Theory of the firm

Microeconomics starts by studying how a single person decides what to buy. The theory of the firm asks the same kind of question about a business instead of a person.

It looks at how a firm chooses what to produce, how much to charge, how much to make, and how those choices turn into profit or loss.

The workbook gives no formula, percentage or numeric example for the theory of the firm. It is introduced as a short, qualitative extension of microeconomics, covering a firm's decision-making across inputs, outputs, prices, production levels, profits and losses, without a computation attached.

What the workbook does connect it to is the wider point of microeconomics itself: prices and production levels across an economy are driven by consumer demand, and the theory of the firm applies that same logic from the seller's side. A firm adopts different strategies to increase its own profits within that demand environment.

Illustrative — the workbook gives no worked example of its own. A garment manufacturer buys cotton yarn at Rs 220 per kg. Each shirt uses 0.4 kg, so yarn costs Rs 88 a shirt. Add Rs 150 of labour, overhead and packing and the total cost is Rs 238. The shirt sells for Rs 299, leaving a margin of Rs 61.

Yarn then rises to Rs 260 per kg. Yarn per shirt becomes Rs 104, total cost Rs 254, and the margin falls to Rs 45 — down 26% on an unchanged selling price.

The firm now has three choices, and the theory of the firm is the framework for comparing them:

One input price moved, and every option above is a decision about output, price or production level — the exact set of choices this theory exists to describe.

Chapter 5, section 5.1 (Basic Principles of Microeconomics), introduces the theory of the firm in a single paragraph while setting up the micro/macro distinction before moving into macroeconomic variables. Expect a definitional question distinguishing it from macroeconomics, rather than a computation.

• This is a microeconomics concept, not macroeconomics. The workbook draws the theory of the firm directly out of microeconomics, in contrast with variables like GDP, inflation and unemployment rate, which sit under macroeconomics in the very next section.
• The workbook does not develop this into cost curves, marginal analysis or a specific model. Do not import that machinery from outside this paper's text.