The Role of the Firm

5

Production

The discussion thus far has focused primarily on the demand side of the market.We have seen,for example,that a firm’s total revenue will depend, in part,on the selling price of the product,which is determined by the interaction of consumer and producer behavior in the market.We have also investigated the conditions under which a firm might increase its revenues by changing the selling price of its product.

In spite of all that has thus far been accomplished,we have yet to examine the conditions under which firms produce the goods and services that are demanded by consumers,and perhaps more importantly from the perspective of senior management,the associated costs of production.If we are to investigate more closely the first-order and second-order conditions for a firm to maximize its profits,we must understand not only the revenue component of the profit equation,but the cost component as well.In this chapter we will examine the general problem of transforming productive resources in goods and services for sale in the market.

THE ROLE OF THE FIRM

The firm is an organizational activity that transforms factors of production,or productive inputs,into outputs of goods and services.Economics itself is the study of how society chooses to satisfy virtually unlimited human wants subject to scarce productive resources.In fact,this economic problem can be viewed as a constrained optimization problem in which the objective is to maximize some index of human happiness,which is assumed to be

a function of the consumption of limited,or scarce,amounts of goods and services.

Let us examine this fundamental economic paradigm a bit more closely. For theoretical purposes,it is useful to assume that human material wants and desires are insatiable.While this might not be so for any individual commodity,by and large the vast majority of individuals are never completely satisfied with what they have.Consumers will,in general,always want more of something.Unfortunately,consumers cannot have everything they want for the simple reason that the productive inputs necessary to produce these goods and services are finite.In other words,outputs of goods and services (Q) are limited because the productive resources necessary to produce them are limited.

Productive resources,or inputs,or factors of production are used by firms to produce goods and services.These productive resources may conceptually be divided into two broad categories—human and nonhuman resources.Nonhuman resources may be further classified as land, raw materials,and capital.While these classifications are arbitrary,they are conceptually convenient.

Land (e.g.,arable land for farming,or the land under buildings and roads) may be described as a “gift of nature.”Raw materials include such natural resources as coal,oil,copper,sand,and trees.Finally,capital represents manufactured inputs that are used in the production of final goods and services.Capital goods include tools,machinery,equipment,office buildings,and storage facilities.

In an economic sense,“capital”does not refer to such financial assets as money,corporate equities,savings accounts,and U.S.Treasury securities. There is a loose conceptual connection between the economic and financial definitions of the term in that firms that wish to acquire capital equipment will do so only if the additional return from an investment in capital goods is sufficient to cover the opportunity cost of the interest that might have been earned by investing in a financial asset.

Human resources,on the other hand,might be classified as labor and entrepreneurial ability.Labor consists of the physical and mental talents of individuals engaged in the production process.Labor services are similar to services derived from nonhuman resources in that the rental value of labor services (wages,salaries,health benefits,etc.) is determined by the interaction of supply and demand conditions in the market for factors of production.Labor is unique among the other factors of production,however,in that in a free society,labor decides for itself how intensively its services will be made available in the production process.

Entrepreneurial ability is a special subset of human resources because without the entrepreneur,all other factors of production cannot be combined.In other words,the services of land,labor,and capital are “rented” to the highest bidder through the interaction of supply and demand.The