THE COST THEORY:

Costs are expenses of the firm. They are the total payments made by a firm for the factors of
production. Of fundamental importance in cost theory is the concept of opportunity cost or
alternative cost. This concept holds that the cost of a good is measured in terms of the
unproduced goods that could have been produced with the inputs used to produce the good in
question.

The total cost generated by the firm’s decision may be divided into two categories.
• Costs paid out or provided by the firm, known as private costs.
• Costs not paid by the firm which also include the use of free resources. These are the
costs, which the society bears on account of production of a commodity.
Social cost includes both private cost and the external cost. The external cost includes the cost
of resources for which the firm is not compelled to pay a price as for instance, the price of the
atmosphere, rivers, and lakes. It also includes the cost in the form of disutility created through
air, water and noise pollution.

Such costs do not feature in the cost structure of the firms and hence are termed external costs
from the firm’s point of view, and social cost from the society’s point of view.

The private costs of production can be distinguished into explicit cost and implicit cost.
Explicit costs consist of all the monetary outlays and expenses incurred by the firm in the
production process. These are the actual payments made by a firm; and they are normally taken
as the expenses of the firm.
These costs include payment for such inputs as labour, raw materials, rent, electricity and for
any other inputs which are owned and supplied by the owner of the firm.

Implicit costs, which are normally overlooked when calculating the expenses of the firm, are
the costs that are self-owned. A good example is where a businessman has invested some of
his own money in his enterprise, and also perform various jobs. Certainly his own money
should earn interest and his own labour should be rewarded. Even if some businessmen do not
explicitly recognize these costs of owned inputs, the economist always does.

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COST FUNCTION: Cost function is the functional relationship between cost and the quantity
of output produced. C = f (Q)
Where C = cost; f = function; Q = level of output produced.
Example: TC = 1000 + 10Q2
The cost function of the firm depends on:-
1) Production function.
2) Price of the inputs.
Therefore Cost = quantity of inputs x prices of per unit input.
= Inputs x Price.

SHORT RUN AND LONG RUN COSTS:

Economic theory distinguishes between short run costs and long run costs.
Short run costs are the costs over a period during which some factors of production are fixed.
The costs, which vary with the variation of output, the size of the firm, remain the same.

Long run costs are the costs over a period long enough to permit the change or all factors of
production. They are incurred on fixed assets like plants, buildings, and machinery. Such costs
have long run implications in the sense that these are not used up at a single time at the time of
production. They are used over a time in the process of production.
The total cost both in the short run and the long run is a multivariable function.

SHORT RUN COSTS:

1. TOTAL FIXED COST (TFC):
A fixed cost is the cost incurred by the firm regardless of the level of output produced.
Fixed costs do not vary as the level of output varies. They are the same whether output is
zero or 10 units. Examples are house rent, interest payments on loans, insurance. From
Table 3.2, TFC are represented by column 2. Fixed costs are also referred to as
supplementary cost, overhead cost or indirect cost. A straight line parallel to the output
axis graphically denotes the total fixed cost (figure 3.6).

2. TOTAL VARIABLE COST (TVC):

These are the costs that changes as the level of output vary. If the output is zero, the variable
costs are zero. Examples include the cost of raw materials, labour, transport cost. Variable
costs are also referred to as prime costs, direct cost, running cost or operating cost.

2
 The shape of TVC curve reflects the law of variable proportions (Law of Diminishing
returns). According to this law, at the initial stage of production as more of the variable
factor is employed within a given plant, its productivity increases and the average variable
cost falls. This continues until the optimal combination of the fixed and variable factor is
reached. Beyond this point as increased quantities of the variable factor are combined with
the fixed factor, the productivity of the variable factor declines (AVC rises). TVC is
represented by column 3 in table 3.2 and Figure 3.6.

3. TOTAL COSTS (TC).

Total costs are the sum of total fixed costs and total variable costs (TC = TFC + TVC). The
total cost function and the total variable cost function have the same shape, but they differ
by a constant amount (TFC). The difference between TC and TVC measures TFC.
At zero output, TFC = TC since TVC is zero. Note that for output 5, TC = 21000 and TVC
= 15000 and the difference between TC and TVC is TFC which is 6000 (Table 3.2).

Table 3.2 Short run costs of the firm.

(1) (2) (3) (4) (5) (6) (7) (8)

QTY TFC TVC TC MC AFC AVC ATC
1 6000 5000 11000 5000 6000 5000 11000
2 6000 8000 14000 3000 3000 4000 7000
3 6000 10500 16500 2500 2000 3500 5500
4 6000 12600 18600 2100 1500 3150 4650
5 6000 15000 21000 2400 1200 3000 4200
6 6000 18000 24000 3000 1000 3000 4000
7 6000 22000 28000 4000 857.1 3142.9 4000
8 6000 28000 34000 6000 750 3500 4250
9 6000 37000 43000 9000 666.7 4111.1 4777.8
10 6000 52000 58000 15000 600 5200 5800

NOTE: There are two important features of the TC curve.

First, when output is zero, total costs are given by the fixed costs.
Second, the shape of the TC curve is determined solely by the shape of the short run variable cost curve.

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Figure 3.6 Shows the graphs of TC, TFC and TVC

4. MARGINAL COST (MC):

Marginal cost is defined as the change in total costs (or total variable costs) resulting from
changing the level of output by one unit. It is the cost for producing one more unit of output.
The following formula can also be used to obtain MC.
MCnth = TCn – Tcn – 1 or MCnth = TVCn – TVCn-1
MC6th = TC6 – TC6 – 1 or MC6th = TVC6 – TVC6 – 1
3000 = 24000 – 21000 or 3000 = 18000 – 15000
Graphically, marginal cost is the slope of the tangent on either total cost curve or total variable
cost curve (figure 3.7).

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Figure 3.7 Derivation of marginal cost

As output increases, MC falls, reaches a minimum and rises continuously.

Note: The MC will never be zero or negative. It is impossible to produce the commodity either at zero
or negative cost.
The shape of MC curve is related to the behavior of the marginal product. If at low levels of
output, firm benefits from increasing marginal returns to the variable factor (that is increasing
MP), MC will be declining. MC reaches a minimum to the level of output at which MP is at
a maximum. When the firm encounters diminishing marginal returns, so that MP is falling,
MC begins to rise. Whenever there is a fixed factor, so that the law of diminishing returns
comes into operation, the MC curve should be rising (figure 3.8).

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Figure 3.8 Relationship between marginal product, average product and
Marginal cost, average cost:

5. AVERAGE FIXED COST (AFC):

Average fixed cost is obtained by dividing total fixed costs by the quantity produced. It is
the total fixed cost per unit output produced.

AFC = TFC
Q
AFC declines continuously as output increases because the given level of fixed costs will
be spread over a bigger level of output. This can be described as spreading the overheads.
This is what determines the shape of the AFC.
Graphically, the AFC is the slope of the line from the origin to the total fixed cost (figure
3.9).

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Figure 3.9 Derivation of AFC

The slope of 0a is: aQ1

0Q1

Which is the average fixed cost for output 0Q1

aQ1 bQ2 cQ3
> >
0Q1 0Q2 cQ3

as output increases, the slope becomes smaller.

0Q1 < 0Q2 < 0Q3

6. Average Variable Cost (AVC):

Average variable cost can be obtained by dividing total variable costs by the quantity
produced.
AVC = TVC
Q

It is the total variable cost per unit of output produced. From table 3.2, AVC reaches a
minimum when output is 5 and 6. This is the level of output at which average productivity
of labour is at maximum. The fixed and variable factors are optimally employed.

