Theory of the firm is hard. It’s “ToF” to get your head around. The first year I taught IB Economics, my students really struggled with the diagrams and all of the memorisation in this part of the course. And I didn’t know how to help them remember it.
But I love taking something hard and making it easy. So I love mnemonics and finding a structure (or a system) that you can always use to get great results. This approach is the only thing that works for me.
So, while this is obviously an Economics post, you can also take this as a lesson in how to use mnemonics to pack otherwise hard-to-remember information into your brain. I read a lot of books on this subject to help my students (people like Cal Newport, Adam Robinson and Joshua Foer) and I’ve applied what I’ve learned here.
You might want to read your Theory of the Firm textbook chapters before reading this post, because this article won’t teach you the theory. That would require a very long and detailed post. Instead, what I want to do here is give you a powerful system to help you remember what most people struggle to: the 5 most important points in the theory of the firm.
First, here are the important ToF facts that most people try to memorise, but fail to, because they don’t use a system:
If a product is sold…
1) Where Marginal Revenue = 0 total, total revenue is maximised.
2) Where Marginal Cost = Average Total Cost (or, you can say, where Marginal Cost = Average Cost) productive efficiency is maximized AND the firm breaks even. (2 things to memorise there, rather than just one for each of the others).
3) Where Marginal Revenue = Average Variable Cost, the firm will have to shut-down. That’s their shutdown price. Well actually it’s the minimum price a firm can sell their product for before they have to shut-down –but we call it the shutdown price anyway.
4) Where Marginal Cost = Average Revenue, social benefit (or allocative efficiency) is maximized.
5) Where Marginal Cost = Marginal Revenue, profit is maximized.
I know, I know. By now you’re wishing you’d taken History instead of Econ. But you didn’t. You, my friend, are destined for greatness, so you’re just going to have to learn this and be great.
Let me tell you about these 5 rappers (or MC’s as we used to call back in the day). Each of these MC’s sell their albums for a particular price.
The 5 MCs
Here are their names and their personalities:
MR Zero doesn’t understand about costs. He just wants the biggest possible pay cheques (the most revenue). But, in the end, he doesn’t end up with a lot of profit (because revenue is not the same as profit). That might make him a big zero in your book, but doesn’t care. He just keeps smiling.
MC Average TC is just an average guy, so he’s not rich. He just breaks even every month. He’s also in the rock group MC AC, which is known for being against waste. (I show my students this video.) The helicopter pilot on this show was named TC. He was just an average guy and I don’t recall him ever wasting anything.
Where MR = AVC
MR AVC (pronounced as “Havoc”). This guy is the worst! No one likes him. Every time he goes to a club they know they’re going to have to shut down (if it gets even one penny worse). That’s how bad he is.
MC AR used to be so cool. Books were written about him. That’s how cool he was. Instead of calling him AR, we call him ARal (pronounced “Harold”) or MC ARal (Harold) Potter. The “al” part of his name is because he does do what’s good for society (allocative efficiency), allocating resources in a way that society sees as the best way.
MC MR profit is rich. He’s clever, so he sells at the price that makes the most amount of profit possible.
So there you go
If you try to think about the diagram in terms of these rappers, their personalities and what they accomplish by selling at the price they do, you’ll find it much easier to remember what the diagrams mean. For example, you can now remember that, if you if you sell your product at the price where MC=MR, you’ll maximize profit, but not allocative efficiency (because you’re not producing at MC=AR). And you won’t maximize your revenue, despite making all that profit, because you’re not selling where MR=0).
And as a free bonus
I’m going to spare you the rest of the work I did on this post. I tried to make up a rap song about these guys to help you remember even easier, but I’m actually not a very good rapper. I know, surprising right?! I’m as shocked as you are. Anyway, you lucked out not having to hear it. Just imagine me, with a backwards ballcap rapping like, “Mr Zero’s got more cash than anyone could ever handle, Yet not as much profit as an everyday vandal.” It was bad.