2.1 — Production and Firms

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# 2.1 — Production and Firms

## ECON 306 • Microeconomic Analysis • Spring 2023

### Ryan Safner<br> Associate Professor of Economics <br> <a href="mailto:safner@hood.edu"><i class="fa fa-paper-plane fa-fw"></i>safner@hood.edu</a> <br> <a href="https://github.com/ryansafner/microS23"><i class="fa fa-github fa-fw"></i>ryansafner/microS23</a><br> <a href="https://microS23.classes.ryansafner.com"> <i class="fa fa-globe fa-fw"></i>microS23.classes.ryansafner.com</a><br>

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# Outline

### [Production, Specialization, & Comparative Advantage](#7)
### [What Do Firms Do?](#33)

---

# Producer Behavior

.pull-left[

- How do **producers** decide:
  - which products to produce
  - in what quantity
  - using which inputs
  - and sold at what price?

- Answers to these questions are building blocks for .hi-red[supply curves]
]

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.center[
![:scale 100%](../images/workshop.jpg)
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]

---

# The Basics of Production

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- Nearly all goods must be **produced** before we can exchange & consume them

- .hi[Consumption] is the **using up** of value to gain utility
  - .hi-purple[Consumption is the ultimate goal of all economic activity]
]

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.center[
![](../images/valueadd.jpg)
]
]

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# The Basics of Production

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- .hi[Production] is the **creation** of value, by transforming *lower*-valued goods (resources, inputs, etc) into *higher*-valued goods (outputs, consumer products, etc)

- Iron Ore `$\rightarrow$` Steel `$\rightarrow$` Buildings, Bridges, Ovens, Water Bottles
]

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.center[
![](../images/valueadd.jpg)
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# It's Demand all the Way Down!

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- .hi-red[Supply] is actually .hi-blue[Demand] in disguise!

- An .hi[(opportunity) cost] to buy (scarce) inputs for production because **other people** .hi-blue[demand] those same inputs to consume or produce **other valuable things**!
  - Price necessary to **pull them out of other valuable productive uses** in the economy!
]

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![](../images/disappear.jpg)
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# What Do Firms Do?

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# The Firm

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- In modern market economies, most production takes place in an organization known as a .hi[firm]
  - A legal fiction for particular purposes

- It does not *have* to be this way, and for most of history it was not this way!
    - Craft guilds
    - Independent artisans
    - Independent contractors

]

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.center[
![:scale 100%](../images/firms.png)
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]

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# If Markets Are So Great, Why Do Firms Exist?

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.smallest[
- Firms exist in the forms they do because they are .hi-turquoise[an efficient response to particular problems of economic organization]

- Lots of interesting & Nobel-prize winning analysis

- For now, we'll sidestep these and just *assume* firms exist. Learn more in my .hi[Industrial Organization] course:
  - [Why Are There Firms?](https://ios20.classes.ryansafner.com/class/3.1-class/)
  - [The Firm as Nexus of Contracts](https://ios20.classes.ryansafner.com/class/3.2-class/)
  - [Asset Specificity and Vertical Integration](https://ios20.classes.ryansafner.com/class/3.3-class/)
  - [Contractual Restraints & Property Rights](https://ios20.classes.ryansafner.com/class/3.4-class/)

]
]

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.center[
![:scale 80%](../images/io_hex.png)
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# What Do Firms Do? I

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- We'll assume “the firm” is the agent to model:

- So what do firms do?

- How would we set up an optimization model:

1. **Choose:** .hi-blue[ < some alternative >]

2. **In order to maximize:** .hi-green[< some objective >]

3. **Subject to:** .hi-red[< some constraints >]

]

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.center[
![:scale 100%](../images/thefirm.JPG)
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# What Do Firms Do? II

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.smaller[
- Firms convert some goods to other goods: 
]
]

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.center[
![:scale 70%](../images/inputoutput.jpg)
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# What Do Firms Do? II

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.smaller[
- Firms convert some goods to other goods:

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.center[
![:scale 70%](../images/inputoutput.jpg)
]
]

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# What Do Firms Do? II

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.smaller[
- Firms convert some goods to other goods:

- **Inputs**: `$x_1, x_2, \cdots, x_n$`
  - <span class="green">**Examples**: worker efforts, warehouse space, electricity, loans, oil, cardboard, fertilizer, computers, software programs, etc<span>
  
