Microeconomics: Theory of the Firm

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Theory of the Firm — Key Facts for Sri Lanka A/L Examination

Key Concepts:

• Production Function: Relationship between inputs and outputs
• Costs: Fixed, variable, total, average, marginal
• Revenue: Total, average, marginal
• Profit Maximisation: Where MR = MC

Cost Formulas:

Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)
Average Cost (AC) = TC / Q
Marginal Cost (MC) = Change in TC / Change in Q

Profit = Total Revenue - Total Cost

⚡ A/L Exam Tip: The firm maximises profit where MARGINAL REVENUE equals MARGINAL COST (MR = MC). This is the fundamental rule!

---

🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Microeconomics: Theory of the Firm — Detailed Study Guide

Production Theory

Factors of Production:

Factor	Payment	Description
Land	Rent	Natural resources
Labour	Wages/Salary	Human effort
Capital	Interest	Manufactured goods for production
Entrepreneurship	Profit	Risk-taking and management

Production Function:

Q = f(K, L)
where:
Q = Output
K = Capital input
L = Labour input

Short Run vs. Long Run:

Short Run (at least one input fixed):

• Fixed factors: Cannot be changed in the period
• Variable factors: Can be changed
• Law of Variable Proportions applies

Long Run (all inputs variable):

• All factors can be adjusted
• Returns to Scale applies
• No fixed factors

The Law of Variable Proportions

Total Physical Product (TPP/TP):

• Total output produced
• Increases, reaches maximum, then may fall

Average Physical Product (APP/AP):

AP = Total Product / Units of Variable Input
   = TP / L

Marginal Physical Product (MPP/MP):

MP = Change in TP / Change in L
   = ΔTP / ΔL

Stages of Production:

Stage	TPP	MPP	APP	Manager’s Choice
Stage 1 (Increasing returns)	Rising	Increasing	Rising	MPP > APP
Stage 2 (Diminishing returns)	Rising but at decreasing rate	Positive but falling	Rising then falling	MPP = 0 at end
Stage 3 (Negative returns)	Falling	Negative	Falling	Never optimal to be here

Why Diminishing Marginal Returns Occur:

• Fixed capacity (in short run)
• Adding more variable factor eventually leads to reduced per-unit productivity
• Fixed space, equipment, or supervision spreads too thin

Cost Theory

Types of Costs:

Cost Type	Definition	Example
Fixed Cost (FC)	Cost that doesn’t change with output	Rent, permanent staff salaries
Variable Cost (VC)	Cost that changes with output	Raw materials, hourly wages
Total Cost (TC)	FC + VC	—
Sunk Cost	Irrecoverable cost	Already spent, cannot be recovered

Cost Schedules:

Output (Q)	TFC	TVC	TC	AFC	AVC	AC	MC
0	100	0	100	—	—	—	—
1	100	50	150	100	50	150	50
2	100	90	190	50	45	95	40
3	100	120	220	33.3	40	73.3	30
4	100	160	260	25	40	65	40
5	100	220	320	20	44	64	60

Cost Curves:

• TFC: Horizontal line (constant)
• TVC: S-shaped, rising
• TC: Parallel to TVC, starts at TFC
• MC: U-shaped curve, crosses AC at minimum
• AC: U-shaped curve, always above AFC

Relationship Between Costs:

• MC is the slope of TC (and of TVC)
• When MC < AC, AC is falling
• When MC > AC, AC is rising
• MC = AC at minimum point of AC curve

Revenue Concepts

Total Revenue (TR):

TR = Price × Quantity Sold
   = P × Q

Average Revenue (AR):

AR = TR / Q = P

Marginal Revenue (MR):

MR = ΔTR / ΔQ

Revenue Under Different Market Structures:

Market Structure	Demand Curve	AR = MR?	Price > MR?
Perfect Competition	Horizontal (perfectly elastic)	AR = MR	P = MR
Monopoly	Downward sloping	AR > MR	P > MR
Monopolistic Competition	Downward sloping	AR > MR	P > MR

Perfect Competition:

• Firm is price taker
• AR = MR = P (horizontal demand curve at market price)
• TR is a straight line from origin (constant price)

Monopoly/Monopolistic Competition:

• Downward sloping demand
• P > MR (to sell more, price must fall)
• MR curve lies below AR curve

---

🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Microeconomics: Theory of the Firm — Complete Notes for A/L Sri Lanka

Profit Maximisation

The Profit Maximisation Rule:

Profit Maximised where: MR = MC

Reasoning:

• If MR > MC: Produce more — additional units add to profit
• If MR < MC: Produce less — additional units cost more than they earn
• At MR = MC: No incentive to produce more or less — maximum profit

Profit = TR - TC

Maximum profit when:
d(Profit)/dQ = d(TR)/dQ - d(TC)/dQ = 0
MR - MC = 0
MR = MC

Short-Run Equilibrium Under Different Market Structures:

Perfect Competition:

Condition	Outcome
P > AC	Super-normal/Abnormal profit
P = AC	Normal profit (break-even)
P < AC	Loss
P < AVC minimum	Shutdown

