Chapter 6: Theory of the Firm

This chapter deals with the decisions on what goods and services to produce.

  • What to produce
  • How production is to take place e.g. what raw materials and machinery should be utilized
  • Where a production plant is to be located
  • When to produce
  • The scale of production e.g. how big should the factory be.
  • When and where to invest.
  • How production can be improved and controlled
  • What type of business unit to engage in?

6.1 Distinction between Firm and Industry

In economics, a firm holds important position as at the firm level managerial decisions are taken. In common language a firm is considered as a manufacturing unit involved in production of goods. The scope of the term firm in economics is broad. It represents any business organization that provides service & agriculture organization also.

Definition of the Firm

A firm can be defined as a unit of production that employs factors of production (or inputs) to produce goods & services under given state of technology. When we talk about a firm, we refer to an independently administered business unit that is responsible for producing goods and/or services. It is a center of control where the decisions about what to produce & how to produce are taken. We can also describe a firm as a business entity that employs productive resources to produce goods and service.

Characteristics of a Firm

Based on the above definitions of the firm, there various characteristics or features that can be identified:

  • It is a place where all decision making related to production are taken vizwhat, where & how much to produce.
  • It is a place where manpower is hired for production.
  • It is a place where all the resources of production are brought together, production is done as well as sale & distribution of the manufactured product is carried out.
  • The state of technology is defined by the firms production function.

The ultimate goal of a firm is to maximize profits by engaging in the productive processes of manufacturing, distributing and marketing goods and services. Every firm aims to maximize profits in the long run irrespective of the short term profits or losses.

Definition of an Industry

An industry is a group of related firms, selling similar products and services. For example, companies selling dairy products belong to one industry known as a dairy industry. Firms such as Apple, Microsoft, Samsung, Google, Facebook, and IBM form the technology industry because they produce IT-related goods.

Types of Industries

Industries are groups of firms that engage in the production, processing, extraction, and conversion of inputs into finished goods. Industry in economics does not mean a factory where goods are produced; it is a group of related firms that are engaged in similar productive processes. There are four major types of industries:

  • Generic Industry: this type of industry involves activities in reproducing and multiplying certain species of plants and animals for the sake of earning profit from their sale. Fish culture, cattle breeding, goatery and piggery are included in genetic industries.
  • Extractive Industry: The industries engaged with the discovery or extracting natural resources like minerals soil, water and forests are called extractive industries. Mining, agriculture and fishing are best examples of extractive industries.
  • Manufacturing Industries: these are types of industries that are involved in the conversion of raw materials into outputs. They include textile, sugar, steel, and leather industries.
  • Construction Industry: The construction industry includes a group of firms involved in the development of infrastructure such as roads, buildings, dams, bridges, and canals.

Key Differences between an Industry and a Firm

From the above descriptions, definition and explanation of the features of a firm and industry, there are several differences between a firm and industry that may be identified. The following are the major differences between firm and industry:

  • Industry is a group of related firms within an economy, while a firm is a business unit operating within an industry
  • There are many firms within an industry
  • A firm is a type of business while an industry is a subsector of an economy.
  • Rules and regulations are made for an industry, and that typically apply to all firms inside the industry.

6.2 Costs of Production

The costs of production are all expenses that a firm incurs in the process of transforming inputs into outputs, or in the process of creating and delivering products and services to the market. The major types of production costs include labor, raw materials, equipment, rent, and marketing costs. The sum of all expenses necessary to produce and sell goods and services is referred to as costs of production.

Short-run v long run production

In economics, short run production is when at least one factors of production such as labor, capital, or land is fixed and cannot be changed. The company can produce more output in the short run by adding more variable factors to the fixed factors of production. On the other hand, long run production occurs when all factors of production can be varied. In the long run, the company can benefit from economies of scale as the scale and capacity of production can increase.

