Firm Theory

Firms combine inputs and technology to produce goods and services. Production in Western economies is primarily done by privately held rms rather than state or government owned rms. In general, privately held rms are thought to be superior to publicly held rms. Private rms allow for: 1. Internalize risk - Only those who wish to bear risk do so. Risk is borne by those with comparative advantage to do so. Public rms force everyone to bear risk whether they wish to or not. 2. Minimize transaction costs - Private rms are motivated to minimize transaction costs, which is good for the rm and for society. Government owned rms/enterprises have a perverse incentive to maximize transaction costs. 3. Internalize the benets of knowledge - Private rms can take advantage of advancements in knowledge. The provides incentives for innovation. 4. Internalize the benets of size - Private rms take advantage of size but also will recognize that there is a limit to the benets of size. Government owned enterprizes have little incentive to recognize that bigger is not always better. Firms earn accounting prot A = T R T C or the dierence between accounting revenues (income) and accounting costs (expenditures). Economists distinguish between accounting prot and economic prot: e = T R T C OC or accounting prot less opportunity cost. Firms can earn zero economic prot even while they are earning positive accounting prot. For the moment, lets assume that opportunity cost is negligible compared to accounting prot. If this is the case, we can focus on accounting prot for the rest of the discussion. Total revenue = P rice Quantity and total cost can be considered a function of Quantity as well. Firms combine inputs and technology to produce output using a production function. Firms bear costs in production because they have to pay their inputs. A production function tells the rm how much it can produce with a given level of inputs. For most rms, there are dierent combinations of inputs that will produce the same amount of input. These combinations can be plotted on an iso-quant.

 A production function is simply a mathematical equation that tells the rm how much it can produce given a certain level of inputs. For example, a production function might look like Q = K L, where Q is output, L is the number of man hours, and K is the number of machines hired. This provides the rm with a production schedule K L Q 1 9 9 2 4 8 3 2 6 4 1 4 5 5 25 6 4 24 9 1 9

Notice that in general there are multiple combinations of inputs that can produce the same amount of output. K L Q 1 9 9 2 4.5 9 3 3 9 4 2.25 9 5 1.8 9 6 1.5 9 9 1 9

An isoquant is a curve that depicts the combinations of inputs that will produce the same amount of output. To produce more output we will need more of one input, or the other, or both. Labor 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8 9 10 Capital The slope of the isoquant is called the marginal rate of technical substitution (MRTS) which is the amount of labor that is required to maintain a given level of output when a unit of capital is taken away. The slope of the isoquant can be written as
L K
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= KL = 9 Q

M PK M PL

where M PK

is the marginal product of capital (the change in output due to a change in capital, holding labor xed), and M PL is the marginal product of labor (the change in output due to a change in the amount of labor, holding capital xed). 2

 Firms take output and sell it at the prevailing price. The more the rm can produce, the more revenue it can generate. Unfortunately, as it produces more it has to hire more inputs and therefore it will cost more. Firms that use more capital relative to labor are capital intensive. Firms that use more labor relative to capital are labor intensive. Firms spend money on inputs T C = F C + wL + rK where F C is xed cost that must be spent before rms produce any output, w is the wage paid to labor, r is the interest paid on capital. wL + rK is known as variable cost because these costs will change with the amount of output the rm produces. Consider T V C = wL + rK . If w and r are xed, then there are dierent combinations of capital and labor that will cost the same amount of money in total. The T V C can be rewritten as L = T V C/w r/wK . This is an equation of a line, assuming that T V C, w, r are xed. This line is called an iso-cost line. Labor

TV C w

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Slope = -r/w

Aordable A

Unaordable B

TV C r

Capital

The slope of the iso-cost line is r/w which is the relative price of capital to labor, i.e., how much labor must be sacriced to purchase one unit of capital. The isocost line is helpful because it depicts the frontier between what the rm can aord (in terms of labor and capital) and what it cannot aord. If the price of labor becomes more expensive, relative to capital, the isocost line will shift and become a bit more steep. If the price of capital increases relative to labor, the isocost line will shift and become a bit atter.

 Combining the isocost line and the isoquants allows us to determine the rms equilibrium level of output and, importantly, exactly how much capital and labor to hire. The rm wants to simultaneously maximize revenue, i.e,. output, while at the same time minimizing costs. Labor
. . . . . . . . . . . . . . . . . . . . . . . . 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . O. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TV C w TV C w

Q1

Q0 Capital

T V CO r

T V C1 r

In the graph depicting the rms choice, if the rm wants only to spend T V C0 amount on production, then it wants to produce the most it can. It is possible for the rm to produce Q0 of output (say at Point B or Point C), but the rm could do better. It could produce Q1 , which is by denition more than Q0 and spend the same amount of money. Note that at Point B, the rm would use more labor than capital, relative to Point E. At Point C, the rm would use more capital than labor, relative to Point E. At the prevailing relative price of labor, the rm would hire inputs at Point E and produce Q1 units of output. Another way to consider the rms problem is that, if it has chosen to produce Q1 units of output, it wants to do so with the least cost mix of capital and labor. The rm could spend T V C1 > T V C0 and produce Q1 but it doesnt have to. It can alter the mix of inputs to lower its costs and still produce the same amount of output. The least cost combination that will produce Q1 occurs at Point E. Point E is a rm equilibrium and is a tangency between the isoquant and the isocost, i.e., the isoquant and the isocost have the same slope at Point E r M PK = w M PL 4

While this condition looks weird, if we reorganize the condition it makes a little more sense: M PK M PL = w r This equation simply states that the rm should hire inputs such that the returns (in terms of output) on the last dollar spent on labor should equal the returns (in terms of output) on the last dollar spent on capital. What happens if the price of capital increases? The iso-cost curve will shift (become steeper) and this will alter the optimal mix of inputs and also alter the amount the rm can produce for a particular T V C . Labor
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TV C w

L1 L0

Q1

Q0 Capital

K1

K0

T V C0 r1

T V CO r0

Notice that as the price of capital increases, for a given amount of money to spend on production, the rm would hire more labor and less capital. The reverse holds as well - as labor becomes more expensive rms will hire more capital and less labor.