The Science of Everything Podcast - Episode 48: Theory of the Firm

Episode Date: July 9, 2013

A discussion of the nature of the firm, the different types of firms, and the reasons for the existence of firms. This leads to an overview of the objectives of firms, including decisions regarding how to produce and the profit maximizing quantity to produce, and a discussion of the implications of this behavior for consumers and the economy at large. Recommended prelistening are Episode 12: The Price System and Episode 16: Profits and Competition.

You're listening to The Science of Everything podcast, episode 48, Theory of the Firm, and I'm your host, James Fodor. So, sorry, it's been a while since the last episode. I've been rather busy with university and other things, but I've got a bit of time over the next few weeks, so hopefully we'll be getting a good number of episodes out for you. Also, just before we start, just a note on the previous episode that I'd promised, which would be on computation in the visual system, I've decided to postpone that episode because I think I've done enough on Vision for the moment, and I'd like to move on to some other topics. And I think what I'll do is I'll combine some of that material into a single future episode where I'll just talk about neural computation in a more general framework,

not specifically just about Vision. So stay tuned. I might get to that in a few months' time after I cover a few other topics, but that's why I'm not doing that episode, even though that's what I'd said I'd be moving on to next time. Instead, we're going to be looking at Theory of the Firms, Specifically what firms are, what they do, why they exist, and how they work. We'll be talking about things like how firms use inputs to create outputs,

the types of costs that firms face, like fixed costs and variable costs. We'll be talking about some important issues in regards to firm behavior, including the efficient level of production, diminishing marginal product, returns to scale, and some of the various other factors that affect firm behavior. Recommended prerequisites for this episode, episode 12 on the price system and episode 16, profits and competition. You'll probably also benefit from listening to episode 5 on corporate conspiracies. These two episodes would sort of fit well together, but that's not really essential.

Okay, so let's get into it. First of all, what is a firm? Well, a firm is also known as an enterprise or a business or, well, corporation, although corporation does have a more specific meaning as well. But in economics, generally the generic term firm is used to refer to a business or an enterprise or so on. But from now, I'll just use the word firm. A firm is simply an organization, that is a group of people, you know, organized together for a particular purpose, that is involved in the production and trading of goods and services to consumers. Another way we can look at this is a firm is an organization that takes in inputs,

such as labor, materials, energy and so on, and turns those into outputs, that is the goods and services that it sells. So economists often think about firms in this sort of black box sense. That is, you can imagine drawing a rectangular box and calling it firm A or whatever, and we could draw an arrow into the box or multiple arrows into the box, and those arrows represent the inputs, like labor and capital and raw materials and other things. And then coming out of the box, we draw generally one or more out arrows representing the outputs of the firm, the goods or services that it produces.

And economists are usually, at least traditionally, not so much interested in what happens inside that black box. That is, not so much happened interested in all the details of what the firm does and exactly how it conducts itself. They're more interested in how firms behave as they interact with each other and with consumers and with the market structure that they're embedded in. In this episode, we'll talk mostly about the latter, but also a little bit about what happens inside the black box. What happens inside the black box is a bit more a question for psychology and man and, and, management science to address rather than economics, although there is certainly overlap. Another important thing to understand about firms is that there's no requirement as to the nature of what they produce or whether you think it's valuable or not.

So firms can include anything from pharmaceutical companies to supermarkets through to drug gangs or prostitution rings or whatever. It makes no difference from an economic standpoint. Okay, so what are the different types of firms? There's sort of four main types that generally identified in economics and in sort of finance and business generally. The sole proprietorship, the partnership, the corporation and the cooperative. You may have heard of some or all of these before, so I'll just talk about them briefly. A sole proprietorship is a business owned by a single person. The owner may run the business themselves, or they may employ others.

The owner of the business has what is called unlimited liability for any debts incurred by the business. That means that there's no distinction between the business or the firm that the person's running and the person themselves. So if they take out a, if the sole proprietor takes out a loan to run, to purchase something for the business and they can't pay back that loan, then the person's own personal assets, like their own, their car or house could be seized in order to cover the cost of the debt if they were unable to pay. Soul proprietorships are usually fairly small. They're usually like small startups or other local businesses because it usually gets pretty hard to manage a sole proprietorship if it gets larger, and also there are tax benefits for converting to other forms of

businesses. So the next form of type of firm is called a partnership. Now, don't get confused about the name partnerships. Don't have to be, are not limited to be comprised of only two people. A partnership is simply a business that's owned by two or more people. Somewhere I heard up to a dozen or something, I think the legal limit differs between jurisdictions and countries and so forth, but it's a small number of people who own the business collectively. And also the share doesn't have to be exactly 50-50 or, you know, 25, 25, 25, 25. The share of the business that they own can be specified in the partnership agreement that defines the existence of the firm.

And technically, at least in some jurisdictions, I'm not sure if this is how it's treated everywhere, but I believe at least traditionally, you can't actually change the membership of a partnership. That is, if one partner wants to leave the partnership and someone else wants to join, technically what happens is the old partnership is dissolved and a new one is formed, so you can't really change the membership. It's just completely changing the partnership, because the partnership is defined by its members and their relative shares, and if you change that, then you've completely changed the partnership.

