The Business Firm

Last month’s column introduced the individual consumer and showed that (s)he buys a bundle of goods and services, subject to a budget constraint, to maximize his/her satisfaction. This column explains the position of the firm.

The firm attempts to maximize its profit. It produces and sells a product for which it receives revenue. On the other side of its ledger are production costs; these consist of four productive factors:

Factor of Production

  • Workers in various skills, otherwise called the services of labor, for which the firm pays wages and salaries.
  • The services of land and natural resources which it must rent and for which it pays rent. If it owns the land, we can think of it as paying rent to itself.
  • The services of machines, or capital, which it acquires by borrowing money, for which it pays interest.
  • The business services which the owner provides, known as enterprise. These include coordinating the activity of the land, labor and capital, introducing inventions into the production process and the all-important assumption of risk; the business may lose as well as earn money if production costs exceed revenue.

The four types of costs (including enterprise) known as factors of production, are listed in the following table, along with their form of compensation.

Factors of Production

Production Factor

Form of Compensation

Labor in various skills

Wages and salaries

Land and natural resources

Rent

Capital to buy machinery

Interest

Enterprise

Profit

The firm’s profit is what the firm attempts to maximize.

Output Equals income

The four types of factor compensation add up to income of people in society. An important insight can now be gained: output and income are equal. They are two sides of the same coin. To show this, we use an example of a desk manufacturer. His costs are made up of wages, rent, interest and profit, and these are incomes of people who rendered the services. In addition, he buys lumber from other firms, which is a product intermediate between the raw material (forest wood) and the final good (desk).

In turn, the producer of lumber also pays the four factors of production, which make up income, and buys raw materials (forest wood) purchased from a wood-chopping firm. But the output of raw wood can also be decomposed to the four factors compensations or forms of income. So, if we add up all the incomes generated in the production process it adds up to the value of the product or output. Hence, income equals output. Put another way, the price of output can be decomposed into incomes of the four factors.

Stages of production

Another feature to be noted in the above example is that it was made up of:

  • Raw material (forest wood)
  • Intermediate production (lumber)
  • Final good (desk)
  • To this one can add wholesale and retail distribution which add to the price of the product and income of recipients’ same amounts

Complex manufacturing products, such as an automobile, often require hundreds of intermediate stages as parts are made and assembled into the final assembly plant. But the principle of equality between income and output remains inviolate.

We can now address the main questions of microeconomics

What goods and services are to be produced and in what quantities?

In our market system, this is determined by the consumer as (s)he selects the bundle of goods and services that maximizes their satisfaction, and through these purchases sends a signal to producers about what to produce. In a regimented communist state this is decided by a planning authority. Often goods and services are excessively produced and are not sold, or are produced in insufficient quantities and shortages develop. In a capitalist system, the amounts are determined by consumer demand.

How is each good and service produced?

This boils down to the factor combination in the production process, such as: much labor and little machinery (labor intensive process) or much machinery and little labor (capital intensive process). The producers, taking note of the prices of labor and capital prevailing in the market, combines them in such a way as to minimize his cost.

The sectoral composition of the economy is largely determined by the consumer allocation of his income and the producer organization of the production process. Today in the U.S., under five percent of the workforce is employed in agriculture; about 20 percent in manufacturing and nearly 70 percent in services.

How is the income (which equals output) to be distributed?

The distribution among productive factors depends on the market and the price set for each factor. But social interest sometimes attaches to the equality or inequality of income distribution and society might wish to modify the distribution generated by the market, usually to make it more equal. This is done by government through a system of taxes and subsidies: tax the rich more heavily than the poor and subsidize the poor. At the extreme, the distribution can be made very equal. But as a social objective, it must be noted that a very equal distribution can interfere with incentives to work and excel which often come from prospective pecuniary benefits. So, the view of “fair distribution” must be tempered with retention of incentives.

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Mordechai E. Kreinin

Mordechai E. Kreinin

Mordechai Kreinin is a University Distinguished Professor of Economics, emeritus at Michigan State University and past President of the International Trade and Finance Association. He is the author of about 200 articles and books about economics, including the widely used text, International Economics. He can be reached at kreinin@msu.edu or by cell phone at (517) 488-4837

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