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7 Firms and Production

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Learning Outcomes

After reading this chapter, you should be able to

• Explain why firms come into existence.

• Define the various types of firms.

• Calculate the least cost method of production to determine economic efficiency.

• Use a production function to explain increasing and diminishing marginal returns.

• Show how a firm chooses its mix of inputs to maximize output.

156

Section 7.1 Firm Theory

Introduction Imagine that you are Chelsea Sloan and you have recently launched a trendy, previously owned clothing and accessory store with your brother, Scott. Several years later, your pri- vately owned company is franchised and now has 40 locations in 17 states. Expanding into e-commerce would enable you to reach customers across the country and allow people to shop 24 hours a day! You already have a website, which leaves you with one big question: Which type of fulfillment structure should you choose? Once an order is placed, the items must be selected, packaged, and shipped. You could handle the fulfillment yourself, which would require creating a system for managing orders, hiring additional employees, and build- ing a shipping platform. The other option would be to outsource fulfillment to another com- pany specializing in fulfillment that would take care of all the details but charge you a flat fee for each order, an additional fee for each item per order, and a monthly storage fee. There are pros and cons to each option—how do you decide? This chapter will provide tools and guid- ance to help you with this decision.

7.1 Firm Theory It is easy to take the existence of firms for granted because we have all had dealings with many types of firms. We need to ask why firms exist. A firm buys or rents productive resources (also known as inputs) and attempts to transform them into marketable outputs in goods or services. Remember that the productive factors are land, labor, capital, and enterprise. This chapter examines the process of transforming inputs into marketable outputs, which econo- mists call production. Economic theory recognizes that firms exist to accomplish certain eco- nomic objectives and are organized in different ways to meet those objectives.

Households as Firms In many ways, households compete with firms. Firms exist to organize production, and house- holds also organize some production. Thus, there are aspects of household activities that are similar to the activities of firms. Firms put “things” together to make other “things” that have economic value. Households clearly do, too. Households cook meals, and so do restaurants. Households organize entertainment, and so do movie theaters.

An interesting economic question is why households don’t do everything for themselves. Why don’t they make their own cars, for example? That’s an easy one. They don’t make their own cars because it is more efficient for them to buy cars from firms that produce cars. It gets more difficult when we ask why households don’t make their own clothes or build their own homes. The answer is that some do. As the price of clothes and homes produced by firms increases, more households may compete with organized firms to produce their own prod- ucts for consumption.

In fact, as relative market prices change, the kinds of production carried out by households change. In recent years, some households have started to generate their own electricity in response to rising energy prices and concerns about fossil fuel emissions as they relate to global warming. This home production, in turn, has affected the demand for products of firms that produce solar panels, wind turbines, and related products.

157

Section 7.1 Firm Theory

What Firms Do First and foremost, firms in a market economy are organized by entrepreneurs to make prof- its. These firms are organizations that plan production. They assign tasks, monitor those tasks, and generate incentives that reward individuals for completing assigned tasks. An important point is that there are many different sizes of firms. At one extreme, households behave like very small firms. At the other, governments can be seen as extremely large, multipurpose firms.

Within the category of firms, there is great diversity. Many firms in the U.S. economy are vertically integrated firms, which means they perform many steps in a production process. One example is Target, which produces and sells its own brands, acting as a manufacturer and a retailer. Firms that are not vertically integrated may perform only one step in the pro- cess, such as making a face lotion that is then sold at a Target. Still others are horizontally integrated firms, which means that they perform many similar production operations in the same industry, operating many plants at the same stage of production—for example, the Coca-Cola Company owns hundreds of different soda brands around the world. Many large firms are conglomerates, which means that they engage in many, often quite unrelated, activities. Berkshire Hathaway, for example, owns GEICO (insurance), Dairy Queen (restau- rant), Fruit of the Loom (underwear), and more.