- **Output**: `$q$`
  - <span class="green">**Examples**: gas, cars, legal services, mobile apps, vegetables, consulting advice, financial reports, etc<span>
]
]

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.center[
![:scale 70%](../images/inputoutput.jpg)
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# What Do Firms Do? III

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- .hi[Technology] or a .hi[production function]: rate at which firm can convert specified **inputs** `$(x_1, x_2, \cdots, x_n)$` into **output** `$(q)$`
`$$q=f(x_1, x_2, \cdots, x_n)$$`

]

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.center[
![:scale 70%](../images/inputoutput.jpg)
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# Production Function as Recipe

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.center[The production function

![](../images/recipe1.PNG)
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]

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.center[The production algorithm

![](../images/recipe2.PNG)
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]

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# Factors of Production I

`$$q=A \,f(t,l,k)$$`

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.smaller[
- Economists typically classify inputs, called the .hi[“factors of production” (FOP)]:

<table>
 <thead>
  <tr>
   <th style="text-align:left;"> Factor </th>
   <th style="text-align:left;"> Owned By </th>
   <th style="text-align:left;"> Earns </th>
  </tr>
 </thead>
<tbody>
  <tr>
   <td style="text-align:left;"> Land (t) </td>
   <td style="text-align:left;"> Landowners </td>
   <td style="text-align:left;"> Rent </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Labor (l) </td>
   <td style="text-align:left;"> Laborers </td>
   <td style="text-align:left;"> Wages </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Capital (k) </td>
   <td style="text-align:left;"> Capitalists </td>
   <td style="text-align:left;"> Interest </td>
  </tr>
</tbody>
</table>
]
.smallest[
- `$A$`: .b["total factor productivity"] (ideas/knowledge/institutions)

]
]
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.center[
![](../images/factors.jpg)
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]

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# Factors of Production II

`$$q=f(l,k)$$`

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- We will assume just two inputs: labor `$l$` and capital `$k$`

]

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.center[
![](../images/factors.jpg)
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# What Does a Firm Maximize?

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- We assume firms .hi-purple[maximize profit `\$(\pi)\$`]

- Not true for all firms
    - <span class="green">**Examples**: non-profits, charities, civic associations, government agencies, criminal organizations, etc</span>

- Even profit-seeking firms may also want to maximize *additional* things
    - <span class="green">**Examples**: goodwill, sustainability, social responsibility, etc </span>

]

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.center[
![](../images/gnomes.png)
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# Profits Have a Bad Rap These Days

.center[
![:scale 80%](../images/peopleoverprofits.jpg)
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# What is Profit?

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- In economics, .hi-purple[profit] is simply **benefits minus (opportunity) costs**

]

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.center[
![](../images/profitloss2.jpg)
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# What is Profit?

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- In economics, .hi-purple[profit] is simply **benefits minus (opportunity) costs**

- Suppose firm sells **output** `$q$` at price `$p$`

]

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.center[
![](../images/profitloss2.jpg)
]
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# What is Profit?

.pull-left[

- In economics, .hi-purple[profit] is simply **benefits minus (opportunity) costs**

- Suppose firm sells **output** `$q$` at price `$p$`

- It can buy each **input** `$x_i$` at an associated price `$p_i$`, i.e.
    - labor `$l$` at wage rate `$w$`
    - capital `$k$` at rental rate `$r$`

]

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.center[
![](../images/profitloss2.jpg)
]
]

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# What is Profit?

.pull-left[

- In economics, .hi-purple[profit] is simply **benefits minus (opportunity) costs**

- Suppose firm sells **output** `$q$` at price `$p$`

- It can buy each **input** `$x_i$` at an associated price `$p_i$`, i.e.
    - labor `$l$` at wage rate `$w$`
    - capital `$k$` at rental rate `$r$`

- The profit of selling `$q$` units and using inputs `$l,k$` is:

]

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.center[
![](../images/profitloss2.jpg)
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# Who Gets the Profits? I

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`$$\pi=\underbrace{pq}_{revenues}-\underbrace{(wl+rk)}_{costs}$$`

]

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.center[
![](../images/riskprofit.jpg)
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# Reminder from Macroeconomics: “The Circular Flow”

