The Science of Economics

by Fred E. Foldvary

Chapter 7

Production and Profit

1. The 3 sectors of an economy

Having analyzed consumption, we turn now to production.
We already have seen how production uses three factors, land,
labor and capital goods. We can now examine the second
dimension of an economy, its three sectors: household, firms,
and government. The third dimension was described in Chapter 5,
the categories of expenditure as consumption, investment, and

Households consist of individuals, families, and other
living-together arrangements, such as room mates and communes.
Firms are the organizations which engage in the production of
wealth. Government is the agency that has authority and power
over the rules that firms and households are legally required to
abide by in their consumption and production.

All wealth is owned by households. They either own
firms personally or own shares in corporations. Households who
are citizens are the ultimate owners of the land of a country
and of its government's wealth. As owners, households rent
their factors to firms, hiring themselves to firms as workers,
loaning firms their capital goods, and renting land to firms.
Firms may, of course, nominally (in name) own capital goods, but
the ultimate owners are some households.

Households obtain an income from loaning the factors to
firms, and they use this income to invest in capital goods (for
firms or government), for their own consumption, or for waste
imposed on them by thieves and government. Households are
thus the sector that consumes the wealth produced by the firms.

Firms input factor resources and output consumer goods.
Capital goods produced by firms and sold or rented to other
firms in effect remain in the sector of firms.

Firms can be generally divided into four types: 1)
families; 1) for profit firms; 2) non-profit organizations; 3)
government enterprises. Non-profit organizations include
churches and foundations. The motivation of for-profit firms is
normally to maximize profits, but the ultimate goal is the
maximization of utility, which can also involve achieving a
large size of firm or getting prestige.

For-profit firms in turn have various possible forms of
organization. The simplest is a single proprietorship, where an
individual owns the firm. Next in complexity is a partnership,
owned by several persons. A family is one possible partnership;
it engages in household production, such as gardening. A
marriage is also a partnership.

Most complex are corporations, firms whose owners have
shares of stock and elect a board of directors to operate the
firm. Typically, the board hires a president or manager. A
corporation may take the form of a cooperative, in which a
shareholder is also a member, and each member has one vote
regardless of shares. Another form is a non-stock corporation,
such as condominium housing, in which the owners are members and
have various types of voting rights, but where ownership
consists of having title to units, like apartments, which are
tied into the membership of the firm.

In many countries, corporations have legally limited
liability, which means that the ordinary shareholders may not be
liable for debts of the company beyond the value of their
shares. The board, though, is usually liable for the debt
beyond their shares in the company. A disadvantage of
corporations in the U.S. is that corporate income is taxed
twice, once when the corporation earns it, and secondly when it
distributes dividends to the shareholders, which is taxed again
as personal income.

An advantage of corporations with shares of stock is
that the shares trade on active exchange markets, so an
investment in the corporation is highly "liquid," and also
divisible. This enables a corporation to raise large amounts of
money by issuing stock.

A problem with corporations is that the management may
seek to promote its own well-being rather than that of the share
holders. This is resolved by means of profit-sharing methods of
payment as well as managers competing for their positions and
the possibility of a takeover if a firm becomes too fat with
management benefits. Laws preventing takeovers thus work to
reduce corporate efficiency.

Besides stocks and units of ownership, companies can
also issue debt in the form of bonds. These pay interest for a
certain period of time, after which the bond "matures" and the
company takes them back and pays back the principal.

The agents who organize the factors of production are
called the entrepreneurs. Often they are owners of firms or
executives with a great deal of control, but sometimes they can
be sales persons or anyone that is able to organize production.
Entrepreneurs are the drivers of a market economy; they actively
seek out opportunities to bring resources to a more productive
use, such as by developing new products or new methods, or
bringing goods to markets they were not previously available in.
If you have a vegetable garden in your back yard, you too are an
entrepreneur, since you decide what to grow, how to grow it, and
who gets the produce.

