Testing the Orthodox Theory of the Firm
Learning Objectives
By the end of this section, you will be able to:
- Construct testable hypotheses from the orthodox theory of the firm
- Test these hypotheses against the given data
Let’s review the basic properties of the orthodox theory of the firm as given in previous chapters (“Cost and Industry Structure,” “Perfect Competition,” and “Monopoly”). To keep things simple, we’ll focus on the short run behavior of a single firm, and we’ll look to the similarities of this behavior regardless of whether the market is competitive or monopolistic. First, the firm is portrayed as a functional relationship between inputs (factors) and outputs (products). Because we’re considering the short run, there are variable and fixed inputs, and therefore variable and fixed costs.
Second, the firm accepts the demand for its product as given and determines how much it should produce–its quantity of output (Q)–so that its profits are maximized where the cost of producing the last unit equals the revenue from selling it–that is, where marginal cost (MC) equals marginal revenue (MR). We assume that the firm is subject to diminishing marginal returns. Therefore marginal costs will always eventually rise to meet marginal revenue and will cause average total cost (ATC) to eventually rise (giving it its ‘U’ shape). Hence, the very simple Hypothesis 1: over some short-run period, managers are aware of their firms’ marginal costs associated with increasing (or decreasing) their production, and they generally find that marginal cost increases over a relevant range of production.
Now, consider the conditions presented in the chapters “Cost and Industry Structure” and “Perfect Competition”:
- If MC < ATC, then ATC is decreasing (marginal cost is ‘dragging down’ average total cost the same way a low test score would drag down your course grade). Therefore, if ATC is decreasing, it must be the case that MC < ATC.
- Profits = Q(P-ATC), where P represents price. Therefore, firms make losses when P < ATC, break even when P = ATC, and make profits when P > ATC.
- Profit maximizing firms under perfect competition produce where MC = MR = P.
We can read these three conditions in reverse to establish a necessary condition for firms to avoid making a loss. Plugging (3) into (2), it should be clear that, since the firm will produce where P = MC, the profit equation can be restated as Profits = Q(MC – ATC) under perfect competition. Hence, if the firm is going to break even or make a profit then MC must be ≥ ATC. Taking this back to (1), then, for MC to be equal to or greater than ATC, ATC must either be constant or increasing at some reasonable level of output.
Hence, Hypothesis 2: if firms maximize profits by producing a quantity where marginal cost equals marginal revenue, then under competitive conditions firms must normally be producing in a situation in which average total cost is either constant or increasing. Really, this is just an extens