At level of output beyond 6, the variable factor has progressively less of the fixed factor to
work with and its average productivity declines. The results in higher AVC as output
increases. Conversely, AVC falls unit output reaches 5 because at low levels of output the
variable factor has too much of the fixed factor to work with. AVC is therefore U shape.

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 However, if a firm encounters diminishing returns as soon as it start production, it would
have an upward-sloping AVC curve.
Graphically the AVC is the slope of the line from the origin to the total variable cost (figure
3.10)

Figure 3.10 Derivation of AVC

For instance at the output 0Q1, the AVC is the slope of the line 0a.
0a = aQ1
0Q1
The minimum point of AVC corresponds to the tangency between the line from the origin (0D)
and the TVC.

Note: The steeper the line from the origin, the greater the AVC .

7. Average Total Cost (ATC).

Average total cost or simply average cost is the total cost per unit of output produced. It is
obtained by adding together AFC and AVC.

8
 ATC = TFC + TVC
Q Q
ATC = AFC + AVC. Alternatively, ATC can be obtained by dividing total costs by the level
of output.
ATC = TC
Q
Graphically, ATC is slope of the line from the origin to the total cost curves (figure 3.11). ATC
is U-shaped. The ATC or simply the average cost (AC) is u-shaped. In the short run, there are
fixed factors and variable factors. The AC has three portions.

Figure 3.11 Derivation of ATC

Falling portion of AC. Total output is increasing at an increasing rate i.e. total output and
marginal products are all increasing. The productivity of the variable factor increases as more
of the variable factor is employed. The fixed factor is still in large abundance and it is being
used extensively. Total cost is increasing due to the steadily increasing variable cost. However,
the increase in the total output is greater than the increase in the total cost. Dividing a small

9
number (TC) by a big number (output) results into a smaller number (AC) as more of the
variable factor is employed. The fall in AFC outweighs the rise in AVC so that AC falls.
The minimum point of AC. It is reached when the plant is operated optimally. There is an
optimal combination of the fixed and variable factors.
Rising portion of AC. Total output is increasing at a decreasing rate i.e. the marginal product
is decreasing and later on, it become negative when total output is decreasing. The productivity
of the variable factor decrease as more of the variable factor is employee. The law of
diminishing returns occurs. The fixed factor of production decreasing incorporation to the
variable factor. The variable factor has less and less of the fixed factor to work with as more of
the variable applied to the fixed factor. Total cost is now increasing very rapidly since more of
variable factor is being employed. The increase in TC is greater than the increase in total output.
Dividing a big number (TC) by a small number (total output) results into a bigger number (AC)
as more of the variable factor is employed. The rise in AVC offsets the fall in AFC so that AC
rises.

RELATIONSHIP BETWEEN MC AND AC (AVC):

The relationship between MC and AC also applies to MC and AVC. The MC cuts the AC and
AVC at their lowest points. The AC at each level of output is found by dividing total cost by
output. Thus the AC at output level Qn.

ACn = TCn
Qn
ACn + 1
At the AC level of Qn + 1 = Qn + 1

TCn + 1 = TCn + 1 + MC

If the MC of the (n+1)th unit is less than ACn (the AC of the previous n units), the ACn+1 will
be smaller than ACn. If the MC of the (n+1)th unit is higher than ACn (the AC of the previous
n units), the ACn+1 will be higher than the ACn. So long as the MC lies below the AC curve, it
pulls the AC downwards. When the MC rises above the AC, it pulls the AC upwards. It follows
therefore that the two curves are equal only when AC is at the minimum.

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Figure 3.12 Relationships between MC and ATC (AVC):

MC = ATC when ATC is at the minimum (see output level 7). Before the minimum ATC,
MC is less than ATC. After the minimum ATC, the increase in MC is greater than the increase
in TC i.e. MC is above ATC.

RELATIONSHIP BETWEEN AFC, AVC AND ATC.

Recall that ATC = AFC + AVC. Both ATC and AVC are U-shaped but ATC is above AVC.
The distance between AVC and ATC (which measures AFC) at each output level measures
the AFC. As AFC decreases, AVC tends to ATC and vice versa. AVC will never be equal to
ATC because AFC will never be zero (figure 3.13). AVC approaches ATC.
The minimum point of ATC occurs to the right of the minimum point of AVC. This is due to
the fact that ATC includes AFC, which falls continuously as output increases.
After the AVC has reached its lowest point at a, it starts to rise. The rise of AVC between Q1
and Q2 is offset by the fall in the AFC so that the ATC continues to fall despite the increase in
AVC. Beyond Q2, the rise in AVC offsets the fall in AFC so that ATC starts to rise.

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Figure 3.13 AFC, AVC and ATC vary as output changes

BREAK EVEN AND SHUT DOWN POINT OF THE FIRM:

Theory of costs has an important application in the decision making of the firm regarding
the level of output at which it will break even, i.e. at which its total revenue will be equal
total cost and therefore it will attain no profit, no loss position.

Break even analysis can be made by assuming linear cost-output and revenue-output
relationships and; by assuming non-linear cost and revenue functions.

LINEAR BREAK EVEN AND SHUT DOWN ANALYSIS:

(a) Under perfect competitive market structure:
The major point to address is shut down point and breakeven point of the firm (figure 3.14).
If one is considering the issue of when the firm closes a plant, then the output levels of 0Q4 and
0Q5 should not be considered. If the issue of breakeven point is being considered then, the
output level of 0Q4 should be the one to be taken into account.

The firm does not close down its plant if it is incurring a loss. This is because an entrepreneur
incurring a loss in the short run will continue to produce if and only if, he loses less by
producing than by closing the plant entirely. The firm continues to produce so long as it covers
its variable costs. The firm hopes to cover the fixed costs in the future.

12
The shutdown point of the firm is when the AR is tangent to AVC with output 0Q2. Marginal
cost is equal to the average variable cost. The firm just covers the variable cost. It will not
produce less than 0Q2 since the firm does not cover its variable cost. The firm will produce
0Q2 and 0Q3 even though the revenue does not cover the total cost. The firm is covering the
variable costs.

Output 0Q4 indicates the break-even point of the firm. The firm neither makes economic
profits nor incurs losses. If less than 0Q4 is produced, losses will be incurred. If more than 0Q4
is produced, economic profits will be earned. With output 0Q5, the firm makes economic
profits. From the figure, it is clear that the position of MC above the minimum AVC is the
supply curve of a firm under perfect competition.

Figure 3.14 Shutdown and breakeven point of the firm:

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(b) Under imperfect competitive market structures:
Break even analysis is based on revenue functions and cost function. Fig. below
represents.
When price of the product remains constant as the firm expands its production and sales,
the total revenue will be linearly related to output.
Thus, the total revenue function in figure below represents the total revenue that the firm
will earn at each level of output, assuming that the price of the product for the firm
remains constant.

TR
Y TC
Total Revenue Pofit
Revenue and Cost

Break-even point

Variable Costs

F Loss TFC
Fixed Cost

O OB X
Quantity of output and sales

Fig…. Break-even level of output and sales

sasales
Similarly, total cost function TC is a straight line starting from point F on the Y-axis and
thus represents the linear relationship between total cost and output.
Note: Average variable cost falls over a range of output in the beginning and then begins
to rise.
However, the managers of business firms who use the break-even analysis are interested
in a relevant middle ranges of output without considering the extremes of low and very
high ranges of output at which average variable cost falls or rises.
Hence linear cost function represented by the straight-line curve is generally used in
break-even analysis.

