Analysis of Choice: The Firm
It is now time to get back to our discussion of choices, in this case the choices that confront firms. Before we are done with our analysis of firms, we will have looked at an array of choices they will need to make including decisions about what mix of inputs to use in production, what level of output to produce, and what means of financing the operation should be used. If you are running a university for example, you will need to determine how many computers to buy and how many faculty to hire, how many students to accept, how to raise the revenue needed to stay in business. First, however, we need to talk about who are these firms that we will be discussing. There are many millions of firms (20+ million) and thus it will be essential for us to develop some categories - ways of grouping these firms. In this unit we will discuss a few important classification schemes - by type of ownership, by size, by industry, and by market structure. Here we will talk about the service sector, corporations, and monopolies - the terms you are likely to run across in your reading of the news.
We will also need to discuss what it is that is guiding these firms in their choice situations. There are many possibilities - just as there are many possible explanations of an individual's choices. One possibility would be sales or market share. If size matters, then you may expect a firm to simply focus attention on growth in sales or market share. For example, in the 1980s Japanese companies were thought to be very different from American firms because the Japanese firms were said to take the longer view of decisions, or in more technical terms, they discounted the future less than American companies. As a result of this longer view, Japanese firms tended to be very concerned with market share, the percentage of an industry's total sales, and this year's profit was not a major concern to them. Japanese firms would absorb poor profit results in the short-term because the long-term benefits were seen to be quite large. American firms, meanwhile, have been accused of taking a much shorter view of the world, a view which heavily weights current profit in their decisions.
A second possibility would be that firms are satisficing and not trying to maximize profit or market share. The basic premise here is that firms simply do not have enough information to make any real attempt at maximizing profit and therefore they set some goals - a 6 percent sales growth, a profit rate of 8 percent, and a stock price of $45. In this situation profit would be only one of the factors influencing firms' decisions. In most cases, however, the goals would have something to do with the financial condition of the firm. If the firm happens to be a public corporation, you have access to the firm's financial statements. In accounting courses you will learn the basics that will allow you to help produce these statement. You may want to check out the company site where you can find some of the company financial forms. The two we have talked about are balance sheets and income statements, an example of which has been pulled off the web. In September of 1999 this company had assets of approximately $1 billion - about one third in the form of cash. The companies liabilities were approximately $195 million leaving the company's net worth at approximately $825 million - the amount of money left if all of the companies assets were sold and bills paid. Where the balance sheet is concerned with what a company is worth, the income statement describes what the company earns. In 1999 the company's sales revenue equaled approximately $950 million. The materials they sold cost them approximately $500 million which gave them a gross profit of about $450 million. Out of this the company paid for expenses and taxes and ended up with a profit of nearly $140 million.
In this course we will follow the lead of most economics texts and focus our attention on profit maximization as the firm's primary goal and derive the guidelines for behavior based on this goal. "If you are a profit maximizing firm, then you should...." What you should recognize at the outset is the conditions which we derive are ONLY valid when we are talking about this narrow objective. Stated somewhat differently, what is good for a profit maximizer is not necessarily good for a firm attempting to maximize market share.
The place to start is with the concept of Profit. Profit is defined as the difference between revenues and costs [Profit = Total Revenues - Total Costs]. In our example, it costs you $810 million to run the company and it bring in revenues of $950 million, then the profit is $140 million. These are the concepts that we will be focusing on in our analysis of the firm.
The logical structure of the analysis of business choices when firms are interested in maximizing profit is described in the diagram below. Given the firm's goal is to maximize profit, then its decisions can be expected to be affected by both costs and revenues. The place to start is with analyses of costs and revenues. In the discussion of costs and revenues we need to acknowledge the importance of the time horizon. When we talk about the short-run, we will be talking about a period of time short enough so that capital (machines and facilities) cannot be changed. The long-run represents a period of time sufficient to allow for changes in all inputs - long enough, for example, to build a new plant.
In this unit we will be focusing our attention on the cost side of the equation, material that appears in red in the diagram. To fully understand the relationship between output and cost, we will need to decompose our analysis into two parts - production relationships that define the link between inputs and outputs, and cost relationships that link output and cost. These important relationships will be described in the Outline section. You will also find a section in which the graphical representation of the concepts are presented and an example of the concepts based on the operation of the university RIU.
The Logic of Business Choice
One thing to keep in mind as you work through the analysis of the firm is the importance of the time horizon. Here we will be making the distinction between the short-run and the long-run and ignoring the very long-run. The difference between short-run and long-run is based on the ability to alter inputs and thus varies across industries. When we talk about short-run we are not allowing enough time for the level of all inputs, to vary and thus we focus on the relationships between one input and output and cost. In long-run analysis, meanwhile, all inputs are allowed to vary and we examine what happens to output and cost when all of the inputs change. At this time we will not discuss the very long-run which is a time-frame that allows for the technology to change.
Production Relationships
The analysis of production describes the process by which a firm transforms inputs (ex. labor and machines) into outputs (haircuts, automobiles, education). Here we will be introducing some important productivity concepts (marginal productivity) and discussing the link between the production and cost concepts. It is also a time where you will be introduced to the concept of diminishing marginal product. In the long-run analysis we will discuss the concept of returns to scale which provides us with an answer to the question: what happens to output if we double all of our inputs? This is one of the key places technology, or more specifically, technological change, affects the market system by affecting the individual firms.
