Total Fixed Cost

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THEORY OF THE FIRM

DINESH BAKSHI


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Total Fixed Cost

Total fixed cost will remain constant even though output changes.

Average Fixed CostAverage fixed cost will fall as output increases.


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Total Variable costAs output increases, total variable cost will increases.

Average Variable CostThe average cost curve is U-shaped. As output increases, average variable cost falls because of

spreading of cost.


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Total CostIt can be defined as total variable cost plus total fixed cost.

Marginal CostMarginal cost will initially fall, reach the minimum and finally rise.


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Production in the Long runIn the long run there are no fixed factors of production. All factors are variable, and firms are therefore

able to adjust their input of all factors of production. The process of change of input of all factors of

production is the change in the scale of production.

When a firm changes it inputs but the change in output is more than the change input, the firms is said to

be experiencingincreasing returns to scale. On the other hand, when a firms output experiences a less

proportionate increase as compared to the increase in input, it is said to be diminishing returns to

scale.

A firm experiencing an increased return to scale will f ind its average costs falling. This is termed

as economies of scale. Whereas, a rise in average cost of production due to diminishing return to scale

are termed as diseconomies of scale.

Long run cost curvesIn the long run all the factors of production are Variable and a firm can expand or decrease the level of

output by varying its variable factors.

There is no time dimension as to determine whether it is short run or long run. When the firm can alter it

fixed factors, it is said to be a long run.

Long run Total Cost (LRTC)It is the total cost incurred as a result of producing a commodity in the long run. It can start from 0 as

there is not fixed cost.

Long run total cost will initially increase at a decreasing rate and then at an increasing rate due to law of

return to scale.


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Long run Average Cost (LRAC)It is U shaped. In the long run, as output increase, the average cost will fall due to internal economies of

scale. As output increases further, average cost will remain constant and if the output is increased further,

the average cost will increase again due to internal diseconomies of scale.


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Consumer SurplusThe individual consumer surplus is the difference between the maximum total price a consumer would bewilling to pay (or reservation price) for the amount he buys and the actual total price.

ExampleSuppose you are in Wal-Mart and you see a DVD on the rack. No price is indicated on the package, so

you bring it over to the register to check the price. As you walk to the register, you think to yourself that

$20 is the highest price you would be willing to pay. At the register, you find out that the price is actually

$12, so you buy the DVD. Your consumer surplus in this example is $8: the difference between the $20

you were willing to pay and the $12 you actually paid.

If someone is willing to pay more than the actual price, their benefit in a transaction is how much they

saved when they didn't pay that price. For example, a person is willing to pay a tremendous amount forwater since he needs it to survive, however since there are competing suppliers of water he is able to

purchase it for less than he is willing to pay.The difference between the two prices is the consumer

surplus.

The maximum price a consumer would be willing to pay for a given amount is the sum of the maximum

price he would be willing to pay for the first unit, the maximum additional price he would be willing to pay


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for the second unit, etc.

Typically these prices are decreasing; in that case they are given by the individual demand curve. If these

prices are first increasing and then decreasing there may be a non-zero amount with zero consumer

surplus. The consumer would not buy an amount larger than zero and smaller than this amount because

the consumer surplus would be negative. The maximum additional price a consumer would be willing to

pay for each additional unit may also alternatingly be high and low, e.g. if he wants an even number ofunits, such as in the case of tickets he uses in pairs on dates.

The lower values do not show up in the demand curve because they correspond to amounts the

consumer does not buy, regardless of the price. For a given price the consumer buys the amount for

which the consumer surplus is highest.


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What is Utility?Why do you buy the goods and services you do? It must be because they provide you with satisfaction

you feel better off because you have purchased them. Economists call this satisfaction utility. The

concept of utility is an elusive one. A person who consumes a good such as peaches gains utility from

eating the peaches. But we cannot measure this utility the same way we can measure a peachs weight

or calorie content. There is no scale we can use to determine the quantity of utility a peach generates.

Total UtilityIf we could measure utility, total utility would be the number of units of utility that a consumer gains from

consuming a given quantity of a good, service, or activity during a particular time period. The higher a

consumers total utility, the greater that consumers level of satisfaction.