For example, a company that is producing clothes has one factory, machines, labor, and cotton for the production of clothes. Cotton as raw materials can be added to increase production in the short run. The firm can also hire more workers to increase labor for more production. However, the firm cannot easily replace machines or build a new factory to increase production in the short run. In the short run, labor and raw materials are variable, while machines and infrastructure are fixed. It comes to a time when adding more labor or raw materials is inefficient because the firm does not have enough productive capacity. For instance, more and more labor can be added until a time when there is more labor than machines, and some workers stay idle because they lack machines to operate. In the long run, new machines and new factories can be added to accommodate more raw materials and labor.

Types of Production Costs

Costs of production can be classified into different types depending on the time range when the costs are incurred. This depends on short run or long run production. The major types of production costs are:

  • Fixed costs
  • Variable costs
  • Total costs
  • Average cost
  • Marginal cost

Fixed Costs: these are costs which do not change with changes in the output. For example: Land, equipment and infrastructure. A company incurs fixed costs regardless of whether production activity is carried out or not. For instance, the firm incurs land rates and rents regardless of whether he does business on the land or not.

Variable Costs: variable costs are costs that can change in respect to changes in production output. Variable costs relate directly to the production or sale of a product. For example, wages, raw materials, and energy costs are variable costs because they change when the production levels change. When there is limited demand for clothes, the firm buys less raw materials and hires fewer workers, hence incurring less labor costs and less raw materials.

Total Costs: Total costs are the aggregate costs derived from the summation of all variable and fixed costs involved in the producing a certain level of output.

Total Costs (TC) = Fixed Costs (FC) + Variable Costs (VC)

Average Costs: Average costs are unit costs of production, or costs incurred for the production of a single unit of product or service. It is calculated by dividing total costs by total output as shown below:

Average cost formula

Average variable cost (AVC) = Variable Cost (VC)/output (Q)

Average fixed cost (AFC) = Fixed cost (FC)/output (Q)

Average Cost (AC) = AVC + AFC

Marginal Costs: Marginal Costs (MC) refer to the changes in total costs as a result of changes in output.


AVC reaches the lowest point at a lower level of output Q1 compared with ATC. This is because ATC includes both AFC and AVC.

6.3 The Concept of Revenue

Revenue is the receipt from the sales of a good or service. Total revenue is obtained by multiplying the quantity of goods sold (output) with the price per unit.

Total Revenue (TR) = Price (P) x Quantity sold (Q).

TR = PQ.

Average Revenue is given by:


Marginal revenue (MR) it is the increase in revenue brought about on extra unit sold.


6.4 Economies and Diseconomies of Scale

Economies of Scale

Economies of scale are the benefits or advantages that accrue to a firm by virtue of its large size. Economies are either internal or external. They include internal and external economies of scale.

Internal Economies of Scale

The internal economies of scale are the advantages or disadvantages that a firm derives from within the internal environment of the firm; they help in reducing costs of operation. Some sources or examples of internal economies of scale include:

  • Technical economies: also known as indivisibilities; may occur when a large firm is able to take advantage of an industrial process which cannot be reproduced on a small scale, for example, a blast furnace which cannot be reproduced on a small scale while retaining its efficiency.
    • Increased Dimensions:  These occur when it is possible to increase the size of the firm’s equipment and hence realize a higher volume of output without necessarily increasing the costs at the same rate.  For example, a matatu and a bus each require one driver and conductor.  The output from the bus is much higher than that from the matatu in any given period of time, and although the bus driver and conductor will earn more than their matatu counterparts, they will not earn by as many times as the bus output exceeds the matatu output, i.e. if the bus output is 3 times that of the matatu counterparts.
    • Economies of Linked Processes:  Technical economies are also sometimes gained by linking processes together, e.g. in the iron and steel industry, where iron and steel production is carried out in the same plant, thus saving both transport and fuel costs.
  • Specialisation: Specialisation of labour and machinery can lead to the production of better quality output and higher volume of output.
  • Research: A large firm will be in a better financial position to devote funds to research and improvement of its product than a small firm.
  • Marketing economies of scale: The buying advantage: A large-scale organisation may buy its materials in bulk and therefore get preferential treatment and buy at a discount more easily than a small firm.
  • The packaging advantage: It is easier to pack in bulk than in small quantities and although for a large firm the packaging costs will be higher than for small firms, they will be spread over a large volume of output and the cost per unit will be lower.
  • The selling advantage: A large-scale organisation may be able to make fuller use of sales and distribution facilities than a small-scale one. For example, a company with a large transport fleet will probably be able to ensure that they transport mainly full loads, whereas small business may have to hire transport or dispatch part loads.
  • Financial economies of scale-: A large firm will have more assets than a small firm. Hence, it will find it cheaper and easier to borrow money from financial institutions like commercial banks than a small firm.
  • Research and developmental economies.
  • Welfare economies.
  • Risk bearing economies.

