STUDENT: Hello, Teacher. Yes, I know what’s coming up now! For several coming Modules you are going to lecture me about “Microeconomics”!
And I also know that “Macroeconomics is the study of how the economy functions in broad outline”, because you lectured me on that one before. You have also told me before that “Microeconomics is the part of economics dealing with the activities of individual markets and firms”.
TEACHER:. Good for you. I see that you remember my previous lecture on the subject of economics very well.
STUDENT: Yes, and I also remember having asked you “why should I, as a business person, be interested in macroeconomics”? Now, I will ask you this… why should I, as a business person, be interested in microeconomics?
TEACHER: Simply because economics is a very relevant subject if a business person is to understand the environment in which he or she operates. A skill that may help the business to be successful, of course.
STUDENT: You mean to say that to be a good business person I need to be a good economist?
TEACHER: Not exactly. A deep knowledge of economics is neither necessary nor sufficient for being successful in business. However, a good grounding in economics will help you to analyze business situations much better. Now let me ask you something? Do you know what kind of science economics is?
STUDENT: I remember something like “the dismal science”.
TEACHER: That was ages ago, when Malthus made very negative forecasts about what would happen as population increased faster than food production. No, the answer I was hoping for was “economics is a social or behavioral science”. And this is so because basically economics deals with how people behave in different circumstances. By the way, you know who Malthus was, don’t you?
STUDENT: Thomas Robert Malthus (1766-1834) was an English economist, sociologist, clergyman and pioneer in modern population study. Malthus argued that poverty and distress were unavoidable because population, when left unchecked, increased faster than the means of subsistence.
And getting back to your definition of economics, what it means is that what economists do is theorize on behavior. Is that all?
TEACHER: After congratulating you for your encyclopedic knowledge, let me tell you that economics is a social science that tries to explain the behavior of the economy; more exactly, the behavior of the economic agents which are, after all, people. Naturally since economics is not an exact science, economists develop theories which are sometimes called economic models.
STUDENT: And why and when are these models useful to a business manager?
TEACHER: Economic models are simplifications of the real world. They may be useful in explaining how the world works. Of course, the ultimate test of how useful economics is to business is… does it really explain or accurately predict what is going on in the real world?
STUDENT: Fine. And so which is the subject we will discuss in this first Module of microeconomics?
TEACHER: We will outline some of the key topics that are of interest to both economists and business persons. Later you and I will discuss them in greater detail.
To begin with, let me state that all business firms operate within a market. Would you attempt to define what a market is?
STUDENT: Sure. A market is the environment in which suppliers and demanders of a given product or service interact. And let me add that this interaction determines what is produced and consumed and in what quantities.
TEACHER: A very good “economic” definition. Obviously you mean that this “determination of what is produced and consumed and in what quantities” is reached via the price mechanism, the result of the interaction of suppliers and demanders in the market.
STUDENT: Sure. And I may add that this is why any business person must have a very good understanding of the markets in which he or she operates. But I have a question. Do all activities of a firm actually take place in a market?
TEACHER: Not necessarily. A key question for managers of firms to be asking all the time is: should we be doing activity X within the firm, or should we buy it the market from another firm? In other words… should we make it or purchase it?
STUDENT: So, an activity conducted within a firm is an alternative to a transaction in the market.
TEACHER: Exactly. While firms always operate in some market, they also perform internal activities, and one of the key economic issues managers face is to decide which transactions should be internal to the firm and which ones should be left to the market.
STUDENT: I see; and it seems to me that lately there has been a strong tendency towards “farming out” functions.
TEACHER: True. From administrative tasks to manufacturing, more and more functions are contracted in the market. EDS and IBM have dramatically increased their taking over of IS activities from firms; and farming out manufacturing to “toll producers” has also increased very much.
The theory of the firm
But allow me to expand on the subject of markets, and mention “the theory of the firm”. When we discuss how markets work, we are primarily interested on the determination of the price and quantity sold of specific products.
* The theory of the firm will be used to study the supply decisions of firms.
* Consumer demand theory will help us to generate predictions about how demand will change in response to changes in key economic variables, such as the price of the product and the incomes of consumers.
The Economics Of The Firm
While in a large economy decisions are made by an enormous number of participants, many of which are individuals, one of the key economic decision-making units is the business firm. Can you imagine why this is so?
STUDENT: Well, the business firm is an economic actor that hires workers, buys inputs, and produces some product that it then sells in the market. Of course, a firm may be organized in many different ways from a legal point of view; sole proprietorships, partnerships, corporations, etc.
TEACHER: True, but from the economics point of view the firm is an entity in itself that is conceptually separate from its owners and workers.
STUDENT: And what is the conceptual difference between the word ‘firm’, and others such as ‘business’, ‘enterprise’, ‘company’, ‘corporation’, etc. ?
TEACHER: Conceptually, there is no difference at all, according to the broad definition given above. When I use the word ‘firm’ I will be referring to this broad definition. Obviously, sometimes I will refer to specific types of firms, since in fact there are important legal (although not economical) differences between a partnership and a corporation, for instance.
