THE THEORY OF THE FIRM
We now begin the all-important topic in microeconomics known as the theory
of the firm:
how and why firms make economic decisions.
organize firms to produce economic goods.
The entrepreneurs develop a
business plan to produce and sell economic goods.
contract with households to obtain land, labor, and capital in exchange for
income, which goes to the household as rent, wages, and interest,
If the revenues of the firm exceed the costs of inputs during the
period of production and sale, the firm makes a profit, which goes to the
The profit motive is the only reason that entrepreneurs
organize and operate firms.
Firms that make the best decisions make the
most profit, and can operate for long periods of time.
Firms that make bad
decisions make little or no profit, or take losses, and go out of business.
centuries, economists have observed how firms make decisions, and how
those decisions have resulted in profits and losses.
Unlike other theories,
such as evolution and global warming, the theory of the firm is
, and no economist disagrees with any of the principles that you are
about to learn.
Remember, all production takes place in the firm.
Inputs are combined to
produce economic goods, or products.
There are three production runs that
define the production process for any economic good:
the long run, the short
run, and the market period
The Long Run
Production runs are not definitive periods of time, such as 6 months or 1 year.
Production runs will differ from firm to firm and from industry to industry.
Production runs are defined by
the number of inputs that can be altered
during a given time period
or at a given point in time when the entrepreneur
considers making a change in the production process
IN THE LONG RUN, ALL INPUTS ARE VARIABLE.
INPUTS ARE FIXED.
By variable, we mean that the quantities of the inputs used to produce output
Sonny Hatley's cotton farm requires land, labor, and capital.