Marginal UtilityThe amount by which total utility rises with consumption of an additional unit of a good, service, oractivity, all other things unchanged, is marginal utility.

Law of diminishing Marginal UtilitySuppose that you are really thirsty and you decide to consume a soft drink. Consuming the drink

increases your utility, probably by a lot. Suppose now you have another. That second drink probably

increases your utility by less than the first. A third would increase your utility by still less. This tendency of

marginal utility to decline beyond some level of consumption during a period is called the law of

diminishing marginal utility . Failure of marginal utility to diminish would lead to extraordinary levels of

consumption of a single good to the exclusion of all others. Since we do not observe that happening, it

seems reasonable to assume that marginal utility falls beyond some level of consumption.


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Equi-Marginal PrincipleThe Law of Equi-Marginal Utility is an extension to the law of diminishing marginal utility. The principle of

equi-marginal utility explains the behavior of a consumer in distributing his limited income among various

goods and services.This law states that how a consumer allocates his money income between various goods so as to obtain

maximum satisfaction.

Let us assume there are only three commodities available in the market, A, B and C. Also assume that

Tom has a daily income of only $15 to spend and that he can exactly order his utility preference for each

of the three products. Product A costs $1 per unit, Product B costs $3 per unit and Product C costs $5.

Note that diminishing marginal utility sets in immediately for each of the three products. Marginal utility

information is described on per $ basis, because a consumers choice are influenced not only by the

amount of additional utility that successive units give him but also how many dollars he give up to get

them.

Let us consider each dollar spent. Marginal utility per dollar shows that one dollar spend on Product Aprovides the highest satisfaction of 20 utils as opposed to only 12 and 8 utils from products B and C,

respectively.

Second dollar spends again buys the highest utility of 15 utils. However, when Tom spends the third

dollar, a switch to Product B promises 15 utils of added satisfaction as opposed to 11 utils from Product

A. Following the principle, the best combination Tom can purchase with $15 would be 4 units of A, 2 units

of B and 1 unit of C. The total utility generated would be 154 utils. $4 spent on A give 54 utils of

satisfaction; $6 spent on Product B gives 60 utils and $5 spent on C gives 40 utils. This gives a total of

154 utils. No other combination will result in as high utility as this with an expenditure of $15.

The results from the table above can be generalised to n commodities and the following condition should

hold in equilibrium:


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Production in the Short RunShort run is a period of time when at least one of the factors of production is fixed. Usually labour is the

easiest factor to change. Thus in short run a firm can increase production only by employing more labour

because no more land or capital is available. Thus, labour is the variable factor in the short run.'Short run' for various firms is different. It may be few days for some industries and may be years for some

industries.

Production functionIt is the equation that expresses the relationship between the quantities of productive factors (such as

labour and capital) used and the amount of product obtained. It states the amount of product that can be

obtained from every combination of factors, assuming that the most efficient available methods of

production are used.

Law of increasing returnsThis states that as more units of variable factor are added to a fixed factor, output will first rise more than

proportionately. Thus, the firm experiences increasing returns.

Law of diminishing returnsThe law states that as more units of a variable factor are added to a fixed factor, there will come a point

when output will rise less than proportionately. The firm experiences diminishing returns.


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This graph shows firm's total product curve with the ranges of increasing marginal returns, diminishing

marginal returns, and negative marginal returns marked. This firm experiences increasing marginal

returns between 0 and 3 units of labor per day, diminishing marginal returns between 3 and 7 units of

labor per day, and negative marginal returns beyond the 7th unit of labor.

Marginal productMarginal product of labour is the change in total output when one more worker is employed. It can be

calculated as

Change in total product

Change in number of workers

Average productAverage product of labour is the total product divided by the number of workers producing it. In other

words, output each worker.

Total product

Number of workers


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The Budget LineConsumers choices are limited by the budget available. Total spending for goods and services can fall

short of the budget constraint but may not exceed it.

Suppose a college student, Rocky, wants to go in for Music classes and Karate classes. A day spentpursuing either activity costs $50. Suppose she has $250 available to spend on these two activities each

semester.

The budget line shows combinations of the Music classes and Karate classes Rocky could

consume if the price of each activity is $50 and she has $250 available for them each semester.