Again, like sole proprietorships, each partner has unlimited liability for the debts incurred by the business. So again, if the partnership incurs debts that the business can't afford to pay, then its members can have their assets seized in order to cover the cost of the debts that they've incurred. Although there are some other types of partnerships like limited liability partnerships where that's a little bit different, but we won't worry about those too much. Again, partnerships are usually relatively small, although some of them can be quite big, like some of the big firms on Wall Street, the big investment banks and so on,

I forget exactly which ones, at least up until recently were partnerships, and law firms is another thing that, and, you know, local doctor surgeries. things like that might be things that at least in the past tended to be partnerships. Nowadays, perhaps not as much because many private partnerships have become incorporated. And that leads us on to our third type of firm, which is the corporation. Now, many people think about businesses and corporations as being synonymous, and that's the qualification that I sort of made before. A corporation is not the same thing as a business.

A business is just a generic name for a firm of any sort. It could be a sole proprietorship, partnership, whatever. corporation is a specific type of firm or a specific type of business. Specifically, it's a limited liability business that has a separate legal identity from its members. The idea of a corporation having a separate legal identity is quite new. It only goes back a few hundred years to, well, the legal and economic history, going back into the mercantilist era of Europe is interesting, but not something that we'll discuss here. But if any of you have seen Michael Moore's film The Corporation,

although I certainly don't agree with everything in that film, they do make a good point of emphasizing this fact that corporations are legally persons. They have a distinct identity. They are not comprised simply of the people who work for them or the people who own them. They are their own people. So you can sue a corporation without suing any person in the corporation, for instance.

And the corporation pays tax by itself as distinct from the tax paid by any of its owners or employees. Corporations can be government-owned or they can be privately. owned. Corporations can also be for-profit or not-for-profit. That should be fairly obvious what that means. Corporations can also be privately held corporations or they can be publicly traded corporations. Publicly traded corporations are those that have shares that are traded on a stock market and more or less anyone can buy us all the shares of that corporation. Privately held corporations don't have that. So privately held corporations are usually owned by families. Perhaps they were once

partnerships or even sole proprietorships that became incorporated, but have not have not been floated, that is, they have not sold shares on the stock market. So not all corporations are on the stock market, although these days most of them are, because it's a very convenient way of raising large amounts of capital. The way corporations work is that they are legally owned by their shareholders in proportion to how many shares you have. So the more shares you have, the more of the corporation you own. And if someone has a controlling share in a corporation, that means they own more than 50%

of the shares. And that's called a controlling share, because essentially the way that the corporation is run is that the shareholders elect a board of directors who in turn hire managerial staff for the firm. So you've probably heard of a CEO before, Chief Executive Officer or CFO, Chief Financial Officer. There's many similar titles. These people don't own the firm generally. They just manage it. They are hired paid a salary, often a very large salary, to make management decisions for the firm.

The people who hire them and monitor their performance are called the Board of Directors. And the Board of Directors are in turn elected by the shareholders at, I think, think generally an annual general meeting. Of course, usually people don't actually turn up in person to the annual general meeting, but they have proxies who vote for them, but that's another issue. The management of a corporation is kept distinct from its ownership. A corporation is owned by its shareholders, but managed by the executive offices as monitored by the Board of Directors. And there's some interesting issues there that come up with differing interests of the shareholders versus the executives. But that's something we'll talk about in another episode.

So that's corporations. Oh, and just one more thing about corporations. Many people think about corporations being really large. Corporations can be large, but they don't have to be. You can have a small corporation. You could turn a sole proprietorship into a corporation if you wanted to, although it would be expensive to do all the paperwork and so forth. A large reason why people turn partnerships or sole proprietors

into corporations once they become large enough is because the tax benefits and other factors become overriding for them, other benefits to becoming incorporated. So the fourth type of firm that we'll talk about briefly is the cooperative or co-op. A cooperative is similar to a corporation in that it has limited liability. And again, it can be for profit or not for profit. The main difference between a corporation and a cooperative is that a cooperative doesn't have shareholders. It doesn't have people who own it.

It has members. So in that sense, it's kind of like a partnership, although it's, again, it's a limited liability. and the members of a cooperative share in the decision-making authority for the cooperative. So you can think of a cooperative as kind of like a hybrid between a partnership and a corporation, except it's going to have more people or more members than a partnership. But it doesn't have owners distinct from managers like a corporation does. By the way, I just realized I didn't explain properly what limited liability means. So unlimited liability, remember, this is the type that sole proprietorships and partnerships have,

means that if the business goes into debt, people who are owed money can go and take the assets of the owners of the business in order to meet their debt obligations. Limited liability means that that can't happen. So, the shareholders of a corporation can't have their assets taken away. They can't lose their house or lose their cars

if the corporation in which they own shares goes bankrupt. That's not the same for a partnership. If a partnership goes bankrupt, the partners could lose everything, lose all of their assets in order to cover the debts, but a corporation, not so. The only asset you can lose as a shareholder of corporation is the value of your share in the corporation. So your shares might become worthless if the corporation goes bankrupt, but they can't take any of your other assets. That's why it's called limited liability, because your liability for the corporation's debts is limited by the values of your share, basically.