14
As it is seen from the diagram: total variable cost increases as quantity of output produced
and sold increases. But TC line is linear starting from point F, which shows that average
variable cost is constant.
It will be further seen that the slope of the total revenue curve (which indicates the price
at which additional units of the good are sold) is greater than the slope of the total cost
curve (which indicates the additional variable cost incurred per unit of output by the
firm).
This means the price which the firm receives for every unit of the good sold exceeds the
additional cost incurred per unit of output on labour, raw materials and other variable
factors.
Since the total profit-loss position depends on total revenue and total cost (i.e., variable
costs plus fixed cost). It will be seen that at output QB produced and sold, the total revenue
received equals the total cost (TR = TC) and therefore, the firm makes neither profits, nor
incurs losses. Thus, a Break-even point.
Breakeven level of output shows the minimum level of output required to be sold if the
firm will just be in no profit, no loss position. Hence the firm will undertake the
production of a commodity if it estimates that it will be able to sell the quantity of output
equal to or greater than the Break-even point.

The Break-even analysis is useful also for determining the level of output necessary to
make a certain target amount of profits.

TC + X

Y TR
TR, H
Profit

TC TC

E Total Variable
Costs

F TFC
Fixed Cost

O QB QT X

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To realize target amount of profits π or ET, the level of output necessary to be produced
and sold increases to QT.

LINEAR BREAK-EVEN ANALYSIS: ALGEBRAIC METHOD:

Although graphical analysis of Break-even point is more useful way of illustrating cost-
output, revenue-output and profit-output relationships; break-even analysis through
algebraic model is of great help in decision-making problems by a firm;
Let: P = Price per unit of commodity sold
Q = Quantity produced and sold
TFC = Total fixed cost
AVC = Average variable cost per unit of output
π = Profits
Since profit π is the difference between total revenue (TR) and total cost (TC);
i.e. π = TR – TC
But Total Revenue (TR) is equal to the price (P) per unit of the commodity times the
quantity of output sold. Therefore; TR = P.Q

On the other hand, total cost is the sum of total variable cost (TVC) and total fixed cost
(TFC). Total variable cost (TVC) is the variable cost per unit multiplied by the output
produced and sold (TVC = AVC.Q)
Therefore; TC = TVC + TFC
TC = AVC.Q + TFC
As it is known, break-even quantity of output produced and sold occurs at the level at
which total revenue (TR) equals total cost (TC).
Let QB = the break-even quantity.

Therefore, we at QB; TR = TC
i.e. P.QB = TFC + AVC.QB
P.QB – AVC.QB = TFC
QB(P – AVC) = TFC
QB = TFC
(P – AVC)

16
Hence, break-even quantity of output produced and sold is determined by total fixed cost
(TFC), price of output (P) and variable cost per unit of output (AVC).
Change in any of these variables will cause a change in the break-even quantity. The
denominator (P – AVC) is the profit contribution per unit and the numerator TFC is the
total fixed cost.

LINEAR BREAK-EVEN ANALYSIS AND TARGET AMOUNT OF PROFITS:

Break-even analysis can be used to determine the quantity of output required to be
produced and sold to achieve a target amount of profits.
Let π = profit target
Then this target profit π can be added to total fixed cost in the expression below;

Therefore QT = TFC + π
P – AVC
The expression above shows that to achieve a profit objective, the difference between P
and AVC must be large enough to recover the total fixed cost (TFC) and target amount of
profit (π).

Example:
A book publishing company incurred total fixed cost of Kshs: 50,000 on typesetting,
providing illustrations, proof reading etc. variable cost incurred per copy on printing
paper, binding, author’s royalty per copy, book seller’s commission is equal to Kshs 15
per copy. Suppose a price of Kshs 40 per copy of the book is fixed. What is the break-even
number of copies of the book printed and sold?
i.e. in this example: TFC = Kshs: 50,000
AVC = Kshs: 15
P = Kshs: 40
Break-even quantity: QB = TFC
(P – AVC)

QB = 50,000 = 2,000 copies

40 - 15
Thus, if the company produce and be able to sell 2000 copies, it will achieve no profit, no
loss situation.
ii) Suppose the publishing company has a profit objective of making Kshs: 10,000 from
the book, then required quantity of sales can be calculated to realize the target amount of
profits of Kshs. 10,000 by using the formula below:-
QT = TFC + π
P – AVC
QT = 50,000 + 10,000 = 2,400 copies.
40 – 15

17
Thus, if the company is able to sell 2,400 copies of the book, it will recover the fixed and
variable costs and also make profits of Kshs. 10,000/=. The profit will be greater if it
sales more than 2,400 copies.

NON-LINEAR BREAK-EVEN ANALYSIS: - SELF READING

In a linear break-even point, we assume that both cost-output and revenue-output
relationships are linear.
However in the market forms of monopoly and imperfect competition such as monopolistic
competition and oligopoly revenue output relationship is non-linear. In these market forms,
total revenue curve increases at a diminishing rate.
On the other hand, short run total cost curve generally first rises at a diminishing rate and
then it starts rising at an increasing rate. Break-even point of a firm with non-linear cost-
output and revenue-output relationships is illustrated in a diagram below:

Break-even point
TC
K
TR
Break-even point
B
TR and TC

QB Output Qm Qu
Y
Profits

O X
QB Qm Qu
Output

Fig. Break-even chart showing Break-even point and profit maximizing

output in case of non-linear revenue and cost functions:

18
Total revenue curve is increasing at a diminishing rate. This is because for a firm working
under monopoly or imperfect competition, price of its product falls as it sells more and
marginal revenue is less than price.
Total cost curve starts from a point F which lies above the origin; OF being the fixed cost
which the firm has to incur even if it stops production in the short-run. It is seen that total
short-run cost curve TC initially increases at a decreasing rate and then after a point it
increases at an increasing rate.
From the diagram; up to the level of output OQB, TC curve lies above TR curve showing
that as the firm raises its output in the initial stages total cost (TC) is greater than total
revenue (TR) and the firm is incurring losses.

When it products OQB level of output; total revenue just equals total cost and the firm is
therefore neither making profits nor losses. That is, the firm is only breaking even at
output level OQB. Thus, the point B or output level OQB is called Break-even point.

When the firm increases its output beyond OQB, total revenue becomes larger than total
cost and profits begin to accrue to the firm. It will be noted from the figure that profits
are increasing as the firm increases production to output OQm, since the distance
between the total revenue curve (TR) and total cost curve (TC) is widening.

At OQm level of output, the distance between the TR curve and TC curve is the largest and
therefore profits will be maximum. If the firm expands output beyond Qm, the gap
between TR and TC curves goes on narrow in down and therefore the total profits will
be declining.

It is therefore clear that at Qm level of output where total revenue exceeds total cost by
the largest amount firm’s profits are maximum. At output Qu, TR is again equal to TC (TR
curves cuts TC curves at point K corresponding to output Qu). Thus, point K again a
break-even point, usually called upper break-even point. It is not of much relevance
as it lies beyond firm’s profit maximizing level and may actually lies beyond firm’s
capacity to produce.