Now please allow me to discuss…
The elementary theory of the firm
We call it the elementary theory of the firm because in order to simplify the “model”, we discuss a single-product firm; usually the product is assumed to be a manufactured one.
STUDENT: Is this not an over-simplification?
TEACHER: No, because the principles involved can be applied to any firm. What is it that any firm typically needs in order to manufacture any product?
STUDENT: I’m sure it needs plant and equipment, and workers to operate the equipment and for ancillary tasks. It must also buy inputs, such as components, raw materials, energy, etc.
TEACHER: Right. How would you, in general, call the plant and machinery a firm employs?
STUDENT: You are obviously referring to land, buildings, machines, tools, vehicles, etc. This is often referred to as capital or capital goods. But I am a bit confused. There is no question that land, buildings, etc., are capital. But we also often speak of capital when we talk about money in the bank and other financial assets.
TEACHER: Good point. In the theory of the firm “capital” will generally be used to refer to physical capital, such as plant and equipment. Of course the word capital is also validly used to mean financial assets, such as “working capital”, which is not invested in physical capital. But again, in the theory of the firm we will in general use it meaning physical capital
STUDENT: Fine, now I understand. But I have another question. Since the theory of the firm is based on a single-product firm, does this mean that economics can not deal with multi-product firms?
TEACHER: Economics can deal perfectly well with multi-product firms. As a matter of fact, these firms are an important topic in the branch of economics known as Industrial Organization. Don’t worry, we will discuss this matter in one of the following Modules of this Subject.
STUDENT: Would you please summarize what exactly the theory of the firm is about, in practical terms?
TEACHER: Sure. In the theory of the firm, we analyze how the technology used in production, combined with input prices, affects unit costs as the volume of output is changed. We also discuss how the demand for the firm’s product changes at various prices.
STUDENT: Sounds great. And what is the usefulness of all this analyzing?
TEACHER: The importance of all this is that, given the cost structure at different levels of output and the market demand at different prices we can conclude what level of output will maximize the firm’s profit.
STUDENT: A precise way to put it, Teacher.
TEACHER: Thanks. And since I mentioned “market demand”, let me tell you that the choices available to firms in the markets they sell to are very much influenced by the competition in those markets.
STUDENT: Easy to agree with; and I’d add that, to some extent, the firms may also be constrained by the competition in the markets where they purchase their inputs.
TEACHER: True. Competition in the market a firm sell in may be more or less intense depending upon the availability of similar or superior products, potential substitutes, and the number and characteristics of competing firms. There are basically three types of markets from the point of view of the structure of the competition.
Under perfect competition, there are many firms in the market producing an identical product and none of the firms is sufficiently large to influence the market price. Can you think of an example?
STUDENT: I guess they are not too many examples for manufactured products, but in general producers of commodities such as those of grains, crude oil, etc. operate under perfect competition. An let me add that you forget one conditions, which is that for a market to operate under perfect competition all buyers and sellers must be constantly informed of the prevailing price at which transactions are taking place.
TEACHER: Good observation. Not let’s describe…
The most common structure in which firms operate is imperfect competition. In this type of market there are a finite number of competing suppliers, each selling differentiated products that can, to varying degrees, be substitutes for each other. What type of situation do you think firms face in these types of markets?
STUDENT: I guess most firms will have to make decisions about how much to produce and at what price to sell.
TEACHER: Correct. And also of course they have to worry in varying degrees about what the competition is doing. Now let me ask you … what type of competition do you think would be in extreme contrast to perfect competition?
STUDENT: This is the M word: monopoly!
TEACHER: Right, monopoly. This is a situation where there is only one producer of a product; the single producer faces no competition from other local producers and the product can not be imported.
A monopolist has the power to set not just output but also the price of the product.
STUDENT: Nice situation for any business to be in!
TEACHER: Sure. No other suppliers can take market share from a monopolist. But while monopoly may be good for the firm involved, it will generally be bad for consumers, because the monopolist will tend to charge higher prices than those that would prevail under a competitive situation.
STUDENT: Naturally, I’m sure this is why most countries have regulations to prohibit monopolies, or to control them when they can not be avoided -cases like water, electricity or local telephone service.
TEACHER: The latter are examples of “natural” monopolies, where under prevailing technologies consumers would have to pay more if several firms were competing in the market, than they pay if a well regulated monopoly is allowed. The key word is “prevailing technologies”; long-distance phone service used to be a natural monopoly years ago, but this is no longer so due to modern communications technology.
The basic condition for a monopoly to operate is the existence of some barriers to entry, like those given by patent protection.
But let’s return to the commonest type of market, imperfect competition. This type of market lies between the two extremes of perfect competition and monopoly, and involves a range of different cases. In general, imperfectly competitive markets involve products that, actually or in the mind of the buyers, are similar but not identical. Can you think of another condition?
STUDENT: There are a limited number of potential producers, each of which can influence the others by its own behavior; changing output, prices, advertising, etc.
TEACHER: True. The most common cases of imperfect competition are oligopoly and monopolistic competition.