They can't take away anything else. Okay, so that's a bit of background on the different types of firms. Just a brief note on the various things that firms do. I mean, firms essentially do everything in the economy. Almost every significant act of production is organized by firms, whether they be large firms or small firms or partnerships or corporations or whatever, public or private firms. The particular type of activity that the firm engages in is usually referred to as the industry of the firm.

So, don't get confused. Industry can mean like factories and smoke and all that sort of stuff. That's one meaning of industry, as distinct from agriculture and services and so on. But industry can also be used in a broader sense, just referring to the particular thing or type of product or service that a firm does. So different types of industries would be like real estate industry or restaurants or software or banking, finance, mining. Any of these things, they're different industries, they're different sectors of the economy. Education would be another one. Health would be another one. So industries or sectors, transportation is another one, utilities like electricity and water and so on.

So all of these types of activities are essentially run by firms. Okay, so we've talked a little bit about what firms are, but why do they exist? What's the point of firms? In particular, this is perhaps a question you haven't thought of before, but it's a good one to think about. Because in episodes 12 and 16, in particular we talked about the virtues of the price system and free competition and free markets in managing production and being responsible for the efficient allocation of resources in, an economy. So if markets are so great and so good at doing that, what's the point of firms? Because a firm is just the exact opposite of a market. A firm is a command and control structure. A firm is a top-down organization where the bosses tell the employees what to do. And, you know, there's no, generally, there's no trading inside a firm, or certainly not in the normal sense. It's like its own mini-command economy. So if markets are so efficient, what's the purpose of firms? There's a number of reasons. There's a number of reasons. reasons that economists have given, and the exact reasons will differ slightly between different

industries and different firms. But generally, the two main reasons given for the existence of firms are economies of scale and transaction costs. Economies of scale I want to come back to, because we'll talk more about that later in the episode. But the basic idea is that it's just economies of scale means that it's easier or cheaper to produce things in larger quantities than in smaller quantities. So in other words, that's why we produce cars in big factories rather than, you know, one at a time with some guy working in his garage, because it's just much cheaper to do them in one factory, making many of them than just making one at a time.

So that gives firms a natural advantage, a natural reason to exist if you can organize production on a larger scale. The second reason, probably the main one that I want to focus on, though, is to reduce transaction costs. Now, a transaction cost is just a cost or an inconvenience or a burden of some sort that must be born in order to engage in some sort of transaction. So there are many types of transaction costs and reasons they exist, but examples of reasons for the existence of transaction costs include

that you need to put time and effort into finding out who produces things, who the sellers are, what prices they're charging, the quality of different goods. It also takes time and effort to physically go to the place where the goods being sold, to pick it up, to transport it. Contracts need to be written and monitored. trust needs to be earned and maintained. There are all sorts of reasons why it's costly to engage in transactions. Just think about any significant purchase that you make. You know, wanting to buy a new

computer or hiring a plumber or getting someone, or purchasing a new car would be a good example. You can't just go out and buy something like that. You have to do lots of research and investigating and looking around. All of those things are called transaction costs. Their cost of engaging in the transaction. Transaction costs can be significantly reduced or eliminated by the existence of firms. Essentially because in a firm, everything is centrally organized and managed, in theory at least, if it's well run. And so the transaction cost in that sense can be dramatically reduced. I mean, just imagine if you were running a business and, I don't know, let's say it's a software company like Microsoft. If Microsoft had to write a new contract every time it wanted its

offices cleaned or every time it wanted to, I don't know, print a piece of paper for something, or every time its employees wanted to, I don't know, get some food to eat while working, or like any little thing like that. If anything outside of their main business objective of producing software, you had to contract out to do that, it would just be dramatically costly. It would take an enormous amount of time. I mean, some of those things Microsoft Daly does outsource that they do write contracts for, but they don't do it for everything.

Some things are done in-house just because it's easier. Another way of thinking about it is that Microsoft Dedly does. doesn't consist of a bunch of independent programmers all writing contracts with each other. So I'll submit this bit of code to you. If you submit this bit of code to me and you write this, you know, do this database stuff, or I do this web development stuff and whatever. It would be too costly to manage that. It's much easier just to have a single person sitting over the top managing the whole project

and him telling everyone what to do beneath him, rather than everyone doing their own thing and trying to write contracts with each other to somehow get the whole thing to work. Again, that latter approach can kind of work. I mean, that's a little bit sort of what Wikipedia is, for example. although that's not a corporation. So it's not necessarily a case of things can or cannot be done in a firm or outside a firm. It's just that in some cases it's easier to have that command and control approach.

In other cases, it's easier not to because it's a cost and benefit situation. What's easier? What's cheaper? What's a better way of doing it? Because when firms get too large, you have, often what happens is that it becomes more and more difficult for management to figure out what's going on. They're so far removed from the actual site of production, the actual people working in the trenches, so to speak. that they have difficulty figuring out what's working, what's not working, they have difficulty determining worker morale, all of these sorts of things.

Ideas take a long time to go up the hierarchy and often get lost or not passed on for various reasons. Incentives become more difficult to maintain. So there are costs and benefits to firms, and firms will generally exist in circumstances where the reduction in transaction costs and increase in economies of scale outweigh the disadvantages of lower incentives or difficulties in communication and management difficulties and so forth. Okay, so that's a bit of a background on why firms exist. Now we're going to take a look a little bit more at the details of how firms behave.

