Neo-classical Theory of the Firm

1. All the goods in the market are homogenous.

2. There are many buyers and many sellers.

3. There is perfect information – buyers and sellers know
everything and information is symmetric.

4. There are no barriers to entry or exit in the market.

5. There are no transport costs.
D = AR = MR
40
£
35
Revenue and
costs
30
25
Profit
Maximisation
occurs at the
level of output
where MC=MR
MR
20
MC
Profit
15
10
5
0
Output
The neo-classical theory f the firm
Market
Firm X
MC
P
P
AC
S1
P1
D=AR=MR
D1
Qd
Q1
Qd
•
Normal profit is equal to the opportunity cost of being in that business
• Eg. A businessman earns £30,000 profit per annum running a coffee bar
• Next best alternative is running a dry cleaners
• The benefit foregone from the next best alternative is for £28,000 a year
• Normal profit = £28,000
• Supernormal profit = £2,000 (everything above the normal profit
• Normal profit is therefore included as a cost in average and variable cost curves.
Market
P
Because there is
supernormal profit and
perfect information –
this attracts new
entrants into the
market
P
Firm X
MC
AC
S1
P1
D=AR=MR
D1
Qd
Q1
Qd
New entrants into the
market increase supplyFirm X
and the market price
level falls
Market
MC
P
P
AC
S1
S2
P2
D=AR=MR
D1
Qd
Q2
Qd
Now AC is greater than
AR so there is a loss –
Firm
X leave the
and
firms
market
Market
MC
P
P
AC
S1
S2
P2
D=AR=MR
D1
Qd
Q2
Qd
Supply in the market
Firmback
X to S3
falls
Market
MC
P
P
AC
S3
S2
P3
D=AR=MR
D1
Qd
Q3
Qd
Now AR = AC and there
are only
profits
Firmnormal
X
being made.
Market
MC
P
P
AC
S3
S2
P3
D=AR=MR
D1
Qd
Q3
Qd
Market
Firm X
MC
P
P
AC
S3
S2
P3
D=AR=MR
D1
Qd
Q3
In the long run only normal profits are made
Qd