Economics in Action: Warren Buffett on Why He’ll Never Sell a Share of Coke Stock

Berkshire Hathaway also owns almost 10% of the Coca-Cola Company, and Warren Buffett is a Coca-Cola Company board member. Watch this video to hear Warren Buffett explain why he’ll never sell a share: https://www.youtube.com/watch?v=4p1_5bZ8I4M.

sframephoto/iStock/Thinkstock Tatomm/iStock/Thinkstock

Vertically integrated firms perform many steps in a production process. For example, one firm could be responsible for every step required to make a T-shirt. The firm might grow the cotton, weave the cloth, dye the cloth, and sew the cloth into T-shirts.

https://www.youtube.com/watch?v=4p1_5bZ8I4M

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Section 7.2 Firms in Practice

7.2 Firms in Practice A firm is organized by an entrepreneur (or group of entrepreneurs) to combine inputs of raw materials, capital, labor services, and technology in order to produce marketable outputs of goods and services.

Firms are parts of industries. There are many ways to define an industry. In general, what economists mean by an industry is a group of firms producing similar or related products.

Global Outlook: Labor-Managed Firms Around the Globe

This chapter discusses different forms of business organizations with a focus on the types of firms prevalent in the United States and most other market-oriented economies. There is, however, another form of organization that appears in many socialist economies: workers’ self-management.

In the United States, worker management exists in a few craft industries and has been attempted on occasion when manufacturing plants were about to close (e.g., in the steel industry). There are some companies in the United States in which labor unions have become significant stockholders and have received an automatic seat on the board of directors in exchange for salary concessions to avoid bankruptcy. For example, in 2012 Chrysler Group CEO Sergio Marchionne allowed a United Automobile Workers representative onto the board of directors, primarily to manage the health care costs of retired unionized workers—a clear example of a movement toward workers’ self-management (Szczesny, 2012).

In other parts of the world, workers actually own the plant and decide how it will be managed through workers’ councils. The ownership rights end when a worker leaves the firm, so these ownership rights are different from stockholder rights in U.S. corporations. For example, the John Lewis Partnership owns John Lewis, the largest department store in England, along with the Waitrose supermarket chain and other smaller brands. The John Lewis employees elect an 82-person governing body called the Partnership Council, which elects about one third of the board. In 2017 the partnership earned $10.2 billion in revenues and has seen an increase in annual earnings every year since 2009. This partnership has achieved high performance using an employee ownership model, demonstrating economic success while providing fair compensation to its 85,500 partners (John Lewis Partnership, 2018).

Economists are interested in how such organization and control by workers affects incentives and ultimately the economic well-being of a firm. As we have seen, entrepreneurs try to maximize profits. If the firm is owned by workers, will something other than profit be maximized? Workers’ self-management means that workers may seek to maximize wages and other benefits that they can capture while they are with the firm. Since workers have no ownership rights that they can sell, they may opt for a management policy that increases the short-term income of the firm over policies that would increase the firm’s value over time. It is up to the management structure to ensure that the long-term health and competitiveness of the firm is kept in mind.

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Section 7.3 Economic Efficiency

Enterprises, Entrepreneurs, and Firms An enterprise is the productive resource provided by an entrepreneur. What is it that entre- preneurs do? They identify consumer demands, organize production, allocate resources, and acquire assets. In the process, they take risks. Entrepreneurs are rewarded with profits if they have good ideas, or they go bankrupt if they are wrong. Many more may go bankrupt than suc- ceed. Although around 80% of businesses survive their first year, only half exist after 5 years (Bureau of Labor Statistics, 2016).

Economics in Action: Why Do Businesses Fail?

The Young Entrepreneurs Forum found that 90% of small businesses fail for similar reasons. Find out more at https://www.youtube.com/watch?v=0WhKcDIe3Ps.