Specifically, we described firms earlier as organizations that take in inputs and produce outputs, that is, goods or services that they then sell. Just a quick word on inputs, on the nature of them. There are three main types of inputs that we talk about in economics. You can subdivide these into much more specific categories, but the three broad types that we talk about are capital, labour and raw materials, or you can also say natural resources. So capital refers to buildings, equipment, machinery, anything, any big physical things like that

that cost a lot of, would generally cost a lot of money to purchase, although that's not essential. The essential thing about capital, though, is that they are long-lived, they last a long time, and they're physical objects. So some firms require a lot more capital than others. So a lemonade stand requires almost no capital, whereas Boeing producing... Jumbojet aircraft requires an awful lot of capital in order to have all the machinery and the specialized plants and so on to produce the aircraft. So the amount of capital you need differs dramatically depending on the type of industry you're in. Second type of input, labor. This does not

just refer to the number of workers, but it also refers to the type of workers, their skills, and the relationships with each other and so forth. So increasing the amount of labor that you hire as a firm could mean getting more highly trained workers or more highly educated workers. rather than simply hiring more workers. And finally, raw materials or natural resources, these are things like oil, water, you know, wheat for bakeries, aluminium, plastic, paper, steel, all of these kind of raw inputs that the business uses.

They're not really capital or labour, they're raw material inputs. So just bear in mind when we're talking about inputs, capital, labour and raw materials are the three types we're mostly talking about. Okay, so now that we know that a firm takes in inputs and produces outputs and we know a bit about the types of inputs, and we know sort of why firms exist in an economic sense, sense, what is the purpose of firms in the sense of why do the firms, what objective do the firms have? What are their owners trying to achieve? We said before that firms exist in order to reduce

transaction costs and promote economies of scale, but that's not why the managers of the firm get up in the morning. They're not thinking about how can I reduce transaction costs. What are they thinking about? What is their actual objective, specifically for their own interest? In economics, we assume that that objective is that of profit maximization. That is, firms want to earn as much profit as they possibly can. And in simple models, at least, that's the only thing they care about. Now, profit is defined as the difference between revenue and costs. Revenues are just the total amount of money that the firm earns through sales, and costs are the total amount of money that the firm spends on purchasing all of its inputs and taxes and any other costs that might have.

All costs. So all revenues minus all costs gives you the total profit. And the assumption is that firms want to maximize profit. They want to make it as big as possible. Now, in the real world, this assumption is unlikely to hold perfectly. I mean, it definitely doesn't hold perfectly. I think that it usually holds very well. Most firms can be very successfully and accurately modeled as if they maximize profits. But certainly there are other objectives for firms as well. Firms might have humanitarian objectives. They might have objectives relating to the working environment that they produce all the corporate culture. Pretty much all firms claim to have such goals. The extent, the importance of them, I suppose, is a matter of debate.

even from an economic or accounting standpoint, you can look at different ways to which the firms may behave. For example, rather than maximizing economic profit, firms may maximize accounting profit, which is a slightly different way of measuring profit, or they may try and maximize share price, or they may try and maximize earnings per share, or total value of the company as capitalized on a share basis.

All of these different types of accounting or economic measures are very closely related to each other. So if a firm is maximizing economic profit, they're probably also maximizing earnings per share and also maximizing share price. The differences are subtle, and if you don't really understand exactly what the differences are, then don't worry. It's not that important. I just wanted to emphasize that there are different ways of looking at specifically how firms behave, and managers don't necessarily always just consider

what is the effect of this on profit. But generally, that's a very, look at, just assuming that firms behave as if they maximize profit, makes the models much simpler and makes the analysis much more convenient, in most cases, without losing too much realism, because maximizing profits does seem to be the most important objective of firms, and it correlates well with other sort of accounting or economics-related objectives like share prices and so forth. So it's not perfect, but we'll stick with it for this analysis because it gets the job done. Okay, so the firm wants to maximize profits, and again, we're assuming this applies to sole proprietorships or partnerships, corporations, cooperatives, big firms, large firms, from an economics standpoint, they're all

all the same. Corporations are not perceived to be any greedier than sole proprietorships. They're all perceived to be equally greedy in wanting to maximize profits. We know that's what firms want to do, but how do they do that? Well, it turns out that in order to maximize profits, there's two sort of subsidiary decisions that the firm has to make, two lower-level decisions that must be made in order to make sure that you're maximizing profits. The first is how should we produce, and the second is how much should we produce, should the firm produce? Now, these might sound the same, but they're different questions. The first question is how to produce. In other words, what method should we use to produce? This generally relates to the inputs that

the firm takes in, because the firm might be able to produce their output using lots of machinery and not very much labour, or lots of labour, not very much machinery, or maybe they can substitute in an expensive type of raw material for a less expensive type, or they could try this machine or that type of machine, there are many, many ways that the firm can go from its raw materials, its inputs to its outputs. Which will the firm pick? Well, the answer is they'll pick whichever one allows them to produce the given level of output at the lowest possible price. This optimum bundle of inputs may vary depending on how much output you want to produce. If you only want to make one shoe a year, because, I don't know, you're making shoes for

