No Such Thing as a Free Lunch: Principles of Economics (Part 30)

History shows that where ethics and economics come in conflict, victory is always with economics. Vested interests have never been known to have willingly divested themselves unless there was sufficient force to compel them.

B. R. Ambedkar

The Production Process: The Behavior of Profit-Maximizing Firms

(Part A)

by

Charles Lamson

In parts 25-29 of this analysis, we took a brief look at the household decisions that lie behind supply and demand curves. We spent some time discussing household choices: how much to work and how to choose among the wide range of goods and services available within the constraints of prices and income. We also identified as some of the influences on household demand in output markets (markets in which goods and services are exchanged), as well as some of the influences on household supply behavior in input markets (markets in which resources---labor, capital, and land---used to produce products, are exchanged.

We now turn to the other side of the system and examine the behavior of firms. Business firms purchase inputs to produce and sell outputs that range from computers to string quartet performances. In other words, they demand factors of production in input markets and supply goods and services in output markets. Figure 1 repeats the circular flow diagram you first encountered in the last post. In the next several posts we look inside the firm at the production process that transforms inputs into outputs.

Although upcoming posts describe the behavior of perfectly competitive firms, much of what we say in these posts also applies to firms that are not perfectly competitive. For example, when we turn to monopoly later on in this analysis, we will be describing firms that are similar to competitive firms in many ways. All firms, weather competitive or not, demand inputs, engage in production, and produce outputs. All firms have an incentive to maximize profits and thus to minimize costs.

Central to our analysis is production, the process by which inputs are combined, transformed, and turned into outputs. Firms vary in size and internal organization, but they all take inputs and transform them into things for which there is some demand. For example, an independent accountant combines labor, paper, telephone service, time, learning, and a website to provide help to confused taxpayers. An automobile plant uses steel, labor, plastic, electricity, machines, and countless other inputs to produce cars. Before we begin our discussion of the production process, however, we need to clarify some of the assumptions on which our analysis is based.

Production Is Not Limited to Firms Although our discussions in the next several posts focus on profit-making business firms, it is important to understand that production and productive activity are not confined to private business firms. Households also engage in transforming factors of production (labor, capital, energy, natural resources, etc.) into useful things. When I work in my garden, I am combining land, labor, fertilizer, seeds, and tools (capital) into the vegetables I eat and the flowers I enjoy. The government also combines land, labor, and capital to produce public services for which demand exists: national defense, police and fire protection, and education, to name a few.

Private business firms are set apart from other producers, such as households and government, by their purpose. A firm exists when a person or a group of people decides to produce a good or service to meet a perceived demand. They engage in production---that is, they transform inputs into outputs because they can sell their products for more than it costs to produce them.

Even among firms that exist to make a profit, however, there are many important differences. A firm's behavior is likely to depend on how it is organized internally and on its relationship to the firms with which it competes. How many competitors are there? How large are they? How do they compete? While many different kinds of market organization can be observed in the economy, it makes sense to begin the analysis with the simplest: perfect competition.

Perfect Competition Perfect competition exists in an industry that contains many relatively small firms producing identical products. In a perfectly competitive industry, no single firm has any control over prices. In other words an individual firm cannot affect the market price of its product or the prices of the inputs that it buys. This important characteristic follows from two assumptions. First, a competitive industry is composed of many firms, each small relative to the size of the industry. Second, every firm in a perfectly competitive industry produces homogeneous products, which means that one firm's output cannot be distinguished from the output of the others. 

These assumptions limit the decisions open to competitive firms and simplify analysis of competitive behavior. Firms in perfectly competitive industries do not differentiate their products, and do not make decisions about price. Instead, each firm takes prices as given---that is, as determined in the market by the laws of supply and demand and decides only how much to produce and how to produce it.

The idea that competitive firms are "price-takers" is central to our discussion. Of course we do not mean that firms cannot affix price tags to their merchandise; all firms have this ability. We simply mean that, given the availability of perfect substitutes, any product priced over the market price will not be sold.

These assumptions also imply that the demand for the product of a competitive firm is perfectly elastic (see Parts 16-24 of this analysis). For example, consider the Ohio corn farmer whose situation is shown in Figure 2. The left side of the diagram represents the current conditions in the market. Corn is currently selling for $2.45 per bushel. The right side of the diagram shows the demand for corn as the farmer sees it. If she were to raise her price, she would sell no corn at all; because there are perfect substitutes available, the quantity demanded of her corn would drop to zero. To lower her price would be silly because she can sell all she wants at the current price. (Remember, each farmers production is very small relative to the entire corn market.)

In perfect competition we also assume easy entry---that firms can easily enter and exit the industry. If firms in an industry are earning high profits, new firms are likely to spring up. There are no barriers that prevent a new firm from competing. Fast food restaurants are quick to spring up when a new shopping center opens, and new gas stations appear when a housing development or a new highway is built. When it became clear a few decades ago that many people would be buying products online, thousands of e-commerce startups flooded the web with new online "shops."

We also assume easy exit. When a firm finds itself suffering losses or earning low profits, one option is to go out of business, or exit the industry. Everyone knows a favorite restaurant that went out of business. Changes in cost of production, falling prices from international or regional competition, and technology may all turn business profits into losses and failure.

The best examples of perfect competition are probably found in agriculture. In that industry, products are absolutely homogeneous---it is impossible to distinguish one farmer's wheat from another's---and prices are set by the forces of supply and demand in a national Market. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 129-131*

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