Government plays three different roles. First, some of
its agencies act as firms. Governments run enterprises such as
the post office, railroads, and street maintenance. In this
role, government is a firm hiring factors and producing wealth.
So part of government is also in the category of firms. Like
firms, governments also issue bonds.

Secondly, government enacts rules that must be followed
by the three sectors (including itself). These rules are of two
types: 1) rules creating markets, and 2) rules that intervene or
interfere in markets. The distinction follows the universal
ethic developed in Chapter 1. Rules which coerce households and
firms, which impose costs or restrictions, i.e. any rule other
than prohibiting and penalizing coercive harm to others, are
interventions. Subsidies are also interventions.

Other rules create and maintain markets. For example,
uniform and constant rules protecting property rights and
enforcing contracts enable markets to operate efficiently. Laws
setting up copyrights make a market in literature and art more
efficient, preventing publishers from having to write a contract
with each buyer regarding copying of the books. Laws setting up
patents also simplify transaction costs, also preventing firms
from having to write complex contracts with each user of the
firm to avoid copying, and making the enforcement easier. Some
people feel that copyrights and patents create monopolies and
are thus inefficient, but this is a static view of these
instruments. Patents and copyrights are general contracts
between the sellers and buyers of new products, without which
the new products might not be created or written.

The third function of government is redistribution.
Governments typically take much of the wealth from the first and
second distributions (see Chapter 5) and forcefully
redistributes it to others. Hence, much consumption is done by
recipients of redistributed income who have not earned it by
supplying factors to firms.

There is another agent in the economy, the thief. A
thief also performs forced redistribution, taking wealth and
income by force. Thieves in effect are underground governments,
since their redistribution is not legally sanctioned; they
impose their own independent rules and redistribution. Hence,
their role can be subsumed under the redistributive and
rule-making aspects of government, there being two categories of
government, official, above-ground legal agents and underground,
illegal agents called "criminals".

Thieves obtain some of the wealth of households by force
and, as far as the rest of society is concerned, waste it. Some
government expenditure is also typically wasted.

There are two circular flows in the economy among the
sectors, for goods and money. Goods, produced by firms
(including government firms), flow to households and to
government. In turn, households supply factor resources to
firms and government.

The second flow, money, circulates in the opposite
direction, since a consumer obtains goods in exchange for money.
Firms pay money to households and to government for the use of
factors. Households and government then use the money to pay
the firms (including government) for goods, or lose some money
to thieves or to government.

2. The production possibilities curve

When we disaggregate wealth into various products, the
question arises as to how much of each is to be produced. We
begin the analysis with a simple economy with only two products,
bread and lettuce. The economy could produce only bread or only
lettuce or some of each. Suppose that only bread is being
produced, for a total of 100 loaves. Now we want to produce ten
heads of lettuce. If the economy was fully employed in making
the 100 loaves, some resources must be taken away from bread
making to make the lettuce.

To analyze the economics of the trade-off between the
two products, we again begin with the foundational principles.
Proposition #1 states that some natural resources are scarce.
So there is a finite amount of land and labor available in an
economy, which is why only so much bread or lettuce can be
produced, and not enough to satisfy everyone if they were free.
Proposition #2 states that resources vary in quality, and
proposition #4 tells us that different amounts of inputs will
produce different amounts of outputs. Applying this, we see
that some land is more productively used to grow wheat for
bread, while other land is more productively used to grow
lettuce; and likewise some labor has been trained to grow wheat
and bake bread while other labor has been educating in growing
lettuce. Then capital goods, of course, have been made
specializing in one or the other.

When we use a bit less land, labor, and capital goods to
produce bread and use it to make lettuce, how do we do this.
Proposition #12 states that people economize. So we economize
by giving up that wheat-growing land that is most suitable for
growing lettuce, as well as labor, etc., that was trained to
grow nice lettuce. Likewise, if we had been growing only
lettuce, the most productive resources would be used to grow the
first increment of wheat and to bake bread. The next most
productive resources will be used to produce the next increments
of the products.

If we then plot all combinations of bread and lettuce
that can be produced, we get a curve. We have bread on one axis
and lettuce on the other axis, and for each amount of bread,
there is a certain maximum amount of lettuce that can be grown.
This is the "production possibilities curve," PPC.

This curve demonstrates several principles. First is
the principle of efficiency. Production is efficient if the
total product is on the PPC. If the total output lies within
the PPC, then one or more of the products can be increased
without decreasing the other; hence, society is not producing
efficiently. Efficient production means that the production of
any product cannot be increased without reducing the amount of
any other product. The existence of waste, of course, implies
that society is inside the PPC relative to the desires of those
obtaining the income of the first two distributions.

A second principle is opportunity cost. To produce more
bread, we must produce less lettuce; the opportunity cost of
producing more bread is less lettuce.

The third principle is the "law of increasing cost."
Economizing persons use the most productive resources first.
Increased amounts of the good will require less productive
resources, resources which may be used more productively in
other uses. So the law of increasing cost states that as we
increase the production of one good, the opportunity cost of
foregone production of other goods tends to increase.
Therefore, the shape of the PPC is "bowed out," like a rainbow.
Economists say it is "concave to the origin," but you can just
think of it as bowed out unless you want to impress your
friends. The curve is bowed because at first, giving up a
little wheat gets you a lot of that first amount of lettuce, and
vice versa.

The effect of better technology is to push out the whole
PPC outwards, so that the same amounts of inputs yields a
greater amount of output. The effect of accumulating more
capital goods is also to push out the PPC, since land and labor
become more productive. There is therefore a trade-off between
consuming now and consuming tomorrow. We can consume less today
and invest in new capital goods in order to consume more

3. The production function

Since a firm, in abstract, is an organization inputting
resources and outputting products, we can describe it as a
production function, or a product as a function of inputs. A
function is a relationship between a dependent variable and some
independent variables. The inputs are the independent
variables, and output is dependent. The relationship can be
concisely stated as Q/T = f(N,L,K), where Q/T is output per time
interval, N is the number and quality of workers, L is the
amount and quality of land, and K represents capital goods.
Note that these are all physical inputs and output; there is no
financial capital such as money in the function.

The methods of production, the technology and rules
(including government regulations, the role of luck, and the
goals of the firm owners) are included in the functional
variable f.

We can see then that if the amount of a resource such as
N, labor, is varied, output will vary. The marginal product of
labor is in fact the change in output Q/T caused by a change in
labor, N.

In order to maximize profits, costs must be minimized,
and this implies that the amount of each input will be
determined by its marginal product, proportional to its cost.
In the cost-minimizing combination of inputs, the marginal
productivity of a dollar's worth of all inputs must be the same.
If the marginal product of one input, divided by price, is lower
than that of another, then costs can be reduced by switching, if
possible, to the inputs with the higher relative productivity.

4. The theory of exchange

Some people have the idea that agriculture or
manufacturing is "productive," but trading, buying goods in one
place and selling in another, or exchanging one good for another
among two persons, is not productive, but just moves things
around. But Menger showed that this is not so.

Menger showed how in an exchange of goods, the goods
have unequal rather than equal value. They may have an equal
market value, but the subjective values must be different,
otherwise the trade would not take place. Trade only takes
place if person A has some good that is of less value to him
than some good that B has.

Using Menger's (1871, p. 183) example, suppose A has
horses and B has cows. Because of diminishing marginal utility,
each extra horse has less and less value to A, and so with cows
for B. Suppose the first cow or horse has a value of 50 to A
and B, and that each extra one has a value of 10 less than the
previous. Then if A has 5 horses, the fifth is only worth 10 to
him. But it would be worth 50 to B. Same with cows. So they
trade. A now has 4 horses and 1 cow. He lost 10 of value by
giving up the horse, and gained 50 by getting the cow, for a net
gain of 40. Likewise, B has a net gain of 40 from getting a

As Menger states (p. 184), "each of the two traders
obtained an economic gain from this first exchange equivalent to
the gain that would accrue to him if his wealth had been
increased by a good whose value to him is equal to 40... Trade
is therefore no less productive than industrial or agricultural
activity." Economic exchange contributes to consumers' utility
and thus an increase in the subjective value of their wealth
just as effectively as the physical increase of more goods. As
Menger stated, "the end of economy is not the physical
augmentation of goods but always the fullest satisfaction of
human needs" (p. 190).

Both will continue to exchange as long as the marginal
utility of the other's good is greater than that of the goods
they have. The next horse or cow has a marginal utility of 20
to the owner and 40 to the other, so they exchange, each
increasing utility by 20. After that, the marginal utilities
are 30 for both, so they stop trading. Note that once the goods
are of equal marginal value, trade comes to a halt. Trade went
on because of unequal rather than equal subjective marginal

An important principle of exchange is that trade will
continue until the economic gains are exhausted, until the
marginal values of what one has is equal or greater than what
others have.

5. Supply curves

We derived demand curves in Chapter 5, and now we will
derive supply curves, the supply of goods offered by firms.

A market supply is the quantity of goods that a producer
is willing to produce at particular prices. Like demand, the
quantity is a function of (dependent on) price, but the quantity
axis is horizontal and the price is on the vertical axis, by the
convention set by Alfred Marshall.

Like demand schedules or curves, a supply can either be
a flow, or quantity produced during some time interval, or a
stock, a certain amount of goods at one particular moment in

The amount of goods competitive firms are willing to
supply at various prices depends on the costs of production.
Costs in the short run are either fixed or variable, fixed costs
being those which cannot be changed during that time interval.
In the long run, all costs can be changed; indeed, the "long
run" is defined for any particular firm as that time interval at
which all costs are variable.

Average costs are simply total costs divided by the
number of units, while marginal cost is the cost of producing
one more unit (or tiny amount of product). A firm obtains a
maximum profit when total revenues are greater than total costs
and its marginal cost just equals its marginal revenue, since
any extra unit would cost more than it gets in revenues. If the
average variable cost and the long-term average cost are greater
than the price, then the firm will shut down, unless the owners
enjoy taking losses.

While demand curves slope down, there is no universal
slope to supply curves. As noted in Chapter 3 on land, the
supply curve for land as space is vertical, as is the supply
curve for goods no longer in production, like rare coins and
stamps, or old art.

But for goods in current production, supply curves
usually slope up diagonally. This is due to the universal
propositions about physical resources. Inputs are scarce, and
some are more productively devoted to one use than another,
relative to the values placed on them by consumers. So to
increase the amount of bread, as we saw, resources must be drawn
away from the production of lettuce, which may not be as
productive for bread as the previous resources devoted to bread.
So the relative price of the new inputs is higher. Greater
quantities are produced only if the price fetched in the market
is higher, and the supply curve slopes up.

Therefore, short-run total marginal costs typically may
decline at first with increasing production as the fixed cost is
spread over more units, but then increase as the cost of using
more inputs goes up and as the marginal product of variable
factors declines, since some of the inputs such as land are
fixed during that time.

However, over the long run, this tendency of input
prices to increase can be offset by a change in f, the
technology and method of production. At greater amounts of
production, in some industries, more efficient ways of producing
can be achieved. For example, it is more expensive to make a
few cars than to mass-produce them in huge factories. There can
be physical reasons for long-run economies of scale; the volume
of facilities such as pipes and buildings increase at a greater
rate than their surfaces, so the per-unit volume costs can go
down with larger structures.

This is called "economies of scale": unit costs decrease
with greater production. So an industry with such economies of
scale will have a downward-sloping supply curve. Offsetting
economies of scale are diseconomies or increasing costs of
managing an ever larger firm, as management gets more and more
complicated and bigger as a portion of costs, so at time amount
of production, it is possible for these diseconomies to outweigh
any continuing economies, and the supply curve would go up

It is also possible for the supply curve to be
horizontal, if the costs of inputs are the same at all levels of
production and there are no economies of scale. This is called
a "constant cost" industry.

