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 concept of a firm—run by managers separate from the firm’s own-ers, and who hire and manage a large number of workers—did not even exist. Modern corporations emerged only in the latter part of the 19th century.1

Today we take firms for granted. It is hard for us to imagine the production of automobiles without large companies like Ford and Toyota, the production of oil and natural gas without companies like Exxon-Mobil and Shell, or even the production of breakfast cereal without companies like Kellogg and General Mills. But stop for a minute and ask yourself whether we really need firms to produce the goods and services that we consume regularly. This was the ques- tion raised by Ronald Coase in a famous 1937 article: If markets work so well in allocating resources, why do we need firms?2

1. Why Do Firms Exist?

Do we really need firms to produce cars? Why couldn’t cars be produced by a collection of individuals who worked independently and contracted with each other when appropriate, rather than being employed by General Motors? Couldn’t some people design a car (for a fee), other people buy steel, rent the equipment needed to stamp the steel into the shapes called for in the design, and then do the stamping (also for negotiated fees), other people make steering wheels and radiators, still other people assemble the various parts, and so on, where again, every task would be performed for a negotiated fee?

Or take another example: We—the authors of this book—work for universi- ties, which are essentially firms that provide educational services along with research. We are paid monthly salaries and in return are expected to teach regu- larly (to students recruited by our “firms” and in classrooms the “firms” pro- vide), do research and write (in the offices our “firms” give us), and carry out administrative tasks. Couldn’t we simply bypass the universities and offer our teaching services on an hourly basis in rented classrooms to students who show up and pay us, and likewise do research on a paid piecemeal basis? Do we really need colleges and universities with all their overhead costs?

In principle, cars could indeed be produced by a large number of indepen- dent workers, and an education could be produced by a number of independent teachers. These independent workers would offer their services for negotiated fees, and those fees would be determined by market supply and demand. It shouldn’t take you long, however, to realize that such a system of production would be extremely inefficient. Think about how difficult it would be for inde- pendent workers to decide who will do what to produce cars, and negotiate the fees that each worker will charge for each task. And if there were any change in the design of the car, all of these tasks and fees would have to be renegotiated. For cars produced this way, the quality would likely be abysmal, and the cost astronomical.

Firms offer a means of coordination that is extremely important and would be sorely missing if workers operated independently. Firms eliminate the need for every worker to negotiate every task that he or she will perform, and bargain over the fees that will be paid for those tasks. Firms can avoid this kind of bar- gaining by having managers that direct the production of salaried workers—they tell workers what to do and when to do it, and the workers (as well as the man- agers themselves) are simply paid a weekly or monthly salary.

There is no guarantee, of course, that a firm will operate efficiently, and there are many examples of firms that operate very inefficiently. Managers cannot always monitor what workers are doing, and managers themselves sometimes make the theory of the firm (and more broadly, organizational economics) has become an important area of microeconomic research. The theory has both positive aspects (explaining why managers and workers behave the way they do) and normative aspects (explaining how firms can be best organized so that they operate as effi- ciently as possible).3 We will discuss some aspects of the theory later in this book. At this point we simply stress that firms exist because they allow goods and ser- vices to be produced far more efficiently than would be possible without them.

2. The Technology of Production

What do firms do? We have seen that firms organize and coordinate the activi- ties of large numbers of workers and managers. But to what purpose? At the most fundamental level, firms take inputs and turn them into outputs (or prod- ucts). This production process, turning inputs into outputs, is the essence of what a firm does. Inputs, which are also called factors of production, include anything that the firm must use as part of the production process. In a bakery, for example, inputs include the labor of its workers; raw materials, such as flour and sugar; and the capital invested in its ovens, mixers, and other equipment needed to produce such outputs as bread, cakes, and pastries.