19
It is the first break-even point B or output level OQB which is highly significant as a firm
will not plan to produce if it cannot sell output equal to at least OQB at which total revenue
just covers total cost of production so that its economic profits are zero.
It is seen vividly in the profit curve which measures the distance between TR and TC
curves. That up to output level OQB profit curve lies below the X-axis showing that the
firm is making losses if it produces less than OQB. At output level QB, the firm’s net profits
are zero because at this output level total revenue just covers total cost of production.

Therefore, OQB is break-even level of output. As the firm expands its level of output
beyond OQB profit curve is rising until it reaches at its maximum profit point H
corresponding to the level of output OQm. Beyond level of output OQm, profit curve slopes
downward indicating that profit declines beyond output Qm.
Thus, at output level OQm, the firm maximizes its profits. At a higher output level OQu net
profits are again zero indicating the upper break-even point which is not relevant.

LIMITATIONS OF LINEAR BREAK-EVEN ANALYSIS:

While linear break-even analysis (cost-volume profit analysis) is very useful and is often
used by business firms to know their no-profit, no loss level of output and also to know
the amount of losses or profits they would earn at different levels of output or sales. It
can be applied only in cases where the assumptions:
• of constant selling prices and constant average variable cost holds
• That a firm produces a single product or a constant mix of products.
• It may be difficult to apportion the fixed costs among various products.
This does not represent the real-world where firms often produce multiple products or
when over time the product mix changes; however, despite these limitations break even
analysis is very useful in managerial decision making.

Other factors a firm should consider before it simply closes its operations:
In theory, the firm will stop operating if it does not cover the variable costs. Practically,
however, the question of whether or not to stop operating will depend on other factors. It is
difficult for a firm simply to close its operations without considering other factors. For instance:

20
 1. Prospects of securing a loan from financial institutions. If this is possible, the firm
will continue operating.
2. The financial reserves of the firm. If they are adequate, the firm will continue
operating.
3. Nature of the problem. If the difficulties faced by the firm are of short term, the firm
will continue operating.
4. Number of products. If a firm has been producing a number of commodities that have
led to increased costs, it may now reduce on the number.
5. The adoption of new and better technique of production: The firm may adopt a new
and better technique of production that can reduce the costs of production.
6. The firm may abandon a particular line of production that has caused losses and
adopt a new one.
7. Number of workers. The firm may reduce the number of workers so as to reduce costs
of production.
8. Pricing policy. The firm may change the pricing policy so that it can continue its
operation. If the price has been too high, it can be reduced or if it has been too low, it
can be increased.
9. Administration. Review or change the administration in order to continue operating.
10. Revision of the marketing, distribution advertising and promotional strategies:
Review the strategy of marketing, distribution, advertising and other promotional
activities so that the firm can continue operating.

THE LONG-RUN AVERAGE COST CURVE (ENVELOPE CURVE):

The long run average cost curve (LRAC) corresponds to the minimum possible cost for
producing a particular level of output on the assumption that all factors are variable.
In the long run, the firm can build any type of plant that it wants; the LRAC indicates the
minimum average cost of production for each level of output, given that the plant of the
appropriate capacity has been constructed.
It is a locus of points denoting the least cost of producing the corresponding output.

When deriving the LRAC, it is assumed that a firm can set upon infinite number of plants of
different capacities. However, in some industries only a few plants can be set up and in such a
case, LRAC cannot be continuously smooth. LRAC is derived from short run cost curves.

21
Each point on the LRAC corresponds to a point on a short run cost curve, which is tangent to
the LRAC at the point.
Initially, we can assume that the firm has three methods of production, each with a different
plant size: a small plant which operates with costs denoted by the curve SAC1; a medium plant
operating with costs SAC2 and a large plant which operates with costs SAC3 (Figure 3.15).
Each plant is suitable for a particular range of output.

Figure 3.15 Derivation of long run average cost curve:

To product output 0Q1, the firm should use a small plant since the costs of production 0C1 are
low compared to a medium size plant and large plant. For output 0Q2, the firm should use a
small plant. However if future demand is expected to increase, then the firm should use medium
plant.
Note: The decision of a firm to set up a new plant depends not only the costs but most
important on the expected future demand.

If it plans to produce output 0Q3, the firm should use the medium plant. For output 0Q6, it
should use a large plant. The lower portion of the curves indicates the LRAC.
If now we assume that the firm uses more than three plants, and there are a large number of
plants, a continuous LRAC curve can obtained (figure 3.16).

22
Figure 3.16 Derivation of LRAC in case of various plants

The LRAC envelops all the short run average cost curves. This is why at times it is referred to
as the envelope curve.
When the LRAC curve is declining, it is tangent to the short run cost curves to the left of their
minimum points. This is when the firm is experiencing economies of scale. When LRAC is
rising, it is tangent to the short run cost curves to the right of their minimum points. The firm
experiences diseconomies of scales. The LRAC curve is tangent to the minimum point of the
short run cost curve when it is at the minimum. In this case, the firm is using an optimum plant
incurring the lowest possible cost (SAC4 produces output 0Q0 at a cost of 0C0).

The position of LRAC depends on the external economies of scale. External economies of
scale reduce costs per unit of output and shift the LRAC downwards (Figure 3.17) while
external diseconomies increase average costs and shift the LRAC upwards.

Figure 3.17 Effect of External Economies and Diseconomies on the position of

LRAC

23
LRAC2 illustrates the external diseconomies of scale. The cost per unit increases to 0C2.
LRAC, shows external economies of scale indicating a lower cost of 0C1 for output 0Q1.

ECONOMIES OF SCALE:
Economies of scale are the advantages of large-scale production. They accrue to the firm
because it is producing in a large quantity. Output increases at a decreasing cost per unit of
output. A downward sloping portion of the long run average cost curve indicates economies of
scale (figure 3.18).

Figure 3.18 Economies and Diseconomies of scale.

Economies of scale can be distinguished into real economies and pecuniary or financial
economies of scale.
• Pecuniary economies of scale are the advantages of large scale production due to
paying lower prices for the factors used in the production and distribution of the
product.
• Real economies of scale are those associated with a reduction in the physical quantity
of inputs, raw materials, various types of labour and capital.
Less factor inputs are used to produce the same unit of output while for the pecuniary
economies lower costs are incurred for the same of output.

24
Economies of scale can be internal or external.

INTERNAL ECONOMIES OF SCALE:

These are advantages of large-scale production enjoyed by a single firm due to indivisibility
and specialisation. They are due to the organisation of the firm, they include:-

i) Technical economies: These are the economies, which accrue to firm from the use of better
machines, and techniques of production.
The main technical economies arise from specialization and indivisibility of capital.
Specialization of capital equipment becomes possible only at larger scales of production. A
larger plant becomes economic only when output is large e.g. tractors cannot be economic on
a small piece of land. The high cost of such machines can be spread over a larger output.

ii) Managerial economies. Large scale production permits management to be split into
separate departments. Managerial economies could be on the production side and on the selling
side since the managerial team is concerned with production and distribution activities.
Managerial economies may arise because of specialisation management.
A large firm can afford to employ various specialist managers who can supervise and manage
various departments e.g. manager for production, assembling, packaging, sales, administration,
etc.
The division of managerial work increases the experience of managers in their areas of
responsibility and hence greater output.
Managerial economies may also arise from mechanisation of managerial functions. Large firms
may use techniques of management, which involve a high degree of mechanisation. These
techniques are time saving. For instance, computerised accounting may be a cost saving method
for a large firm while it is very costly for a small firm.

iii) Marketing economies. A large firm enjoys the economies of buying and selling. A large
firm buys its inputs in large quantity, and therefore it is able to secure them at low prices.
However, the marketing economies are basically related to the distribution of the product. They
are mainly of two types.
• Advertising economies. Advertising costs increase less than proportionately as output
increases. A large firm can afford to distribute samples at a low cost.

