Firms, Production and Externalities

• A Firm is a producer or business. It combines inputs of labor, capital, land, and component materials to produce outputs
• A successful firm is one where the outputs are more valuable than the inputs.

Firm Structure §

Production §

• Production requires various inputs

  • Natural Resources - the raw materials needed for making the product, as well as the land on which production will be made.
  • Labor - physical and mental human effort
  • Capital - the physical assets that are needed to produce the product
    • Capital is fixed in the short run.
  • Technology - the process for producing the product.
  • Entrepreneurship - the decision making process that guides how inputs produce output.

• Production can be summarized with a production function. Here stands for total product

• The inputs of production may either be fixed or variable depending on how easy it is for them to change in a short period of time.

  • A shorthand for the production function considers the variable inputs and fixed inputs , written as

• The short term is the period of time when some factors of production are fixed.

  • Because capital is fixed short term. the production function in this case is of the form .

• In the long term, all factors are variable.

• The marginal product is the additional output of one worker. It is with respect to labor

• Production in the short-run is characterized by the Law of Diminishing Marginal Product. This arises because fixed capital acts as a limiting factor.

• Production in the long run allows convergence towards the most efficient way to produce any level of output. This is because all production factors are variable.

Cost §

• Cost pertains to the expenditures paid for producing and selling the products

  • Explicit costs are actual payments (i.e., wages)
  • Implicit Costs pertain to the opportunity cost of using resources that the firm already owns, as well as the depreciation of goods.
    • Sometimes even if more profitable opportunities exist, the implicit cost prevents firms from switching

• Accounting profit pertains to explicit cash. It only considers the explicit cost.

• Economic profit pertains to a measure of economic success. It considers both explicit and implicit costs.

• For every factor of production, there is an associated factor payment paid for the use of said factors.

  • Raw Material Prices for raw materials
  • Rent for land and buildings
  • Wages and Salaries for labor
  • Interest and Dividends for the use of financial capital
  • Profit for entrepreneurship.

• The cost depends on how much labor and physical capital the firm uses.

  • Costs can be fixed or variable depending on if they correspond to fixed or variable inputs.
    • Fixed costs do not change in the short run
    • Fixed costs are essentially overhead. We can spread the overhead by allocating other inputs (such as labor) towards paying for them. This works since fixed costs do not change (assuming no additional capital).
  • The total cost is denoted
  • Average Cost is one cost metric calculated with respect to .
  • Marginal Cost is another cost metric. It is with respect to quantity.

• Cost increases as the firm produces higher quantities of product. In the short term this is because of diminishing marginal product.

  • Marginal cost is generally upward slowing due to diminishing returns.
  • Low marginal costs pull down the average cost, and conversely high marginal costs pull the average cost up.

• The pattern of costs varies among industries and even among firms in the same industry

Long Term Costs §

• In the long run, firms will consider alternative production technologies. The choice of production technology is dependent on the needs of the firm and the actual productivity gained from these technologies compared to cost.

  • As an input becomes more expensive, firms will attempt to conserve on using that input and shift to relatively less expensive inputs
  • Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce.
  • The Long-run average cost (LRAC) curve is based on an average of short-run average cost (SRAC) curves representing one level of fixed costs. The LRAC shows the cost of producing each quantity in the long run.
  • The LRAC will be the least expensive cost curve for any level of output.

• The LRAC shows various situations

  • In economies of scale more quantity = less cost per unit. Here grouping economic activity is productive than spreading it out
  • In constant returns to scale - the average cost of production does not change much as scale rises or falls.
  • In diseconomies of scale, more quantity = more cost. This can arise from firms that are too large to run efficiently.

• The LRAC also reveals something about the industry

  • If the LRAC has a clear minima, then all firms in the industry are of the same scale.
  • If the LRAC has a flat bottom (i.e., there are alternatives to the minima), then the firms in the industry will have variable sizes.
  • The degree to which the quantity demanded differs from the quantity produced as dictated by the LRAC determines the degree of competition
    • If quantity demanded is less than or slightly above the minima, then there will be less competition and a monopoly will arise.
    • The larger the difference between quantity demanded and quantity in the minima, the more competition in the industry

• New developments in production technology can shift the LRAC in ways that can alter the size distribution of firms in an industry.

• Technology that increases production will drive the LRAC down. It may also allow for more economies of scale (depending on the technology)

  • Introducing this technology will give a clearer minima (i.e., the bottom of the LRAC is more pointed). This means firms will compete to adopt this new technology.
  • Competition drives more innovation which then leads to more competition and more production

Profit §

• All businesses try to earn a profit

• The average profit is obtained using the profit margin of the firm ¹.