yourself, it probably doesn't pay to buy a lot of specialized machinery or get really specialized skills to make just one shoe. But if you're making a thousand shoes an hour, then it would pay you to have those really expensive materials. So depending on the level of output that you want to produce, you will choose a different combination of inputs and a different method of production in order to produce that. So what the firm does is they make this first decision about how to produce just for all different possible levels of production, or at least, you know, a representative sample. Because they don't know how much they want to produce yet. They haven't decided that. that's the next question. That's stage two. How much should we produce? The first stage is just, well, we don't know how much we're going to want to produce. So let's just work out the most efficient way of producing a certain amount for all sorts of different amounts, whether it be 10 or 100 or 1,000 or whatever. Of course, in practice, the firm's not going to work out how much it would cost to produce 10 shoes if in reality they're going to be making 10 million or 11 million. They're only going to look at areas around about where they think they're going to be producing. They're not going to bother with quantities.

of output that are unrealistic. But, you know, from a formal standpoint, just looking at treating the model on a simple basis, technically what the firms do is look at all possible combinations of output and pick the ones, all possible levels of output, and pick the combinations of inputs that minimize the cost for each level of output. So that's the first decision. They decide how to produce. And so they've got this big list of, if I want to produce one unit, this is how I should do it, if I want to produce two units, this is how I should do it, and so on. Once they've got that, they can work out how much profit they will make for each level of output. If I make one shoe, I make this much profit, I make 20 shoes, I make this much profit, 20 million shoes, I make this much

profit, and so on. And they write up all of the different profits for the different levels of output, given that they're producing that level of output the most efficient way, that was our first decision, and then they pick whichever one makes them the most profit. So it turns out I make the most profit making 100 shoes, that's how many shoes I'm going to make, or 1,000 shoes I'm going to make. So the second decision is based purely on which of the different levels of output makes them the most profit. And so they picked that one. And then that's their two decisions made, how to produce and how much to produce. You may have noticed that the two decisions will depend upon different factors.

The first decision, that is how to produce, producing at the lowest cost, only depends upon technology factors and the prices of inputs. You know, how much does labor cost versus how much this machine costs and how much output can we get from different types of machines and how the machines. work together or the technological processes we have available and so on. It's got nothing to do with how much people want the good or so on. It could be that, I mean, you could work out the most efficient way of producing completely useless things, because it just, that decision, that first decision of how to produce has no bearing on whether people want to buy the thing you're producing or not. That only comes in in the second part of the decision when you have to ask, okay, how much that I produce. Then, this part of the decision only depends upon levels of consumer demand, or how

much people want the demand, and also taxes and the amount of substitutes that are available and other things like that. But basically, it's just how much do people want this? If they want it a lot, you'll probably be producing more. If you want it less, you'll be producing less. Well, I should also say there is one other factor that affects the second choice, and that's the competition that exists in terms of the other firms in the industry, but that's something we'll look at in the next episode. The two decisions are a good way of splitting up what the firm does, because they are determined by different factors. The first decision, how to produce is determined by technology. The second decision, how much to produce, is determined by the market

structure and the level of consumer demand. In the practice, in the real world, the firms don't necessarily think in this way of, now I'm thinking about how efficiently to produce, now I'm thinking about how much to produce. They don't necessarily mentally think about it in that way. This is a model. This is a model that helps us to understand what firms do and helps us to understand what will happen when different things change. And from this perspective, it's really useful to think about deciding how to produce versus deciding how much to produce, because they are affected by completely different factors. Okay, so, if we understand those two stages of the firm's maximizing profit decision,

now we can look at a few other aspects of cost and production. In particular, there are two different types of costs that firms face. Again, in the real world, there are more than two types, but this is just a way of categorizing them. Fixed costs and variable costs. This is an important concept that you should know. Fixed costs are those that are independent of the level of output. That is, regardless of how much output the firm produces, be it one unit or a, a million units, they must still pay this same fixed cost.

Rent on a factory would be a good example of that, or sometimes at property taxes, perhaps. It doesn't matter if the factory is doing nothing all year or whether it's working full-time. The firm still has to pay that fixed cost of rent. The second type of cost, variable costs generally increase with the level of output. So, labor or electricity costs will be a good example of that. The more you produce, the more you have to pay. And because of fixed costs and variable costs behave differently, they have different effects on the level of output.

And this also leads us to another concept about time and the variability of inputs. Economists, again, simplifying things, they think about two types of time in terms of theory of the firm, the long run. Exactly how long these last vary from industry to industry and from firm to firm. That's not important. It doesn't matter how long the short run is, or how long the long run is. The importance is conceptual. The short run is a period of time sufficiently brief such that at least one input cannot

practically be varied. The long run is any period of time sufficiently long, such that all factors, all inputs can be varied. What does that mean? Well, it means that eventually, if enough time passes, every type of cost is variable. You know, rents don't last forever, mortgages don't last forever, eventually I can move out of the factory or avoid paying the fixed cost in some other way. It's just a matter of how much time has to pass before that can be done. You could look at it the other way. Over a sufficiently short period of time, every cost is a fixed cost. I might be able to lay the worker off next week, but I can't necessarily lay him off today if there's not enough work for him to do right now. So for today, the worker is a fixed cost. Next week, it