7.3 Economic Efficiency The firms that produce most of the United States output are private, profit-maximizing firms. An entrepreneur must combine resources efficiently if the firm is to maximize profits. To do this, entrepreneurs must decide among competing ways of producing a given product. Sup- pose, for example, that a publisher of self-help books is faced with the alternatives listed in Table 7.1. The production engineer tells the production manager that 100,000 units can be produced in any of these four ways. The production manager informs the president and CEO of the firm, the entrepreneur, who must decide how to actually produce the product. The entrepreneur must have a basis on which to select a production alternative. The determining factor will be profit maximization. Without profit maximization as a goal, the entrepreneur will have to choose on some other basis, such as physical units of input or output.

Table 7.1: Alternative ways to produce 100,000 copies of a self-help book

Method Capital (machines)

Price of capital services (per machine)

Labor (worker- years)

Price of labor services (per worker-year)

Land (acres)

Price of land services (per acre) Total cost

A 5 $30,000 5 $4,000 1 $10,000 $150,000 + $20,000 + $10,000 = $180,000

B 4 $30,000 10 $4,000 1 10,000 $120,000 + $40,000 + $10,000 = $170,000

C 3 $30,000 15 $4,000 1 10,000 $90,000 + $60,000 + $10,000 = $160,000

D 2 $30,000 25 $4,000 1 10,000 $60,000 + $100,000 + $10,000 = $170,000

https://www.youtube.com/watch?v=0WhKcDIe3Ps

160

Section 7.4 Production Functions in the Short and Long Run

A market system puts the inputs into dollar terms and lets the entrepreneur choose the least cost method of producing. The least cost method, or the economically efficient method, is cho- sen by the entrepreneur because of the profit maximization objective. Economic efficiency is therefore defined as the least cost method of production. In Table 7.1 the publisher would choose method C to produce the books. Regardless of the price of the book, method C helps maximize profits (or minimize losses) because costs are less than the alternative ways to pro- duce 100,000 units. However, the entrepreneur must know the prices of the various inputs in order to make this choice.

7.4 Production Functions in the Short and Long Run A production function is a description of the amounts of output expected from various com- binations of inputs. It is usually expressed in the form of a table or graph, but it can also be shown by a mathematical formula. The production function describes a technical or tech- nological relationship. These technological relationships are sometimes simple and in other cases complex. Sometimes engineers, agronomists, chemists, or other technical experts must be consulted to determine the relationships.

Only the productively efficient input combinations are included. For example, it might be that an output of 100 units could be produced by 5 units of capital, 20 units of labor, and 2 units of land; or by 6 units of capital, 30 units of labor, and 3 units of land. The second combination is inferior to the first because it takes more of all inputs to produce the same output and is not productively efficient. The production function reflects the most efficient technology avail- able to produce a given level of output.

When considering a production function, it is possible to distinguish between fixed inputs and variable inputs. Fixed inputs are the productive resources that cannot be varied in the short run, such as the size of a hotel building. Variable inputs are the productive resources that can be increased or decreased in the short run. Which inputs are fixed and which are variable usually depends on the problem under consideration. In many cases, however, the land and the buildings of a firm (the physical operations) are considered fixed inputs and labor the variable input. Labor would be a variable input when operating a hotel.

When economists distinguish between fixed and variable inputs, they are referring to a time period called the short run. In this context, the short run is the period of time that is too short to vary all the inputs; one or more of the inputs must remain fixed. In the short run, labor is generally the only variable factor of production. The long run is the period of time in which all inputs, including physical operations and equipment, can be varied. Short-run decisions are those concerning the profit-maximizing use of the existing physical operations and equip- ment. The plant is used more intensively by increasing the amount of variable inputs, usually labor. Long-run decisions are those concerning the selection of physical operations that will maximize profits, such as the number of hotels owned by a company.

These time horizons cannot be defined in the calendar sense, such as in weeks or months, because they are different in different industries. In some industries firms may be able to increase in size very rapidly. In some cases contractions can occur more quickly, depending on whether the plant and equipment are adaptable for other uses. It is primarily for conve- nience of analysis that decisions are classed as being either short run or long run. Keep in

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Section 7.4 Production Functions in the Short and Long Run

mind that such decisions are inherently interrelated. Once a long-run decision to build a plant of a certain size is made, a whole series of short-run decisions are affected because they must deal with that size of plant.

