CHAPTER SIX
THEORY OF THE FIRM
A firm; This is a single unit of business organization that brings together the factors of production to produce any
given commodity. Firm may also be defined as a business enterprise under one management and control.
Example; Mumias sugar factory, Bata Shoe Company e.t.c
- Firms may be sole proprietorship, partnerships or companies.
They may therefore be small e.g. an artisan or mechanic working in her/his garage or large like a multinational
limited company producing many different products e.g. coca-cola company.
-A firm even though under one management and control may have several branches/plants.
(ii) An industry;
This refers to all those firms producing the same product for a specific market/a group of related firms that compete
with one another i.e.
a) Firms that produce the same product e.g. the firms operating as sugar manufactures as Mumias Sugar Company,
Sony Sugar Company and Miwani Sugar Company.
b) Firms that extract the same raw materials e.g. the salt mining firms, Magadi Soda Company and other firms
which mine salt at the North coast
Region near Malindi.
c) Firms that provide similar services e.g. the transport industry such as Akamba Bus service, coast Bus Company
and Easy Coach Company.
In the definition of the firm, its assumed that a firm in a unit that makes decision with respect to the production and
sale of goods and services in the regard,
- All firms are profit-maximisers i.e. they seek to make as much profit as possible.
- Each firm can be regarded as a single consistent decision making unit.
The life of all business enterprises/firms are therefore characterized by several decision-making processes which are
all aimed at facilitating realization of the objectives(profit maximization) such decisions may include; what to
produce and how much, where and when to produce, how much to invest and how much to price goods/services e.t.c
Decision on What Goods and Services to Produce
A firm makes a number of important production decisions. Some of the decision may involve;
i. What to produce
ii. How production is to take place e.g. what raw materials and machinery should be utilized.
iii. Where a production plant should be located.
iv. When to produce.
v. The scale of production e.g. how big should the factory.
vi. When and where to invest.
vii. How the production can be improved and controlled.
viii. What type of business activity to engage in.
One production decision may lead to a series of decisions requiring to be made e.g.
- for a firm to decide on what goods and services to produce, market research to evaluate the likely success of the
product is necessary.
- after establishing the viability of the product in the market, other activities like product design are carried out (the
firm may consider redesigning existing products, introducing a product similar to the one in the market or
developing a completely new product.
- production may then follow
Factors that influence decisions on what goods and services to produce
Certain factors have to be considered before committing a firm into production of either a new product, adopting or
redesigning the existing
product.
ECONOMICS CHAPTER 6 THEORY OF THE FIRM NOTES PREPARED BY MR. ANTONY AMBIA Page 1
,These factors include;
i. Whether the firm is product-oriented or market-oriented
Product oriented firms: This is when the nature of the product itself (its
functions and unique qualities) are enough to make sure that the product sells e.g. when cars were first developed, its
uniqueness sold it
Market oriented firms; These are firms that produce products that are meant to meet the consumer needs e.g. over
time cars are being developed to suit consumer needs.
ii. Level of competition
In order to survive in a competitive market, firms must come up with products that consumers prefer.
Firms may therefore develop products which are not currently available or copy rivals ideas and improve on them.
iii. Level of available technology
The level of technology has a strong influence on the product that a firm produces.
New inventions and innovations often result in new products or improved products.
- Improved technology may also reduce the costs of production.
This means the same output maybe produced using less factors of production or more output may be produced using
the same factors of production.
iv. Management role
Senior management have the sole responsibility of deciding on what product to produce. A wrong decision may ruin
rather than bailed the enterprise.
The manager’s ability to design a viable product is therefore a vital factor in product development.
v. Financial viability
In order to determine whether a product will be viable or not, the cost of production and the expected returns should
be considered.
Funds may only be approved for the product that promises long term benefits to the firm.
So if the benefits of the product outweigh the costs, then such product will be developed and if not so, it will be
dropped.
vi. Amount and type of capital in the firm
Capital refers to machines, equipment, factories, plants and other human made aids to production.