Cost Relationships
After the discussion of production, we will shift to a discussion of a variety of cost concepts. As we proceed through this section, however, it is essential you realize we are talking about economic cost and not accounting costs. One place where you would see a difference between economic and accounting cost would be in the cost of capital. When you run a business you need to keep some funds in cash or a checking account which earns little or no interest. This costs you nothing in an accounting sense, so it would not even enter into the profit calculations. There is, however, a cost to tying that money up since it could be used in other ways that would make money. If you tie up $10,000 in cash in running the business and you could earn 5 percent on your money if you invested it, then using the $10,000 would cost you $500 (.05*$10,000). This $500 would show up as a cost. In this case the economic cost would be $500 higher than the accounting cost. An understanding of the economic cost concept is the only way that you will be able to understand the concept of zero profit which is so important to economists.
In this component of the course you will also examine the division of costs between fixed costs and variable cost. These concepts will be extremely important in the next unit where they are used to explain the rules governing the input choices of firms. Another concept we will discuss, one that will enter into the calculations of profit maximizing behavior, will be marginal cost. It is in this unit you will see the error in statements such as: "Because we have already spent $2 billion on this project, we should spend the $100 million more to complete it." When we are finished with this unit you will also have a new perspective on "knowing when to cut you losses."
Revenue Relationships
This analysis of costs will be followed by a thorough discussion of the revenue side of the equation in following units. Since revenue is dependent upon the price charged and the quantity bought, any analysis of revenue will need to begin with a discussion of demand. This is where demographics enters the scene since demand will depend upon the size and composition of the population. The important revenue relationships will be described in the Outline section. You will also find a section in which the graphical representation of the concepts are presented. It is at that time we will introduce the concept of market structure and discuss the output decisions of firms under perfectly competitive, monopolistic, and imperfectly competitive conditions. If all goes well, here is where you will begin to understand why in the summer of 1998 suit was brought against Bill Gate's Microsoft. You will also better understand the benefits associated with getting into an industry early.
Output and Pricing Decisions and Input Choices
Once we have the two pieces, we will look at the implications of this model. We will first look at it from the perspective of the firm. It is here that you will be introduced to the optimal output / pricing rule for profit maximization. Here is where you will first see the marginal revenue equals marginal cost rule (MR = MC) that should guide the behavior of firms attempting to maximize profit. These important relationships will be described in the Rule section. You will also find a section in which the graphical representation of the concepts are presented and an example of the concepts based on the operation of the university RIU. This will be followed a unit later with a discussion of optimal input choice and the rules that will guide a firm when deciding on the use of inputs.
As we work through the analysis of the output and input decisions of the firm keep in mind that they are simply two sides of the same coin. A firm's decision regarding how much to produce is also a decision regarding how many inputs to use. The link between the two is the production function that we discuss in the production section. This tends to be a bit confusing because you will see two versions of the concept of marginal cost and marginal revenue. In the case of the output market you will discuss the marginal cost and marginal revenue of additional output, while in the input market you will be talking about the marginal cost and marginal revenue of an input.
Perfect Competition and the 'Ideal' World
Once our analysis of the cost and revenue side of the ledger has been completed, we will then look at the situation when the firm is operating in a market characterized by perfect competition. This segment of the course will close with a brief discussion of the implications of the combined model of individual and firm choice from the perspective of the broader society. Are there reasons to believe society will benefit from a 'hands-off' approach by government that allows firms to pursue profit? This is at the heart of much of our thinking on the role of the government in society and we will spend time at the end of this course looking at the pros and cons of government involvement.
Now that we know where we are going, how do we get there? How do we present the material? As indicated at the outset of this course, there are many ways to get to the same point. We could take the highly mathematical algebraic approach, the graphical approach which dominates introductory textbook, or a less mathematical treatment that relied more heavily on tables and words. In this course we will generally avoid the algebraic approach and downplay the graphical analysis which should be good news to most of you. In this version of microeconomics we will rely heavily on tables and words.
To make life a little easier we will also introduce the basic concepts with the help of two example you should be able to relate to. Throughout this section of the course you will be following the situation at RIU, an institution of higher education similar to where you have been spending your time. In this example output will be the number of students and the input is the number of faculty. We will leave for another time discussion of difficult issues such as the quality of education. The second will be the situation faced by Chris, a student in an introductory ECN course who is using tutors to improve the economics grade. The question here will be - how many hours should be spent studying with the tutor?
One of the questions we will not be addressing, but one that economists have examined, is why firms exist if the market is so effective at allocating scarce resources? Firms and markets can be viewed as alternative means of allocating resources - one very centralized (firm) and one where authority is decentralized (market). One way of looking at the situation would be to consider the best way to obtain an important piece of machinery. If you bought a good number of the items which are fairly standard , non specialized items, them you would most likely want to use the market. If URI were buying computers, it probably would want to buy them on the open market. An oil company, however, interested in buying an oil platform may not want to rely on the market because of the possibility of opportunistic behavior. We also will not examine some potential deficiencies with the optimization model, problems associated with the structure of corporations. When there is a separation from ownership and management, we are likely to be confronted with a principal-agent problem. If you are a sales person working on a salary and are working Newport in the summer, is it likely that you will find yourself on the beach rather than making appointments on a beautiful day? You would certainly be more likely to do it if you owned the company. There is also the problem of associated with team production, a problem with shirking. When working in groups you may find that the goals of the individual are different from that of the team which creates management and organizational difficulties, the subject matter of some courses in organizational theory and management.