Policy Focus: Should a Publicly Held Corporation Give Money Away?

Economists view a firm as existing to make profits for the owners. Some economists argue that it is therefore improper for a publicly held corporation to be involved in philanthropy (charity) because it is giving away the profits of its stockholders, who are not part of the decision to give the money away. They argue that the profits should be distributed to the stockholders, who can give it to charity themselves if they wish. However, corporations have been giving money to various causes for decades. For many years, this corporate giving was at the whim of the CEO, or whoever had the ear of the CEO. In recent years, the pattern has changed somewhat. Corporate giving is now more likely to be based on self-interest, accountability, and cause-related marketing.

Corporate philanthropy is big business. According to the Committee Encouraging Corporate Philanthropy (n.d.), more than $20 billion was given away in 2017. Gilead Sciences had the largest donations at $447 million, followed by Walmart ($301 million) and Wells Fargo ($281 million). Such gifts serve worthy causes while creating a good image and potential future customers. Research has found a positive relationship between total corporate charitable donations and corporate financial performance (Liang & Renneboog, 2017). There is evidence that customer satisfaction may be the mechanism by which charitable donations contribute to future sales, suggesting that consumers reward firms for “good” behavior.

The biggest givers in corporate America are some of the biggest corporations. Table 7.2 lists 10 of these and the size of their contributions (in millions).

Table 7.2: Corporate giving

Corporation Amount (millions)

Gilead Sciences 447

Walmart 301

Wells Fargo 281.3

Goldman Sachs 276.4

ExxonMobil 267

Chevron 225

JPMorgan Chase 224

Bank of America 168.5

Alphabet (Google) 167.8

Citigroup 142.8

From “The 2016 philanthropy 50,” by The Chronicle of Philanthropy, 2016, Retrieved from https://www.philanthropy. com/specialreport/the-2016-philanthropy-50/87.

(continued)

https://www.philanthropy.com/specialreport/the-2016-philanthropy-50/87

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Section 7.4 Production Functions in the Short and Long Run

Policy Focus: Should a Publicly Held Corporation Give Money Away? (continued)

Then there are the donors who gave the most in 2017, who happen to also be affiliated with large corporations. Table 7.3 lists 10 of these and the size of contributions (in millions). The first three names are certainly recognizable as the founders/owners of Microsoft (Bill Gates), Facebook (Mark Zuckerberg), and Dell Computers (Michael Dell). As seen in the table, Bill and Melinda Gates lead the list with a $4.8 billion donation to their foundation.

If firm owners can choose to donate privately using their own wealth, the question becomes whether stockholders should be “forced” to contribute based on the preferences of the companies in their stock portfolio. Is there anything they can do to control such contributions? If the research on the corporate benefits to supporting philanthropy is accurate, there are likely reciprocal benefits to the company that outweigh the amount given.

Table 7.3: Donors who gave the most in 2017

Rank Donor Amount (millions)

1 Bill and Melinda Gates 4,780

2 Mark Zuckerberg and Priscilla Chan 2,018.9

3 Michael and Susan Dell 1,000

4 Henry Hillman 850

5 Michael Bloomberg 702

6 Florence Irving 680

7 Charles Butt 290

8 John and Laura Arnold 285

9 Pierre and Pam Omidyar 258

10 Roy and Diana Vagelos 250

From “The 2016 philanthropy 50,” by The Chronicle of Philanthropy, 2016, Retrieved from https://www.philanthropy .com/specialreport/the-2016-philanthropy-50/87. Reprinted with permission.

Economics in Action: Is All Corporate Philanthropy Good for Those Who Get It?

