Business Firm Choice

Business firms engage in production, which is the transformation of inputs into outputs.

Technically efficient input combinations are those that cannot be improved upon. That is, the equivalent output cannot be obtained by using less of some input without using more of some other input.

Technically efficient relationships between a firm's physical units of inputs and outputs are expressed in its production function. It presents the maximum output that can be obtained from given amounts of inputs at a given level of technological development or the different technically efficient combinations of inputs that can produce a given output.

An input combination is economically efficient if it produces a given output at the lowest possible cost.

Firms make decisions for three different time spans: the short run, the long run, and the very long run. The short run allows a firm the least amount of flexibility because at least one of its in puts cannot be varied. The long run allows complete flexibility within the firm's production function. In the very long run, a firm's production function can be altered through technological change.

The theory of production in the short run predicts that when a firm adds successive units of a variable input to some fixed inputs, it will first result in increasing returns (rising marginal product), then diminishing returns (falling marginal product), and eventually in negative returns (falling total product and negative marginal product).

The theory of production in the short run separates production into three stages. In Stage I total product rises, average product rises, and marginal product first rises and then falls. In Stage II total product rises at a decreasing rate, marginal product falls, and average product falls. In Stage III total product falls, marginal product is negative, and average product continues to fall.

The economic theories of increasing and diminishing returns explain the shape of a firm' short-run cost,curve.

Business firms are assumed to want to maximize their profits and therefore to want to minimize the costs of what they choose to produce. Economists separate a firm's costs into seven short run cost concepts. These are: TO, TFC, TVC, ATC, AFC, AVC, and MC. They are related in the following ways:

    TO = TFC + TVC

    ATC = TO @ quantity level of output

    ATC = AFC + AVC

    AFC = TFC @ quantity level of output

    AVC = TVC @ quantity level of output

    MC = the change in TO when output

         changes by one unit.

In the long run, there are three cost concepts: LRTC, LRAC, and LRMC. When LRTC in creases at a decreasing rate, LRMC will be below  LRAC, which is falling. Such long-run increasing returns are called economies of scale. When LRTC increases at a constant rate, LRMC and LRAC will be constant and equal. This condition is called constant returns to scale. When LRTC rises at an in creasing rate, LRMC will be above LRAC, which is rising. Such long-run decreasing returns are called diseconomies of scale.

With plants designed for increasingly higher levels of output, LRAC is expected first to decrease, then to level off, and finally to increase. Each larger and larger plant size calls for the adoption of a somewhat different method of production. At first there are gains from specialization, but eventually these fade out, and finally wasteful bureaucracy is expected to set in. 

The LRAC curve is made up of points from all the short-run ATC curves. Each short-run ATC curve represents a certain-sized plant. In the long run, economists predict that a firm will choose a plant or plants that offer minimum ATC at the level of output it wishes to produce. Only in the constant-returns-to-scale range of plant size will a firm achieve both minimum short-run and minimum long-run ATC. In the output ranges of economies and diseconomies of scale, short-run minimum ATC will not coincide with long-run minimum  ATC.

Very- long - run business decisions involve invention and innovation. Invention is the discovery of a new product or process, and innovation brings it to practical use. 

Very-long-run business decisions affect productivity. Productivity-usually measured in terms of product output per hour of labor input can be changed by input substitution and by changing the quality of inputs. Productivity increases have slowed significantly in the United States over recent decades.