External Economies of Scale

These are savings or cost advantages that come from outside the firm because a firm is located near others. They include:

  • Ready markets: I.e. availability of commercial facilities.
  • Development of good transport and communication.
  • Development of financial institutions.
  • Development of training institutions.
  • Research through pool of capital resources.
  • Development of trading associations
  • Creation of labor force which is skilled in various techniques.

Diseconomies of Scale

Diseconomies of scale are disadvantages or problems that a firm incurs as it expands and/or increases in size. The diseconomies of scale are internal or external in nature.

Internal diseconomies of scale include:

  • Managerial diseconomies: This mainly arises due to management difficulties and rising prices of inputs such as labour. Increase in development makes coordination tasks become more difficult. The firms are big so communication is problematic. Maintenance of morale is also more difficult. Control as well as implementation is extremely difficult in practice.
  • Selling / marking diseconomies
  • Labor diseconomies

External economies of scale include

  • Traffic congestion.
  • Shortage of accommodation.
  • Air, water pollutions.
  • Increased price on land.
  • Increase in crime.
  • Development of slums.
  • Shortage of food.

6.5 Location of the Firm

The location of the firm refers to the selection of a place where the proposed firm would be established. This selection of location is one of the problems facing management and as such an appropriate decision has to be made. This is so because a good location would lead to success while bad location would lead to failure of business enterprise.

Factors Affecting the Location of a firm

The factors influencing location of firms include:

  • Raw materials: this is usually the case where raw materials are heavy and bulky such that costs of transporting them to far distances would be too high e.g. nature of raw materials determines/influences the location of a firm and this explains why sugar mills and textile industries are located in those areas where sugar cane and raw cotton are produced. Firms that use perishable raw materials ought to be located near the source of raw materials e.g. tea factories are located near the farms.
  • Market: a firm may be located near market for its products to avoid costs involved in transportation of finished brick-making firms may be located near market because bricks are bulky and it would be very expensive to transport them. A firm that deals in perishable/fragile products needs to be located near market to avoid breakages/spoilage as those commodities are transported for long distances to market E.g. bread and milk usually go bad very quickly and therefore need to be consumed immediately they are produced. Glass breaks very easily and therefore their transportation need to be avoided as much as possible.
  • Human resources (labor): can be classified into either skilled, semiskilled or unskilled labour. Labour intensive firms must be located in areas where there is not only abundant labor force but also an appropriate in Kenya, firms requiring labor of any kind may be located in urban centers because in such areas labor is in plentiful supply.
  • Transport and communication: firms require constant supplies of raw materials, often in large quantities from different sources, and finished goods have to be distribute to various destinations. Therefore, good transport network is another very important locational factor to be considered when establishing firms. When communication network is poor, business people will not be able to give or get information in time.
  • Power and water supply: power is needed for running the industrial machines while water is required for cleaning, cooling and even as a raw material. Firms that require a lot of power and water need to be located where there is adequate supply of these webuye paper mills is located near source of water because paper mills require a lot of clean water.
  • Government policies: government can encourage development of firms by offering special concessions to industries such as;
    • Offering free or cheap land.
    • Reduction of taxes
    • Offering subsidies
    • Offering direct financial assistance
    • Improvement of infrastructure.