The slope of this budget line is -1, the negative of the price of Music classes divided by the price

of Karate classes

For a consumer who buys only two goods, the budget constraint can be shown with a budget line. A

budget line shows graphically the combinations of two goods a consumer can buy with a given budget.


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As the Price of karate classes will fall relative to Music classes, Rocky will substitute Karate classes for

Music Classes. This is known as the substitution effect of a price change.

Labour Market - IntroductionWhen we use the model of demand and supply to analyze the determination of wages and employment,we are assuming that market forces, not individuals, determine wages in the economy. The model says

that equilibrium wages are determined by the intersection of the demand and supply curves for labour in a

particular market.

Workers and firms in the market are thus price takers; they take the market-determined wage as given

and respond to it.

We are, in this instance, assuming that perfect competition prevails in the labour market.

Just as there are some situations in the analysis of markets for goods and services for which such an

assumption is inappropriate, so there are some cases in which the assumption is inappropriate for lab or

markets.

We will begin our analysis of labour markets in the next section by looking at the forces that influence the

demand for labour

Demand for labourDemand for labour is a derived demand. It means that the firms demand for labour is due to its decision

to produce certain goods and services. Thus labour is demanded not for its own sake but because it is

essential to the production of those goods and services.

How much labour will the firmemploy?A profit-maximizing firm will base its decision to hire additional units of labour on the marginal decision

rule: If the extra output that is produced by hiring one more unit of labour adds more to total revenue than

it adds to total cost, the firm will increase profit by increasing its use of labour. It will continue to hire more

and more labour up to the point that the extra revenue generated by the additional labour no longer

exceeds the extra cost of the labour.

For example, if a computer software company could increase its annual total revenue by $50,000 by

hiring a programmer at a cost of $49,000 per year, the marginal decision rule says that it should do so.

Since the programmer will add $49,000 to total cost and $50,000 to total revenue, hiring the programmer

will increase the companys profit by $1,000. If still another programmer would increase annual total

revenue by $48,000 but would also add $49,000 to the firms total cost, that programmer should not be

hired because he or she would add less to total revenue than to total cost and would reduce profit.

Marginal revenue product of labour


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The amount that an additional unit of a factor adds to a firms total revenue during a period is called the

marginal revenue product (MRP)marginal revenue productThe amount that an additional unit of a factor

adds to a firms total revenue during a period of the factor.

An additional unit of a factor of production adds to a firms revenue in a two-step process:

first, it increases the firms output.

Second, the increased output increases the firms total revenue.

We find marginal revenue product by multiplying the marginal product (MP) of the factor by the marginal

revenue (MR).

MRP=MPMR

In a perfectly competitive marketThe marginal revenue a firm receives equals the market-determined price P. Therefore, for firms in

perfect competition, we can express marginal revenue product as follows:

MRP=MPP

The law of diminishing marginal returns tells us that if the quantity of a factor is increased while

other inputs are held constant, its marginal product will eventually decline. If marginal product is

falling, marginal revenue product must be falling as well.

Demand for labour and Wage

determinationLabour demand is a derived demand, in other words the employer's cost of production is the wage, inwhich the business or firm benefits from an increased output or revenue. The determinants of employing

the addition to labour depends on the Marginal Revenue Product (MRP) of the worker. The MRP is

calculated by multiplying the price of the end product or service by the Marginal Physical Product of the

worker. If the MRP is greater than a firm's Marginal Cost, then the firm will employ the worker. The firm

only employs however up to the point where MRP=MC, not lower, in economic theory.

Wage differences exist, particularly in mixed and fully/partly flexible labour markets. For example, the

wages of a doctor and a port cleaner, both employed by the NHS, differ greatly. But why? There are

many factors concerning this issue. This includes the MRP (see above) of the worker. A doctor's MRP is

far greater than that of the port cleaner. In addition, the barriers to becoming a doctor are far greater than

that of becoming a port cleaner. For example to become a doctor takes a lot of education and trainingwhich is costly, and only those who are socially and intellectually advantaged can succeed in such a

demanding profession. The port cleaner however requires minimal training. The supply of doctors

therefore would be much more inelastic than the supply of port cleaners. The demand would also be

inelastic as there is a high demand for doctors, so the NHS will pay higher wage rates to attract the

profession.