becomes a variable cost. And maybe next month, the rent on the factory becomes variable, because then I can choose whether to continue or not to continue with the contract. And maybe five years from now, the loan that I've taken out to fund the factory becomes a variable cost, because maybe the loan lasts for five years, and there's nothing I can do about it in the meantime. So whether a cost is fixed or variable all depends on your time frame. The difference between long run and short run is simply, defined, it's purely defined based on whether at least one cost is a fixed cost. If there's at least some fixed costs, then you're considered to be in the short run. If there are no fixed costs and everything can be varied over the time frame you're looking at, then that timeframe is said

to be the long run. As a really rough guide, short run is usually like months, sorry, weeks to months, long run usually sort of years, but that is going to vary a lot depending on the type of industry and how much capital they have and all sorts of other factors. Another two very important concepts that we need to discuss in regards to the theory of the firm. And these are the concepts of diminishing marginal product and returns to scale. Possibly things you've heard of before, but they're really, really important. They come up a lot, so it's good to know about them. Now, diminishing marginal product, or diminishing marginal output,

is very similar to the concept of diminishing marginal utility or diminishing marginal benefit, which we talked about in the Consumer Choice episode. Diminishing marginal product refers to the fact that when a firm increases just one input, so labor or capital just by itself, holding everything else fixed, the amount of extra output that they get becomes less and less. That is, it diminishes. Now, it's important to understand diminishing marginal product does not mean diminishing total product. These are different things. Diminishing total product would mean, I hire more workers and I get less shoes. More workers and less shoes in total. That would be really bad and really stupid to hire the more workers

if they're actually going to reduce your total output. And that could happen if the workers kept bumping into each other and getting in their way so that total output goes down. But generally that doesn't happen. Generally what happens is you hire more workers, and you get more shoes. It's just that those extra workers don't produce as many shoes per worker as your first few workers did. So this is what happens when you have diminishing marginal product. The extra input doesn't produce as much extra output as earlier units did. Effectively the reason for this is that there's generally some optimal ratio at which you want to use inputs.

So you need a certain number of workers for every machine. If you have too many workers without enough machines, I mean, it helps a little bit. You know, they can do odd jobs, so output goes up a little bit, but it doesn't go up nearly as much because they're not being as productive. You know, think about people mowing the lawn mower. If you have one person per one lawn mower, that's probably the optimal ratio. If you have a few extra people, well, they can take over while the other people have breaks. That'll increase your efficiency a bit. If you have heaps more people, well, I don't know, you can get people going out with scissors and cutting the grass,

which would, I suppose, increase the rate at which you cut the grass a little bit, but you're really hitting into diminishing returns by that point, because you're only increasing one input, you're only increasing the number of people mowing the lawn. What you really need is more lawn mowers if you wanted to get output higher, if you wanted to really increase outputs significantly. However, it's important to understand, if you increase more than one factor of production at the same time,

so if we're getting more workers and more lawn mowers, then we can't talk about diminishing martial product anymore, because we're increasing two things at once. Diminishing martial product is only relevant when we're only increasing one thing at a time. So only workers or only lawnmowers. Not both at the same time. That's no longer within the sphere of diminishing martial product.

Diminishing martial product is an important reason, it's not the only reason, but it's an important reason why supply curves generally slope upwards. Because as firms need to produce more and more output, they have to hire more workers, while perhaps keeping other inputs fixed, like land, for instance, or at least other inputs that are much harder to increase.

And so therefore, the firms hit up against diminishing marginal product, and their price has to go up because their costs have increased. Obviously, the less output that the firm's producing per input than the higher the cost there is of their input and therefore the higher the price they'll have to sell it for. So diminishing marginal product is an important reason why basically things get more expensive as you want more and more of them, because it just gets harder and harder and harder to produce them.

It gets harder and harder to increase all inputs in the same proportions. Now, the second concept that I wanted to talk about is that of returns to scale. And I mentioned this earlier on when I talked about economies of scale as a reason why firms exist. So economies of scale and returns to scale essentially refer to the same thing. Returns to scale relates to the question of what happens when all inputs are increased by the same proportion. So remember, before I said, if you get twice as many workers and twice as many lawnmowers, then you can't talk about diminishing martial product because you're increasing all inputs by the same amount. What we can now talk about is returns to scale.

So whether you talk about diminishing martial product or returns to scale, depends on which or how many inputs have been increased. If it's just one, then that's a diminishing martial product. If it's all of them by the same proportion, you can talk about returns to scale. Even if they're increased by different proportions, then you can't talk about returns to scale, or at least, well, it's sort of a combination of things. There's some returns to scale and there's some martial product changes.

