A firm decides how much to produce by answering one question repeatedly: does making one more unit add more to revenue than it adds to cost? Everything else in the theory of the firm, the cost curves, the revenue curves, the whole apparatus of market structures, exists to answer that question precisely. Get the costs and revenue straight here and the rest of microeconomics becomes an application of them.
Firms are classified in several ways and questions use all of them. By sector: primary firms extract raw materials, secondary firms manufacture, tertiary firms provide services. By size, measured by number of employees, revenue, capital employed or market share, none of which agree with each other. And by ownership, from sole traders and partnerships through private and public limited companies to state-owned enterprises. Size matters analytically because it determines which economies of scale a firm can reach and how much market power it has.
Productivity
Output per unit of input in a given period, most commonly measured as output per worker or output per worker-hour.
Production and productivity are different words and examiners test the difference deliberately. Production is total output. Productivity is output per unit of input. A firm that doubles output by doubling its workforce has doubled production and left productivity unchanged. Using the words interchangeably costs marks in almost every paper.
Costs divide into two kinds and the division is about time rather than size. Fixed costs do not vary with output: rent, insurance, loan interest, salaried management. They must be paid even at zero output. Variable costs vary directly with output: raw materials, hourly wages, electricity used in production. Total cost is the two added together. Average cost, or cost per unit, is total cost divided by output, and it is average cost rather than total cost that determines whether a given selling price is profitable.
TC = TFC + TVC AC = TC / Q TR = price x quantity AR = TR / Q Profit = TR - TCNote that AR equals price whenever every unit sells at the same price, which is why the average revenue curve and the demand curve are the same line. Formulae are not printed in any 9708 paper, so recall all of these.
Finding the profit-maximising output from a cost table
A firm faces total costs of $100 at zero output, then $160, $200, $230, $270, $330 and $420 for outputs of 1 to 6 units. It can sell any quantity at $80 per unit. Identify its fixed cost, calculate profit at each output, and state the profit-maximising level.
Profit maximisation is the standard assumption but it is not the only objective firms pursue. Survival matters most for a new firm or one in a downturn, and may mean accepting losses for a period. Growth of market share can be pursued at the expense of current profit, on the argument that scale brings lower costs and greater power later. Social objectives matter to charities, cooperatives and state-owned firms, and increasingly to firms responding to consumer and employee expectations. Satisficing describes managers doing well enough to satisfy shareholders while pursuing other aims, which happens because in large firms the owners and the managers are different people with different interests.
A firm's total cost is $500 when it produces nothing. Which statement is correct?
A firm increases output from 100 to 120 units by hiring more workers, and its output per worker falls. What has happened?
Draw a diagram with output on the horizontal axis and cost on the vertical axis. Draw a horizontal total fixed cost line, an upward-sloping total variable cost curve starting at the origin, and the total cost curve above them. Then, on a second diagram, draw average fixed cost falling continuously and average total cost as a U shape.
The key insight is why average fixed cost falls continuously without ever reaching zero: a constant amount is being divided by a rising output. This is 'spreading the overheads', and it is the reason average total cost falls at low output even when variable costs per unit are rising.