We need to revise our economic thinking to give full value to our natural resources. This revised economics will stabilize both the theory and the practice of free-market capitalism. It will provide business and public policy with a powerful new tool for economic development, profitability, and the promotion of the public good.
The Production Process: The Behavior of Profit-Maximizing Firms
(Part B)
by
Charles Lamson
 |
The Behavior of Profit-Maximizing Firms
All firms must make several basic decisions to achieve what we assume to be their primary objective---maximum profits. Figure 3 shows three basic decisions. The three decisions that all firms must take include:
 The first and last choices are linked by the second choice. Once a firm has decided how much to produce, the choice of a production method determines the firm's output requirements. If a sweater company decides to produce 5000 sweaters this month, it knows how many production workers it will need, how much electricity it will use, how much raw yarn to purchase, and how many sewing machines to run. Similarly, given a technique of production, any set of input quantities determines the amount of output that can be produced. Certainly the number of machines and workers employed in a sweater mill determines how many sweaters can be produced. Changing the technology of production will change the relationship between input and output quantities. An apple orchard that uses expensive equipment to raise pickers up and to the trees will harvest more fruit with fewer workers in a given period of time than an orchard in which pickers use simple ladders. It is also possible that two different technologies can produce the same quantity of output. For example, a fully computerized a textile mill with only a few workers running the machines may produce the same number of sweaters as a mill with no sophisticated machines but many workers. A profit-maximizing firm chooses the technology that minimizes its costs for a given level of output.  Remember as we proceed that we are discussing and analyzing the behavior of perfectly competitive firms. Thus, we will say nothing about price-setting behavior, product quality, and other characteristics of the product---choices that lead to product differentiation. In perfect competition, both input and output prices are beyond a firm's control---they are determined in the market and are not the decisions of any individual firm. Remember that all firms in a given industry produce the same exact product. When we analyze the behavior of firms in other kinds of markets (in later posts), the three basic decisions will be expanded to include the setting of prices and the determination of product quality. Profits and Economic Costs We assume that firms are in business to make a profit and that a firm's behavior is guided by the goal of maximizing profits. What is profit? Profit is the difference between total revenue and total cost: Profit = total revenue - total cost Total revenue is the amount received from the sale of the product; it is equal to the number of units sold (q) times the price per unit (P). Total cost is less straightforward to define. We define total cost here to include (1) out-of-pocket costs and (2) full opportunity cost of all inputs or factors of production. Out-of-pocket costs are sometimes referred to as explicit costs or accounting costs. These refer to costs as an accountant would calculate them. Economic costs include the full opportunity cost of every input. These opportunity costs are often referred to as implicit costs. The term profit will from here on refer to economic profit. So whenever we say profit = total revenue - total cost, what we really mean is: Economic profit = total revenue - total economic cost  The reason we take opportunity costs into account is that we are interested in analyzing the behavior of firms from the standpoint of a potential investor or a potential new competitor. If I am thinking about buying a firm, or shares in a firm, or entering an industry as a new firm. I need to consider the full cost of production. For example, if a family business employs three family members but pays them no wage, there is still a cost: the opportunity cost of their labor. In evaluating the business from the outside, these costs must be added. The most important opportunity cost that is included in economic cost is the opportunity cost of capital. The way we treat the opportunity cost of capital is to add a normal rate of return to capital as part of economic cost. Unless otherwise stated, we will use this definition of profit, not the accounting definition, in what follows. Normal Rate of Return When someone decides to start a firm, that person must commit resources. To operate a manufacturing firm, you need a plant and some equipment. To start a restaurant, you need to buy grills, ovens, tables, chairs, and so forth. In other words, you must invest in capital. To start an e-business, you need a host site, some computer equipment, some software, and a website design. Such investment requires resources that stay tied up in the firm as long as it operates. Even firms that have been around a long time must continue to invest. Plants and equipment wear out and must be replaced. Firms that decide to expand must put new capital in place. This is as true of proprietorships, where the resources come directly from the proprietor, as it is of corporations, where are the resources needed to make investments come from shareholders.  