25
 • Model change economies. In some cases, firms change the design of their product as
a method of competing with other firms. A change in the design of the product involves
consideration expenses in research. These costs tend to be low as output increases.

vi) Financial economies. A large firm can obtain finances more easily than a small one. It can
raise finances from the banks and other sources because it possesses large assets and good
reputation. A large firm can offer better security than a small one.

vii) Transport and storage economies. Transport and storage costs are incurred partly on the
production side and on the selling side. Transport and storage costs will decline as output
increases. A large firm can obtain transport concessions while a small firm cannot.

viii) Research economies. A small firm cannot afford to do research while a large firm
possesses large resources and can establish its own research department.
It can also hire trained research assistants. From research, new and better methods of
production can be obtained, thereby lowering the cost per unit of output.
ix) Welfare economies. Firms have to provide facilities to their workers. A large firm can
easily provide better working conditions than a small one. It can for instance provide medical
and housing activities at a low cost unlike a small firm.
x) Risk-bearing economies. Generally speaking, a large firm is in a better position than a small
firm in spreading its risks. It can lower its risks of operating.
A large firm can produce a variety of products and sell them in different markets. By producing
a variety of products, a large firm is able to reduce risks by counter-balancing the loss of one
product by the gain from other products. By selling in different markets, a large firm can
counter-balance the fall in demand in one market by the increased demand in other materials
from alternative sources.

EXTERNAL ECONOMIES OF SCALE:

These are the advantages of large-scale production, which are enjoyed by the entire industry.
External economies benefit all firms within the industry as the size of the industry expands.
Such economies are enjoyed if the industry is localised in a particular area. For example,
i) Large scale purchase of raw materials;
ii) Large scale acquisition of external finance at lower rate of interest, particularly from
the commercial banks;
26
iii) Lower advertising rate charged by the advertisement media for large scale advertising;
iv) Concessional rates charged by the transport companies on bulk transport of goods;
v) Lower wage rates if a large scale firm uses its monopsony power in certain kinds of
specialised labour market.
vi) Research, welfare, energy, etc.
Note: External economies reduce costs of production.

DISECONOMIES OF SCALE:
Diseconomies of scale are the disadvantages of large-scale production. The up-sloping portion
of the AC curve illustrates the diseconomies of scale (Figure 3.18). As output increases, the
cost per unit of output increases. Diseconomies of scale can both be internal and external and
of different types.

Internal diseconomies of scale:

(i) Managerial diseconomies. It becomes very difficult for the management to supervise and
control the labour as the firm grows both vertical and horizontally.
ii) Technical diseconomies. Machines wear away and some resources must be put aside for
capital maintenance. Output increases at increasing per unit of output.
(iii) Financial diseconomies. An entrepreneur needs finances to expand firm, but finance may
not be easily available in the required amount the appropriate time or at higher rates of interest.
Lack of finances prevents the firm from expanding.
(iv) Marketing diseconomies. The expansion of a firm beyond a certain point may involve
marketing problems. The demand for the products of the firm may fall as a results of the
changes in tastes and the firm may not be in a position to change accordingly in the short run.
The firm may fail to foresee changes in the market and this results into wastage of resources.
A lot of output remains unsold.
(v) Transport and storage diseconomies
EXTERNAL DISECONOMIES OF SCALE:
As the entire industry expands; the demands for various factors of production like labour,
capital, increases leading to an increase in their prices. Consequently, the cost per unit of output
increases. For example:-
• The roads may become congested;
• There may be lack of power, raw materials, labour and equipment as output increases.

27
 • Air and water pollution is another form of external diseconomies. The costs per unit of
output may increase for the firm that has to purify water before it is used. If air pollution
affects the health conditions of the workers, the firm may incur extra costs when paying
for extra medical facilities.

THEORY OF THE FIRM.

A firm is an entity that purchases various productive factors and transforms them into products
which may be sold. It hires the services of factors of production to produce goods and services.
The firm is the principal agent in any economic system and it is an intermediary between
consumers and resource owners.
A modern firm is characterized by separation of ownership from management. The
shareholder is not the manager. The separation may be due to a number of reasons.

1. The business enterprise may be so large that it cannot be managed by the

shareholders.
2. Illiteracy of shareholder – uneducated. These are shareholders who may have capital
resources but are unable to manage the firm.
3. Lack of skill to manage the business unit. One could be educated but may lack the
skill to manage a particular organisation. For instance, a doctor may own a school but
may not be able to run it.
4. Lack of time, time constraint. One cannot manage to look for raw materials, look for
market, look for capital, etc. Hence, one needs to employ more people.

FACTORS DETERMINING THE SIZE OF THE FIRM:

The size of the firm is determined by the following:
Capital and raw materials; finance; labour; technology; market; Government influence; the
location of the firm – the external economies of scale e.g. transport facilities; the possibility of
merging; management; research; terms of service.

THE GROWTH DECISION OF THE FIRM:

A firm may pursue growth either in a national market or in a foreign market (country) thereby
acquiring the status of a multinational corporation.
In both cases, the expansion or growth can be attained by:
I. Internal expansion-setting up a new plant / adding a new capacity to its existing plant.
II. External expansion-merging with other existing firms or taking over other firms.
I) Expansion in the national market:
INTERNAL EXPANSION can take three forms:
• Horizontal expansion (Differentiation): Increasing the share of the market – by
increasing the quantity of existing products or by differentiation of the produced

28
 commodities. Product differentiation can be attained by changing the technical
characteristics of the product; its style – design and the services associated with it.

• Vertical integration. This involves the undertaking of production of a different product

at a previous stage of the same productive process. This is referred to as upstream or
backward integration. Vertical integration also involves the undertaking of
production of a different product at the subsequent stage of the same productive
process. This is referred to as downstream or forward integration. For example, a
sugar refinery may become fully vertically integrated with sugar plantations (backward
integration) and distribution channels where the final product can be bought (forward
integration). Note; vertical integration involves different products, these products are
technologically related since they belong to the same productive process.

• Diversification. This involves the introduction of a new product totally different from
the one already produced. Diversification refers to growth via the production of
commodities which are completely unrelated, technically or otherwise.
Diversification is also called Conglomerate expansion. The firm enters a different
market, where the product is completely unrelated with its current productive activity.
For example, a firm in the clothing industry diversifies by undertaking the production
of cosmetics. A firm in the automobile industry diversifies by entering the market of
electrical products e.g. (cooker, refrigerators and TV sets).

EXTERNAL EXPANSION:
This is an expansion by merger or takeover of another existing firm. It can take three forms.
• Horizontal integration. This involves the takeover or merger of two or more firms that
produce the same commodity. The firms are normally at the same stage of the same
productive process. For example, Firm A producing sugar cane takeover or merge with
another Firm B producing sugar.
• Vertical integration. It involves the takeover or merger of two or more firms that
produce different products within the same productive process. For example, Firm a
producing sugar may takeover or merge with Firm B producing biscuits.
• Conglomerate merger. This involves the takeover or merger of two or more firms
which produce completely unrelated products. It is diversification by merging or taking
over other already established firms that produce completely different products or are
involved in other different activities.

