Key Definitions and Assumptions
Inputs, also known as factors of production, are used to make output, sometimes called product. As shown in Figure 10.1, the firm is a highly abstract entitya black boxthat transforms inputs into output.
The specific details of how the firm is organized and how it actually combines the inputs to make goods and services is ignored by the theory, hidden in the black box.
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Inputs are often broken down into large categories, such as land, labor, raw materials, and capital. We will simplify even further by collapsing everything that is not labor into the capital category.
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Labor, L, is human toil and effort. It is measured in units of time, usually hours.
Capital has a confusing history in economics. As a factor of production, capital, K, means things that produce other things, such as machinery, tools, or equipment. That is different from financial or venture capital that is a fund of money. The title of Karl Marx’s famous book, Das Kapital, uses capital in the sense of wealth, denominated in money. The Theory of the Firm’s K is measured in numbers of machines.
Like labor, capital is rented. The firm does not own any of its machines or buildings. This is extremely unrealistic, but allows us to avoid complicated issues involving depreciation, financing of machinery purchases (debt versus equity, for example), and so on.
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Another extreme simplifying assumption is that there is no time involved. Like the consumer maximizing utility subject to a budget constraint, the firm exists only for a nanosecond. It makes decisions about how much to produce to maximize profits with no worries about inventories or the trajectory of future sales. It produces the output in an instant.
We avoid complications arising from the production of more than one good or service by assuming that the firm produces only one product. That makes revenues simply price times quantity sold of the one product.
Without going into detail again about unrealistic assumptions, it seems helpful to point out that we are not trying to build an accurate model of a real-world firm. Our primary goal is to derive a supply curve. We want to know how a firm responds to a change in price, ceteris paribus. By assuming away many real-world complications, we can model the firm’s maximization problem, solve it, and do comparative statics to get the supply curve.
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