Theory of The Firm
Lecture 16
Dr. Jennifer P. Wissink
©2017 John M. Abowd and Jennifer P. Wissink, all rights reserved.
March 27, 2017
Announcements: micro Spring 2017

Make-Up Exam Registration Forms
– Don’t forget to submit form for Prelim 2 if you need to.
– Also, the registration form for the final is also up and live now.


Odd MEL Quiz Due Dates – please take note
Snow Day Class This Afternoon!
– Uris Aud from 3:30-4:20
– There will be no i>clicker points (you all already got them).
– If you can not attend, be sure to watch the Panopto Video for the
topic “CONSUMER THEORY APPS” which you can find via this link
https://courses.cit.cornell.edu/econ1110jpw/course.html
Shifting Gears to the
Theory of the Firm
What Is A Firm? Recall...
Broadly: A firm is an organization producing goods
or services, also called a business.
 Examples of common businesses: Grisamore
Farms, Microsoft, FedEx, the campus store (a
business within Cornell University).
 Examples of organizations that are not common
businesses in the same sense: Cornell University
as a whole, U.S. Department of Defense, The
Educational Testing Service.
 What they all have in common: engaging in
economic activity via markets and the need to
allocate scarce resources.

What Is A Market? Recall...


A collection of buyers
and sellers organized
for the purpose of
exchanging goods
and services for
money.
Markets can be
global, national,
regional, or local
depending upon the
item being bought
and sold.
Theory of The Firm

WHY?
– To bake the supply function from
scratch.
– To better understand firm behavior.
– To analyze market structures that
are NOT characterized by simple
demand and supply.

Note:
– There are lots of different types of
firms.
– There are lots of ways to organize
entrepreneurial activity.
– There are lots of firm objectives.
What We Assume (For Now)
 For
our analysis we assume that...
– we have an owner manager,
– who runs a firm or business,
– with the primary objective to maximize economic
profit,
– operating in perfectly competitive input and
output markets.
» Note: We will eventually relax the assumption that we
are in a perfectly competitive market environment.
Recall: A Market Is Perfectly
Competitive ...





When there are many buyers and sellers.
When each item traded in the market is identical to all
the others.
When firms can freely enter and exit the market.
When all buyers and sellers have full and symmetric
information.
So...
– The law of one price prevails.
– No single buyer or seller can cause the price to move up or
down.
– In this case, we say that the firms are “price takers.”
i>clicker question
So… which organization is a “firm” for which the model of perfect competition would be “right” for
predicting behavior?
B
A
C
D
E
Profit Maximization
 We
assume the objective of the firm is to
maximize economic profit.
 Profit (π) = Total Revenue - Total Cost
 Total Revenue:
– determined by the level and nature of
competition in your market
 Total
Cost:
– determined by factor market prices and the
firm’s technology or production function
Profit Maximization



We assume the objective of the firm is to maximize economic profit.
For economic profit we must subtract from revenue ALL the relevant
economic costs.
Two types of costs to differentiate and subtract from revenue:
– Explicit costs: costs incurred for transactions that took place through a
market interface.
– Implicit costs: costs incurred for entrepreneurial supplied factors of
production, where no market transaction outside the firm actually took place,
but for where there was an opportunity cost borne by the entrepreneur.

Accounting profit versus Economic profit
– For accounting profit we only subtract out the explicit costs.
– For economic profit we subtract out the explicit costs AND the implicit costs.
– So, accounting profit will be larger than economic profit.
i>clicker question
You own an economics tutoring center in Ithaca. On January 1st you purchased a $500,000 portrait of
Adam Smith from BritishArt, Inc. to hang in the lobby of your center. To buy this picture you took
$500,000 out of your savings account at Bank of America where it was earning 2% interest per year.
When preparing your cost data for the year you should
A.
B.
C.
D.
enter only the $500,000 you paid as a cost.
enter the $500,000 you paid plus the $10,000 you gave up in interest as the costs.
enter only the $10,000 you gave up in interest as a cost.
enter what the current market value of the portrait is as a cost.

So remember....
Total Revenue
- explicit costs
-----------------------= Accounting profit
- implicit costs
-----------------------= Economic profit
Profit Maximization Requires
Cost Minimization
 Profit
(π) = Total Revenue - Total Cost



There are lots of ways to
describe production and cost
concepts.
You will need to understand
them all.
For example:
– explicit and implicit concepts
– total, fixed and variable
concepts
– long run and short run concepts
– total, average and marginal
concepts
– all related to each other
Consider Jonathan’s
New York State Apple Farm




Jonathan’s farm is a
business organized to
grow and sell apples.
Jonathan realizes he is
operating in a perfectly
competitive apple
market.
Jonathan is the owner
operator/proprietor and
Jonathan tries to
maximize his profits from
the business.
Assume he uses his own
orchard and land, his
own time, and hired labor
to run his apple
business.
Jonathan’s Apple Farm
Short Run Production Function
Jonathan's Apple Farm Production Function
Apples
Land
Labor Proprietor's
(tons/year)
(acres)
(hired) time (hours)
0
100
0
1,100
50
100
2,500
1,100
100
100
3,700
1,100
150
100
5,000
1,100
200
100
6,800
1,100
250
100
10,000
1,100
300
100
15,000
1,100
350
100
27,000
1,100
Jonathan’s Total,
Marginal & Average Products of Labor
Marginal Product of Labor
0.045
Labor (hired
hours)
Total
Product
(tons of
apples)
Average
Product
(tons of
apples)
0
2,500
3,700
5,000
6,800
10,000
15,000
27,000
0
50
100
150
200
250
300
350
0/0??
0.020
0.027
0.030
0.029
0.025
0.020
0.013
Marginal
Product
(tons of
apples)
0.027
0.040
0.032
0.020
0.012
0.006
Tons of
apples/hour
0.040
0.035
Marginal Product
of Labor (midpoint
formula)
0.030
0.025
0.020
Average Product
of Labor
0.015
0.010
0.005
0.000
0
5,000 10,000 15,000
Hours of Labor
From Production Functions to
Seven Short Run Cost Curves

By combining the production function and the factor prices, we
produce the firm’s 7 short run cost curves.
Prices
Labor's time
Owner's time
Rent




$8.00 per hour
$12.00 per hour
$124.00 per acre
Each of the entries in this table represents a
price that Jonathan must pay for an input.
He hires labor at $8/hour.
Notice that he “pays” for his managerial time
because his next best alternative is to earn
$12/hour.
He also “pays” for the land since he could rent
it out if he wasn’t farming it himself.
Jonathan's Apple Farm Production Function
Apples
Land
Labor Proprietor's
(tons/year)
(acres)
(hired) time (hours)
0
100
0
1,100
50
100
2,500
1,100
100
100
3,700
1,100
150
100
5,000
1,100
200
100
6,800
1,100
250
100
10,000
1,100
300
100
15,000
1,100
350
100
27,000
1,100
The Seven Short Run Cost
Concepts
 Total
values
– fc = fixed costs = $PA•Acres + $PM•Manager
– vc = variable costs = $PL•Labor*(q)
– srtc = short run total costs = fc + vc
 Average
values
– afc = average fixed cost = fc/q
– sravc = short run average variable cost = vc/q
– sratc = short run average total cost = srtc/q = (afc + sravc)
 Marginal
values
– srmc = short run marginal cost = srtc/q = vc/q
Jonathan’s Apple Farm Cost Structure
Apples
tons/yr
$fc
$vc
$srtc
$srmc (large
delta)
$srmc (small
delta)
$afc
$avc
$sratc
0
50
100
150
200
250
300
350
Prices
Labor's time
Owner's time
Rent
$8.00 per hour
$12.00 per hour
$124.00 per acre
Jonathan's Apple Farm Production Function
Apples
Land
Labor Proprietor's
(tons/year)
(acres)
(hired) time (hours)
0
100
0
1,100
50
100
2,500
1,100
100
100
3,700
1,100
150
100
5,000
1,100
200
100
6,800
1,100
250
100
10,000
1,100
300
100
15,000
1,100
350
100
27,000
1,100
Jonathan’s Apple Farm Cost Structure
Apples
tons/year
$fc
$vc
$srtc
$srmc (large
delta)
0
25,600
0
25,600
xxx
50
25,600
20,000
45,600
296
100
25,600
29,600
55,200
200
150
25,600
40,000
65,600
248
200
25,600
54,400
80,000
400
250
25,600
80,000
105,600
656
300
25,600
120,000
145,600
1360
350
25,600
216,000
241,600
xxx
$srmc
(small
delta)
$afc
$avc
$sratc
#DIV/0!
#DIV/0!
#DIV/0!
---192
512.00
400.00
912.00
---208
256.00
296.00
552.00
170.67
266.67
437.33
128.00
272.00
400.00
---800
102.40
320.00
422.40
---1,920
85.33
400.00
485.33
73.14
617.14
690.29
---400
---288
---512
Graphs of Jonathan’s Short Run
“Totals” Cost Curves




