No Such Thing as a Free Lunch (Principles of Economics (Part 154)

Economics is mostly how humans rationalize who gets what and why. It's how we instantiate our preferences about status, privileges, and power.

Nick Hanauer

Household and Firm Behavior in the Macroeconomy: A Further Look

(Part D)

by

Charles Lamson

Firms: Investment and Employment Decisions

Having taken a closer look at the behavior of households in the macroeconomy, we now look more closely at the behavior of firms---the other major decision making unit in the economy. In discussing firm behavior in earlier posts, we assumed that planned investment depends only on the interest rate. However, there are several other determinants of planned investment. We now discuss them and the factors that affect firms' employment decisions. Once again, microeconomic theory can help us gain some insight into the working of the macroeconomy.

In a market economy, firms determine which goods and services are available to consumers today and which will be available in the future, how many workers are needed for what kinds of jobs, and how much investment will be undertaken. Stated in macroeconomic terms, the decisions of firms, taken together, determine output, labor demand, and investment.

In this section, we concentrate on the input choices made by firms. By inputs, we mean the goods and services that firms purchase and turn into output. Two important inputs that firms use are capital and labor. (Other inputs are energy, raw materials, and semifinished goods.) Each period, firms must decide how much capital and labor to use in producing output. Let us look first at the decision about how much capital to use.

Investment Decisions At any point in time a firm has a certain stock of capital on hand. Stock of capital means the factories and buildings (sometimes called "plants") firms own, the equipment they need to do business, and their inventories of partly or wholly finished goods. There are two basic ways a firm can add to its capital stock. One is to buy more Machinery or build new factories or buildings.This kind of addition to the capital stock is plant-and-equipment investment.

The other way a firm adds to its capital stock is to increase its inventories. When a firm produces more than it sells in a given period, the firm's stock of inventories increases. This type of addition to the capital stock is inventory investment. Unplanned inventory investment is different from planned inventory investment. When a firm sells less than it expected to, it experiences an unplanned increase in its inventories and is forced to invest more than it plan to. Unplanned increases in inventories result from factors beyond the firm's control. (We take up inventory investment in detail in a later post.) 

Employment Decisions In addition to investment decisions, firms make employment decisions. At the beginning of each, a firm has a certain number of workers on its payroll. On the basis of its current situation and its upcoming plans, the firm must decide whether to hire additional workers, keep the same number, or reduce its workforce by laying off some employees.

Until this point, our description of firm behavior has been quite simple. In an earlier post we argued that firms increase production when they experience unplanned decreases in inventory and reduce production when they experience unplanned increases in inventory. We have also alluded to the fact that the demand for labor increases when output grows. In reality, the set of decisions facing firms is much more complex. A decision to produce additional output is likely to involve additional demand for both labor and capital.

The demand for labor is quite important in macroeconomics. If the demand for labor increases at a time of less than full employment, the unemployment rate will fall. If the demand for labor increases when there is full employment, wage rates will rise. The demand for capital (which is partly determined by the interest rate) is important as well. Recall, planned investment spending is a component of planned aggregate expenditure. When planned investment spending (I, the demand for new capital) increases, the result is additional output (income).

Decision Making and Profit Maximization To understand the complex behavior of firms in input markets, we must assume that firms make decisions to maximize their profits. One of the most important profit-maximizing decisions that a firm must make is how to produce its output. In most cases, a firm must choose among alternative methods of production or technologies. Different technologies generally require different combinations of capital and labor.

Consider a factory that manufactures shirts. Shirts can be made entirely by hand, with workers cutting the pieces of fabric and sewing them together. However, shirts exactly like those can be made on huge complex machines that cut and sew and produce shirts with very little human supervision. Between the two extremes are dozens of alternative technologies. Shirts can be partly hand sewn, with the stitching done on electric sewing machines.

Firms' decisions concerning the amount of capital and labor that they will use in production are closely related. If firms maximize profits, they will choose the technology that minimizes the cost of production. That is, it is logical to assume that firms will choose the technology that is most efficient.

The most efficient technology depends on the relative prices of capital and labor. A shirt factory in the Philippines that decides to increase its production base has a large supply of relatively inexpensive labor. Wage rates in the Philippines are quite low. Capital equipment must be imported and is very expensive. A shirt factory in the Philippines is likely to choose a labor-intensive technology---a large amount of labor relative to capital. When labor-intensive technologies are used, expansion is likely to increase the demand for labor substantially while increasing the demand for capital only modestly.

A shirt factory in Germany that decides to expand production is likely to buy a large amount of capital equipment and to hire relatively few new workers. It will probably choose a capital-intensive technology---a large amount of capital relative to labor. German wage rates are quite high, higher in many occupations than in the United States. Capital, however, is plentiful.

Firms' decisions about labor demand and investment are likely to depend on the relative costs of labor and capital. The relative impact of an expansion of output on employment and on investment demand depends on the wage rate and the cost of capital. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 617-618*

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