(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 229

204 PART 2 • Producers, Consumers, and Competitive Markets
decisions that are in their interest, but not in the firm’s best interest. As a result,
the theory of the firm (and more broadly, organizational economics) has become an
important area of microeconomic research. The theory has both positive aspects
(explaining why managers and workers behave the way they do) and normative
aspects (explaining how firms can be best organized so that they operate as efficiently as possible).3 We will discuss some aspects of the theory later in this book.
At this point we simply stress that firms exist because they allow goods and services to be produced far more efficiently than would be possible without them.

The Technology of Production

• factors of production
Inputs into the production
process (e.g., labor, capital, and
materials).

What do firms do? We have seen that firms organize and coordinate the activities of large numbers of workers and managers. But to what purpose? At the
most fundamental level, firms take inputs and turn them into outputs (or products). This production process, turning inputs into outputs, is the essence of
what a firm does. Inputs, which are also called factors of production, include
anything that the firm must use as part of the production process. In a bakery,
for example, inputs include the labor of its workers; raw materials, such as flour
and sugar; and the capital invested in its ovens, mixers, and other equipment
needed to produce such outputs as bread, cakes, and pastries.
As you can see, we can divide inputs into the broad categories of labor, materials, and capital, each of which might include more narrow subdivisions. Labor
inputs include skilled workers (carpenters, engineers) and unskilled workers
(agricultural workers), as well as the entrepreneurial efforts of the firm’s managers. Materials include steel, plastics, electricity, water, and any other goods that
the firm buys and transforms into final products. Capital includes land, buildings, machinery and other equipment, as well as inventories.

The Production Function

• production function
Function showing the highest

output that a firm can produce
for every specified combination
of inputs.

Firms can turn inputs into outputs in a variety of ways, using various combinations of labor, materials, and capital. We can describe the relationship between
the inputs into the production process and the resulting output by a production
function. A production function indicates the highest output q that a firm can
produce for every specified combination of inputs.4 Although in practice firms
use a wide variety of inputs, we will keep our analysis simple by focusing on
only two, labor L and capital K. We can then write the production function as
q = F(K, L)

(6.1)

This equation relates the quantity of output to the quantities of the two inputs,
capital and labor. For example, the production function might describe the number of personal computers that can be produced each year with a 10,000-squarefoot plant and a specific amount of assembly-line labor. Or it might describe the
crop that a farmer can obtain using specific amounts of machinery and workers.
It is important to keep in mind that inputs and outputs are flows. For example, our PC manufacturer uses a certain amount of labor each year to produce
some number of computers over that year. Although it might own its plant and
3

The literature on the theory of the firm is vast. One of the classics is Oliver Williamson, Markets and
Hierarchies: Analysis and Antitrust Implications, New York: Free Press, 1975. (Williamson won a Nobel
Prize for his work in 2009.)

4
In this chapter and those that follow, we will use the variable q for the output of the firm, and Q for
the output of the industry.