A-level Economics/AQA/Business Economics and the Distribution of Income

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Theory of the Firm

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The theory of the firm is a series of economic models utilised to understand and explain the nature of firms and their interaction with the market.


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One such economic model is that of the costs which a firm faces. There are two main types of costs discussed; fixed and variable costs.Fixed costs are costs which remain constant at all levels of output. Variable costs are those costs which vary with the level of output. Marginal cost is the cost of producing an extra unit of output. Average cost is the average cost of each unit of output for a given level of output. Total cost is the sum total of costs for a firm at a given level of output.

Calculating and Graphing Costs

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In addition to being able to define the different types of costs facing firms it also required that you are able to interpret cost curves and calculate costs. Below is a table illustrating the total, average and marginal costs of a fictional firm.

Output Total Cost Average Cost Marginal Cost
1 100 100 100
2 110 55 10
3 150 50 40
4 180 45 30

As is demonstrated by the table the formula for calculating the average costs of firm is:

The marginal cost is the extra cost incurred by producing an additional unit of output, therefore, to calculate it the total cost of production at the current level of output is subtracted from the total cost of output at the previous level of output.


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There are also equivalent revenues for each of the costs. Average revenue is the average amount of revenue from the sale of a given number of units. Marginal revenue is the additional revenue generated from the sale of an extra unit. Total revenue is the total revenue generated from the sale of a given number of units at a given level of output.

Objectives of the Firm

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There are a number of possible objectives which a firm may aspire to. This may be to maximise profits or to maximise sales. Newspaper editors may want to maximise their readership and will therefore endeavour to produce at the lowest average cost possible in order to achieve the lowest price and the highest level of demand. A firm seeking to maximise profits on the other hand will produce at a level where the marginal cost and the marginal revenue intersect.

Models of Market Structure

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Economists have developed and utilised a series of models of different market structures to explain the different behaviour of firms in markets with different structures. As a model by definition is an attempt to simplify a complicated behaviour each model is based upon a series of assumptions and is therefore of limited use based on the validity of these assumptions.

Perfect Competition

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Figure 1 - A perfectly competitive firm making normal profits

One such model is that of perfect competition. This model attempts to create a situation in which the level of competition leads to both allocative and productive efficiency. It is based on the following assumptions;

  • There are many firms all of whom produce the same quantity of goods or services and all of whom have perfect knowledge of the other firms within the industry.
  • There are many buyers all of whom posses perfect knowledge of the industry.
  • The goods or services produced by the firms are homogeneous and not differentiated by branding or marketing.
  • Firms have absolute freedom to enter and exit the market due to a total lack of barriers to entry.

These four assumptions lead to a further salient characteristic of the model which means that both the consumers and producers are price takers as no single actor has sufficient market power to influence the price level within the industry. In addition to this any firm within the market who will accept the market price is able to sell all of its output, leading to perfectly competitive firms being faced with a perfectly elastic demand curve as shown in figure 1. As it is perfectly elastic both the marginal and average revenue remain constant.

Perfect Competition In The Short and Long Run

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The short run is defined as any period of time in which there is at least one fixed factor of production (i.e. land, labour, enterprise, capital). In the long run, however, all factors of production are variable, meaning that firms can achieve different levels of profit in the short and long run. In the long run it is only possible for a firm to make a normal profit. As all the products produced by the firms in this industry are homogeneous and there are a large number of firms, an increase in the price of one firms goods will lead consumers to switch to a competitor firm's product leading to the firm with the higher price making a loss and eventually going out of business. A firm may, in the short run, take advantage of a new production technique to increase output and therefore reduce the average cost and price of a unit and make a short run abnormal profit (a profit higher than normal profit). In the long run, however, as all firms have perfect knowledge regarding other firms within the industry all firms will copy this new production technique and too lower their average costs and price.


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A monopolist is a sole firm in an industry. A monopoly market structure is essentially the opposite to the market structure of perfect competition. There must be high barriers to entry for a firm to stay as a monopoly.

The following barriers to entry may exist:

  • Natural cost advantages
  • Legal barriers such as patents
  • Marketing barriers
  • Unfair practices