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Factors affecting demand for labourThe fact that a firms demand curve for labour is given by the downward -sloping portion of its marginal

revenue product of labour curve provides a guide to the factors that will shift the curve. In perfect

competition, marginal revenue product equals the marginal product of labour times the price of the goodthat the labour is involved in producing; anything that changes either of those two variables will shift the

curve. The demand for labour will be influenced by

Changes in the Use of Other Factors of

ProductionAs a firm changes the quantities of different factors of production it uses, the marginal product of labour

may change. Having more reference manuals, for example, is likely to make additional accountants more

productiveit will increase their marginal product. That increase in their marginal product would increase

the demand for accountants. When an increase in the use of one factor of production increases thedemand for another, the two factors are complementary factors of productioncomplementary factors of

productionFactors of production for which an increase in the use of one increases the demand for the

other.

Other inputs may be regarded as substitutes for each other. A robot, for example, may substitute for

some kinds of assembly-line labour. Two factors are substitute factors of productionsubstitute factors of

productionFactors of production for which an increase in the use of one decreases the demand for the

other if the increased use of one lowers the demand for the other.

Changes in TechnologyTechnological changes can increase the demand for some workers and reduce the demand for others.The production of a more powerful computer chip, for example, may increase the demand for software

engineers. It may also allow other production processes to be computerized and thus reduce the demand

for workers who had been employed in those processes.

Changes in Product DemandA change in demand for a final product changes its price, at least in the short run. An increase in the

demand for a product increases its price and increases the demand for factors that produce the product.

A reduction in demand for a product reduces its price and reduces the demand for the factors used in

producing it. Because the demand for factors that produce a product depends on the demand for the

product itself, factor demand is said to be derived demandderived demandDemand for a product that isderived from demand for factors used in its production. That is, factor demand is derived from the

demand for the product that uses the factor in its production.

Changes in the Number of FirmsWe can determine the demand curve for any factor by adding the demand for that factor by each of the

firms using it. If more firms employ the factor, the demand curve shifts to the right. A reduction in the


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number of firms shifts the demand curve to the left. For example, if the number of restaurants in an area

increases, the demand for waiters and waitresses in the area goes up. We expect to see local wages for

these workers rise as a result.

Supply of labourThe supply of labour refers to the total number of hours that labour is able and willing to supply at

a particular wage rate.

The more work a person does, the greater his or her income, but the smaller the amount of leisure time

available. An individual who chooses more leisure time will earn less income than would otherwise be

possible. The more leisure people demand, the less labour they supply.

Labour supply curves are derived from the 'labour-leisure' trade-off. More hours worked earn higher

incomes but necessitate a cut in the amount of leisure that workers enjoy. Consequently there are two

effects on the amount of desired labour supplied due to a change in the real wage rate. As, for example,

the real wage rate rises the opportunity cost of leisure increases. This tends to cause workers to supply

more labour (the "substitution effect"). However, as the real wage rate rises, workers earn a higher

income for a given number of hours. If leisure is a normal good - the demand for it increases as income

increases - this increase in income will tend to cause workers to supply less labour (the "income effect").

If the "substitution effect" is stronger than the "income effect" then the labour supply curve will be upward

sloping and vice versa.

Wage Changes and the Slope of the

Supply CurveWhat would any one individuals supply curve for labour look like?

One possibility is that over some range of labour hours supplied, the substitution effect will dominate.

Because the marginal utility of leisure is relatively low when little labour is supplied (that is, when most

time is devoted to leisure), it takes only a small increase in wages to induce the individual to substitute

more labour for less leisure. Further, because few hours are worked, the income effect of those wage

changes will be small.

A Backward-Bending Supply Curve for Labour shows Meredith Wilsons supply curve for labour. At a

wage of $10 per hour, she supplies 42 hours of work per week (point A). An increase in her wage to $15

per hour boosts her quantity supplied to 48 hours per week (point B). The substitution effect thus

dominates the income effect of a higher wage.


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As the wage rate increases from $10 to $15 per hour, the quantity of labour Meredith Wilson supplies

increases from 42 to 48 hours per week. Between points A and B, the positive substitution effect of

the wage increase outweighs the negative income effect.

