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1.5 Theory of the firm

In the previous sections we explained markets, the rules of supply and demand, market equilibrium, the price mechanism and market efficiency and how demand and supply are used to calculate market price and plot market equilibrium. We then explained the concepts of elasticity, considered the role and effects of government intervention in the economy and examined the concept of market failure. In this section we examine the theory of the firm.

By the end of this section you should be able to:

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  • Distinguish between the short run and long run in the context of production.
  • Define total product, average product and marginal product, and construct diagrams to show their relationship.
  • Explain the law of diminishing returns.
  • Calculate total, average and marginal product from a set of data and/or diagrams.
  • Explain the meaning of economic costs as the opportunity cost of all resources employed by the firm (including entrepreneurship).
  • Distinguish between explicit costs and implicit costs as the two components of economic costs.
  • Explain the distinction between the short run and the long run, with reference to fixed costs and variable costs.
  • Distinguish between total costs, marginal costs and average costs.
  • Draw diagrams illustrating the relationship between marginal costs and average costs, and explain the connection with production in the short run.
  • Explain the relationship between the product curves (average product and marginal product) and the cost curves (average variable cost and marginal cost), with reference to the law of diminishing returns.
  • Calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable costs, average total costs and marginal costs from a set of data and/or diagrams.
  • Distinguish between increasing returns to scale, decreasing returns to scale and constant returns to scale.
  • Outline the relationship between short-run average costs and long-run average costs.
  • Explain, using a diagram, the reason for the shape of the long-run average total cost curve.
  • Describe factors giving rise to economies of scale, including specialization, efficiency, marketing and indivisibilities.
  • Describe factors giving rise to diseconomies of scale, including problems of coordination and communication.