THE RUSINESS FIRM:
COMPETITIVE OUTPUT
AND PRICE
THE THEORY OF THE FIRM
IN THE SHORT RUN

In this chapter, we examine how business firms respond to consumer demands. We will focus on firms in highly (“perfectly”) competitive industries, postponing until later a look at the partially monopolized sectors of the economy.

THE THEORY OF THE FIRM

Traditionally, economists and other advo- cates of the private-enterprise system have pic- tured the business firm as, by and large, trying to maximize its profits. If we accept this position, the “theory of the firm” is a relatively simple affair.

Our “model,” or “theoretical,” firm wishes to maximize profits. Profits are the difference between total cost and total revenue. Hence, the firm does what it can (within the legal rules and mores of society) to maximize this difference. It tries to sell more of its own product when the price is high enough to exceed costs, and it tries to keep its costs as low as possible. That is, it tries to produce its output as efficiently as possible.

Whenever the firm can increase its profits by in- creasing its revenues or by reducing its costs, it will do so. Only when it is maximizing its profits (at least to the best of its own ability) will the man- ager be satisfied. Then the firm will be in “equi- librium”—in the sense that it will not change its own actions unless conditions change. Actually, external conditions (for example, consumer de- mand and wage rates) do change frequently, so the business firm will seldom actually reach and stay in equilibrium for long. But the firm will always be aiming at this maximum-profit position in conducting its day-to-day affairs and in its long- run planning.

We know, of course, that not all firms be- have this way, and at the end of this chapter we will take a more detailed look at just how realistic this assumption is. But for the moment, assume that firms in our highly competitive industry have the single goal of profit-maximizing. What, the~i, can we say about how they should make their decisions?

THE COMPETITIVE FIRM IN THE SHORT RUN

In trying to maximize its profits, the firm tries to maximize the difference between its in- come from sales and its costs. Since we are assum- ing highly competitive conditions, in which our firm represents a very small part of the market and turns out a product just like its competitors’, it must take the product price as given—fixed in the market by total demand-and-supply conditions over which no one firm has any significant control. Under this assumption, our firm can’t charge a higher price than the one prevailing in the market. If it does it won’t sell any goods, since consumers can get all they want at the prevailing price from other sellers. This means that the firm sees the demand curve as a horizontal line at the prevailing market price. This assumption may seem to you rather extreme, and it is the limiting case of what ecor~omists call perfect competition. But it is an instructive case with which to begin. We will modify the assumption later.

Comparison of Total Costs and Total Revenue

If the stereo hi-fl firm from Chapter 22 wants to giaximize profits, it can compare its total cost with total revenue at each level of output, and thus determine the most profitable number of sets to produce. This is done in Table 23-1, assuming that the nwrket price is $1,800. (Ob- viously the estimated total revenue will be dif- ferent if the price is different, since total revenue is merely output multiplied by the price.) The table shows that the maximum profit output is six sets per month. At only one set per month, total revenue doesn’t cover costs. When the plant gets up to eight sets a month, costs shoot up so fast that they exceed even the big sales income. In between, any output is profitable, but some more so than others. Profit is the largest if we produce and sell six sets.

This same comparison can be made graph- ically, as in Fig. 23-1. TC is total cost, plotted from the second column of Table 23-1. TR is total revenue, plotted from the third column. Where TR is above TC, the firm makes a profit. The profit is largest where TR is farthest above TC—here at an output of six units monthly, just as in the table. The yellow area between the two curves shows the range over which a profit is possi- ble. The same area is shown separately at the bot- tom of the chart, where it is easy to see where the vertical distance (height of area) is greatest.