Shutdown Point:

• If P < AVC minimum: Shut down in short run
• Only FC is lost by shutting down
• Losses equal TC - TR

Monopoly:

• No entry → can earn super-normal profits in both short and long run
• Profit maximisation: MR = MC
• Charge price on demand curve at that quantity

Monopolistic Competition:

• Some entry over time
• Long-run equilibrium: P = AC, MR = MC
• Only normal profit in long run (like perfect competition)
• But firms have some control over price (product differentiation)

Long-Run Production: Returns to Scale

Returns to Scale:

• Changes when ALL inputs are increased proportionally
• Measures how output changes when scale changes

Type	Input Change	Output Change	Example
Increasing returns	2x inputs	>2x output	Specialisation benefits
Constant returns	2x inputs	2x output	Linear scaling
Decreasing returns	2x inputs	<2x output	Coordination difficulties

Why Increasing Returns:

• Specialisation and division of labour
• Indivisible factors (use full capacity)
• Dimensional relationships

Why Decreasing Returns:

• Management difficulties (less control)
• Coordination problems
• Physical constraints at large scale

Long-Run Average Cost (LAC):

• Envelope of short-run AC curves
• Shows minimum average cost for each output level

Economies of Scale:

Type	Source
Technical	Indivisible inputs, specialisation
Managerial	Specialised management
Financial	Better credit terms, lower interest
Marketing	Bulk purchasing, advertising
Risk bearing	Diversified products

Diseconomies of Scale:

• Coordination difficulties
• Communication problems
• Alienation of workers
• Bureaucracy

Market Structures Overview

Perfect Competition:

Feature	Description
Many buyers and sellers	No individual influence on price
Homogeneous product	Identical products, no differentiation
Freedom of entry/exit	No barriers
Perfect information	All know prices, products
Price taker	Firm accepts market price
No advertising	Not needed (identical products)

Monopoly:

Feature	Description
Single seller	One firm is the industry
No close substitutes	Limited competition
Barriers to entry	Legal, natural, strategic
Price setter	Firm has market power
May earn super-normal profits	If demand exists

Barriers to Entry:

Barrier Type	Example
Legal barriers	Patents, licences, franchises
Natural barriers	Control of resources, economies of scale
Strategic barriers	Limit pricing, predatory pricing

Monopolistic Competition:

Feature	Description
Many buyers and sellers	Easy entry
Product differentiation	Real or perceived differences
Some control over price	Brand loyalty, location
Non-price competition	Advertising, quality

Oligopoly:

Feature	Description
Few dominant firms	Interdependent decisions
Homogeneous or differentiated	May be similar or unique products
Barriers to entry	High start-up costs, brand loyalty
interdependence	Actions affect rivals
Kinked demand	May explain price rigidity

Oligopoly in Sri Lanka:

• Telecommunications (Dialog, SLT, Airtel)
• Banking (Commercial Bank, Sampath, Peoples)
• Retail (Keells, Arpico)
• Beverages (Ceylon Cold Stores, Milco)

Output Decision: The.shutdown Rule

Short-Run Shutdown Decision:

Condition	Decision	Loss
P > AC	Continue	—
AVC < P < AC	Continue (if minimizing loss < FC)	Variable loss < FC
P < AVC	Shut down	Loss = FC + TFC

Shutdown occurs when:

TR < Variable Costs (VC)
P × Q < VC
P < AVC

Continuing is better than shutting down when:

Loss by continuing < Loss by shutting down
(TC - TR continuing) < (TC - TR shutting down)
(FC + VC - TR) < FC
-VC < -TR
VC > TR
P > AVC

Sri Lankan Business Context:

• Many small businesses face shutdown decisions during economic downturns
• COVID-19 pandemic forced shutdown decisions across Sri Lanka
• Manufacturing: High fixed costs (machinery, rent)
• Services: Lower fixed costs (can scale down variable inputs)

Cost Theory: Detailed Derivation

Relationship Between AP, MP, and Costs:

Product	Corresponding Cost
MPP	Minimum MC
MPP rising	MC falling
MPP falling	MC rising
APP	Corresponding to AVC at same output
APP rising	AVC falling
APP falling	AVC rising

Shape of Cost Curves:

• Law of Diminishing Returns explains U-shaped MC
• Initially: More variable input → better utilisation of fixed factor → MPP rises → MC falls
• Later: Variable input too much → congestion, confusion → MPP falls → MC rises

Long-Run Costs:

• LAC is U-shaped (but wider than short-run AC)
• Economies of scale → LAC falling
• Diseconomies of scale → LAC rising
• Minimum efficient scale: Output where LAC stops falling

Economies of Scope:

• Producing multiple products together is cheaper than separate
• Shared inputs, risk diversification
• Example: MAS Holdings produces apparel, but also medical products

⚡ A/L Exam Tip: When asked about profit maximisation, ALWAYS use the MR = MC rule and show working. Calculate the profit at equilibrium!

---

Content adapted based on your selected roadmap duration. Switch tiers using the selector above.