In our previous post, we related microeconomics to individuals and households. Now, let’s take a look at how it relates to businesses.
In this article, we will formally refer to a business as a firm, which organizes factors of production to produce and sell goods and/or services. Note that this applies to any kind of business, from the individual painter trying to sell her paintings, to the multinational conglomerate. A firm may have many goals, but at the end of the day, its fundamental goal is to maximize profit.
However, there are three constraints that limit the amount of profit a firm can earn:
- Technological constraints – The type of technology a firm uses simultaneously advances a production process, but constrains it once it reaches its limits. Example: a manufacturing plant buys a new machine that helps it produce ten widgets a day (versus five a day from the old machinery), but it has to buy another machine to produce twenty widgets a day.
- Information constraints – Firms also face limited information on a variety of issues, from the behavior of its workers, to the preferences of its customers, and the strategies of its competitors. Obviously, management can’t be everywhere at the same time all the time.
- Market constraints – Going back to our previous discussion on supply and demand, in a free market a firm can’t just maximize the price for goods/services it sells and minimize the price it pays for resources (although there are major exceptions to this rule, which we will discuss in the future). Furthermore it incurs an additional cost to influence consumers’ behavior to buy its products, in the form of marketing.
Given these constraints, firms seek to operate in the most efficient way possible. This efficiency is determined by two concepts:
- Technological efficiency – Producing the largest output with the least amount of input. Example: buying for cheap the machine that produces the most widgets.
- Economic efficiency – Optimizing the mix of costs. Example: choosing the right mix between labor (cheap but low output on a per-unit basis) and machinery (expensive but high output on a per-unit basis).
So firms are continually in a balancing act between minimizing costs and maximizing profits. However, there is another factor that influences cost and profit: decision time frames. A firm has to take into account issues in the short run and the long run.
Short Run Considerations
In the short run, many of a firm’s assets are fixed. Such assets include land, machinery, and buildings. Oftentimes, the one asset that can be changed over the short run is labor. So in the short run, a firm’s costs consist of fixed costs and variable costs.
In this situation, a firm would hire or lay off workers until it reaches the optimal point where output is maximized but diminishing returns haven’t set in yet. Firms would experience diminishing returns because once a firm hires too many workers, there would not be enough space and/or technology for them to use, and as a result these extra workers would be idle.
Long Run Considerations
In the long run, a firm can change all factors of production, including fixed assets. Note that fixed assets will be with a firm for a quite a while, and as a result previous purchases of long-term assets are referred to as sunk costs, since they have no bearing on current investment decisions.
One positive aspect of fixed assets is that they may help firms attain economies of scale, where output increases, even as long run average costs decreases. This is often achieved through both specialization of labor and technology (for example, a firm spending a lot of money for more efficient factory machines).
An Example of the Balancing Act
This recent article I pulled from Bloomberg about US retail is an example of short run decisions that firms often have to make.
Here’s a quick breakdown of the article:
- A combination of increasing employment, improving consumer confidence, and lower gas prices has led to optimistic forecasts of holiday sales in the US.
- As a result, retailers are increasing the hiring of seasonal part-time workers.
Remember that firms are more flexible with labor over the short run. In this case, there is a short-term boost in holiday sales for the reasons stated above, so retailers are making a decision to increase costs (by hiring) over the short run. However, also remember that there is a balancing act being performed by these retailers – they want enough labor to increase sales, but not too much that they experience diminishing returns in hiring too many workers. In this case, their solution to this issue is to hire additional workers on a seasonal, part-time basis.
Now that we’ve studied firms from a microeconomic viewpoint, let’s take a step back and look at the situation from a macroeconomic viewpoint. See you in the next post!
Ramon Rodrigo Cuenca, CFA
Source: CFA Program Curriculum Level I, 2009, volume 2: Economics, pp. 96, 99-103, 126-127, 131-133, 142-143