As you can see, we can divide inputs into the broad categories of labor, materi- als, and capital, each of which might include more narrow subdivisions. Labor inputs include skilled workers (carpenters, engineers) and unskilled workers (agricultural workers), as well as the entrepreneurial efforts of the firm’s manag- ers. Materials include steel, plastics, electricity, water, and any other goods that the firm buys and transforms into final products. Capital includes land, build- ings, machinery and other equipment, as well as inventories.

3. The Production Function

Firms can turn inputs into outputs in a variety of ways, using various combina- tions of labor, materials, and capital. We can describe the relationship between the inputs into the production process and the resulting output by a production function. A production function indicates the highest output q that a firm can produce for every specified combination of inputs.4  Although in practice firms use a wide variety of inputs, we will keep our analysis simple by focusing on only two, labor L and capital K. We can then write the production function as

q = F(K, L)                                                       (6.1)

This equation relates the quantity of output to the quantities of the two inputs, capital and labor. For example, the production function might describe the num- ber of personal computers that can be produced each year with a 10,000-square- foot plant and a specific amount of assembly-line labor. Or it might describe the crop that a farmer can obtain using specific amounts of machinery and workers.

It is important to keep in mind that inputs and outputs are flows. For exam- ple, our PC manufacturer uses a certain amount of labor each year to produce some number of computers over that year. Although it might own its plant and machinery, we can think of the firm as paying a cost for the use of that plant and machinery over the year. To simplify things, we will frequently ignore the reference to time and refer only to amounts of labor, capital, and output. Unless otherwise indicated, however, we mean the amount of labor and capital used each year and the amount of output produced each year.

Because the production function allows inputs to be combined in varying proportions, output can be produced in many ways. For the production func- tion in equation (6.1), this could mean using more capital and less labor, or vice versa. For example, wine can be produced in a labor-intensive way using many workers, or in a capital-intensive way using machines and only a few workers.

Note that equation (6.1) applies to a given technology—that is, to a given state of knowledge about the various methods that might be used to transform inputs into outputs. As the technology becomes more advanced and the production function changes, a firm can obtain more output for a given set of inputs. For example, a new, faster assembly line may allow a hardware manufacturer to produce more high-speed computers in a given period of time.

Production functions describe what is technically feasible when the firm oper- ates efficiently—that is, when the firm uses each combination of inputs as effec- tively as possible. The presumption that production is always technically effi- cient need not always hold, but it is reasonable to expect that profit-seeking firms will not waste resources.

4. The Short Run versus the Long Run

It takes time for a firm to adjust its inputs to produce its product with differing amounts of labor and capital. A new factory must be planned and built, and machinery and other capital equipment must be ordered and delivered. Such activities can easily take a year or more to complete. As a result, if we are look- ing at production decisions over a short period of time, such as a month or two, the firm is unlikely to be able to substitute very much capital for labor.

Because firms must consider whether or not inputs can be varied, and if they can, over what period of time, it is important to distinguish between the short and long run when analyzing production. The short run refers to a period of time in which the quantities of one or more factors of production cannot be changed. In other words, in the short run there is at least one factor that cannot be varied; such a factor is called a fixed input. The long run is the amount of time needed to make all inputs variable.

As you might expect, the kinds of decisions that firms can make are very different in the short run than those made in the long run. In the short run, firms vary the intensity with which they utilize a given plant and machinery; in the long run, they vary the size of the plant. All fixed inputs in the short run repre- sent the outcomes of previous long-run decisions based on estimates of what a firm could profitably produce and sell.

There is no specific time period, such as one year, that separates the short run from the long run. Rather, one must distinguish them on a case-by-case basis. For example, the long run can be as brief as a day or two for a child’s lemonade stand or as long as five or ten years for a petrochemical producer or an automo- bile manufacturer.

We will see that in the long run firms can vary the amounts of all their inputs to minimize the cost of production. Before treating this general case, however, we begin with an analysis of the short run, in which only one input to the pro- duction process can be varied. We assume that capital is the fixed input, and labor is variable.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.