• The profit-maximizing choice occurs when marginal revenue equals marginal cost.

• The marginal revenue may be seen as the following derivative

Externalities §

• Externalities pertain to the effects of a market exchange on a third party who is external to the exchange.
• Negative externalities induce additional external costs to the firm — in particular social costs.
  • If there were no social costs, the interaction between regular supply and demand will coordinate social costs and benefits.
  • If the social costs tamper with a common pool of resources that is used for production, a tragedy of the commons ensues.
  • However, having firms pay for the social costs has a tradeoff because firms will sell less and charge more ².
• Externalities can be international (for example, global warming)

Negative Externalities §

• Command-and-Control regulation - a law that requires firms to increase their costs by counteracting pollution. There are three challenges to this

  • It offers no incentive to improve the quality of the environment beyond the standard set.
  • It requires the same standard for all polluters and the same pollution control technology. This does not consider the firms’ ability to meet the costs.
  • It is prone to rule bending and political manipulation.

• Market-oriented regulation - a more flexible alternative to command and control regulation.

  • Pollution charge - a tax imposed on the quantity of pollution the firm emits.
    • It incentivizes reducing emissions as long as the marginal cost of doing so is less than the tax.
    • Firms commonly face increasing costs to reduce marginal emissions since doing so requires more effort (cost).
  • Marketable Permits - a permit that determines the overall quantity of allowed pollutions. It then divides a number of permits allowing only this quantity of pollution among the firms that emit the pollutant.
    • The effect of the policy is determined by the market behavior on selling and buying permits.
    • The firms that find it the least expensive to reduce pollution will do so the most.
  • Better-Defined Property Rights - aims to balance economic activity and pollution.
    • Property Rights - legal rights of ownership on which others are not allowed to infringe without paying compensation.

• The benefits of these laws can be categorized into the following reasons

  • People may stay healthier and live longer
  • Certain industries that rely on a clean environment may benefit
  • Property values may be higher
  • People may simply enjoy a cleaner environment in a way that does not involve a market transaction.

• Not all regulations are a good idea. More regulation = more cost

• When the quantity of environmental protection is low, the marginal benefit of reducing pollution is high and the cost is low.

Positive Externalities §

• Positive externalities are a step towards Pareto optimality.

  • Subsidies can be used to incentivize behavior that will lead to positive externalities.

• Innovation can be a positive externality

  • While competition incentivizes innovation, it can also punish the innovators themselves.
  • Innovation, if adopted and made widespread, generally leads to more production capabilities and economic growth. However, most innovation comes with negative externalities due to impact on the environment.

• Intellectual Property Rights incentivize innovation by protecting the innovator. However, there are limits such as:

  • Innovators receive payments disproportionate to the economic value of their contribution
  • When the technology advances rapidly, the innovation can become obsolete
  • IP rights may be granted too easily — leading to questionably new innovations.
  • The time period for a patent may not cover enough period of time for the innovator to receive a good return.

• Alternatives to IP rights exist in the form of government policy.

  • Government funds the research directly. However, this uses taxpayer money (which means that citizens may be inadvertently funding something they would not want). Additionally, this is subject to politics
  • Give firms a tax break for R&D depending on how much R&D they do.
  • Cooperative Research to create new industries through a collaborative effort between firms.

• Education is a positive externality — a student invests in their education and (for the most part) gains private returns. At the same time, governments subsidize educational institutions and gain a productive workforce (social returns).

Public Goods and Common Goods §

• A public good is a good where private firms could not expect to receive any of the social benefit. More specifically they are:

  • Non-exchangeable - it is costly or impossible to exclude someone from using the good.
  • Non-Rival - when one person uses the public good, another can also use it.

• Public goods have inherent positive externalities.

  • However, because it is non-exchangeable and non-rival, free-riders are incentivized to let others pay for the public good.
  • The trick, therefore, is for governments to incentivize everyone to make a contribution.
    • Imposing taxes
    • Some other form of “price” that is not necessarily money. For example — advertisement space.
    • Impose a mixture of free public use while charging for something adjacent to it to cover costs.
    • Use social pressures
  • Examples: National defense, Public Healthcare

• Common goods are those that are non-excludable but rivalrous. They are prone to the tragedy of the commons.

Links §

• Shapiro, MacDonald and Greenlaw - Ch. 7, 12 - 13
• Manufacturing

Footnotes §

1. Note that the actual definition is profit per unit produced. However, using the definition of profit and average revenue / cost, we get a simplified version in terms of profit margin. ↩

2. This is why “green” products are more expensive — not only due to the technology needed for mass production but also because of economic incentive. ↩