Theory of the Firm Review and Definitions

Here is my final review for the Theory of the Firm. Over the last week I have worked in putting together this powerpoint in order to help myself review the definitions and terms. However, upon completion I figured it would also serve as a good tool for helping others study. Feel free to use it and share it on your own blog, as I would really appreciate the reference.

Concepts of the ‘Law of the Firm’ and Tennis Balls

Friday in class we practiced an activity in which our class practiced the some of the concepts of the Law of the Firm. In the game we had two buckets, and a variable amount of workers responsible for moving the balls from one bucket to another. For every ball moved, one product was produced. This process would be repeated with increasing amounts of variable factors, in this case workers. This activity allowed us to form a table consisting of many Law of the Firm concepts. Three of these concepts are the law of increasing return, the law of constant return and the law of diminishing return. The law of increasing return states that for the first few factors of variable cost (workers in our activity) added, the increase in output will be greater than the increase in cost. The law of constant return states that for the following factors of  variable cost added, the increase in output will be equal to the increase in cost. The law of diminishing return states that for the final factors of variable cost added, the increase in output will be less than the increase in cost. According to these concepts, we can set a price for our products, and determine how many workers we should use to produce a set amount of product in order to maximise our revenue to cost ratio, similar to real business.

Pricey Raw Materials Causes a Rise in Beer Production Costs

The price of beer production is set to increase as the price of raw materials for beer production increases as well. Using our understanding of Economics and Cost vs Output, we can represent this shift. In Figure 1, TVC represents the Total Variable Cost, which is graphed as price over output.. The raw materials costs for the production of beer are variable costs, as they can change based on the market. Variable costs are subjected to the three major laws of cost output: Increasing Return, Constant Return and Diminishing Return. Increasing Return states that as the initial units of variable cost (those directly proceeding the costs origin) produce a large return for a small increase in cost. In Figure 1, this is represented by the steep curve projecting from the graphs origin. Following this, Constant Return shows an equal increase in output for every unit of variable cost added. This is represented by the linear section of the graph following the area of Increasing Return. Finally, the law of Diminishing Return states that at a certain point, for every unit of variable cost added, the output is less. On Figure 1 this is represented by the rising curve toward the right of the TVC curve.

In Figure 1, the rise in the price of raw materials for beer is represented with the shift from TVC to TVC1. From this shift, we see that the initial variable cost remains at 0, as both TVC curves cut the axis’ at 0. However, due to the increase in price of raw materials, the TVC1 curve rises above the initial TVC curve representing higher prices for equal output between the two lines.