As the wage rises above $15, the negative income effect just offsets the substitution effect, and Ms.Wilsons supply curve becomes a vertical line between points B and C. As the wage rises above $20, the

income effect becomes stronger than the substitution effect, and the supply curve bends backward

between points C and D.

Shifts in Labour SupplyWhat events shift the supply curve for labour?

The supply curve for labour will shift in response to changes in the same set of factors that shift demand

curves for goods and services.

Changes in PreferencesA change in attitudes toward work and leisure can shift the supply curve for labour. If people decide they

value leisure more highly, they will work fewer hours at each wage, and the supply curve for labour will

shift to the left. If they decide they want more goods and services, the supply curve is likely to shift to the

right.

Changes in IncomeAn increase in income will increase the demand for leisure, reducing the supply of labour. We must becareful here to distinguish movements along the supply curve from shifts of the supply curve itself. An

income change resulting from a change in wages is shown by a movement along the curve; it produces

the income and substitution effects we already discussed.


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Changes in the Prices of Related Goods

and ServicesSeveral goods and services are complements of labour. If the cost of child care (a complement to work

effort) falls, for example, it becomes cheaper for workers to go to work, and the supply of labour tends to

increase. If recreational activities (which are a substitute for work effort) become much cheaper,

individuals might choose to consume more leisure time and supply less labour.

Changes in PopulationAn increase in population increases the supply of labour; a reduction lowers it. Labour organizations have

generally opposed increases in immigration because their leaders fear that the increased number of

workers will shift the supply curve for labour to the right and put downward pressure on wages.

Changes in ExpectationsOne change in expectations that could have an effect on labour supply is life expectancy. Another isconfidence in the availability of Social Security. Suppose, for example, that people expect to live longer

yet become less optimistic about their likely benefits from Social Security. That could induce an increase

in labour supply.

Wage determination under free

market forcesWe have seen that a firms demand for labour depends on the marginal product of labour and the price of

the good the firm produces.

We add the demand curves of individual firms to obtain the market demand curve for labour.

Supply in a particular market depends on variables such as worker preferences, the skills and training a

job requires, and wages available in alternative occupations.

Wages are determined by the intersection of demand and supply.

The operation of labour markets in perfect competition is illustrated in Graphs (given below), Wage

Determination and Employment in Perfect Competition. The wage W1 is determined by the intersection of

demand and supply in Panel (a). Employment equals L1 units of labour per period. An individual firmtakes that wage as given; it is the supply curve s1facing the firm. This wage also equals the firms

marginal factor cost. The firm hires l1 units of labour, a quantity determined by the intersection of its

marginal revenue product curve for labourMRP1 and the supply curve s1. We use lowercase letters to

show quantity for a single firm and uppercase letters to show quantity in the market.

Wage Determination and Employment in Perfect Competition


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Wages in perfect competition are determined by the intersection of demand and supply in Panel (a). An

individual firm takes the wage W1 as given. It faces a horizontal supply curve for labour at the market

wage, as shown in Panel (b). This supply curve s1 is also the marginal factor cost curve for labour. Thefirm responds to the wage by employing l1 units of labour, a quantity determined by the intersection of its

marginal revenue product curve MRP1 and its supply curve s1.

Changes in Demand and Supply of

labourIf wages are determined by demand and supply, then changes in demand and supply should affect

wages. An increase in demand or a reduction in supply will raise wages; an increase in supply or areduction in demand will lower them.

The dynamic graph given below shows the affect of changes in demand and supply of labour on the

wages.

Role of trade unions in wage

determinationIn many markets the demand and supply of labour are affected by the actions of the trade unions and thegovernment. Such interventions produce imperfections in the labour market.

Role of trade unionsA trade union orlabour union is an organization of workers who have banded together to achieve

common goals in key areas such as wages, hours, and working conditions. The trade union, through its


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leadership, bargains with the employer on behalf of union members and negotiates labour contracts with

employers. This may include the negotiation of wages, work rules, complaint procedures, rules governing

hiring, firing and promotion of workers, benefits, workplace safety and policies.

Affect of Trade unions on Labour Market

Looking at this graph,

At the equilibrium wage, the quantity of labour employed is L.