Quantity of apples (q) on
the horizontal.
Costs ($) on the vertical.
Fixed Costs are “flat”.
Variable Costs increase
with apple production.
– They increase at a
decreasing rate at first.
– They eventually
increase at an
increasing rate. WHY?

Short Run Total Costs
are simply the vertical
sum of fixed and variable
costs.
Graphs of Jonathan’s Short Run
Marginal & Average Cost Curves

Average Fixed
Cost

Average Variable
Cost

Short Run
Average Total
Cost

Short Run
Marginal Cost
0
THE COST GRAPH
THE COST GRAPH
1360
485.33
400
0
Short Run Cost Curves:
Locations, Shifts and Movements

Locations

Shifts

Movements
Along
Short Run Cost Curves With
Multiple Variable Factors: Bang/Buck




Suppose there are two types of hired labor: skilled and unskilled,
Ls and Lu, with wages per hour Ps and Pu, respectively.
How would this change Jonathan’s cost structure?
Would need to know the short run production function for how
skilled and unskilled labor can be substituted for each other.
Suppose we knew this information and that it led to us knowing
the marginal product curves for skilled and unskilled labor.
– Suppose we are operating where marginal product curves are declining.

How would our derivation of the 7 short run cost curves change?
– The only real change occurs in the variable cost function.
– NOW... vc = $Ps•Ls*(q) + $Pu•Lu*(q)

So: How do you determine Ls*(q) and Lu*(q)?
– Employ the “equal bang per buck” rule.
– So… given the input prices and marginal productivity information, find the
combination of skilled and unskilled labor where the following is met:
– at LS*(q) and LU*(q) you need to have [MPs/$Ps] = [MPu/$Pu]
Example: The Bang/Buck Rule






Suppose q=100 tons of apples.
Suppose:
Ls=10 hours & the MPs at 10th hour is 48 tons.
Suppose:
Lu=25 hours & the MPu at 25th hour is 36 tons.
Suppose Ps=$12/hour
Suppose Pu=$6/hour
Jonathan’s Variable Cost = $12•10 + $6•25 = $270
tons
48
mpskilled
Hours
Skilled
Labor
10

Bang/buck in skilled = MPs/Ps = 48/12 = 4 tons

Bang/buck in unskilled = MPu/Pu = 36/6 = 6 tons

i>clicker Question
Given this information, to make q=100 tons
of apples more cost efficiently, Jonathan should
A.
B.
C.
D.
E.
do nothing – he’s doing great!
use more Skilled and the same Unskilled.
use only Skilled.
use more Skilled and less Unskilled.
use more Unskilled and less Skilled.
tons
mpunskilled
36
25
Hours
Unskilled
Labor