Production and Supply

The key principles and concepts underlying the microeconomic analysis of supply include:

• First, the short-run production decision of a business based on the combination of one or more variable inputs with one or more fixed inputs. This decision is primarily influenced by the law of diminishing marginal returns.


• Second, the opportunity cost of short-run production, especially the marginal cost of incrementally changing production by a single unit. This cost is also influenced by the law of diminishing marginal returns.


• Third, the degree of competition and the resulting structure of the market in which a business operates. Market structures affect the amount of control a business can exert over the price charged for production.

Objectives

Real world firms, however, might not, and many times do not, make decisions based exclusively on the profit-maximization objective. Other objectives include sales maximization, pursuit of personal welfare, and pursuit of social welfare. In some cases, these other objectives help a firm pursue profit maximization. In other cases, they prevent a firm from maximizing profit.

Consider these four firm objectives in more detail:

• Profit Maximization: The primary objective of a business is usually to obtain the highest possible level of profit through the production and sale of goods and services. If a business can produce a good for less cost than the revenue generated, then profit is enhanced by producing more. If production generates higher cost than the revenue received, the profit is increased by producing less.


• Sales Maximization: A reasonable, and often pursued, objective of a business is to maximize sales. That is, to sell as much output as possible. Clearly sales lead to revenue, meaning that maximizing sales is bound to maximize revenue as well. If the cost of producing each extra unit is less than the extra sales revenue received, then sales maximization is bound to increase profit--which is not necessarily a bad business strategy. The business might not maximize profit, but it could very well increase profit.


• Pursuit of Personal Welfare: The folks who manage a business, whether owners or not, might occasionally use the business to pursue their own personal welfare, that is, to maximize their utility. To the extent that their personal utility is connected to the profit of the business, this can be achieved through profit maximization. However, to the extent that they achieve utility in other ways, such as luxurious office accommodations or extended lunch hours, then greater personal welfare is bound to inhibit profit maximization.


• Pursuit of Social Welfare: The folks who manage a business, whether owners or not, also might occasionally use the business to pursue a social or political agenda. They might donate revenue to a charitable organization or a political campaign. They might sponsor a junior league sports team or run "public service" announcements promoting a particular political point of view. If such expenses are unrelated to the operation of the business, then profit is likely sacrificed.

Legal Types

• Proprietorship: A business owned and operated by one person. The owner and the business are legally considered one and the same. As such, the owner receives any and all profit and has what is termed unlimited liability. With unlimited liability, the owner is held personally responsible for any and all debts of the business. While a large number of businesses in the economy are proprietorships, they tend to be relatively small.


• Partnership: A business owned and operated more or less equally by two or more people. The owners and the business are legally considered one and the same. As such, each owner also has unlimited liability, which means that any owner is held personally responsible for any and all debts of the business, including those of a partner. This form of business is common for professional-types, including lawyers, accountants, dentists, and physicians.


• Corporation: A business established through ownership shares (or corporate stock). A corporation is considered a distinct legal person, that can be sued, forced to pay taxes, etc., comparable to a human person. Unlike proprietorships and partnerships businesses, a corporation business exists separately from its owners. As such, the owners have limited liability. Owners cannot be held personally responsible for corporate debts. The owners can only lose the value of their ownership shares, but no more.

Liability

• Unlimited Liability: This is the condition in which owners are personally held responsible for any and all debts created by a business. The liability of the owners is, as such, unlimited. In addition to the assets and wealth of the company, the personal assets and wealth of the owners can be used to pay off any and all debts of the business.


• Limited Liability: This is the condition in which owners are NOT held personally responsible for the debts created by a business. The liability of the owners is limited, usually to the amount that is invested in the business. The personal assets and wealth of the owners cannot be used to pay off any debts of the business.

Market Structures

• Perfect Competition: Perfect competition is a market with a large number of relatively small firms that sell virtually identical products and that have ease of movement into and out of the market. The key feature of perfect competition is that each firm has no market control--that is, a firm has no ability to control the price. While real world markets come close to this ideal of perfect competition, NONE are PERFECT competition.


• Monopolistic Competition: Monopolistic competition is a market with a large number of relatively small firms that sell similar but not identical products and that have ease of movement into and out of the market. Monopolistic competition is very similar to perfect competition, the primary difference is that products sold by monopolistically competitive firms are slightly different. Product differentiation gives each firm some market control and some ability to control the price. A large portion of real world markets are monopolistic competition. In fact, monopolistic competition can be considered the real world's best effort to achieve perfect competition.


• Oligopoly: Oligopoly is a market with a small number of relatively large firms. The key feature of oligopoly is that entry into and out of the market is usually restricted. This restriction tends to limit the number of firms in an industry and gives each firm a great deal of market control, with a substantial ability to control the price. A large portion of real world markets are oligopoly.


• Monopoly: Monopoly is a market with a single seller of a good that has virtually no close substitutes. For a monopoly market structure, the single business IS the market, it has complete control over the market price. And it has this control because buyers have no substitutes available. Several real world markets come close to monopoly, but like perfect competition, no markets are complete monopoly.