Some companies offer to donate a good or service to a person in need each time someone purchases their product. Are corporate gifts like this actually good? Watch Adam Conover cover the “Buy one, give one” model of corporate giving here: https://www.youtube.com /watch?v=hX0g66MWbrk.

https://www.philanthropy.com/specialreport/the-2016-philanthropy-50/87

https://www.youtube.com/watch?v=hX0g66MWbrk

163

Section 7.4 Production Functions in the Short and Long Run

Diminishing Returns As more and more units of a variable input are added to a set of fixed inputs, the result- ing additions to output will eventually become smaller. This economic conclusion is referred to as the principle of diminishing returns. The principle of diminishing marginal returns is a fascinating and pervasive phenomenon. For example, it is more costly to add a floor to

a 20-story building than to a 10-story building. Adding water to parched soil yields remarkable crop improvement, but adding the same amount of water to already moist soil has very little effect. If a firm adds a worker when its labor force is already large, the increase in output is less than if a worker is added at a time when the labor force is small. These are only a few examples of the principle of diminishing returns.

Think of your own experience in studying for exams. The output is your test score, and the variable input is the time you spend studying. Assume that you could get a score of 55% with- out studying. One hour of studying would boost your score to 66%, 2 hours to 75%, 3 hours to 80%, 4 hours to 84%, 5 hours to 86%, and so on.

Each additional unit of variable input (hour spent studying) produces a smaller increment in output (improvement in test score). The first hour of studying produces an improvement of 11 percentage points, the second hour yields 9 points, the third hour 5 points, and so on. There is a diminishing marginal return to studying. It is up to you to decide when the return for an additional hour of studying is not worth the opportunity cost of that hour in terms of the other things you could be doing. So you see, even deciding how much to study is an exer- cise in rational economic choice.

Average and Marginal Relationships There is a technical relationship between average values and marginal values. Think of your grade point average. If your grade in this course (the marginal grade) is below your grade point average for all courses you have taken, your average will fall. If your grade in this course is above your grade point average, your average will rise. If a basketball player’s season shoot- ing percentage (average) is higher this week than last week, you know that in the intervening games, the player has shot higher-than-average (marginal) percentages. If a marginal value is above average, it will pull the average up. If the average value is falling, the marginal value must be below the average.

In production, the relationship of marginal and average values is between marginal product and average product. In order to describe more precisely the relationship between inputs and outputs, economists use the concept of the marginal product. Marginal product (MP) is the change in total output that is produced by a unit change in an input. The marginal product of

fotokostic/iStock/Thinkstock The principle of diminishing returns exists outside of economics. For example, water will have less of an effect on soil that is already moist than it will on soil that is dry.

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Section 7.4 Production Functions in the Short and Long Run

labor, for example, is the change in total output per unit change in the use of labor services. That is,

MPL = ΔTP ΔL

where MPL is the marginal product of labor, ΔTP is the change in the total product, and ΔL is the change in the number of units of labor employed. The total product (TP) is the amount of output that a firm produces in units. The average product (AP) of an input is simply the total product divided by the number of units of the input employed. For example, the average product of capital (APK) is

APK = TP K

where K is the number of units of capital used.

Table 7.4 illustrates these relationships for a short-run production function. All the inputs are fixed except labor. Labor, the variable input, can vary between zero and 10 units. In Table 7.4, as more variable input is added to the fixed inputs, output goes through four distinct stages. When the first three units of labor are added, output increases at an increasing rate. That is, the marginal product of labor is increasing (MPL > 0). Adding the fourth unit of labor causes output to increase but by a smaller amount than for the third unit of labor. At this point, the marginal product of labor is now declining, and diminishing marginal returns has set in. The 8th unit of labor produces no increase in output (MPL = 0), and the 9th and 10th units of labor actually cause total output to fall (MPL < 0).