II) Expansion in a foreign market:

Multinationals may be established in a foreign market to:
• Produce the same product as the parent firm in the national market.

29
 • Provide upstream or downstream vertical integration to the operations of the parent firm
in a national market.
• Produce a new product-conglomerate diversification.

Expansion in a foreign market can be internal or external. The internal expansion in the foreign
market can take three forms: Horizontal expansion; Vertical integration and Conglomerate
expansion. The external expansion in the foreign market can take three forms: Horizontal
merger; Vertical merger and Conglomerate merger (Figure 3.19).

Figure 3.19 Growth of a firm.

FIRMS OF DIFFERENT SIZES IN THE SAME INDUSTRY;

It is possible to have firms of different sizes in the same industry. For instance within the oil
industry, there are firms of different sizes. Shell, Oryx, Kobil, Caltex, Agip, Gapco and Total
are not of the same size.
This can be explained by the following reasons/factors:-
i) Management – specialization of management. If the management is specialized, the
firm tends to be big and vice versa.
ii) Market. A firm with a small market tends to be small and vice versa.
iii) Finances. Some firms may have various sources of finances and others may not and
hence different sizes.
iv) Raw materials, source of raw materials. Some firms may have a ready source of raw
materials and others may not have.

30
 v) Capital – equipment i.e. Technical. Firms have different equipment and therefore tend
to be of different sizes.
vi) Location of the firm. The firm may be located where it enjoys external economies of
scale like; Transport and power facilities, while others may not be in such places.
vii) Terms of service – wages, medical facilities, transport facilities, etc. if the terms of
service are favourable, workers tend to put in more effort and therefore the firm may
be bigger compared to another firm where the terms are unfavourable.
vii) Economies and diseconomies of scale. Firms may be of different sizes because some
may be enjoying economies of scale while others may be experiencing diseconomies
of scale.

BENEFITS OF LARGE SCALE PRODUCTION:

There are a number of benefits obtained by a firm when it produces in large quantities.
Costs per unit of output can be reduced when large quantities are produced. This is because of
the following:
Fixed costs are spread over a large quantity; specialisation is possible, division of labour is
possible. Highly specialized machines can be utilized; highly qualified managers can be
employed.
Consequently, output increases further; various sources for finance; marketing; the commodity
can be sold in bulk; raw materials can be bought in bulk, resulting into discounts and lower
prices; technical advantages; risks can be spread; and, research can easily be carried out. From
research, new techniques of production can be found which lead to a greater output.

THE PREDOMINANCE OF SMALL FIRMS:

Despite the economies of large scale enjoyed by big firms, small firms are still in existence.
This is due to a number of reasons.
• Lack of capital. There may be a difficulty in raising capital for further expansion.
• The demand for the commodity may be small. This is possible when the commodity or
service offered is of limited appeal.
• Little capital may be needed in a firm as for instance repairing watches, hair dressing.
In each case, production has to be on a small scale.
• Desire to be self employed

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 • The owner may be contented with a small scale firm r may not have the ability to look
after a large firm.
• A firm may be concentrating on the production of a small component and therefore a
need for a small firm.
• Little resource wastage. Within a small firm, there is hardly any resource wastage.
• Personal contact is possible-contact between the employer and the employees. This
reduces the chances of striking and hence continuous production.
• Management of the firm is quite easy. It is easy to manage a small firm and this enables
the firm to survive for a long time.
• Production can be varied to meet various changes in tastes of consumers.
• Simple techniques are required. The use of simple techniques enables the firm to
produce for a long-time.

Arguments against small firms:

• Small firms incur high costs per unit of output and do not enjoy various economies of
scale (Figure 3.20). A small firm produces 0Q1 and incurs a high cost of 0C1 unlike a
large firm, which produces 0Q2 at a lower cost of 0C2.

Figure 3.20 AC in case of small and large firms.

OBJECTIVES OF A FIRM:
Firms have a number of objectives, which can be grouped into two categories:
a) Profit objectives and;
b) Non-profit objectives.

32
Profit-maximisation. In theory, the major objective of the firm is to maximize profits. The
firm’s decision is made in such a way that the profits are maximized.
Total profit (p) is defined as the excess of Total Revenue (TR) over Total Cost (TC), i.e.
p = TR – TC
Profit is maximum where TR – TC is maximum. A profit maximizing firm seeks to maximize
TR – TC. In order to achieve this goal, the firm chooses a price and an output which maximize
TR – TC. If the price for its product and its cost function are given, then the firm produces a
quantity that yields maximum profit.

This can be illustrated through the revenue and cost functions of firm, as follows.
Suppose that TC and TR functions of a firm are, respectively, given as
TC = 100 + 60Q-12Q2 + Q3 and TR = 60 Q (where Q is quantity produced and sold).
The cost and revenue data for output from 0 to 12 obtained from the above cost and revenue
functions, respectively, are given in Table 3.3.

Table 3.3 Cost and Revenue Functions

TC =
MC* = 60 – MR =
Q 100 + 60Q – 12Q2 + TR = 60 Q p = TR - TC
24Q + 3Q2 DTR/DQ
Q3
0 100 0 -100 100 -
1 149 60 -89 39 60
2 180 120 -60 24 60
3 199 180 -19 15 60
4 212 240 28 12 60
5 225 300 75 15 60
6 244 360 116 24 60
7 275 420 145 39 60
8 324 480 156 60 60
9 397 540 143 87 60
10 500 600 100 120 60
11 639 660 21 159 60
12 820 720 -100 204 60

*Except for zero output

The firm’s cost and revenue functions have been graphed in Figure 3.21.
Since price is assumed to be constant (at Tshs.60), TR curve is a straight line with a slope
equal to DTR/DQ = 60.

33
It shows that TR increases at a constant rate of Tshs.60 with each unit produced and sold.
The cost function which is of cubic form, gives a TC curve that shows increase in total cost
at varying rates – it increases first at increasing rates and then at decreasing rates.

Figure 3.21 Maximum profit:

As figure 3.21 shows, up to Q1 units of outputs and beyond Q2, TC curve lies above the TR
curve. The firm is therefore, incurring losses to the extent of TC – TR. It means that the firms’
profitable range of output lies between Q1 and Q2 units. But the total profit varies from output
to output.
Note: The distance between TR and TC first increases, reaches a maximum, and then
decreases. It implies that profit first increases with the increase in output, but beyond a
certain level of output it begins to decrease.

The maximum profit lies in between Q1 and Q2 with output Qp. Given the TR and TC curves,
there are two ways to find the maximum profit:

Equilibrium of the firm: Distance between TR and TC approach:

One way is to measure the distance between TR and TC over the range where TR > TC. Profit
is maximum where distance is maximum, at output Qp;
However by vision it is not easy to locate where exactly is the largest distance between TR and
TC curve. In order to do so tangents at various points on the TR and TC curves have to be
drawn; where the tangents at the corresponding points on the TR and TC curves are parallel to
each other, the distance between TR and TC curves will be the largest and hence profit at the
maximum. Or
One draws directly the total profit curve showing the difference between total revenue and total
cost at various level of output. Fig. 3.22 below refers; the level of output at which this profit
curve stands highest from the x – axis will be the profit maximizing level of output.
A tangent drawn on the profit curve at this point have to be parallel to the x - axis indicating
the greatest distance between the profit curve and the x – axis at a profit maximizing output.
Hence maximum profit and equilibrium position of the firm.