A strong trade union can force up wages to Wu.

Number of jobs offered by employers falls to Lu.

At this wage the number of people who would like to work is higher (Lc)

This will lead to a shortfall between who can actually want to work and those who can actually work.

Government intervention through

minimum wagesA minimum wage is the lowest hourly, daily or monthly wage that employers may legally pay to

employees or workers.


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The main aim of introducing minimum wages is to reduce poverty and the exploitation of workers who

have little or no bargaining power with their employers.

If a higher minimum wage increases the wage rates of unskilled workers above the level that would be

established by market forces, the quantity of unskilled workers employed will fall. The minimum wage will

price the services of the least productive (and therefore lowest-wage) workers out of the market. ... The

direct results of minimum wage legislation are clearly mixed. Some workers, most likely those whose

previous wages were closest to the minimum, will enjoy higher wages. Other, particularly those with the

lowest prelegislation wage rates, will be unable to find work. They will be pushed into the ranks of the

unemployed or out of the labor force.

Suppose the current equilibrium wage of unskilled workers is W1, determined by the intersection of the

demand and supply curves of these workers. The government determines that this wage is too low and

orders that it be increased to Wm, a minimum wage. This strategy reduces employment from L1 to L2, but

it raises the incomes of those who continue to work. The higher wage also increases the quantity of

labour supplied to L3. The gap between the quantity of labour supplied and the quantity

demanded, L3 ? L2, is a surplusa surplus that increases unemployment.

An alternative approach to imposing a legal minimum is to try to boost the demand for labor. Such an

approach is illustrated in the graph below. An increase in demand to D2 pushes the wage to W2 and at

the same time increases employment to L2. Public sector training programs that seek to increase human

capital are examples of this policy.


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Arguments in favour of Minimum

Wage LawsSupporters of the minimum wage claim it has these effects:

Increases the standard of living for the poorest and most vulnerable class in society and raises average.

Motivates and encourages employee to work harder.

Does not have budget consequence on government. "Neither taxes nor public sector borrowing

requirements rise."

Minimum wage is administratively simple; workers only need to report violations of wages less than

minimum, minimizing a need for a large enforcement agency.

Stimulates consumption, by putting more money in the hands of low-income people who spend their

entire paychecks.

Increases the work ethic of those who earn very little, as employers demand more return from the higher

cost of hiring these employees.

Decreases the cost of government social welfare programs by increasing incomes for the lowest-paid.


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Does not have a substantial effect on unemployment compared to most other economic factors, and so

does not put any extra pressure on welfare systems.

Arguments against Minimum Wage

LawsOpponents of the minimum wage claim it has these effects:

Excludes low cost competitors from labor markets, hampers firms in reducing wage costs during trade

downturns (etc.), generates various industrial-economic inefficiencies as well as unemployment, poverty,

and price rises.

Hurts small business more than large business.

Reduces quantity demanded of workers. This may manifest itself through a reduction in the number of

hours worked by individuals, or through a reduction in the number of jobs.

Reduces profit margins of business owners employing minimum wage workers, thus encouraging a move

to businesses that do not employ low-skill workers.

Businesses try to compensate for the decrease in profit by simply raising the prices of the goods being

sold thus causing inflation and increasing the costs of goods and services produced.

Does not improve the situation of those in poverty, it benefits some at the expense of the poorest and

least productive.

Discourages further education among the poor by enticing people to enter the job market.

Causes outsourcing and loss of domestic manufacturing jobs to other countries.


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Monopsony in the labour marketWhat is Monopsony?

A Monopsony occurs in the labour market when there is a single dominant buyer of labour. In such asituation this monopoly buyer is the price setter for labour.

Monopsony is the buyers counterpart of monopo ly. Monopoly means a single seller; Monopsony means

a single buyer.

The monoponist will hire workers by equating the marginal cost paid to employ a worker with the marginal

revenue product gained from this employment. The wage paid by the monoponist is W m. This is actually

below the wage that should be paid if he was paying the full value of their marginal revenue product,

which is Wmrp. The level of employment is Lm.

In this situation the power of the employer in the labour market is of over-riding importance and the

employer can set a low wage because of his buying power.

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