Economics Anti-Textbook: Chapter 5

What is the goal of a standard firm?

• To use factors of production:

  • Workers

  • Capital (buildings, machinery equipment)

  • Land…

  • with inputs purchased from other firms (raw materials, security services) to produce goods and services for sale.

• While firms can be different legal types, their main goal is profit maximization.

What is the “short run” in an economic sense? Explain how production in the short run works.

• Short run: a period where some inputs (raw materials, security services) are fixed, and managers can only change production levels by varying a flexible input (like # of labor/workers).

  • Technology describes the relationship between inputs and outputs

  • The marginal product is the extra output produced when one additional worker is hired.

    • Textbook example: a bakery using labor and a fixed amount of capital to produce bread

  • The law of diminishing marginal returns: a CORE concept that claims that if you keep adding more and more of one input (like workers) while holding others fixed (like ovens), the extra output from each new worker will eventually start to decrease.

    • This principle shapes all the short-run cost curves.

Explain how costs in the short run work and what kind of costs there are.

• Fixed costs (FC): costs that don’t change with the level of production

• Variable costs (VC):* costs that change as output changes

• Total costs (TC):* fixed cost plus variable cost

• Average costs: costs per unit of output produced by a firm

• Marginal costs (MC):* the cost of producing one additional unit of output

Due to the law of diminishing returns, average variable costs, average total costs, and marginal costs are all U-shaped in the short run. This means that they fall initially and then they rise.

Explain the definition of the long-run period, the different types of returns to scale, and the typical textbook model in terms of cost curves.

• Long run: is a period long enough for the firm to vary all its inputs — the varying of inputs changes the overall scale (magnitude) of its operations

• Economists categorize the output change / scale change using different types of returns to scale:

  • Constant returns to scale: output changes in the exact same proportion as the inputs (i.e. doubling inputs exactly doubles output); this results in constant long-run average costs

  • Increasing returns to scale (economies of scale): outputrises in a greater proportion than the inputs, which leads to declining long-run average costs

  • Decreasing returns to scale (diseconomies of scale): output rises in a smaller proportion than the increase in inputs, leading in rising long-run average costs

• The typical textbook model features a U-shaped long-run average cost curve — showing initial increasing returns followed by decreasing returns; the lowest point on this curve is the minimum efficient scale (MES)

Explain the two cases of firms pursuing profit maximization in the long run.

1. Price-taking competitive firms: they maximize profit by producing where long-run marginal cost = market price (marginal revenue)

2. Price-setting non-competitive firms:

   1. These firms face a downward-sloping demand curve, which means it must lower the price to sell more.

   2. Because of this, the revenue from selling one more unit (marginal revenue) is always less than the price.

   3. The firm maximizes profits where marginal revenue = marginal cost; the demand curve then determines the price the firm will charge

3. Relationship between firm’s MES and total demand dictates the market structure (how many firms can profitably exist in the industry)

How is the law of diminishing marginal returns often a myth?

• Overview of the LDMR: if a firm keeps adding workers, each additional worker will eventually produce less output — this guarantees that the firm’s marginal costs (the cost of producing one more unit) will eventually rise, leading to a U-shaped cost curve.

  • This rising cost is necessary to limit how much an individual competitive firm will produce

• The reality: surveys of real businesses show that this is mostly untrue within that operating range:

  • 48% of firms report constant marginal costs (they can produce more without the cost per unit rising)

  • 41% report decreasing marginal costs (the cost per unit falls as they produce more)

  • Only 11% report increasing marginal costs

• However, firms often postpone this by having idle capacity (extra machines or ovens) or by reorganizing worker shifts.

  • This means that rising marginal costs don’t limit production in the actual range most firms operate in

How is the notion of decreasing returns to scale often a myth?

• Overview of the DRS theory: to ensure that many small firms can coexist (perfect competition) textbooks argue that firms face decreasing returns to scale (diseconomies of scale) in the long run.

  • This means that if a firm gets too big, its average costs start to rise (creating a U-shaped long-run average cost curve) — this rising cost supposedly limits the maximum size of a firm

• The evidence: empirical studies overwhelmingly show that long-run average cost curves are typically L-shaped, not U-shaped.

  • This means that firms initially experience increasing returns (average costs fall) as they grow

  • But instead of costs rising later, they usually become constant (L-shaped)

How does the Anti-Text argue that textbooks ignore the reality of corporate power?

By stating that textbooks treat the firm as a passive entity that only adjusts its output based on given market prices and costs, ignoring the reality of corporate power. For example:

• Political lobbying/influence: real world firms spend significant resources (incurring costs) to influence their external environment (laws, regulations, taxes) to increase their profits

  • Example — tobacco industry: companies such as Phillip Morris fund front organizations with neutral names (like "Citizens Against Lawsuit Abuse") to lobby against laws that would harm their profits, such as efforts to limit consumer lawsuits or research into the harms of their products (which they often refer to as “junk science”)

• Public choice theory: explains why corporate power is so effective because small, highly concentrated groups (industries) find it cheap and easy to organize and lobby for specific laws that benefit them greatly.

  • Conversely, large/diffuse groups (consumers, taxpayers) find it difficult to organize due to:

    • The free-rider problem — they assume someone else will bear the cost of fighting for the common good

Explain the uneven balance of power within the firm (principal-agent problem)

• In many large firms, there is an imbalance of power between:

  • Owner-shareholders, their elected board of directors (on one hand)

  • The managers they appoint (on the other hand)

• Lthough theory asserts that profit maximization is the main objective of the firm, managers can have their own objectives — this is an example of the principal-agent problem, where:

  • The principals (shareholders) seek ways to get their agents (the board of directors) to appoint managers (the agents of both the shareholders and the board) to maximize profits. They face two main difficulties:

    • Imperfect and asymmetric information: managers have better info about the true performance of the firm and the nature of their efforts

    • Rational ignorance: if there are many shareholders (none holds a significant block of shares) they may exhibit “rational ignorance.”

      • This allows top management to gain control of the firm, especially given the influence managers have over boards of directors.