Firms as Agents of Production
The firm can be defined as the unit that takes decisions with respect to the production and sale of
goods and services. This concept includes all kinds of business organizations, from the single
proprietorship or sole trader to the corporation. It also covers the entire variety of business sizes
and methods of financing, from taking small loans from the bank to thousands of shareholders
Goals of the Firm
The neoclassical theory of the firm makes two key assumptions:
Firms are profit maximizers.
Each firm can be regarded as a single, consistent decision-taking unit.
The desire to maximize profits is assumed to motivate all decisions taken within a firm, and such
decisions are assumed to be unaffected by the peculiarities of the persons taking the decisions
and by the organizational structure in which they work. Using these assumptions, economists can
predict the behaviour of firms. To do this, they first study the choices open to the firm,
establishing the effect that each choice would have on the firm’s profits. They then predict that
the firm will select the alternative that will produce the largest profits.
In order to produce the goods and services that it sells, each firm needs inputs. Hundreds of
inputs may enter into the production of any specific output. Some inputs are called intermediate
goods and services; that is, they are produced by firms for use in the production of final goods
and services by other firms. These intermediate goods and services appear as inputs only because
the stages of production for the final product are divided among different firms. If these
intermediate products are traced back to their sources, all production can be accounted for by the
services of the three kinds of input. These inputs, also known as
factors of production
Labour – the physical and mental efforts provided by people.
Capital – factories, machines and other man-made aids to production.
Land – the gifts of nature, such as soil, minerals and other raw materials.
The production function relates inputs to outputs. It expresses the technical relationship between
a set of inputs that a firm uses and the output of a good or service that it produces. You can
therefore think of a production function like a recipe for sweetbread; it tells you the quantities of
each ingredient, how to combine and cook, and how many loaves you will produce.
When using this function, it is important to remember that production is a flow, that is, it tells us
how many units are produced
per period of time.
For example, when we say that production rises
from 100 to 101 units; this does not mean 100 units are produced this month and 101 units in the
following month. Instead, we mean that the rate of production has risen from 100 units each
month to 101 units each month.
Using functional notation, the production function can be written as: