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204 PART • Producers, Consumers, and Competitive Markets decisions that are in their interest, but not in the firm’s best interest As a result, the theory of the firm (and more broadly, organizational economics) has become an important area of microeconomic research The theory has both positive aspects (explaining why managers and workers behave the way they do) and normative aspects (explaining how firms can be best organized so that they operate as efficiently as possible).3 We will discuss some aspects of the theory later in this book At this point we simply stress that firms exist because they allow goods and services to be produced far more efficiently than would be possible without them The Technology of Production • factors of production Inputs into the production process (e.g., labor, capital, and materials) What firms do? We have seen that firms organize and coordinate the activities of large numbers of workers and managers But to what purpose? At the most fundamental level, firms take inputs and turn them into outputs (or products) This production process, turning inputs into outputs, is the essence of what a firm does Inputs, which are also called factors of production, include anything that the firm must use as part of the production process In a bakery, for example, inputs include the labor of its workers; raw materials, such as flour and sugar; and the capital invested in its ovens, mixers, and other equipment needed to produce such outputs as bread, cakes, and pastries As you can see, we can divide inputs into the broad categories of labor, materials, and capital, each of which might include more narrow subdivisions Labor inputs include skilled workers (carpenters, engineers) and unskilled workers (agricultural workers), as well as the entrepreneurial efforts of the firm’s managers Materials include steel, plastics, electricity, water, and any other goods that the firm buys and transforms into final products Capital includes land, buildings, machinery and other equipment, as well as inventories The Production Function • production function Function showing the highest output that a firm can produce for every specified combination of inputs Firms can turn inputs into outputs in a variety of ways, using various combinations of labor, materials, and capital We can describe the relationship between the inputs into the production process and the resulting output by a production function A production function indicates the highest output q that a firm can produce for every specified combination of inputs.4 Although in practice firms use a wide variety of inputs, we will keep our analysis simple by focusing on only two, labor L and capital K We can then write the production function as q = F(K, L) (6.1) This equation relates the quantity of output to the quantities of the two inputs, capital and labor For example, the production function might describe the number of personal computers that can be produced each year with a 10,000-squarefoot plant and a specific amount of assembly-line labor Or it might describe the crop that a farmer can obtain using specific amounts of machinery and workers It is important to keep in mind that inputs and outputs are flows For example, our PC manufacturer uses a certain amount of labor each year to produce some number of computers over that year Although it might own its plant and The literature on the theory of the firm is vast One of the classics is Oliver Williamson, Markets and Hierarchies: Analysis and Antitrust Implications, New York: Free Press, 1975 (Williamson won a Nobel Prize for his work in 2009.) In this chapter and those that follow, we will use the variable q for the output of the firm, and Q for the output of the industry
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