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Decision Making Relationships: Rational Firm

Decision Making Relationships: Rational Firm

Author: Kate Eskra

This lesson will explain the economic idea of the rational firm.

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Hi, welcome to economics. This is Kate. This tutorial is called Decision-making Relationships-- the Rational Firm. As always, my key terms will be in red and my examples will be in green. So at the end of this tutorial, you're going to be able to understand the various costs that a firm faces. You'll be able to explain that minimizing cost is what allows firms to maximize their profit. And finally, you'll be able to identify the overall economic cost of a production decision to see if it's profitable or not.

OK, so before we get started, I figured I should let you know that these three words will very often be used interchangeably. So they all mean the same thing. A firm is just another word for a business, which is a producer of goods or services. OK, so firm, business, and producer all mean the same thing.

I want you to get into the mindset of the business for this tutorial. It's very easy to think like a consumer because we are consumers every day. We're always buying things. But we don't all own our own companies. So for right now, think like a business.

So what's the point of owning a business? For most business owners, it's to make a profit. So how do you make a profit? Well, you sell some stuff and you bring in revenue. But you probably had to pay out a whole lot in terms of cost in order to get that product to market. So if you're left over with money, you are left with a profit. So profit equals our revenue minus our costs.

All businesses have to make three main decisions. And those three decisions are first of all, how big should we get? How much should we produce in terms of quantity? Second, once you figure that out, then have need to figure out, OK, well, how will we go about producing it? Should we use a lot of technology? Should we not, and instead it use mostly labor?

And then finally, once you figure out those two things, then you get into figuring out how much land, labor, and capital you need to purchase. I'll be talking about those in a little bit. Actually, I'll be talking about them right here.

So what are some business costs? Firms purchase what we call resources. And again, these three terms are sometimes used interchangeably. So resources are the same things as inputs, because they're the things that businesses have to purchase that go into their production process. They're also known as factors or factors of production. And there are three of them, as I noted before-- land, labor, and capital.

So land is just that-- anything that is the land itself or anything from the land. Labor is-- again, pretty self explanatory-- any labor that people do-- so people working to provide goods or services. Capital is the one that's sometimes a little bit confusing. It's stuff that's already been produced, like buildings, machines, equipment, that help us to further our production process.

OK, second, business costs are very often categorized into two different categories-- fixed and variable. So a fixed cost is one that doesn't change. It's fixed. It stays the same from month to month or year to year. So it's things like rent or property taxes. Whereas a variable cost varies with production. So depending on how much you want to produce, how big you want your company to grow to be, if I want to produce more, I probably need to buy more raw materials. I probably need to pay more workers. So my wages will increase.

All right, so let's get to your first key term. And that is a finite resource. A finite resource is a fixed amount of supply that is irreplaceable and non-recoverable, meaning there's a limit to it. So scarcity exists in the world with almost everything. Land, labor, and capital that we justified are definitely limited. There is not an endless quantity to them. Because there's not an endless quantity, that means that businesses have to choose how much of each of these resources they're going to purchase.

So for example, how much lumber do we need? That would be a land example because lumber comes from the land. How many workers should we hire? That's a labor decision. And then how many machines should we buy? That would be a capital decision.

All of these are going to involve a cost benefit comparison. And we have to keep in mind that businesses definitely face opportunity cost-- that's a key term for you-- the sacrifice made by choosing one value or opportunity over another due to limited resources. So because our resources are limited, we have to sacrifice something whenever we make a decision.

Whenever consumers make decisions, they face opportunity costs. So if I buy this expensive cup of coffee at Starbucks, oh, maybe I won't go out to lunch with my co-workers tomorrow. But we use our own individual preferences to make those decisions.

Firms are going to face opportunity costs with their resources. So if they're hiring more workers, they're going to have to sacrifice either land or capital or something else. So they have to weigh those alternative uses of land, labor, and capital all the time. We as consumers way our benefits and costs before we purchase something. The rational firm has to definitely do the same thing.

So how many workers should we hire? Wouldn't you think you should always hire another worker to get more done? Not necessarily. You have to look at the opportunity costs of hiring that additional worker, because it means that's money that can't be spent upgrading technology, for example. So you're making a sacrifice in capital. That what technology is, is capital. You're sacrificing that if you are deciding to purchase more labor.

Another example would be this. I don't know about in your area, but in mine, it seems like the grocery stores are adding more and more self-checkout lanes all the time. That's an example of capital. So how many should they add? Well, each one I'm sure costs a lot of money. Each cost there represents workers that can't be hired or improvements in other areas of the store that they cannot make.

What they want to look to do is minimize cost. So cost minimization is an output strategy that incurs the least amount of cost. OK, so literally speaking, the least amount of cost would mean spending no money on anything. But that's not what we mean. For the purposes here, we're talking about opportunity cost. What's opportunity cost? It's what we give up, right? It's what we sacrifice. So what we're looking to do is, as a business, use the production methods that minimize how much we're giving up or sacrificing in other areas.

And that will lead us to maximize our profits. That's the bottom line of the whole name of the game of owning a business. Profit maximization is the procedure of determining quantity and cost that yields the greatest profit.

OK, so now we come to economic profit. And I want to take you through an example here. So if you're deciding to invest in a business-- let's say an investment opportunity comes your way to open up a food truck-- you just so happened to have $40,000 saved up. And that's going to be the initial investment amount, let's say, to purchase the truck itself. That's $40,000 was earning 5% in bonds. And I'll come back to why that's important in a little bit.

After sitting down with some people and doing some estimations, you figure that you might be able to take in revenue, $50,000 dollars in revenue the first year. But you're also estimating that that first year, you're out of pocket costs are going to add up to $49,000. OK. So is this a good investment? Well, let's take a look.

OK so here's a little chart for you. Like I said, your total revenue was $50,000. And you're out of pocket expenses were $49,000. It seems modest. But it does appear that your profit or return would be $1,000 in the first year.

Here's the problem. That leaves something really important out. It leaves out opportunity cost. OK, so coming back to that 40,000 that you invested initially, if you had just left it in the bank-- or I put she, because I'm a she. If I had just left it in the bank, I could've earn 5%, or $2,000. So if I calculate my opportunity cost in here, which is what an economist does, yes, we have food costs, we have labor costs, but we also have what we gave up the opportunity to do with our invested amount of money. So that adds up to $51,000, which means that our costs exceed our revenue, OK?

So an economic profit is always going to take into account opportunity costs. So we know that profit equals revenue minus cost. What's really important is that you include these opportunity costs.

So the example I just gave you was this first one. What return could the initial invested amount be earning? That's an example of an opportunity cost that very often an accountant wouldn't maybe look at. But another example would be if you decided to actually quit your job, where you how to salary to start the business, that would be an opportunity that you absolutely need to take into account, OK?

So what did you learn in this tutorial? You learned what decisions businesses need to make, the different types of costs, how we categorize them. And you learned how they seek to minimize costs and maximize profit. Finally, we just ended with an example showing how economic costs include all costs, especially opportunity.

Terms to Know
Cost Minimization

Output strategy that incurs the least amount of cost.

Finite Resource

A fixed amount of supply that is irreplaceable and nonrecoverable.

Opportunity Costs

The sacrifice made by choosing one value or opportunity over another.

Profit Maximization

Procedure of determining quantity and cost that yields the greatest profit.