Both financial and physical capital facilitates the production process.
The amount of capital in a business will therefore influence what goods it can produce and in what qualities i.e. a
firm with physical capital that is very specific may not be able to produce other type of products e.g. a clothing
factory may not be able to produce any other goods such as cement.
Other factors may include;
- Need of the consumers
- Need for better quality or more fashionable product
- Need for an easier to market product.
- Unmet needs.
- Need for a product for which factors of production and technology are easily available
Cost of Production
Cost: This is a payment made to the factors of production for their services.
Production costs thus refers to the expenses incurred in acquiring factors of production (inputs) The sum total of all
payments to the, factors of production engaged in its production.
Types of production costs:
I. Opportunity costs; These are values of any alternatives forgone.
The cost forgone when the choice of one thing requires the next best alternative to be abandoned.
Example: A student with only sh.50 may have to decide on whether to buy a text book or a pair of shoes.
If she decides to buy a text book, the pair of shoes will have to be forgone because it’s not possible to buy both with
only sh.500.
The opportunity cost of buying a text book in this case is the cost of the pair of shoes which was abandoned.
II. Fixed and variable costs
Costs may be classified according to their behavior in relation to various levels of output as follows:
a) Fixed costs
b) Variable costs
ECONOMICS CHAPTER 6 THEORY OF THE FIRM NOTES PREPARED BY MR. ANTONY AMBIA Page 2
, c) Semi-variable costs
a) Fixed costs
These are expenses which do not change with changes in levels of output/quantity of output. These costs therefore
remain the same whether the
firm is producing anything or not i.e.
b) Variable costs
These are costs that vary proportionately with changes in levels of output.
This means that when output decreases the variable costs decrease in the same proportion and when output
increases, they also increase in the same proportion.
If nothing is produced VC = 0
Examples;
a) Payments on raw materials
b) Wages paid to casual labour
c) Water, transport and electricity bills
c) Semi-variable costs
These are costs that vary in relation to changes in output but not proportionately e.g.
if output doubles, the semi-variable costs might increase by half.
Those production costs that do not fit in either fixed or variable costs are semi-variable costs.
Example
(i) Labour (permanent employees); No matter what level of output, their salary is fixed. However if one is asked to
work extra time and on weekends to cope with extra production levels, then the extra cost is variable. Thus because
labour is not totally fixed nor totally variable, it becomes semi-variable.
(ii) Cost of telephone charges. This is because there is often a fixed or standing charge plus an extra rate which
varies according to the number of calls made.
-Thus semi-variable (semi-fixed) costs have both fixed and variable component.
(iii) Total costs
Total cost is the sum of all costs incurred in the production at a given level of output i.e. the sum of fixed and
variable costs.
Total cost = Fixed costs+ variable costs.
- As output increases total costs will also increase.
(iv) Direct and indirect costs
Costs can be classified according to the way they affect the product.
They can either be direct or indirect costs.
a) Direct costs
These are costs that can be physically traced to the final product/process.
Examples
i) Raw materials i.e. all the materials that can be physically traced to the final product.
ii) Direct labour i.e. wages for those factory employees directly engaged in the manufacture of the product e.g.
wages for machine operators,packers,mixers,assemblers e.t.c.
iii) Packing materials used.
iv) Direct expenses i.e. expenses which are directly allocated to a particular unit of goods being made.e.g
maintenance costs of machines and equipment, designs and drawings, hire for special tools or equipment for a
particular production.
- These costs are also known as prime costs. They are usually variable costs.
Indirect costs (factory overheads)
These are costs which cannot be traced or directly identified in the final product i.e. they cannot be attributed to any
specific output.
They also include the costs that appear in such small quantities that their effects are negligible.
Examples:
i) Payment for stationary and other items such as lubricating oil, small tools, telephone use, cleaning and transport
ECONOMICS CHAPTER 6 THEORY OF THE FIRM NOTES PREPARED BY MR. ANTONY AMBIA Page 3
THEORY OF THE FIRM
A firm; This is a single unit of business organization that brings together the factors of production to produce any
given commodity. Firm may also be defined as a business enterprise under one management and control.