34
 Figure 3.22 Profit maximization by a firm.

This method seems to be reasonable and often employed by businessmen; however it has some
limitations;
• That it is difficult to find out the longest distance between total revenue and total cost
at glance, many tangents have to be drawn before one finds the corresponding tangents
to two curves to be parallel to each other indicating the level of output which yields
maximum money profit.
• That, price per unit of output cannot be known at first sight from the diagram since
price is not directly shown in the diagram. In order to know the price we have to divide
the total revenue at the profit maximizing point by the total output.
Thus with these limitations complicated problems of equilibrium analysis of the firm cannot
be easily discussed with this method.
Hence, in modern economic theory marginal analysis involving marginal cost and marginal
revenue curves are therefore employed.

Equilibrium of the firm: Marginal Revenue and Marginal Cost Approach:

The firm will not produce an additional unit of the product which adds more to cost than to
revenue because to produce that unit will mean losses. The firm will be making maximum
profit by expanding output to the level where marginal revenue is equal to marginal cost.
If it goes beyond the point of equality between marginal revenue and marginal cost, it will be
incurring losses on the extra units of output and therefore will be reducing its profits.

35
Thus, the firm will be in equilibrium position when it is producing the amount of output at
which marginal revenue equals marginal cost.
Therefore the condition for the equilibrium of the firm is that marginal revenue should be equal
to marginal cost;
i.e. MC = MR, or MR – MC = 0 (being the first order condition);
That is, dTR/dQ = dTC/dQ
The second-order condition requires that, the necessary condition must be satisfied that the
slope of MC exceeds that of MR.
That is d2TR/dQ2 < d2TC/dQ2;
Slope of MR < Slope of MC. It implies that MC must have a steeper slope than MR
or MC curve must intersect the MR curve from below.
The second order condition requires that its second derivative of the profit function is
negative;
¶II ¶ 2TR ¶ 2TC
= -
¶Q ¶Q 2 ¶Q 2

¶ 2TR ¶ 2TC ¶ 2TR ¶ 2TC

Þ - <0 OR <
¶Q 2 ¶Q 2 ¶Q 2 ¶Q 2

¶ 2TR
Since gives the slope of MR and;
¶Q 2

¶ 2TC
Gives the slope of MC;
¶Q 2
The second order condition can also be written as,
Slope of MR < Slope of MC.
Þ MC must have a steeper slope than MR; or MC must intersect the MR from below.
Thus, profit is maximized where both the 1st and 2nd order conditions are satisfied.

For example: Suppose the demand function is given as Q = 50 - 0.5P and the total cost

function is given as TC = 10 + 0.5Q 2 . What is the profit maximizing output?

Solution:
Given the demand function, price function can be derived as follows;
P = 100 - 2Q

36
 Then; TR = (100 - 2Q)Q

TR = 100Q - 2Q 2
¶TR ¶TC
We have noted that profit is at maximum where MR = MC or =
¶Q ¶Q
Given the total revenue function TR = 100Q - 2Q 2 and

Total cost function TC = 10 + 0.5Q 2

¶TR ¶TC
MR = = 100 - 4Q and MC = =Q
¶Q ¶Q
Since Profit is maximum when MR = MC ;
\100 - 4Q = Q
5Q 100
=
5 5
Q = 20 Units.
Note: The output 20 units also satisfies the second order condition; which requires
¶ 2TR ¶ 2TC
that; - <0
¶Q 2 ¶Q 2
¶MR ¶MC
i.e. - <0
¶Q ¶Q
¶(100 - 4Q) ¶(Q)
= - <0
¶Q ¶Q
=-4–1<0
Therefore, profit is at maximum when Q = 20 units.
However, the goal of profit maximisation has been criticized mainly on two grounds. Several
economists have argued that firms cannot attain the goal of profit maximisation because;
• They do not have the necessary knowledge, information or ability to determine the
level of profits. Firms do not know with certainty, their demand and cost curves, and
hence they cannot apply the marginalistic principle MC = MR.
• Secondly, profit maximisation is not the only goal of the firm. Even if firms could
pursue profit-maximisation, they may not wish to do so. Because a modern firm has a
number of objectives. It is made up of different people making different decisions.

EQUILIBRIUM OF THE FIRM IN THE LONG RUN.

37
One of the conditions of a firm operating under perfect competition is the easy entry into
and exit out of the industry. This is because potential firms cannot acquire the necessary
fixed inputs in the short run, and existing firm cannot get rid of their fixed inputs in the
short run. Existing firms have the options of adjusting the quantities of their fixed inputs
in the long run. In the long run we expect three things to happen:-
1. Existing firms to make adjustments to their outputs and costs.
2. A firm to leave the industry if after adjustments it is still unable to cover total costs.
3. New firms to enter into the industry if after adjustments a firm is still earning
super normal profits.
In the long run, firms are in equilibrium when they have adjusted their plant so as to
produce at the minimum point of the long-run average cost curve. Firms earn normal
profits in the long-run. These are the profits that make the firm to stay in the industry
without attracting in other firms. They are included in the long-run average costs curve.

Note: Normal profits are a payment to the entrepreneur. They are therefore normally
included in costs as a component of total costs.

Normal profits are earned when average revenue (AR) is tangent to the average cost.
If, in the short run, firms are earning economic profits or super-normal profits, new firms
enter into the industry. The total supply of the commodity will increase causing the price
to fall. There will be a downward shift in the demand curve of the individual firm. The
total supply of industry will increase (supply curve for the industry shifts to the right) but
the supply of one firm will decrease since the total demand has not increased. Firms will
continue entering into the industry until normal profits are earned. The adjustment is
illustrated in figure below:

Note: In the long-run, equilibrium output (where MC = MR) is equal to the optimum
output (where MC = AC). In either case, the output is Oq2.

Fig… Long-run adjustment when firms are making economic profits under perfect
competition:

38
When firms incur losses (sub normal profits) some firms leave the industry until those
remaining behind earn normal profits. The industry supply is reduced causing the price
to increase (supply curve of the industry shifts to the left). The individuals firm’s demand
curve shifts upwards. The individual firm now supplies more as illustrated by figure 4.6.

In the long run, as losses are being sustained in an industry, industry supply reduces –
shifting the supply curve to the left. As this happens, price rises. The gradual price rise
reduces losses for firms remaining in the industry until those losses are ultimately
eliminated.

Fig… Long-run adjustment when firms are incurring losses under perfect competition.

To summarize, we can say that the long run equilibrium position of the firm is reached
when P = AR = SAC = LAC = SMC = LMC (Figure … below)

Fig. Competitive firm in the long-run equilibrium.

39
In the long run, a competitive industry undergoes two sorts of adjustment. Existing firms are
adjusting their outputs so that the LAC = P to maximize profits and at the same time also adjust
their plant sizes so that SAC = LAC, to minimize the cost of their output. At the same time,
new firms may be entering or unprofitable firm may be leaving. All these adjustments cause
changes in price which trigger further adjustments. The industry will settle when all incentives
for entry or exit are eliminated.
This means that price must equal minimum LAC for a typical firm. The typical firm must also
be an equilibrium so that it has no incentive to adjust either output or plant size. This requires
that P = LMC and SAC = LAC and hence P = AR = SAC = LAC = SMC = LMC.