Table 7.4: A short-run production function (Q = f (L))

Variable input (L) (units of labor)

Total product (TP) (units of output)

Marginal product of labor (MPL)

Average product of labor (APL)

0 0 0 0.0

1 6 6 6.0

2 14 8 7.0

3 24 10 8.0

4 32 8 8.0

5 38 6 7.6

6 42 4 7.0

7 44 2 6.3

8 44 0 5.5

9 42 –2 4.7

10 36 –6 3.6

165

Section 7.5 The Choice of Inputs

7.5 The Choice of Inputs We can use the concepts of production function and diminishing marginal returns to consider the choice of a production method. Earlier in this chapter, we demonstrated the concept of economic efficiency by showing how a printer might choose to produce a book. We can now add complexity and realism to this example.

Assume that we are again looking at the production of books. This means that the firm is in the short run, and as a result, its size cannot be altered. Let’s also assume that there are only two variable inputs: labor and printing presses. Table 7.5 shows the possible quantities of labor and printing presses and their corresponding marginal products. You can see from those values that this firm is in the range of diminishing returns.

Economics in Action: The Average, the Marginal, and the Short Run

Watch Jacob Clifford of Crash Course Economics consider the role of labor in short-run production and how more laborers does not necessarily mean better productivity. https://youtu.be/xLSRMt-wWAM.

Table 7.5: Inputs for printing books and their marginal products

Variable input: labor (units)

Marginal product of labor (MPL)

Variable input: presses (units)

Marginal product of presses (MPP)

7 6 5 10

8 5 6 9

9 4 7 8

10 3 8 6

11 1 9 3

12 0 10 0

The question facing the firm is to determine which combination of labor and presses will pro- duce the largest number of books for a given expenditure of dollars. Let’s say that presses cost $2 per unit per day, labor costs $1 per unit per day, and the firm has a budget of $26 per day.

The firm will maximize output by using labor and presses to the extent that will make its mar- ginal products per dollar spent equal. This is written as follows:

MPL PL

= MPK PK

The firm would use 10 units of labor and 8 presses per day because 3/$1 = 6/$2.

https://youtu.be/xLSRMt-wWAM

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Section 7.5 The Choice of Inputs

You can easily see why this input combination maximizes output, given a spending constraint of $26. Add 2 units of labor to replace the 8th press, for example. This combination also costs $26. If presses are reduced from 8 to 7, 2 units of output will be lost, and if labor is increased from 10 to 12 units, only 1 unit of output will be added. The firm would lose a unit of output with this alternative mix of inputs.

We now can see that a firm maximizes output by choosing its mix of inputs so that the mar- ginal product of a dollar’s worth of each input is equal to the marginal product of a dollar’s worth of every other input. If

MPa > MPb

the firm reallocates its inputs to use more of input a and less of input b. As the firm uses more of a, it will drive down the marginal product of a and bring about equality between MPa/Pa and MPb/Pb. This conclusion can be generalized to include all inputs.

Note that the principles developed here are very similar to those developed for utility analy- sis. According to utility theory, the consumer maximizes utility for a given income, or budget constraint. Here, the firm maximizes output given a cost constraint. The principles of maxi- mization are the same.

The principles of production are a foundation for analyzing costs. The next chapter will dis- cuss how production functions and the principle of diminishing marginal returns relate to the cost functions that firms face.

Check Point: Production Functions and Inputs

• At least one input is fixed in the short run. • All inputs are variable in the long run. • The marginal product of an input is the change in output produced by a one-unit

change in that input. • Diminishing marginal returns is exclusively a short-run phenomenon. • If the marginal product is negative, total product is declining.

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Conclusion

Conclusion Imagine again that you are Chelsea Sloan and you are embarking on a new e-commerce expansion for your store. Which type of fulfillment structure should you choose? Handling the fulfillment yourself would mean a fixed cost for the technological component and additional variable labor costs, depending primarily on the number of orders you receive each day. Your brother and business partner points out that outsourcing fulfillment to a third-party special- ist offers peace of mind but at a fairly steep average cost per order. There are pros and cons to each option—you need to weigh the costs and benefits while considering the convenience of having another company fill your orders versus the potential cost savings by keeping ful- fillment operations in-house. Given your low labor costs and the fact that you can use your current retail storage for no additional cost, it becomes clear that it is far more economically efficient to do your own fulfillment. One decision down; 1,000 more to go!