Example; Mumias sugar factory, Bata Shoe Company e.t.c
- Firms may be sole proprietorship, partnerships or companies.
They may therefore be small e.g. an artisan or mechanic working in her/his garage or large like a multinational
limited company producing many different products e.g. coca-cola company.
-A firm even though under one management and control may have several branches/plants.
(ii) An industry;
This refers to all those firms producing the same product for a specific market/a group of related firms that compete
with one another i.e.
a) Firms that produce the same product e.g. the firms operating as sugar manufactures as Mumias Sugar Company,
Sony Sugar Company and Miwani Sugar Company.
b) Firms that extract the same raw materials e.g. the salt mining firms, Magadi Soda Company and other firms
which mine salt at the North coast
Region near Malindi.
c) Firms that provide similar services e.g. the transport industry such as Akamba Bus service, coast Bus Company
and Easy Coach Company.
In the definition of the firm, its assumed that a firm in a unit that makes decision with respect to the production and
sale of goods and services in the regard,
- All firms are profit-maximisers i.e. they seek to make as much profit as possible.
- Each firm can be regarded as a single consistent decision making unit.
The life of all business enterprises/firms are therefore characterized by several decision-making processes which are
all aimed at facilitating realization of the objectives(profit maximization) such decisions may include; what to
produce and how much, where and when to produce, how much to invest and how much to price goods/services e.t.c
Decision on What Goods and Services to Produce
A firm makes a number of important production decisions. Some of the decision may involve;
i. What to produce
ii. How production is to take place e.g. what raw materials and machinery should be utilized.
iii. Where a production plant should be located.
iv. When to produce.
v. The scale of production e.g. how big should the factory.
vi. When and where to invest.
vii. How the production can be improved and controlled.
viii. What type of business activity to engage in.
One production decision may lead to a series of decisions requiring to be made e.g.
- for a firm to decide on what goods and services to produce, market research to evaluate the likely success of the
product is necessary.
- after establishing the viability of the product in the market, other activities like product design are carried out (the
firm may consider redesigning existing products, introducing a product similar to the one in the market or
developing a completely new product.
- production may then follow
Factors that influence decisions on what goods and services to produce
Certain factors have to be considered before committing a firm into production of either a new product, adopting or
redesigning the existing
product.
ECONOMICS CHAPTER 6 THEORY OF THE FIRM NOTES PREPARED BY MR. ANTONY AMBIA Page 1
,These factors include;
i. Whether the firm is product-oriented or market-oriented
Product oriented firms: This is when the nature of the product itself (its
functions and unique qualities) are enough to make sure that the product sells e.g. when cars were first developed, its
uniqueness sold it
Market oriented firms; These are firms that produce products that are meant to meet the consumer needs e.g. over
time cars are being developed to suit consumer needs.
ii. Level of competition
In order to survive in a competitive market, firms must come up with products that consumers prefer.
Firms may therefore develop products which are not currently available or copy rivals ideas and improve on them.
iii. Level of available technology
The level of technology has a strong influence on the product that a firm produces.
New inventions and innovations often result in new products or improved products.
- Improved technology may also reduce the costs of production.
This means the same output maybe produced using less factors of production or more output may be produced using
the same factors of production.
iv. Management role
Senior management have the sole responsibility of deciding on what product to produce. A wrong decision may ruin
rather than bailed the enterprise.
The manager’s ability to design a viable product is therefore a vital factor in product development.
v. Financial viability
In order to determine whether a product will be viable or not, the cost of production and the expected returns should
be considered.
Funds may only be approved for the product that promises long term benefits to the firm.
So if the benefits of the product outweigh the costs, then such product will be developed and if not so, it will be
dropped.
vi. Amount and type of capital in the firm
Capital refers to machines, equipment, factories, plants and other human made aids to production.
