Question

what describes how individual economic units determine what other individuals are most likely to do in a certain situation given specific conditions

Answer 1

“Firm” is simply another word for company or business. The basic economic marketplace consists of transactions between households and firms. Firms use factors of production – land, labor, and capital – to produce goods that are consumed by households. They may be organized in many different ways – corporations, partnerships, sole proprietorships, and collectives are all examples of firms. Economists who study the theory of the firm attempt to describe, explain, and predict the nature of a firm, including its existence, behavior, structure, and relationship to the market.

The Evolution of the Firm

Not all markets and societies involve firms. In many medieval cities, most production was done by individual craftsmen who were loosely organized into guilds, or by tenant farmers who rented family-sized plots of land. Transactions took place primarily between individuals.

Firms generally appear and become prevalent as an alternative to individual trade when it is more efficient to produce in a non-market environment. For example, in a labor market, it might be too difficult or costly for firms or organizations to engage in production when they have to hire and fire their workers depending on demand/supply conditions. While the advantages of consolidation for efficiency are potentially many and varied, the underlying concept is that integrating operational paradigms enables potential synergy via the construct of a firm.

Firms also allow economic growth, not only for the firm but for the broader society in which it resides. Through separating the business from the individual(s) who starts it, the funding, insurance and liability of a firm can function independently of a person. The separation of a firm from the individual also allows more specifically applicable regulations and laws, broader accumulation of investment capital and more complex strategic alliances. While the detailed implications of a firm and it’s relationship with individuals and society are complex, the important takeaway is that firms play an integral role in economic structure.

The Firm: Organizing production under firms reduces the transaction costs of coordinating production in the market.

The Transaction Theory of the Firm

According to Ronald Coase, people begin to organize their production in firms when the transaction cost of coordinating production through the market exchange is greater than within the firm. He notes that a firm’s interactions with the market may not be under its control (for instance because of sales taxes), but its internal allocation of resources are: “Within a firm, … market transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur … who directs production.” He asks why alternative methods of production (such as the price mechanism and economic planning), could not either achieve all production, so that either firms use internal prices for all their production, or one big firm runs the entire economy.

For Coase the main reason to establish a firm is to avoid some of the transaction costs of using the price mechanism. These include discovering relevant prices (which can be reduced but not eliminated by purchasing this information through specialists), as well as the costs of negotiating and writing enforceable contracts for each transaction (which can be large if there is uncertainty). Moreover, contracts in an uncertain world will necessarily be incomplete and have to be frequently re-negotiated. The costs of haggling about division of surplus, particularly if there is asymmetric information and asset specificity, may be considerable. Organization into a firm can considerably reduce these costs.

Trade Leads to Gains

Producers and consumers trade because the exchange makes both parties better off.

Producers and consumers trade because the exchange makes both parties better off. The benefit of exchange to producers is measured by the amount of profit – that is, the difference between the average cost of producing an item and the price received for that item. The benefit of exchange to a consumer is measured by net utility gained. This is measured by taking the difference between the maximum price a consumer is willing to pay and the actual price they do pay. To understand this, imagine purchasing a car. You would be willing to pay up to $15,000 for a car in good condition, but you are able to buy one for only $12,000. Since you value the car at $3,000 more than you paid for it, $3,000 is the benefit that you gained from the transaction.

Economists refer to these benefits from exchange as producer and consumer surplus. Consumer surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay. Producer surplus is the amount that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for.

The amount of consumer and producer surplus that is gained from a transaction can be seen on a standard supply and demand graph. Consumer surplus is the area (triangular if the supply and demand curves are linear) above the equilibrium price of the good and below the demand curve. This reflects the fact that consumers would have been willing to buy a single unit of the good at a price higher than the equilibrium price, a second unit at a price below that but still above the equilibrium price, etc., yet they in fact pay just the equilibrium price for each unit they buy.

Likewise, in the supply-demand diagram, producer surplus is the area below the equilibrium price but above the supply curve. This reflects the fact that producers would have been willing to supply the first unit at a price lower than the equilibrium price, the second unit at a price above that but still below the equilibrium price, etc., yet they in fact receive the equilibrium price for all the units they sell. The sum of consumer and producer surplus is

Exchange and Pareto Optimality

An allocation of resources is Pareto efficient when it is impossible to make any one individual better off without making at least one individual worse off. For example, imagine that two individuals prefer peanut butter and jelly sandwiches to a sandwich with only peanut butter or only jelly. A distribution in which Individual A has all of the peanut butter and individual B has all of the jelly is not Pareto efficient, because both parties would be better off if they shared their resources.

Similarly, an action that makes at least one party better off without making any individual worse off is called a Pareto improvement. Any transaction in a free market always produces a Pareto improvement because it makes consumers and/or producers better off without making either party worse off (if this were not the case, the consumer and/or the producer would refuse to participate in the transaction in the first place). It is commonly assumed that outcomes that are not Pareto efficient are to be avoided, and if a Pareto improvement is possible it should always be implemented.

One way to look at whether a transaction is a Pareto improvement is to ask whether it increases consumer or producer surplus without decreasing either party’s surplus. Lowering an item’s price without changing the quantity sold, for example, may increase consumer surplus, but is not a Pareto improvement because producers suffer negative consequences.

Exchange and Pareto Optimality

An allocation of resources is Pareto efficient when it is impossible to make any one individual better off without making at least one individual worse off. For example, imagine that two individuals prefer peanut butter and jelly sandwiches to a sandwich with only peanut butter or only jelly. A distribution in which Individual A has all of the peanut butter and individual B has all of the jelly is not Pareto efficient, because both parties would be better off if they shared their resources.

Similarly, an action that makes at least one party better off without making any individual worse off is called a Pareto improvement. Any transaction in a free market always produces a Pareto improvement because it makes consumers and/or producers better off without making either party worse off (if this were not the case, the consumer and/or the producer would refuse to participate in the transaction in the first place). It is commonly assumed that outcomes that are not Pareto efficient are to be avoided, and if a Pareto improvement is possible it should always be implemented.

One way to look at whether a transaction is a Pareto improvement is to ask whether it increases consumer or producer surplus without decreasing either party’s surplus. Lowering an item’s price without changing the quantity sold, for example, may increase consumer surplus, but is not a Pareto improvement because producers suffer negative consequences.

In economics, a market is defined as a system or institution whereby parties engage in exchange. A market economy is an economy in which decisions regarding investment, production, and distribution are based on supply and demand, and prices of goods and services are determined in a free price system. The major defining characteristic of a market economy is that decisions on investment and the allocation of producer goods are mainly made through markets. This is the opposite of a planned economy, where investment and production decisions are embodied in a plan of production.

A free market is a market structure that is not controlled by a designated authority. Free markets may have different structures: perfect competition, oligopolies, monopolistic competition, and monopolies are all types of markets that may exist in a capitalist economy. The most basic models in economics assume that markets are free and experience perfect competition – there are many buyers and sellers so no individual actor may affect a good’s price; there are no barriers to exit or entry; products are homogeneous; and all actors in the economy have perfect information.

Market Equilibrium

In a free market, the price and quantity of an item is determined by the supply and demand for that item. The market demand function describes the amount of a good that all consumers will purchase at a given price, while the market supply function expresses the amount that producers will supply at a given price. Consider the market for computers. At a price of $1,200, the market may demand 8,000 computers, while producers are willing to supply 15,000 computers. This is not the equilibrium price because at $1,200, supply exceeds demand. In order to reach equilibrium, the price must drop, causing demand to rise and supply to fall until the two are equal. This can be expressed graphically by drawing the market supply function and the market demand function and finding the point where the two curves intersect.