.center[
![:scale 60%](../images/circularflow.png)
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# Who Gets the Profits? I

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`$$\pi=\underbrace{pq}_{revenues}-\underbrace{(wl+rk)}_{costs}$$`

- .hi-purple[The firm's costs are all of the factor-owner's incomes!]
    - Landowners, laborers, creditors are all paid rent, wages, and interest, respectively

]

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.center[
![](../images/riskprofit.jpg)
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# Who Gets the Profits? I

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`$$\pi=\underbrace{pq}_{revenues}-\underbrace{(wl+rk)}_{costs}$$`

- Profits are the .hi-purple[residual value] leftover after paying all factors

- Profits are income for the .hi[residual claimant(s)] of the production process (i.e. **owner(s)** of a firm):
    - Entrepreneurs
    - Shareholders

]

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.center[
![](../images/riskprofit.jpg)
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# Who Gets the Profits? II

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`$$\pi=\underbrace{pq}_{revenues}-\underbrace{(wl+rk)}_{costs}$$`

- Residual claimants have incentives to maximize firm's profits, as this *maximizes their own income*

- Entrepreneurs and shareholders are the only participants in production that are *not* guaranteed an income!
    - Starting and owning a firm is inherently **risky**!

]

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.center[
![](../images/tightrope.jpg)
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# People Overestimate Profits

.center[
![:scale 52%](../images/profitmargins.png)
]

.source[Source: [American Enterprise Institute](https://www.aei.org/carpe-diem/the-public-thinks-the-average-company-makes-a-36-profit-margin-which-is-about-5x-too-high-part-ii/)]

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# Profits and Entrepreneurship: A Preview

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- In markets, production must face the .hi[profit test]:
    - <span class="hi-purple">Is consumer's willingness to pay `$>$` opportunity cost of inputs?</span>

- Profits are an indication that **value is being created for society**

- Losses are an indication that **value is being destroyed for society**

- Survival in markets *requires* firms continually create value & earn profits
]

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.center[
![](../images/feedback.png)
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# The Firm's Optimization Problem I

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- So what do firms do?

1. **Choose:** .hi-blue[ < some alternative >]

2. **In order to maximize:** .hi-green[< profits >]

3. **Subject to:** .hi-red[< technology >]

- We've so far assumed they maximize profits and they are limited by their technology

]

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.center[
![](../images/management.jpg)
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# The Firm's Optimization Problem II

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- What do firms **choose**? (Not an easy answer)

- Prices?
    - Depends on the market the firm is operating in!
    - Study of <span class="hi">industrial organization</span>
    
- Essential question: .hi-turquoise[how competitive is a market?] This will influence what firms (can) do
]

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.center[
![](../images/marketpower.jpg)
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# Industrial Organization: A Roadmap I

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- Begin with one extreme case: .hi[“perfect competition”]
  - Firms can choose to sell as much `$q^*$` as they want
  - Firms are constrained to sell at the (exogenous) market price `$\bar{p}$`

- Appropriate for settings with *many* firms, each small relative to market
]

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.center[
![](../images/commodities.png)
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# Interlude

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- After we find firm's .hi-purple[optimal decisions] in this market (and have Exam 2), we will then finally look at .hi-purple[Unit III: Market Equilibrium]

- Put .red[Supply] and .blue[Demand] together
]

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]

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# Interlude

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- We've seen how **consumers** cause and respond to market changes
  - e.g. `$(\Delta p_x$`, `$\Delta p_y$`, `$\Delta m$`)
  
- We're about to explore how **producers** cause and respond to market changes

- Finally we can explain all of these market changes with Supply and Demand .hi[equilibrium models]

- Discuss how markets work, why they are good & efficient, and when they fail
]

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]

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# Industrial Organization: A Roadmap II

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- Examine another extreme case: .hi[monopoly] of a single seller
    - Appropriate for some markets

- .hi-purple[“Imperfect competition”]: models of .hi[monopolistic competition] & .hi[oligopoly]
    - In latter case, firms act **strategically**, so we will need <span class="hi-purple">game theory</span>
    
- Firms can choose *both* `$q^*$` & `$p^*$` to maximize `$\pi$`

]

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.center[
![:scale 100%](../images/chessknights.jpg)
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