Firms' Decisions and Strategies Notes

H2 Economics Chapter 3 Notes This document is intended as a summary of the points provided in the NJC 2024 H2 Economics Chapter 3 Seminar Notes. It is to be used as a study guide to provide a structure for studying the Chapter 3 Notes. 1 Introduction to Firms Before we begin our study, let us clarify the focus of our study. We are studying individual firms’ decisions and strategies individually. We are NOT studying the decisions and strategies of firms as a whole industry. 1.1 Key Terms and Concepts Chapter 3 is the most difficult chapter for students to completely understand because the scope of content is extremely large. Hence, the approach to studying this chapter is to first master the big idea of the chapter, before understanding each subsection in great detail. It is highly advised that you spend a large amount of time to properly and fully understand the basic concepts covered in this section before moving on to any other sections. A Firm is a business organisation that hires factors of production, combines them in a productive process to create and sell the resulting output for a profit. A Plant (or factory) refers to the geographical location where the actual production is carried out. A firm may own one or several production plants. An Industry refers to a group of firms producing similar goods or services. Firms within the same industry are usually competitors in the same market. Profit (π) is the difference between total revenue (TR) and total cost (TC) of production Short Run is defined as a period over which at least one factor of production is fixed. In the short run, output can only be adjusted by changing the quantities of variable factors. Long Run (LR) refers to a period of time extensive enough to allow the firm to change all resources employed within the confines of a given state of technology. 1

Important Things to Note and Key Clarifications Firm What is a firm? Typically, a firm is seen as a separate entity from its shareholders, i.e. those who own the firm. A firm is typically seen more as an intangible entity which is defined by (1) its profit-maximising objective and (2) its ability to hire factor inputs to produce goods and services. Separation between employees and shareholders: ● Shareholders are the owners of a firm. Typically, they own a part of the firm by investing in shares of the firm. When the firm profits, the shareholders receive part of the profits in terms of dividends. Shareholders typically make the major decisions of the firm (electing board members, deciding on mergers and acquisitions, investment decisions, hiring and firing the CEO) ● Employees typically serve the role of labour in firms. They are what keeps the firm operating, and they are rewarded by the firm in terms of wages. Firms can also hire paid managers like CEOs and CFOs which are in charge of the operations of the firm in terms of pricing and non-pricing strategies, hiring or firing workers, ordering stock, etc. These managers are the ones who provide entrepreneurial resources that the firm needs. However, entrepreneurial resources can also be provided by shareholders as they are in charge of major decisions. Traditionally, we would consider managers to also be profit maximising, as they are generally paid higher salaries if the firm’s profits increase. However, since they are motivated by salaries and not profits directly, this may not always be true. ● However, in smaller firms, the owner can also operate the firm. For example, in hawker centres, hawker stall owners operate the firm. These smaller firms may be known as sole proprietorships or partnerships, while the larger firms may be known as corporations or companies. 2

Plant What is a Plant? Plants refer to factories and buildings where the production of the goods and services actually occur. It is what people would usually call ‘capital goods’. They contain labour and other machinery which are part of the production process. A firm is seen as more of the entity that makes decisions, while the plant is seen as the entity which carries out these decisions. Industry What is an Industry? An industry is typically what students have understood as the concept of ‘market supply’. An industry typically addresses one particular want or need of consumers via the selling of slightly differentiated products. For example, in the energy industry, the firms would be companies producing or distributing energy (e.g., oil, gas, renewable energy sources). Competition Between Firms Firms in an industry are usually competitors of each other. Competition is the rivalry between firms seeking to achieve a particular objective, typically to maximise profits, market share, or customer base. In a market context, competition arises because multiple firms or sellers offer similar or substitute products and services either at different prices or different quality . We say that goods that firms sell are price competitive or quality competitive when they are goods which consumers are more willing and/or able to buy. An increase in competition is usually associated with the concept of an increase in the number of firms in the industry. This is because with new firms, some consumers will typically switch over to these new firms because individual consumers have different tastes and preferences, and some goods and services appeal to some consumers’ specific tastes and preferences better than others. 3

Profit Total Revenue (TR) is a firm’s total earnings from the sale of its output for a specific period of time. Total revenue is calculated as the average price per unit (P) multiplied by the number of units sold (Q) Total Costs (TC) is a firm’s total opportunity cost from the production of its output for a specific period of time. Supernormal, Normal and Subnormal Profits ● If total revenue and total costs are equal, economic profit is zero. The firm is said to be earning normal profits . This is deemed to be the minimum amount of profits the firm must make in order to continue operations in the long-run. ● A supernormal profit (i.e. positive economic profit) indicates that the total revenue accruing to the firm from sale of its goods and services exceeds the total costs of production. ● A subnormal profit or loss (i.e. negative economic profit) occurs when total revenue falls short of total production costs. The firm may incur subnormal profit in the short run and choose to continue production, but it will exit the industry if it continues to make subnormal profit in the long-run. Economic Profit VS Accounting Profit The total costs of production to the economist are the opportunity costs of using resources in the production of a product — a measure of the sacrifice involved in using factors of production to produce that product. To produce a product