Some of the reasons why government can influence location of industries could be to populate its empty lands, provide jobs in areas of persistent employment in order to reduce imbalance in regional development.

Localization and Delocalization of Firms

Localization of Firms

Localization of firms means the concentration of similar firms in one particular area or region. The factors which encourage localization of firms include;

  • A well-developed infrastructure in an area attracts firms into that area.
  • Availability of large population which may provide both labor and market.
  • Interdependence among various firms in areas such as training of personnel.
  • Government policy requiring firms to be located in a certain area.
  • Availability of raw materials in certain areas.

Advantages of Localization of Firms

  • Encourages establishment of support business enterprises e.g. many firms are located in one region, institutions e.g. banks, insurance, companies and distributors are likely to set up businesses in the area to offer services required.
  • Encourages creation of a pool of labor force. This is because when industries are concentrated in one area, people tend to migrate to that region in search of employment. This enables firms to meet their labor force requirements.
  • Localized firms are likely to attract others which use the finished goods of the established firms as raw materials thereby creating a market for localized firms.
  • Localized firms are able to easily dispose off their waste by either selling them to other firms for recycling or by jointly undertaking waste disposal projects.
  • Concentration of firms in one area encourages creation of employment opportunities in the region.
  • Concentration of firms in one area encourages development of the necessary infrastructure e.g. water systems, roads, communication network, health and education facilities in the region.

Disadvantages of Localization of Firms

  • Concentration of firms in one region may have negative impact on environment in the region e.g. emissions from factories may cause both air and water pollution.
  • May lead to regional imbalance in development e.g. areas of industrial concentration tend to enjoy provision of social amenities e.g. roads, schools, hospitals etc.
  • Concentration of firms in one region contributes to rural-urban migration. Such movements are undesirable because they may cause open unemployment in town while in rural areas they may cause labor deficiency.
  • Increased population in areas of industrial concentration may spark off a series of problems e.g. congestion, increased rate of crime, immorality, spread of diseases e.g. HIV/AIDS and housing problem.
  • Localization of firms may be undesirable because terrorism activities or war can destroy country’s industrial base.
  • A fall in demand of products produced by localized firms would result into a widespread unemployment in the affected area.

Delocalization of firms

Delocalization of firms refers to establishment of firms in different parts of country as opposed to localization where firms are concentrated in one area. The government may encourage delocalization in order to achieve various objectives by using various methods such as giving free land, tax benefits and offering subsidies.

Advantages of Delocalization

  • Reduces effects caused by occurrence of war, terrorism attacks or earthquakes.
  • Provides employment opportunities to people living in rural areas.
  • Reduce rural-urban migration
  • Encourage balanced regional development
  • Provide a market for locally produced raw material.
  • Local communities are able to get the produced goods without necessarily travelling very far.

Disadvantages of Delocalization

  • Spread of pollution to various parts of the country
  • Skilled manpower may not be readily available in rural areas.
  • Security may be a problem in some areas.
  • Service industries e.g. banks may not be available in rural areas.
  • Incentives offered by government are an added burden to tax payer.
  • Continued protection from foreign competition by government may make the firm to continue producing substandard products.

6.6 Size of a Firm

The size of a firm depends on the economies and diseconomies of scale. An optimum firm is a firm which has reached the most efficient size where costs of production per unit output are minimal. It’s the best / ideal point of a firm.

Conditions Necessary for an Optimum Firm

  • Factors of production must be combined in their most efficient manner.
  • The firm must be enjoying internal economies of scale.
  • The firm must have no motive to expand or contract.
  • The firm must be incurring lowest average cost.
  • The firm must be enjoying returns to scale.
  • The entrepreneur must be rational.

Optimum Size of the Firm

Economies and Diseconomies of Scale

This is the most efficient size of the firm, at which its costs of production per unit of output will be at a minimum, so that it has no motive either to expand or reduce its scale of production.  Thus, as a firm expands towards the optimum size it will enjoy economies of scale, but if it goes beyond the optimum diseconomies will set in.