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Business Economics
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The Growth of Firms
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Efficiency
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Productive
• Lowest Cost
– Productive efficiency can be achieved
where the same output could be
produced at lower total cost
– Achieved through re-organisation
(e.g. to cell production), investment
in new technology, training for staff
and so on
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Technical
• Minimum inputs
– Technical efficiency can be achieved
if the same output can be produced
using fewer inputs
– Can be achieved using labour saving
devices, more efficient machinery,
more effective re-organisation of
restructuring and so on
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Allocative
• Needs of Consumers (P = MC)
• Allocative efficiency occurs where the goods
and services being produced match the
demand by consumers
• P = MC – the value placed on the product
by the buyer (the price) = the cost of the
resources used to generate the good/service
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Social
• MSC = MSB
• Social efficiency occurs where the private and
social cost of production is equal to the private
and social benefits derived from their
consumption
• A measure of social welfare
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Motives of Firms
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Profit Maximisation
• Profit maximisation – assumed to be the
standard motive of firms in the private sector
• Profit maximisation occurs where Marginal
Cost = Marginal Revenue
• MC = MR
• The firm will continue to increase output up to
the point where the cost of producing one
extra unit of output = the revenue received
from selling that last unit of output
• This assumes that firms seek to operate at
maximum efficiency
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Profit Maximisation – Diagrammatic Representation
Cost/Revenue
MC
150
145
140
Reduces
total
profit by
this
amount
Total
added
to profit
120
Added to
total
Added
profit
to total
profit
40
30
20
18
100
101
102 103
104
Assume output is at
the
process
firm
were
continues
to
100
units.
The
MC
IfIfThe
the
MC
MR
firm
–
–the
decides
The
addition
cost
toof
th
th
produce
for
each
the
successive
104100
unit,
producing
the
produce
to
total
one
revenue
more
unit
as–
of
producing
this
unit
produced.
unit
cost
isst20.
the
101
alast
result
– the
ofwould
addition
ONE
extra
unit
more
Provided
tocost
produce
the
MCthan
is18, it
to
total
producing
is
now
one
The
MR
received
from
earns
less
than
in
revenue
the
MR
(-105)
it
the
addition
of
more
production
unit
to
of
total
th
selling
that
100 total
unit
this
willoutput
would
be is
worth
reduce
revenue
140
–
the
–
the
price
firm
is
150.
The
firm
can
profit
expanding
and
soto
output
would
not
will
add
received
128
from
profitas
– it
add
the
difference
of
the
worth
difference
producing.
isbe
worth
selling
expanding
thatthe
extra
the
cost
and
between
the two is
output.
unit.
The
profit received
maximising
revenue
from
ADDED to
total
profit.
th unit MR
output
is where
that 100
to =
MC.
profit (130).
MR
Output
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Revenue Maximisation
•
•
•
•
Total Revenue
Average Revenue
Marginal Revenue
In this model the policies to achieve revenue
maximisation may be different to those
adopted to maximise profits
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Other Objectives of Firms
• Sales maximisation:
– Attempts to maximise the volume of sales
rather than the revenue gained from them
• Share Price Maximisation:
– Pursuing policies aimed at increasing the
share price
• Profit Satisficing:
– Generating sufficient profits to satisfy
shareholders but maximising the rewards to
the managers/board and avoiding attention
from rivals or regulatory authorities
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Economic Efficiency
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Definition
• Economic Efficiency: When goods
are produced in the least costly
manner and distributed to those
who value them most.
• Requires:
– Productive Efficiency
– Allocative Efficiency
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Productive Efficiency
• There is no way to re-direct
production among firms to
increase total output. Firms are
producing output where P=
minimum average cost.
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Allocative Efficiency
• Goods are consumed by those who
most value them.
• There is no alternative comb. of
goods that could be produced that
would increase society’s wellbeing.
• Price= MC i.e. value placed on the
good by consumers = cost of
producing the good
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Measuring Allocative
Efficiency
• The sum of consumers’ surplus
and producers’ surplus.
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Recall: Consumers’ Surplus
• The difference
between what a
consumer is
willing to pay &
what he does
pay.
$/un
it
8
A
6
4
B
D
2
1
2
3 4
5 6
7
units
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Producers’ Surplus-SR
perspective
• The difference between the
amount of revenue the firm earns
and the minimum amount
necessary to get the firm to
produce that quantity of the good
in the short run.
• PS = Revenue - total variable
costs.
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Producers’ Surplus-Market
$/un
it
SRS
8
6
4
B
C
2
1
2
3 4
D
5 6
7
units
• Selling 4 units
@$6/unit.
• Total revenue = B
+ C.
• TVC for all firms
is represented by
the area under
the SRS curve
(why?) = C
• B = producers’
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Allocative Efficiency
$/un
it
SRS
8
A
6
4
B
C
2
1
2
3 4
D
5 6
7
units
• A + B = The sum
of consumers’ and
producers’
surplus.
• Vertical distance
between D and S
is the difference
between value to
consumer and MC
to producer.
• What Q
maximizes
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Allocative Efficiency & Perfect
Competition
• Perfectly competitive markets provide
the allocatively efficient quantity of a
good.
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Perfect Comp and Econ
Efficiency
• Conclusion: Perfectly competitive
markets are economically efficient!
• This is one reason why we use
them as a benchmark for our
study of other market structures.
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Excise Taxes and Allocative
Efficiency
• Assume the market for wheat is
perfectly competitive.
• Shade in the sum of consumers’
and producers’ surpluses for the
competitive market equilibrium.
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Wheat
Price/Gal.
S
1.2
5
1.00
0.7
5
D
4
5
• Identify the
market
equilibrium
price and
quantity.
• Shade in the
CS + PS.
6 Bushels of
wheat
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Excise Tax
• Add an excise tax of $0.50 per
bushel to this market.
• What happens to market price and
quantity?
• Shade in CS + PS in light of the
tax.
• Compare your answer to before
the tax. Is it allocatively efficient
to tax this industry?
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Excise tax on wheat-50¢
S’
Price/Gal.
0.50
S
• Price paid by
elevator is
$1.25
• Price kept by
farmer is
$0.75.
1.2
5
1.00
0.7
5
D
4
5
6 Bushels of
wheat
• What is
quantity?
• How is CS +
PS affected?
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Conclusions on Taxes &
Efficiency
• An excise tax cuts the quantity
exchanged below the optimal level.
• This reduces the surplus that
consumers and producers receive.
• Conclusion: Excise taxes reduce
market efficiency.
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Next Time
• Note: We are now one class
period behind the syllabus.
• April 2-4: Monopoly, Ch. 22
• April 9-11: Oligopoly and
Monopolistic Competition, Ch. 23
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Source:
• www.people.vcu.edu/~smitchel/21
0/lec16.ppt
• www.bized.co.uk/educators/1619/economics/.../buseconomics
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