Firms and Their Production Decisions

Firms as we know them today are a relatively new invention. Prior to the mid-1800s, almost all production was done by farmers, craftsmen, individuals who wove cloth and made clothing, and merchants and traders who bought and sold various goods. This was true in the U.S., Europe, and everywhere else in the world. The

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Production with One Variable Input (Labor)

When deciding how much of a particular input to buy, a firm has to compare the benefit that will result with the cost of that input. Sometimes it is useful to look at the benefit and the cost on an incremental basis by focusing on the additional out- put that results from an incremental

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Production with Two Variable Inputs

We have completed our analysis of the short-run production function in which one input, labor, is variable, and the other, capital, is fixed. Now we turn to the long run, for which both labor and capital are variable. The firm can now pro- duce its output in a variety of ways by combining different

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Returns to Production Scale

Our analysis of input substitution in the production process has shown us what happens when a firm substitutes one input for another while keeping output constant. However, in the long run, with all inputs variable, the firm must also consider the best way to increase output. One way to do so is to change

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Measuring Cost of Production: Which Costs Matter?

Before we can analyze how firms minimize costs, we must clarify what we mean by cost in the first place and how we should measure it. What items, for example, should be included as part of a firm’s cost? Cost obviously includes the wages that a firm pays its workers and the rent that

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Cost in the Short Run

In this section we focus our attention on short-run costs. We turn to long-run costs in Section 7.3. 1. The Determinants of Short-Run Cost The data in Table 7.1 show how variable and total costs increase with output in the short run. The rate at which these costs increase depends on the nature of

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Cost in the Long Run

In the long run, a firm has much more flexibility. It can expand its capacity by expanding existing factories or building new ones; it can expand or contract its labor force, and in some cases, it can change the design of its products or intro- duce new products. In this section, we show how

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Long-Run versus Short-Run Cost Curves

We saw earlier (see Figure 7.1— page 239) that short-run average cost curves are U-shaped. We will see that long-run average cost curves can also be U-shaped, but different economic factors explain the shapes of these curves. In this section, we discuss long-run average and marginal cost curves and highlight the differ- ences between

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Production with Two Outputs—Economies of Scope

Many firms produce more than one product. Sometimes a firm’s products are closely linked to one another: A chicken farm, for instance, produces poultry and eggs, an automobile company produces automobiles and trucks, and a uni- versity produces teaching and research. At other times, firms produce physically unrelated products. In both cases, however, a

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Dynamic Changes in Costs—The Learning Curve

Our discussion thus far has suggested one reason why a large firm may have a lower long-run average cost than a small firm: increasing returns to scale in production. It is tempting to conclude that firms that enjoy lower average cost over time are growing firms with increasing returns to scale. But this need

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Estimating and Predicting Cost of Production

A business that is expanding or contracting its operation must predict how costs will change as output changes. Estimates of future costs can be obtained from a cost function, which relates the cost of production to the level of output and other variables that the firm can control. Suppose we wanted to characterize the

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Production and Cost Theory—A Mathematical Treatment

This appendix presents a mathematical treatment of the basics of production and cost theory. As in the appendix to Chapter 4, we use the method of Lagrange multipliers to solve the firm’s cost-minimizing problem. 1. Cost Minimization The theory of the firm relies on the assumption that firms choose inputs to the production process

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Perfectly Competitive Markets

In Chapter 2, we used supply–demand analysis to explain how chang- ing market conditions affect the market price of such products as wheat and gasoline. We saw that the equilibrium price and quantity of each product was determined by the intersection of the market demand and market supply curves. Underlying this analysis is the

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Profit Maximization of the firm

We now turn to the analysis of profit maximization. In this section, we ask whether firms do indeed seek to maximize profit. Then in Section 8.3, we will describe a rule that any firm—whether in a competitive market or not—can use to find its profit-maximizing output level. Finally, we will consider the special case

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Marginal Revenue, Marginal Cost, and Profit Maximization

We now return to our working assumption of profit maximization and examine the implications of this objective for the operation of a firm. We will begin by looking at the profit-maximizing output decision for any firm, whether it operates in a perfectly competitive market or is one that can influence price. Because profit is

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Choosing Firm’s Output in the Short Run

How much output should a firm produce over the short run, when its plant size is fixed? In this section we show how a firm can use information about revenue and cost to make a profit-maximizing output decision. 1. Short–Run Profit Maximization by a Competitive Firm In the short run, a firm operates with

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The Competitive Firm’s Short-Run Supply Curve

A supply curve for a firm tells us how much output it will produce at every pos- sible price. We have seen that competitive firms will increase output to the point at which price is equal to marginal cost, but will shut down if price is below average variable cost. Therefore, the firm’s supply

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The Short-Run Market Supply Curve

The short-run market supply curve shows the amount of output that the industry will produce in the short run for every possible price. The indus- try’s output is the sum of the quantities supplied by all of its individual firms. Therefore, the market supply curve can be obtained by adding the supply curves of

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Choosing Firm’s Output in the Long Run

In the short run, one or more of the firm’s inputs are fixed. Depending on the time available, this may limit the flexibility of the firm to adapt its production process to new technological developments, or to increase or decrease its scale of operation as economic conditions change. In contrast, in the long run,

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Industry’s Long-Run Supply Curve

In our analysis of short-run supply, we first derived the firm’s supply curve and then showed how the summation of individual firms’ supply curves gener- ated a market supply curve. We cannot, however, analyze long-run supply in the same way: In the long run, firms enter and exit markets as the market price changes.