But anyway, returns to scale really just refers to when there's all inputs are increased by the same proportion. what happens to total output. Again, we would expect total output to increase, obviously, but how much does it increase by? If we double the number of lawn mows and double the number of people working, does that double the rate at which we mow the lawn? Or maybe it increases by less than half, maybe it only goes up by 50%. Or maybe it increases by more than double. Maybe it goes up by four times. If it went up by four times, that would be increasing returns to scale, which means that as you increase inputs, as you scale up production, as you produce more and more,

it actually gets more and more efficient. Decreasing returns to scale would be the opposite. It gets less and less efficient as you produce more and more. And, of course, constant returns to scale is in the middle. You double the number of inputs, you double the rate at which you mow the lawn. Probably lawn mowing, at least with ordinary lawn mowers like that, and ordinary people using them, would exhibit constant returns to scale. So if you double the number of lawn mowers and people running them,

you just mow the lawn twice as fast. So that's constant returns to scale. What might be an example of something that exhibits increasing returns to scale? Well, most, and this is what I was talking about before, about economies of scale. Economies of scale is just a situation where you have increasing returns to scale, where the cost per unit gets lower as you're producing more units. So many industrial processes exhibit increasing returns to scale, or, in other words, economies of scale. It's an awful lot cheaper to produce a car, you know, an automobile,

if you produce 10,000 of them in a year, than if you only produce 10 of them in a year, even if it's exactly the same car, because there are increasing returns to scale of having large, machines of having more specialized machines to do things. A large reason for increasing returns to scale is that as you're producing more and more, you can get machines that do more and more specific tasks. And you can also train people to do more and more specific tasks, which it wouldn't be worthwhile to do if you're only produced 10 of them. Again, think about, you know, thinking about a cooking appliance. If you bought a cooking appliance for $1,000 that saved one minute every time you had to, I don't know, cook something in the oven,

that probably wouldn't be worthwhile if you only cook once a day. But if you're cooking constantly, if you're a professional chef, that $1,000 machine may well be worthwhile. And so if you do that for many, many different things, then it's going to get cheaper and cheaper to produce a larger and larger amount of things. Similarly, the skills, it's probably not worthwhile for most people to learn how to chop vegetables really, really fast, like you see that professional chefs do. But it's certainly worthwhile for the chefs to learn how to do it because they have to do that all the time. And so, again, the more you specialize in different things, the better at them you get, and therefore the lower the total cost becomes. And we talked a bit about this in the, I forget which episode, actually, one of the previous episodes about the price system or profits and competition. Specialization results in higher levels of productivity, and specialization can increase when you have a higher total level of production, because there's more things to specialize in and becomes more worthwhile.

Hopefully that's relatively clear as to why that occurs. You can think about many, many different examples in just everyday life of specialization in that sense. But you can also have the opposite. You can have decreasing returns to scale, which results. from organizational holdups. You know, this is the too many cooks spoil the broth idea. If I have one chef in the kitchen, they probably, you know, they produce a certain amount. Maybe if I have two chefs that actually allows them to produce three times as much,

not just twice as much. Twice as much will be constant return to scale. But maybe they can work together and help each other out. I guess it would depend on what they're making. But just suppose that in some circumstance they can help each other out and work together more efficiently than they could by themselves. That would be increasing returns to scale. But now let's say instead of putting two chefs in the kitchen,

I put four shifts in the kitchen. Maybe now the output actually goes down, or at least it goes up by much, much, much less. And this will be a result of organizational holdups. In this sense, they would be literally getting in each other's way, maybe getting into arguments about what they should be doing or what ingredients to use and so forth. That one would be waiting for the other one

to finish using a machine or an appliance so that they could use it. There'd be all these hold-ups, which would mean that each additional chef that you're using there would not be producing as much as the previous one. Actually, I just realized that if you're increasing the number of chefs, you would also have to be increasing the number of all of the different appliances and machinery that the chefs were using. Otherwise, we wouldn't be talking about returns to scale anymore. We'd be talking about diminishing martial products.

So you have to be careful there about which one you're talking about. However, you still can have decreasing returns to scale. Just because, for example, what I said earlier about the chefs disagreeing about what to do, that would be an example of an organizational holder. That's got nothing to do with not having enough machines for each of them. They could still have all of the enough machines for every chef to be using them whenever they want. But if they disagree about what they're doing, and get into arguments, or whatever else, then that's an organizational hold-up which would reduce their efficiency.

And the chefs, that's a silly example. But in the real world, you can imagine how really, really big firms would have a great difficulty managing themselves and working out what all their workers are doing. Okay, so that's an overview of diminishing martial product and returns to scale. Now I just want to touch on a couple of final points about sort of the consequences of firm behavior. Or after having discussed all of these things relating to different types of costs and inputs and decisions about maximizing profit.

What consequences does this have for how firms actually behave and the consequences for consumers? Well, we'll talk more about this in the market structure episode, but there's a few points that I wanted to make here. One is that when the price of an input increases, generally what happens is that firms substitute away from that input. That is, if workers become relatively more expensive because, say, there's a new tax on employees,

or they have to pay increased health care, care insurance rebates or whatever, anything that increases the cost of workers will cause firms to hire fewer workers and instead use more machinery or more raw materials. Also, as a result of that, the overall cost of production goes up. Obviously, it must do so, because if it was overall cheaper to produce the good using the more machinery, then why wasn't the firm using more machinery before? The only reason they would have been using the workers in the first place is because it was cheaper, before.