Both financial and physical capital facilitates the production process.
The amount of capital in a business will therefore influence what goods it can produce and in what qualities i.e. a
firm with physical capital that is very specific may not be able to produce other type of products e.g. a clothing
factory may not be able to produce any other goods such as cement.
Other factors may include;
- Need of the consumers
- Need for better quality or more fashionable product
- Need for an easier to market product.
- Unmet needs.
- Need for a product for which factors of production and technology are easily available
Cost of Production
Cost: This is a payment made to the factors of production for their services.
Production costs thus refers to the expenses incurred in acquiring factors of production (inputs) The sum total of all
payments to the, factors of production engaged in its production.
Types of production costs:
I. Opportunity costs; These are values of any alternatives forgone.
The cost forgone when the choice of one thing requires the next best alternative to be abandoned.
Example: A student with only sh.50 may have to decide on whether to buy a text book or a pair of shoes.
If she decides to buy a text book, the pair of shoes will have to be forgone because it’s not possible to buy both with
only sh.500.
The opportunity cost of buying a text book in this case is the cost of the pair of shoes which was abandoned.
II. Fixed and variable costs
Costs may be classified according to their behavior in relation to various levels of output as follows:
a) Fixed costs
b) Variable costs
ECONOMICS CHAPTER 6 THEORY OF THE FIRM NOTES PREPARED BY MR. ANTONY AMBIA Page 2
, c) Semi-variable costs
a) Fixed costs
These are expenses which do not change with changes in levels of output/quantity of output. These costs therefore
remain the same whether the
firm is producing anything or not i.e.
b) Variable costs
These are costs that vary proportionately with changes in levels of output.
This means that when output decreases the variable costs decrease in the same proportion and when output
increases, they also increase in the same proportion.
If nothing is produced VC = 0
Examples;
a) Payments on raw materials
b) Wages paid to casual labour
c) Water, transport and electricity bills
c) Semi-variable costs
These are costs that vary in relation to changes in output but not proportionately e.g.
if output doubles, the semi-variable costs might increase by half.
Those production costs that do not fit in either fixed or variable costs are semi-variable costs.
Example
(i) Labour (permanent employees); No matter what level of output, their salary is fixed. However if one is asked to
work extra time and on weekends to cope with extra production levels, then the extra cost is variable. Thus because
labour is not totally fixed nor totally variable, it becomes semi-variable.
(ii) Cost of telephone charges. This is because there is often a fixed or standing charge plus an extra rate which
varies according to the number of calls made.
-Thus semi-variable (semi-fixed) costs have both fixed and variable component.
(iii) Total costs
Total cost is the sum of all costs incurred in the production at a given level of output i.e. the sum of fixed and
variable costs.
Total cost = Fixed costs+ variable costs.
- As output increases total costs will also increase.
(iv) Direct and indirect costs
Costs can be classified according to the way they affect the product.
They can either be direct or indirect costs.
a) Direct costs
These are costs that can be physically traced to the final product/process.
Examples
i) Raw materials i.e. all the materials that can be physically traced to the final product.
ii) Direct labour i.e. wages for those factory employees directly engaged in the manufacture of the product e.g.
wages for machine operators,packers,mixers,assemblers e.t.c.
iii) Packing materials used.
iv) Direct expenses i.e. expenses which are directly allocated to a particular unit of goods being made.e.g
maintenance costs of machines and equipment, designs and drawings, hire for special tools or equipment for a
particular production.
- These costs are also known as prime costs. They are usually variable costs.
Indirect costs (factory overheads)
These are costs which cannot be traced or directly identified in the final product i.e. they cannot be attributed to any
specific output.
They also include the costs that appear in such small quantities that their effects are negligible.
Examples:
i) Payment for stationary and other items such as lubricating oil, small tools, telephone use, cleaning and transport
ECONOMICS CHAPTER 6 THEORY OF THE FIRM NOTES PREPARED BY MR. ANTONY AMBIA Page 3
