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Dealing with Three Fundamental
Tasks
The right side of the circular
flow diagram shows the three fundamental tasks of
all firms in an exchange economy.1 First, a firm
must obtain inputs. Inputs include raw materials, energy,
machinery, office space, workers, and anything else needed
to produce output. Second, the firm must combine or use
inputs to produce output. Output may either be a tangible
good such as a pair of shoes or an automobile, or a service
such as a haircut or a medical checkup. Third, the firm must
sell its output to someone else.
A firm that cannot do these three tasks well enough will
not survive. When the automobile was developed in the early
20th century, firms that made carriages died because they
could no longer do task three, selling their output, well
enough. Almost all baskets sold in the United States are
imported. Baskets are handmade, and no firm in the United
States can hire workers at wages low enough to be able to
compete with wages that are acceptable in some other
countries. Here is a case in which American firms (or firms
in any industrialized nation) have difficulty coping with
the first task. The development of the electronics industry
is a case in which the second task has changed. New
technology allows firms to combine inputs to produce goods
that were not possible just a few years ago.
The economic theory of the firm is an analysis of the way
the firm must perform these three tasks to make a profit.
Each task can be described in mathematical or graphical
terms. Supply curves of resources describe the first task.
They indicate how much the firm must pay for the amount of
inputs it wants. The production function describes the
second task. It tells how much output the firm can produce
from a set of inputs. The demand curve for output describes
the third task. It depends on people's wants or preferences
and tells how much the firm can charge for output. Each of
these mathematical ways of representing the three
fundamental tasks can be seen as a constraint or limitation
that the firm faces.
A supply-of-resources curve tells at what prices various
amounts of a resource can be bought or hired. Although one
can view it in a number of ways, it also can be viewed as a
boundary. It tells the firm the minimum it can pay for any
amount of a resource. Sellers of resources imposed this
boundary on the firm, which must buy resources in order to
produce. Points to the upper left of a supply curve are
attainable, whereas those to the lower right are not.
The production function contains information about how
much output can be obtained with various quantities of
inputs. The production function is often discussed as a
relationship between inputs and output, as its name implies.
(Mathematically, a function is a special sort of
relationship.) However, it too can be discussed as a
boundary. It shows the maximum that can be produced with any
combination of resources. Less than this maximum can be
produced--one can always get nothing for something.
The demand curve can be viewed from a number of
perspectives: as a relationship between price and quantity
buyers will buy, as a locus of points of consumer
equilibrium, as a measure of marginal benefit to the buyer,
or as a boundary. This last view, that the demand curve
represents a boundary that buyers impose on the seller, is
one that is most useful when developing the theory of the
firm. The demand curve limits the amount that sellers can
sell at each price. Points to the left of the demand curve
are attainable, while those to the right are not.
1The word "firm" takes
on two meanings in economics. Sometimes, the word refers to
an agent that produces something. Other times, it refers to
a business organization. The second meaning of the word is
more restrictive than the first. A self-employed farmer is
not a firm in the second meaning because he is not an
organization, nor is a nonprofit organization because it is
not a business. Yet both are firms in the first meaning. In
the reading selections of this unit, a firm will have the
first meaning--an agent that produces output and sells
it.
You should be aware that the word
"industry" cannot be used interchangeably with
"firm." An industry is defined as all firms producing
similar products. It can contain one firm or millions of
firms. In practice, there are two complications with this
definition. First, there is no clear rule for deciding how
similar products must be before they belong in the same
industry. For example, what other products belong in the
industry that Coca Cola is in? Does Pepsi Cola, or Seven Up,
or orange juice, or milk, or beer belong in the same
industry? There is no clearly correct answer. Second, the
number of firms in an industry depends on the price of the
product. Firms enter as price rises and exit as price
falls.
Copyright
Robert Schenk
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