THE USEFULNESS OF “PROFIT “IN THE ECONOMIC ANALYSIS: - SELF

READING
1. Economic profits indicate to entrepreneurs, which industries should expand (profit
making) and which should contract (loss making). Resources are diverted away from
such industries.
2. Economic profits encourage entrepreneurs to increase production/supply of a good.
However, when losses are being incurred, firms go out of production.
3. Economic profits provide resources for expansion. Profits can be reinvested.
4. Profits ensure that the most efficient firms carry on production. A firm under perfect
competition is very efficient if it makes the largest profits. Less efficient firms incur
losses and are forced to become efficient.
5. Normal profits make the firm to stay in production otherwise it would be impossible.
Non-profit objectives. Although profit maximisation objective continues to remain the most
popular objective in economic analysis, Baumol W. J. argues that there is no reason to believe
that all businesses pursue the same objectives.
The separation of ownership from management gives a chance to deviate from profit
maximisation.
Some major non-profit objectives of firms suggested can be grouped into five:
• Maximization of the managerial utility function-salaries, prestige, market share, job
security etc.

40
 • Satisfying behavior – standard profit.
• Long-run survival and market share goal.
• Entry prevention and risk avoidance.
• Good image. To serve as a useful part to the community, e.g. soap industry.

Note: Big firms achieve most of the above objectives while small firms are only interested in
profit maximization.

FACTORS DETERMINING THE LOCATION OF A FIRM.

The basic principle behind the location of a firm is cost minimization. However, there are two
major categories of factors behind the location of a firm; economic factors and non-economic
factors.

(a) ECONOMIC FACTORS: These are the factors that have a bearing on the costs of
production. Some of these factors are more important than others in influencing the location of
a firm. Some the factors are:
• Raw materials. Three cases can be considered as regards the location of a firm near
raw materials.
• Heavy raw materials. When the raw materials are very heavy, it is advisable to locate
the firm near the source of raw materials, otherwise it would be very costly to transport
the raw materials.
• Perishable raw materials. When the raw materials are perishable, the firm should be
located near the source of raw materials. Examples are, fish processing, dairy products,
sugar refinery, tea processing.
• Widely spread raw materials. When the raw materials are widely spread, the industry
is also widely spread. This is especially true with the processing of agricultural products
– cotton ginning, maize milling, coffee curing, etc.
• Market. A firm can be located in a certain place due to the influence of the market.
This normally happens when the finished product is costly or difficult to transport. This
may be due to the reason that the finished product is bulky, breakable or perishable.
• Power. Power has a strong influence on the location of a firm. For instance, a few heavy
industrial firms in Uganda are located in Jinja because of the cheap supply of power.

41
 • Transport. To reduce the cost of production, the firm should be located where there
are quick means of transport. Most industrial firms are located in urban areas where
transport facilities are quite well developed.
• Water. Some firms require water as one of their inputs. In such cases, the firm should
be located where there is adequate supply of water.
• Land. It should be noted, however, that land is important since it provides a site where
production takes place.
• Labour. A firm can be located where there is an adequate labour supply. This is
particularly true if the firm requires special labour skills. However, this factor in
deciding where the firm is to be located is less important. This is because labour is
generally mobile geographically.
• Location near a firm that provides an input. The increase in the output of one firm,
may in one way or another, improve the efficiency of another firm. The output of firm
A may be an input of firm B. to reduce the costs of production, firm B should be located
near firm A, e.g. a sweet industry should be located near the sugar industry.

(b) NON-ECONOMIC FACTORS: These have no bearing on the costs of production. The
industrial firm can be located in a given area even though the costs of production are high.
• Government influence. In most cases, it is the government that locates such industrial
firms. The private individual is after profit maximization, while the government is after
the development of the country and raising the standard of living. The government may
influence the location of the industrial firm for the following reasons:
• Development – regional development
• Creation of employment.
• Reduce rural-urban migration
• Reduce income inequality
• To decentralize industries
• To achieve balanced regional development
• Home of government leaders. In some countries, government leaders may direct
locations of certain industrial firms in their home areas where in most cases, the costs
of production are very high.
• Climate. This is another factor worth mentioning. Climate is a non-economic factor. A
firm may be located in a given area because of suitable climate.

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LOCALIZATION OF INDUSTRIES:
Localization is the concentration of a certain industry in a particular area or region. It is related
to specialization by areas or regions. Localization of an industry is due to a number of factors
some of which are: proximity to raw materials, availability of services like power and water
supply, market, labour supply, communication facilities, climatic conditions and political
patronage. De-localisation of industries means spreading of a particular type of industry. The
industry is spread throughout the region as for instance, the sugar and coffee industries in
Uganda.

ARGUMENTS FOR LOCALISATION OF INDUSTRIES:

There are a number of arguments put forward in favour of localisation.
(a) Development of new industries. Subsidiary industries develop due to localisation of
industries. Industries supply inputs to the localized industry develop and at the same
time, industries that use the by-products of the localized industry are set up. For
instance, if the sugar industry is localized, the sugar cane industry develops to supply
sugar cane to the sugar industry. The sweet and biscuit industries develop to use the by-
products of the localised sugar industry.
(b) Employment opportunities. Employment opportunities considerably increase in the
localised place. Employment opportunities are generated from the localised industry,
subsidiary industries which supply inputs to the localised industry, subsidiary industries
which use the by-products of the localised industry, various institutions in the localised
area as for instance, schools, hospitals, banks and insurance companies.
(c) Development of the basic infrastructure. Localisation of an industry leads to the
development of certain facilities. Transport credit and insurance facilities are set up.
Hospitals and schools are also set up.
(d) External economies of scale. These are the advantages of large-scale production
enjoyed by the entire industry. Various types of external economies can be outlined as
follows: economies of concentration-a constant supply of skilled labour, economies of
information-research information, and economies of welfare.
(e) Reputation. The locality where the industry is localised becomes known. This implies
that the product bearing the name of the localised area find wide markets, e.g. Swiss
Watches in the 1950s and 1960s.

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 (f) Reduction in the cost of production. Due to various economies of scale, costs of
production reduce. Consequently, the level of output increases and hence economic
growth.

ARGUMENTS AGAINST LOCALISATION:

There are a number of arguments against localisation.
(g) Regional imbalance. Localisation of an industry in one region leads to regional
imbalance. Some regions develop more than others do. Income inequality emerges.
There are more employment opportunities in those regions where there are localised
industries. Hence the problems of rural urban migration-slums; dependants; urban
unemployment and high cost of living in urban areas.
(h) Limited employment. Employment opportunities are limited to a particular type of
labour. When production of the commodity declines or stops, specialised labour may
fail to get alternative employment elsewhere.
(i) Dependence. The economy becomes dependent both in terms of demand for its
products and income for the people. However, this may be very dangerous in certain
periods as for instance during war or when an earthquake occurs. Production may
completely stop.
(j) Diseconomies of scale. The growing demand for the various factors of production like
labour, capital, raw materials and others may lead to an increase in their prices.
Transport bottlenecks emerge-the roads may become congested. Shortages of power,
labour, capital, raw materials and credit may occur. Air and water pollution is another
form of external diseconomies. The cost per unit of output may increase for the firms,
which have to purify water before it is used. If air pollution affects the health conditions
of the workers, the firms may incur extra costs when paying for extra medical facilities.

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