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4.3.1DECISIONS OF FIRMS AND THE ROLE OF TIME

Economists constantly use the terms short run and long run and the distinction is particularly relevant when considering the decisions taken by firms. The short run and long run are not just set periods of time and are firmand industry-specific.

The short run describes the period of time it takes for a firm to change its scale of production and this depends on its fixed factor of production – usually capital.

In the short run a firm has one or more fixed factors of production, which constrains its possible output.

An ice-cream seller who travels around in his van selling ice-cream cones cannot sell more than his machine, van and supplies can produce unless he decides to put another van on the road. This would take some time depending on his finances and the ease of finding a suitable van, equipment and driver but could possibly be done quite quickly so the short run would be quite short, i.e. the time to get another van up and running.

On the other hand for a ship-building company the short run would be much longer. A significant amount of equipment and machinery is required to build ships and it could take a long time to build new hangars, buy the necessary equipment and find the skilled labour if a ship-builder decided to expand its scale of production. The short run in that case could run into several years.

Usually we consider capital to be the fixed factor in the short run. When economists conduct analysis in the short run it is also assumed that there are a fixed number of firms in an industry, there is no entry of new firms or exit of existing firms.

The expressions short-term, medium-term and long-term are also commonly used in economic forecasting and refer to time-periods of up to three years, three to five years and five years plus respectively.

The long run – when a firm’s output is not limited by fixed factors of production – the amount of any factor of production can be changed and firms can enter or leave an industry.

Essentially the distinction between short run and long run is useful for dealing with day-to-day decisions a firm takes, i.e. short-run decisions – and more long-term or

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strategic issues the firm has to deal with, i.e. long-run decisions. The distinction is useful in the context of how theory is applied in economics because it provides a framework for focusing on a more constrained set of decisions in short-run analysis which can be extended as required to focus on long-run issues.

In considering how firms try to maximize their profits the sections that follow highlight relevant issues for firms separately for the short and long run. This requires consideration of the revenue and costs of a firm. Decision-making based on economics – such as the decision to produce the quantity of output that allows a firm to maximize its profits – uses marginal analysis and this is why not only total revenues and costs but also marginal revenues and costs are examined in the sections that follow.

Marginal analysis is the process of considering the effect of small changes in one factor relevant to an economic decision (e.g. on output levels or pricing) and identifying whether an economic objective will be met. The objective may relate to profit maximization, benefit maximization, cost minimization or revenue maximization as examples.

The logic of marginal analysis is that a small incremental change should be made once an economic objective is met – there is economic rationale to increasing price only if profits rise, if that is the economic objective. If no change enhances the economic objective (if it is already maximized/minimized) the decision variable should be changed no further.

Marginal analysis a method for optimizing decision-making within a reasonably well-defined setting.

4.3.2FIRM REVENUE

The general pattern followed by the total revenue of a firm with a ‘standard’ linear downward sloping demand function was presented in Chapter 3 and is repeated here in Figure 4.1. Total revenue received by a firm is calculated as price × quantity (in equilibrium) so if price is £20 and quantity sold is 50, total revenue is £1,000. Depending on the amount of output the firm sells its total revenue varies. Since quantity demanded varies with price (higher price corresponding to lower quantity demanded and vice versa), then the price the firm charges has a bearing on its revenues. A firm’s demand curve provides the information needed to sketch its total revenue curve.

Consider the total revenue curve in panel A of Figure 4.1. We refer to the call credit example used in earlier chapters except here we deal with one firm supplying some of this market. If the firm charges a price of £150, consumers are not willing to

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	A			B
	TR	c*
	202 500		d*	Rev
	180 000	b*
	112 500	a*		MR
	TR1	9 18 27 36	Q (00)	9 18 27 36 Q (00)

F I G U R E 4 . 1 T O T A L R E V E N U E A N D M A R G I N A L R E V E N U E

buy its product and no revenue is earned (shown as TR1 in the bottom left corner of Figure 4.1) At a price of £125 the firm would sell 900 units and earn revenue of £112 500 (see a ). If price is relatively lower at £100, more consumers buy the product and 1800 units are sold. Hence, total revenue rises to £180 000 (see b ). If price is cut further to £75, more consumers are enticed to buy the product, 2700 units are sold and total revenue rises further to £202 500 (see c ). Two effects are associated with the quantity increase from 1800 to 2700 for example. On the one hand there is a negative impact on firm revenue since the price has dropped from £100 to £75. However, the effect of increasing quantity demanded more than offsets the price effect and so total revenue rises.

Any further cuts in price still increase the quantity sold (e.g. 3600, etc.) but the extra sales at the lower price required to entice more consumers to make their purchase result in lower total revenue for the firm; the effect of the price reduction offsets the rise in sales. The firm maximizes its total revenue if it sells the quantity 2700 but this amount of output can only be sold if the firm chooses the ‘correct’ price.

If revenue maximization is the firm’s objective it needs to consider what demand for its product is in order to set the required price to sell the optimal amount of output. In panel B of Figure 4.1 marginal revenue (MR) is graphed.

Marginal revenue is defined as the change in total revenue associated with a change in quantity demanded.

The marginal revenue function shows the amount of additional revenue generated for a firm at different levels of quantity demanded. It is computed as the change in total revenue divided by the change in quantity demanded:

TR/Q .

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To understand the linear MR curve, take the example of a firm that sets a high price for its product (say £800 for a wooden table) so that quantity demanded is just one unit. The firm earns total revenue of the price of the table × 1 unit = £800.

If the firm drops its price to £725, it could sell two tables. If it did so it would earn total revenue of £725 × 2 = £1450. Since total revenue changes when different prices are charged, so too does marginal revenue.

The change in total revenue when two tables are sold compared to when one was sold is £1450 – £800 = £650.

Therefore, the marginal revenue for the first table sold is £800 while the marginal revenue for the second table is £650. To sell additional tables the firm would have to cut its price further so that the marginal revenue declines further as quantity demanded and sold rises.

Focusing on Figure 4.1 marginal revenue can be computed as:

		Total			MR
Price	Quantity	revenue	TR	Q	TR/ Q
£150	0	0	0	0	0
£125	900	£112 500	£112 500	900	£125
£100	1800	£180 000	£67 500	900	£77.20
£75	2700	£202 500	£22 500	900	£25
£50	3600	£180 000	−£22 500	900	−£25

Conclusion: marginal revenue declines as quantity demanded rises. Firms must lower price to increase quantity demanded and this impacts on total revenue and on marginal revenue.

In Figure 4.1 panel A, total revenue rises up until its maximum at 2700, after which it drops. This means that a small, marginal increase in output from 2699 to 2700 corresponds to the change in output where the effects on total revenue of the drop in the price and increase in quantity of output exactly cancel each other out. Beyond quantity demanded of 2700 any change in total revenue is a decline and this is reflected in the MR function, which dips below 0 beyond this level of output.