No Such Thing as a Free Lunch: Principles of Economics (Part 32)

Geography has made us neighbors. History has made us friends. Economics has made us partners, and necessity has made us allies. Those whom God has so joined together, let no man put asunder.

John F. Kennedy

The Production Process: The Behavior of Profit-Maximizing Firms

(Part C)

by

Charles Lamson

Short-Run versus Long-Run Decisions

The decisions made by a firm---how much to produce, how to produce it, and what inputs to demand all take time into account. If a firm decides that it wants to double or triple its output, it may need time to arrange financing, hire architects and contractors, and build a new plant. Planning for a major expansion can take years. In the meantime, the firm must decide how much to produce within the constraint of its existing plant. If a firm decides to get out of a particular business, it may take time to arrange an orderly exit. There may be contract obligations to fulfill, equipment to sell, and so forth. Once again, the firm must decide what to do in the meantime.

A firm's immediate response to a change in the economic environment may differ from its response over time. Consider, for example, a small restaurant with 20 tables that becomes very popular. The immediate problem is getting the most profit within the constraint of the existing restaurant. The owner might consider adding a few tables or speeding up service to squeeze in a few more customers. Some popular restaurants do not take reservations, forcing people to wait at the bar, which increases drink revenues and keeps tables full at all times. At the same time, the owner may be thinking of expanding the current facility, moving to a larger facility, or opening a second restaurant. In the future, the owner might buy the store next door and double the capacity. Such decisions might require negotiating a lease, buying new equipment, and hiring more staff. It takes time to make and implement these decisions.

Because the character of immediate response differs from long-run adjustment, it is useful to define two time periods: the short run and the long run. Two assumptions define the short run (1) a fixed scale (or a fixed factor of production) and (2) no entry into or exit from the industry. First, the short run is defined as that period during which existing firms have some fixed factor of production---that is, during which time some factor locks them into their current scale of operations. Second, new firms cannot enter, and existing firms cannot exit, an industry in the short run. Firms may curtail operations, but they are still locked into some costs, even though they may be in the process of going out of business. 

Just which factor or factors of production are fixed in the short run differs from industry to industry. For a manufacturing firm, the size of the physical plant is often the greatest limitation. A factory is built with a given production rate in mind. Although that rate can be increased, output cannot increase beyond a certain limit in the short run. For a private physician, the limit may be the capacity to see patients; the day has only so many hours. In the long run, the doctor may invite others to join the practice and expand, but for now, in the short run, this sole physician is the firm, with a capacity that is the firm's only capacity. For a farmer, the fixed factor may be land. The capacity of a small farm is limited by the number of acres being cultivated.

In the long run, there are no fixed factors of production. Firms can plan for any output level they find desirable. They can double or triple output, for example. In addition, new firms can start up operations (enter the industry), and existing firms can go out of business (exit the industry).

No hard-and-fast rule specifies how long the short run is. The point is simply that firms make two basic kinds of decisions: those that govern the day-to-day operations of the firm and those that involve longer-term strategic planning. Sometimes major decisions can be implemented in weeks. Often, however, the process takes years.

The Bases of Decisions: Market Price of Outputs, Available Technology, and Input Prices

As mentioned earlier, a firm's three fundamental decisions are made with the objective of maximizing profits. Because profits equal total revenues minus total costs, each firm needs to know how much it costs to produce its product and how much its product can be sold for.

To know how much it costs to produce a good or service, I need to know something about the production techniques that are available and about the prices of the input required. To estimate how much it will cost me to operate a gas station, for instance, I need to know what equipment I need, how many workers, what kind of a building, and so forth. I also need to know the going wage rates for mechanics and unskilled laborers, the cost of gas pumps, interest rates, the rents per square foot of land on high traffic corners, and the wholesale price of gasoline. Of course, I also need to know how much I can sell gasoline and repair services for.

In the language of economics, I need to know three things:

The next several posts focus on costs of production. In the next post, we began at the heart of the firm, with the production process itself. Faced with a set of input prices, firms must decide on the best, or optimal, method of production (Figure 4). The optimal method of production is the one that minimizes cost. With cost determined and the market price of output known, a firm will make a final judgment about the quantity of product to produce and the quantity of each input to demand. 

*MAIN SOURCE: CASE & FAIR, 2004, :PRINCIPLES OF ECONOMICS, PP. 134-136*

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