Theory of the Firm 1


(i) 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.

Note: In the definition of the firm, we assume that a firm in a unit that makes decision with respect to the production and sale of goods and services in the regard, we assume that.

- All firms are profit-maximisers i.e. they seek to make as much profit as possible.

- Each firm can be regarded as a single consist
tent 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.

NOTE: 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

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

Def: 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

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.

e) Liance fees e.t.c Output (units FC (sh)

100 200

200 200

300 200

400 200

500 200

This may be represented graphically as:

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


a) Payments on raw materials

b) Wages paid to casual labour

c) Water, transport and electricity bills

Output (units) variable cost (shs)

0 0

100 200

200 400

300 600

400 800

500 1000

This can be represented graphically as;

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.


(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.

Output (units) cost (sh)
0 4

1 10

2 18

3 24

4 27

5 32

Theory of the Firm 1 | Theory of the Firm 2 |
Theory of the Firm 3 | Theory of the Firm 4 |
Theory of the Firm 5 | Theory of the Firm 6 |

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