Key Ideas

1. Firms are organized by entrepreneurs to produce outputs by combining inputs. The entrepreneur does this in such a way as to maximize profits.

2. Economic efficiency is the basis for selecting that combination of resources that minimizes the cost of producing a certain level of output.

3. A production function is the technical relationship between inputs and outputs. In the short run, some inputs are fixed. In the long run, all inputs are variable.

4. Firms choose their input mix from the production function to maximize output sub- ject to cost constraints.

Critical-Thinking Questions

1. How does a vertically integrated firm differ from a horizontally integrated firm? 2. What is the difference between the short run and the long run? Which factor of pro-

duction is typically variable in both the short run and long run? 3. Why is the concept of diminishing returns only a short-run phenomenon? 4. Why is economic efficiency more appropriate for businesses to use than technical

efficiency? 5. Why must the marginal product of labor be equal to zero at the point where the total

product is at its peak? 6. At Pate Family Bakers, two workers can decorate 14 cakes in 1 hour, and the average

product with three workers is 6 cakes in 1 hour. The marginal product of the third worker must be _____ cakes, exhibiting (increasing/decreasing) marginal returns to labor.

7. Your grades on weekly quizzes are, in order by week, 90, 85, 75, 65, 90, and 95. What was your average grade after 3 weeks, 4 weeks, and 5 weeks? When your average fell, was the marginal grade above or below the average? What about when your average rose?

168

Conclusion

8. Suppose the following production function describes three ways to produce 1,000 phone cases in a factory. If you were the manager of this factory, which method of production would you choose?

Method Units of capital

(machines) Units of labor

(hours) Units of land

(acres) Units of output

(cases)

A 4 60 1/5 1,000

B 10 10 1/5 1,000

C 30 5 1/5 1,000

9. If the cost basis in Question 8 is $3,000 per 1,000 phone cases and the wage rate is $7.25 per hour (40-hour week), which method of production would you use?

10. What would happen to your choice of inputs if the factory in Question 8 was union- ized and the union contract specified a wage rate of $11.25 per hour?

11. In professional sports, many players become coaches immediately after their playing days end, but there are very few players who coach simultaneously. Based on eco- nomic theories of why firms are formed and what managers do, why might this be the case?

12. If the government created a law encouraging all employees to create unions, how would this impact the management of firms? What pros and cons might there be to such a policy? How would this differ from an employee-owned company?

13. Classify the type of firm resulting from each of the following mergers as vertically integrated, horizontally integrated, or conglomerate. a. ExxonMobil buys more gas stations in California. b. CoverGirl cosmetics buys a fruit smoothie chain. c. American Airlines buys a large travel agency. d. Vons supermarket chain buys Hertz rental car company.

14. Should corporate philanthropy be applauded or condemned from the standpoint of economic efficiency? Why?

Key Terms average product (AP) The total product (output) divided by the number of units of input used.

conglomerates Firms that perform many unrelated operations or produce in many different industries.

economic efficiency The least cost method of production.

firm An organization formed by an entre- preneur to combine inputs in order to pro- duce marketable outputs.

fixed inputs The productive resources that cannot be varied in the short run.

horizontally integrated firms Firms that perform many similar production operations in the same industry.

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Conclusion

industry A group of firms producing simi- lar or related products.

long run The period of time in which all inputs, including plant and equipment, can be varied.

marginal product (MP) The change in total output that is produced by a unit change in an input.

principle of diminishing returns The ten- dency that as more and more units of a vari- able input are added to a set of fixed inputs, the resulting additions to output eventually become smaller.

production The process of transforming inputs into marketable outputs.

production function A description of the amounts of output expected from various combinations of inputs.

short run The period of time that is too short to vary all the inputs.

total product (TP) The amount of output that a firm produces.

variable inputs The productive resources that can be increased or decreased in the short run.

vertically integrated firms Firms that perform many sequential steps in a produc- tion process.