©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved. Theory Of The Firm Dr. Jennifer P. Wissink ©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved.

What Is A Firm? 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 and the need to allocate scarce resources.

Theory Of The Firm Embarking on an analysis of the firm. WHY? Note: 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. Overview

What We Assume 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. We will eventually relax the assumption that we are in a perfectly competitive market environment.

What Is A Market? 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.

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 and, 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.”

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 entreprenur. 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. Total Revenue – explicit costs = accounting profit – implicit costs = economic profit.

Profit Maximization We assume the analysis of the firm is being done today. We know, however, that the life of a firm plays out over time with benefits and costs in each period of the firm’s lifetime. How are we dealing with this? Our profit is the present discounted value of the future stream of benefits and costs to the firm. Note: Given the interest rate, r, the present value of $X in T periods is $X/(1+r)T Example: The present value of $600 exactly 2 years from now at r=.05 is 600/1.052 = $544.22