Whenever resources are used to invest in a business, there is an opportunity cost. Instead of opening a candy store, I could put my funds into an alternative use such as a certificate of deposit or a corporate bond, both of which earn interest. Instead of using its retained earnings to build a new plant, a firm could simply earn interest on those funds or pay them out to shareholders. Rate of return is the annual flow of net income generated by an investment expressed as a percentage of the total investment. For example, if someone makes a $100,000 investment in capital to start a small restaurant and the restaurant produces a flow of profit of $15,000 every year, we say the project has a rate of return of 15 percent. Sometimes we refer to the rate of return as the yield of the investment. A normal rate of return is the rate that is just sufficient to keep owners and investors satisfied. If the rate of return were to fall below normal, it would be difficult or impossible for managers to raise resources needed to purchase new capital. Owners of the firm would be receiving a rate of return that was lower than they could receive elsewhere in the economy, and they would have no incentive to invest in the firm. If the firm has fairly steady revenues and the future looks secure, the normal rate of return should be very close to the interest rate on risk-free government bonds. I certainly will not keep investors interested in my firm if I do not pay them a rate of return at least as high as they can get from a risk-free government or corporate bond. If my firm is rock solid and the economy is steady, I may not have to pay a much higher rate. However, if my firm is in a very speculative industry and the future of the economy is shaky, I may have to pay substantially more to keep my shareholders happy. In exchange for taking such a risk, they will expect a higher return.  A normal rate of return is considered a part of the total cost of a business. Adding a normal rate of return to total cost has an important implication: When a firm earns exactly a normal rate of return, it is earning a zero profit as we have defined profit. If the level of profit is positive, the firm is earning an above normal rate of return on capital. A simple example will illustrate the concept of a normal rate of return being part of total cost. Suppose that Sue and Ann decide to start a small business selling turquoise belts in the Denver airport. To get into the business they need to invest in a fancy push cart. The price of the pushcart is $20,000 with all displays and attachments included. Suppose that Sue and Ann estimate that they will sell 3000 belts each year for $10 each. Further, assume that each belt costs $5 from the supplier. Finally, the cart must be staffed by one clerk, who works for an annual wage of $14,000. Is this business going to make a profit? To answer this question, we must determine total revenue and total cost. First, annual revenue is simply $30,000 (3000 belts * $10). Total cost includes the cost of the belts $15,000 (3000 belts * $5) plus the labor cost of $14,000, for a total of $29,000. Thus, on the basis of the annual revenue and cost flows, the firm seems to be making a profit of $1,000 ($30,000 - $29,000). What about the $20,000 initial investment in the pushcart? This investment is not a direct part of the cost of Sue and Ann's firm. If we assume that the cart maintains its value over time, the only thing that Sue and Ann are giving up is the interest that they might have earned had they not tied up their funds in the pushcart. That is, the only real cost is the opportunity cost of the investment, which is the foregone interest on the $20,000.  Now suppose that Sue and Ann want a minimum return equal to 10 percent---which is, say, the rate of interest that they could have gotten by purchasing corporate bonds. This implies a normal return of 10 percent, or $2,000 annually (= $20,000 * .10) on the $20,000 investment. As we determined earlier, Sue and Ann will earn only $1,000 annually. This is only a 5 percent return on their investment. Thus, they are really earning a below-normal return. Recall that the opportunity cost of capital must be added to total cost in calculating profit. Thus, the total cost in this case is $31,000 ($29,000 + $2,000 in foregone interest on the investment). The level of profit is negative: $30,000 - $31,000 = -$1,000. These calculations are summarized in Table 1. Because the level of profit is negative, Sue and Ann are actually suffering a loss on their belt business.  When a firm earns a positive level of profit, it is earning more than is sufficient to retain the interest of investors. In fact, positive profits are likely to attract new firms into an industry and cause existing firms to expand. When a firm suffers a negative level of profit---that is, when it incurs a loss it is earning at a rate below that required to keep investors happy. Such a loss may or may not be a loss as an accountant would measure it. Even if I earn a rate of return of 10 percent on my assets, I am earning a below normal rate of return, or a loss, if a normal return for my industry is 15 percent. Losses may cause some firms to exit the industry; others will contract in size. Certainly new investment will not flow into such an industry.  *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 132-134* end |
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