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Resource Allocation for Firms

Resource Allocation for Firms

Author: Kate Eskra
Description:

This lesson will explain the economic idea of how resources are allocated for firms.

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Tutorial

RESOURCE ALLOCATION FOR FIRMS

Video Transcription

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The title of this tutorial is Resource Allocation for Firms. As always, my key terms are in red and my examples are in green. All right, so in this tutorial, we'll be talking about the choices that all firms need to make. I'll define and give you some examples of firm resources, or what we call the factors of production. At the end, you'll understand the difference between the short and the long run. And we'll be talking about how firms seek to maximize profit.

OK. So let's get in the mindset of a business. What are the things that all businesses have to decide? Well, first they have to figure out how big should we get? How much should we be producing in terms of quantity? Next they have to figure out how should we go about producing it. And then once they figure those things out, that's when they figure out how much land, labor, and capital do we need to buy in order to produce our good.

OK. So without buying some things, businesses couldn't produce anything, right? So what we call them are resources. They have to purchase resources or factors of production. So factors of production are, like I said, the resources defined as land, labor, and capital that are necessary to produce output for the sake of profit.

Land is the first one. It's the factor of production that occurs naturally in the form of real estate or organic assets. It's pretty straightforward. Obviously land itself is included here. Most businesses have to purchase at least a little bit of land in order to have a place to do their business. But this also includes anything that comes from the land. Wildlife, fertile soil, minerals, timber. Anything that is a natural resource and not man-made.

Labor is the next factor of production, and it's human service that contributes to the creation or distribution of goods or services. So really, it's our whole workforce. I gave you some examples of people laboring. Doctors and nurses, teachers, hairstylists, cashiers. The idea is that you can be producing either a physical good itself or providing a service and be considered labor.

Then we have capital. Capital are material assets in the form of either money or machinery used as a factor of production. I like to think of capital as anything that's already been produced, but will be used to help produce other things. So some examples are buildings, computers, and roads.

As I sit here generating this tutorial right now, I'm producing something but I'm also providing a service. I couldn't labor-- I couldn't do this-- without the use of my computer. So my computer right now is absolutely my capital. It's something that's already been produced and it's helping me to produce this tutorial.

So how is it that firms decide how much land, labor, and capital they need to purchase? Well, a couple of factors. The first factor is they have to figure out how much they are producing. This decision might change vastly if they're producing a lot versus a small amount. And also that plays a role here is the price or the cost of each factor of production or each resource.

What any business is going to try to do is minimize cost. Cost minimization is just selecting the output strategy that incurs the least amount of cost, and that will lead them to maximize their profits. And that's what a business is trying to do at the end of the day. They're trying to determine the quantity, how much they should produce, and the cost that yields the greatest profit.

OK. So sometimes I think it helps to compare firms to consumers. So whereas we as consumers when we're out there buying things seek to maximize our utility or our satisfaction, firms are obviously maximizing their profit. When we're buying things, we're basing our decisions on our individual preferences. Firms are basing their decisions on the opportunity costs. Remember, what's being sacrificed or given up in terms of the factors of production. So the opportunity cost of land, labor, and capital.

We're all constrained by things. Businesses face constraints certainly. A constraint is an element that interrupts production of a firm or consumption by individuals. Here we're focusing on the production of the firm. So whereas consumers are constrained by time and income, businesses are definitely constrained by their factors of production. Land, labor, and capital are definitely limited in the world. So they are constraints.

OK. Now we need to talk about the short run versus the long run. And what I want to do is use an example for you. So let's talk about Tickle Me Elmo. I don't know if you guys remember, but I remember several Christmas seasons ago how Tickle Me Elmo was all the rage. And in fact, mothers and fathers could not get their hands on this doll for their kids. So business was certainly booming.

If you were the owner of that business, wouldn't you want to produce more in order to make a greater profit? I think moms and dads aunt aunts and uncles and grandparents everywhere were willing to pay insane amounts of money for this doll. So if you're the business owner, you want to produce more so that you can make that profit. But right now it's the short run.

OK. So what can you do in the short run? Well, certainly you could hire more workers. You could buy more materials to make the dolls. But you're definitely limited. It's the short run. You might not have enough workspace or enough capital like machines. So you can hire all the workers you want, and you can buy all the material you want, but your workers are probably going to get in one another's way. They don't have enough machines to work on. It won't be enough to justify the additional workers that you hired.

So certainly there's some wiggle room here in the short run. And in the short run, you're just going to optimize your capabilities. You're going to do the best with what you have. But there is something that's what we call a fixed cost or something that is fixed in the short run. OK. So that's how we define it. The temporary period of time with least control over constraints when at least one element is fixed.

So you can't go out there and say, oh, you know what? I'm going to terminate my lease and I'm going to go buy a new building. No. No. No. You have a contract or a lease agreement for some designated period of time. And that's what we mean by something being fixed.

All right. Let's say now we're moving into the long run. Business is still booming. People still want Tickle Me Elmos. You as the business owner can now do a lot more things because you have more time. I'm saying within a year. That's not always what we mean by the long run. The long run is just a period of time in which your opportunities expand, where things are no longer fixed and instead they become variable.

Variable means, obviously, it can change. So you can rent or buy more space within a year. You could have purchased more machines. You could raise the capital in order to do that. You could probably change up your production techniques or your capacity. And if you find that there are advances or different methods of doing things, you can take advantage of that, because you've had the time to investigate it and find the money to do so. The possibilities are endless in the long run.

OK. So here's a summary for you. In theory, this is how we define the short run. The short run is at least one cost is fixed. Not all costs are fixed, but at least one cost is fixed. There's something that you cannot change. So rent is a very good example of a fixed cost. In the long run by definition, all costs become variable. So you can terminate your lease and sign a new one or not.

OK. One last thing that I just wanted to note. Even so that's how we define the short run versus the long run, I just wanted to give you some food for thought. Is everything really variable in the long run? So in theory, the constraint of having a fixed cost does disappear in the long run. Like I said, you can terminate your lease. You could start a new one. You could sell your building and machinery if you wanted to get out of the business or you could buy more if you wanted to expand. You can invest in new technology.

So those are some things that are certainly possible in the long run. But what we need to keep in mind is that the long run really is us just adding up all of our short run decisions. So in the short run, you've already optimized how well you can do each and every time. So because of that, I wanted to leave you with the question, is everything really variable in the long run? Well, that's up for you to make your own opinion on.

So what did you learn in this tutorial? Well, today we talked about the three factors of production or what we refer to as resources or input sometimes. They are land, labor, and capital. We talked about how firms are constrained by their resources. And it varies in the short run and long run. Remember, in the short run there's at least one fixed cost, and in the long run, all costs become variable. Finally, we talked about how firms are always seeking to minimize costs in order to maximize profit. Thank you so much for listening. Have a great day.

Notes on "Resource Allocation for Firms"

Terms to Know

Land

A factor of production that occurs naturally in the form of real estate or organic assets.

Labor

Human service that contributes to the creation or distribution of goods or services.

Capital

Material assets in the form of money or machinery used as a factor of production.

Factors of production 

Resources defined as land, labor, and capital that is necessary to produce output for the sake of profit.

Constraints

An element that interrupts production of a firm or consumption by individuals.

Cost Minimization

Output strategy that incurs the least amount of cost.

Profit Maximization

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

Short-run Constraints

Temporary period of time with least control over constraints when at least one element is fixed.