That is before the increase in the cost of workers. But now the cost of workers has gone up. it's no longer cheaper, and they have to switch to what was previously a more expensive mode of production. When the cost of production increases, though, prices will also rise, and there will be less output in the firm as a whole. So, increases in input prices make consumers worse off because of higher prices and less output, and vice versa. When input prices fall, as a result of, say, falling wages, or cheaper capital or cheaper raw materials, or technological improvements, is generally the most common one, then firms will be able to produce more cheaply,

therefore prices will fall and production will rise and consumers are better off. So that's on the input side. What about when demand changes? How do firms react? Well, when demand falls, think about the firm choosing its many different possible levels of output. Well, when demand falls, the optimal level of output also falls. That is, the output at which they maximize profits, goes down, essentially because less people want their good. And so production will fall and generally price falls as well when demand falls, because the firm's essentially lowering its price so as to try and attract more customers. Again, this is very much in general.

It does depend on the particular structure of the market, and we'll talk more about that again in the next episode. So the point is that this effect of technology or this effect of input price increases or this effect of changes in demand, we can work out what all of these effects will be, at least the directions. We can't necessarily always work out the magnitudes.

To do that, we have to actually go out and measure how big the different effects are, but we can work out the magnitudes just from our theory of how firms behave about maximizing profits and about the two-stage, the two-step process of efficient level of production and, sorry, the efficient method of production and then the profit maximizing level of production. Just knowing that the firm maximizes profits,

we can work out that if one input becomes more expensive, well, then they're going to shift over and use more of another input. They're going to restructure their production. And this is actually very good. It's good that firms behave in this way because it means they produce, again, assuming that there are no market failures and other problems that we've talked about in previous episodes, but assuming away market failures, it means that if firms are producing at the lowest cost, then they're producing most efficiently. They're using scarce resources as efficiently as possible. The fact that this firm doesn't want to use labor, because labor is really expensive, means that the firm is economizing on the use of labor, which frees up the labor to

be used more by another firm that values it more. And you know the other firm must value labor more because they're willing to pay a higher price for it. Obviously, different firms benefit differentially from the inputs that they produce. Like, for example, maybe there'd be a lot of firms who like to use diamond tools or other really expensive metals in their production processes because it's a bit quicker or easier, but those metals are really scarce, and they're really expensive, and the firm can't justify it because it doesn't have much of a benefit for them, and only slightly increases the efficiency of the process, and therefore we wouldn't want them to use the scarce diamonds for their industrial process, because it's not really helpful

for them. We'd prefer for the scarce diamonds to be conserved for the firms for which it makes a really big difference, or for which you can't actually make the good without that input. And so, This fact of firms being profit maximizing and therefore economizing on the use of inputs and choosing the bundle or relative proportions of inputs that minimize the cost of producing a particular level of output is exactly the behavior we would want from an efficient in an efficient market. Similarly, the behavior of firms in selecting their optimal level of output in accordance with consumer demand is also exactly what we would want because we don't want too many heaps and heaps of shoes and not enough hamburgers or not enough cars or something else.

we want the right levels of everything. Well, firms will do this, again, assuming no market failures, firms will do this naturally by themselves, simply as a result of their profit maximizing motive. And again, I've talked about this to some extent in the price system episode in profits and competition, but I just wanted to emphasize here that we can also sort of derive this behavior

from a more detailed analysis of the theory of the firm as opposed to a more supply and demand sort of level analysis that we looked at last time. So, just as a quick summary, firms are organizations that take in inputs, that is, labor and capital and raw materials, and produce outputs. There are different types of firms, including sole proprietorships, partnerships, and corporations, but they all behave more or less the same way. That is, they try and maximize profits, or the difference between revenues and costs.

In order to maximize profits, firms must make two decisions, or a sort of a two-stage decision. The first is how to produce, and the way they do that is for any given level of output, they choose the bundle of inputs and the technological process, the manufacturing process, that minimizes the cost that allows them to produce that level of output as cheaply as possible. And then the second stage in the decision process is that they choose the level of output that makes them the most total profits. And that will be determined by the level of demand that exists for their good and also the alternatives available as a result of competitors in their industry.

Some factors that affect the firm's decisions in these regards are, diminishing marginal product, which means that as you increase one factor while keeping others constant, you tend to get less output in total, and also returns to scale, which can be increasing or constant or decreasing. Returns to scale referring to the amount by which output increases when you increase all factors in the same proportions. And generally, this behavior of firms profit maximizing and then choosing the efficient level of output and the efficient method of production leads to good outcomes from an economic sense, that is, efficient use of resources to satisfy consumer wants.

One reason this can fail, when there is a non-competitive market structure, we will look at in the next episode where I'm going to look at oligopoly and monopoly and monopolistic competition and compare them to perfect competition and look at the welfare implications of this. Anyway, that's enough for now. That's all for this episode. Hope you enjoyed it. If you did, I'd be most grateful if you jumped onto iTunes and gave my podcast a favorable

review. Also, you can jump onto Facebook and search for the Science of Everything podcast page. Give us a like and spread the word about this magnificent podcast to your friends and family. Invite others to listen. Also, this is episode 48, and episode 49 will be coming out very soon, and so after that I'll be looking at doing episode 50. And I hoped to do a special topic for that episode, something a little bit more sort of on the light, entertaining side, but still informative. Maybe like scientific mistakes or inaccuracies in movies, for example, or I could look at common science misconceptions, or look at the scientific accuracy of a particular franchise or film or something like that.

If anyone likes any of those suggestions or would like to propose their own, please send me an email at FODs12F-O-D-S-1-2 at gmail.com or post on the Facebook page. Thanks for listening again, and I'll talk to you next time.