Theory of the Firm
The firm is taken to be a perfectly competitive profit maximizer.
Perfect Competition
Perfectly competitive means there is no product differentiation (no advertising) so that every product is generic.
Further, the firm is understood to be too small to affect the price of the product they produce. The firm is, therefore, a "price taker".. the market determines the price.
In addition, it is assumed that there is "ease of entry and exit" from every market. In other words, when a promising area of production develops, resources are free to move into that line of production. Similarly, when profits "sour" in a given industry, resources will readily more out of that line of production.
Finally, we assume that everyone has perfect knowledge and foresight .. so that people don’t act out of ignorance.
These assumptions are made so that we can analyze markets that work perfectly smoothly without the "friction" of high entry hurdles into various areas of production, or monopoly power and other market imperfections.
The Competitive Firm’s Decision: How Much to Produce
At this point in the analysis, we assume that firms have already decided on which method of production to use (i.e. what resources and which technology), and we assume that these decisions are made efficiently…that the firms are producing a the lowest possible cost. {We shall examine these technological and resource decisions fully later on.) Given this, the only remaining decision the firm has to make is how much to produce in order to maximize profits.
Since the firm is facing a fixed, market determined price for the product it makes, the issue of profitability depends totally on what it costs to produce the product in question. Since we’re economists investigating a maximization (of profit), we’re only interested in the cost of each successive unit produced. If we know the price received, and the cost of each successive (marginal) unit of output, we know which units are profitable to make and sell e.g. those units that cost less than the price are profitable and should be produced.
In order that profit be maximizable, marginal costs will have to fall at first and then rise in order that profit can rise at first, reach a maximum and then decline. For this to happen, there must be some reason for marginal costs to at first fall, and then rise. We call this reason diminishing returns.
Diminishing Returns
Diminishing returns states that:
As we add variable inputs to a productive process which has at least one fixed input (i.e. plant size, etc.) we will find that, eventually, the increase in output attributable to successive increments in inputs will decline.
An example is in order. Let us assume I am producing tomatoes. I have a fixed plot of land (the fixed input) on which to grow my crop. I assume that the only input is labor.
At zero units of labor input, zero tomato production is achieved.
As I add labor to the garden plot, output increases with each additional unit of labor. The first unit of labor adds about 7 units of tomatoes. The second unit adds about 9, and the third of labor adds 11 units of tomato output. By the third labor unit, my total tomato output is 27 units (7 plus 9 plus 11). The addition to output provided by each additional unit of labor is increasing. This is the region of "increasing returns". Note, however, that the 4th unit of labor adds less than the third (about 10 units of tomato output) and each successive unit of additional labor creates a smaller addition to output than the last. Indeed, the eighth unit of labor adds nothing, and the ninth actually reduces total output. This area of successive decline in additions to output (marginal product) is called the region of "diminishing returns".
Diminishing returns are a fact of nature where some input to the productive process is fixed (in this case the size of the garden plot). Were there to be no diminishing returns, I could continue to add labor at a constant increase in tomato production indefinitely. If this happened, I could produce in infinite crop of tomatoes from my plot – all of the world’s needs and more. Clearly this is ridiculous. Diminishing returns are a reality.
The Firm’s Cost Curves
Because marginal product per unit input in the above graph first rises
and then falls, it follows that marginal costs at first fall and then rise.
Obviously, if I’m getting increased tomato output from each successive,
constant cost, unit of labor; the cost of each successive unit of output
(marginal cost) is, at first, falling. When I reach the region of diminishing
returns, however, the output gained from each successive unit of labor
falls. Therefore the marginal cost will be rising. If I graph the marginal
costs, they look like the graph below:
Note that the marginal cost (MC) curve at first falls, and then rises.
Since the producer is a "price taker" and faces a constant price for the
product, the price line P P is horizontal.
The profit maximizing level of output is produced where the MC curve
intersects the P P line – where price equals marginal cost. The quantity
is shown by the vertical, dashed line.
The Supply Curve
Since the firm always supplies output where the marginal cost equals price, the marginal cost curve is the firms supply curve. Note, however, that only the rising portion of the marginal cost curve is the firm’s supply curve. If price is above the minimum marginal cost level, the firm will produce all product whose marginal cost is declining since in increased amount profit is earned on each successive unit sold. When marginal costs begin to rise, the firm will still be profiting on each successive unit as long as marginal cost is less than or equals price. When the marginal cost of the firms output equals price, the firm has produced every possible profitable item, and will not increase the rate of output further.
