10 + 2Q, giving Q = 20. TR = 1,000; TC = 100 + 200 + 400 = 700; economic profit = 300. The fixed cost of 100 affects profit but not the profit-maximising output, because it does not affect MC. If P fell to 12, Q = 1 and the firm would compare price with AVC before deciding to shut down.
Traps
Do not maximise revenue instead of profit; MR = 0 is revenue-maximising. Do not ignore opportunity cost when calculating economic profit. Do not claim perfect competition is efficient in every sense: it is allocatively and productively efficient in long-run equilibrium but may lack dynamic efficiency. In monopoly diagrams, label the deadweight-loss triangle correctly.