Oligopoly exists where the market is dominated by a small group of competing firms. Most large firms operate in this type of markets. Just as an example, let me mention the PC (Personal Computer) industry. Here each firm is greatly affected by what its close rivals do in terms of product prices and innovations.
In this type of markets there are many firms but in general their products or services are differentiated. The restaurant business is a good example, especially if we exclude large chains. Each individual restaurant not belonging to a chain, has a small share of the market as in perfect competition; but the difference is that the restaurant has some discretionary power on the prices it charges. Why do you think this is so?
STUDENT: Because, in contrast to perfect competition markets, here the products are not exactly alike. Restaurants are differentiated by physical location, the type of food they offer, the quality of food and service, ambience, prestige, etc. I am sure this is why they have some price fixing power, but it certainly is a limited one. At some point customers will be willing to travel farther for a meal and/or accept other types and qualities of food and service.
TEACHER: Exactly. Now let’s discuss the following theme: What determines the behavior of the business firm?
Motivation Of The Firm
What do you think is the best answer to that question?
STUDENT: I’d say, as a first approximation, that a firm attempts to maximize profits. Let me add that profits are defined as the difference between the firm’s revenue (or gross income) and its costs.
TEACHER: That all firms attempt to maximize profits is not an unreasonable assumption indeed, since most businesses appear to be interested in making money. The decisions a firm should make in order to maximize its profits are determined by the current state of technology.
Technology, Inputs, And The Production Function
Technology is the total knowledge available concerning the production of certain goods or services. Firms are limited by the current state of technology. In making its decisions, the firm must take this into account.
Input is anything the firm uses in its production process; machines, energy, raw materials, labor, etc.
The Production Function
For any final product, the production function is the relationship between the quantities of various inputs used per period of time and the maximum quantity of the product that can be produced per period of time.
Now, Student, in analyzing production processes we suppose that all inputs can be classified into two categories. Can you guess what these two categories are?
STUDENT: I sure can try. Some inputs are fixed (such as the machines available at a certain point in time) and other inputs are variable; those whose quantity can be changed during the relevant period. In the latter category we may mention, with natural limitations, labor and raw materials.
TEACHER: Good. Whether an input is considered variable or fixed depends on the length of the period under consideration. The longer the period, the more inputs are variable, not fixed. In general we can define two time periods: the short run and the long run.
The short run is defined as the period of time in which at least one of the firms inputs is fixed. Since the firm’s plant and equipment are among the most difficult inputs to change quickly, the short run is generally understood to mean the length of time during which the firm’s land and equipment are fixed.
The long run is that period of time in which all inputs are variable. In the long run, it is assumed that the firm can make a complete adjustment to any change in its environment.
Average Product Of An Input
In order to determine which production technique -that is, which combination of inputs- a firm should use, it is necessary to define the average product and marginal product of an input.
The average product of an input is the total output divided by the amount of input used to produce this amount of output. Example: In an eight hour shift a machine can produce 800 units of product; the average product of the machine is 100 units per hour.
The marginal product of an input is the addition to total output due to the addition of the last unit of input while other inputs used being held constant. Example: assume that a machine makes chocolate tablets which are then put into cases by hand. With the same machine and ten workers putting tablets into cases we can produce 1000 filled cases per hour, an average of 100 cases per worker. If we add one worker, we can produce 1090 cases per hour. The marginal product of a worker is 90 boxes per hour.
STUDENT: Why is it that the additional worker only adds 90 cases of product, while the average of the first ten workers was 100 cases each?
TEACHER: Ah, this is because you have the infamous law of diminishing marginal returns working against you! Which is perhaps the best-known, and certainly one of the least-understood, laws of economics
In short, the idea is that if equal increments of an input are added, the quantities of other inputs being held constant, beyond some point the resulting increments of product will decrease. That is, the marginal product of the input will diminish. The reasons for that general law to apply are different in different situations. In our example we can assume that the chocolate tablets coming out of the machine move on a conveyor belt from which the workers take them to put them into cases. As you put one more person to work on the same conveyor belt, the workers will possibly have less space to work efficiently. It is also possible that the 11th. worker is less trained and efficient than the first ten. By the same token, if you add a twelfth worker it is likely that the marginal product of this additional person will be less than 90 cases per hour, an so on.
THE OPTIMAL INPUT DECISION
Now we are in a position to answer a very important question; what is the optimal input combination to maximize profits? In other words, assuming that the firm is going to produce a particular quantity of output, what combination of inputs should it choose to maximize profits? Any comment?
STUDENT: Well, obviously to maximize its profits the firm must minimize the cost of its output.
TEACHER: Yes, this seems obvious enough. OK, the let me tell you now that “the firm will minimize cost by combining inputs in such a way that the marginal product of a dollar’s worth of any one input equals the marginal product of a dollars worth of any other input used”.
STUDENT: Now is does not sound so obvious. Can you explain what this means?
TEACHER: Sure. Going back to our chocolate tablets example, let’s assume that the firm could either change the speed of the machine -consuming more or less energy per hour- and/or change the number of workers operating the packing line.