If the average cost of firm output first decreases and
then increases, in a U-shaped curve, then the marginal cost
curve must cross it at its lowest point, the marginal costs
first pulling down and then pulling up the average.

Just as we distinguish a shift in a demand curve from a
movement along a demand curve, we distinguish a shift in the
supply curve (a change in the quantity supplied at all prices)
from a movement along a supply curve (a change in quantity
supplied as the price of a product changes). A decrease in
government regulations or improvement in technology, for
example, would shift a supply curve out, making it possible to
produce more for any particular price.

6. Price equilibrium

Now that we have the two sides of the market, demand and
supply, we can join the two curves in one graph. As the demand
curve slopes down, it will in some cases intersect the supply
curve. The point where the curves intersect determines the
market price and quantity at that time. In practice, these
curves are typically fuzzy rather than precise lines; there will
be some range of prices for some product rather than one exact

price everywhere, as consumers realize when they shop around.

It is quite possible that the curves will not intersect
at all. You offer a poem on the market for only a dollar, but
the demand curve starts at 25 cents for one poem and slopes down
to 100 copies of the poem demanded if it is free. But your
supply curve began at $1 for the first poem; you refuse to sell
it for any less, so the curves do not intersect. The quantity
exchanged in that case is zero.

If the curves do intersect, then economists call the
price and quantity an "equilibrium." If the time period is more
than a moment (such as a week), then the equilibrium price is a
range in which the trades have occurred. The equilibrium of a
time duration consists of the equilibria which exist at each
moment in time.

An equilibrium at a moment in time is a situation in
which the gains from trade have become exhausted. If there were
a shortage, gains from trade would be possible as sellers

increased the price to buyers willing to pay more to get the
goods. If there is a glut or surplus of goods, gains from trade
can be made as sellers lower the price to get rid of the stuff.
Either would be called a disequilibrium, since gains from
trading can still be made. At equilibrium, trade halts, because
gains from trade have become exhausted.

But wait a minute! If trade stops, then how can there
be a market equilibrium price? Is this a paradox? The answer
is that at each moment, markets are moving towards equilibrium,
but never actually reach it (or if they do in limited
situations, trade stops). People eat; they are in equilibrium
and stop eating. Then they get hungry again, in disequilibrium,
and go to market. They bid for food, while sellers make offers.
The market price attains an equilibrium price as gains from
trade are exhausted, but then hungry new buyers in
disequilibrium keep coming afterwards, making new bids.

Hence, a market price constantly equilibrates or matches
demands and supplies, and does not grind to a halt. This
equilibrating clears the market - sellers are matched by buyers
at the current price - but new buyers and sellers are always
dynamically making bids and offers. Just because the price is
stable does not mean equilibrium (in each moment) has been
achieved. It just means that bids and offers are somewhat
constant during some time interval. The price is always subject
to change if there is some change in the amounts and flows of
bids or offers. Of course if we consider a time rage greater
than a moment, then, looking back in time, we observe that often
there is some narrow price range in which exchanges have taken
place, and we can consider that to be a equilibrium during that

7. Profit

The term "profit" is used in different ways by
accountants and economists. To an accountant, profit is the
difference between explicit or money revenues and money costs.
An economist subtracts from this profit the implicit costs of a
firm. Suppose a farmer owns his own land, which he could rent
for $10,000 per year. An accountant says his profit was $50,000
that year. But the farmer could have rented his land out for
$10,000; by not doing so, he lost $10,000 in potential revenue.
This is an opportunity cost of using the land himself. Since
the land rent is a cost regardless of to whom it is paid, an
economist subtracts it as an implicit cost, not paid in money
but a cost of using that factor nevertheless. So the economic
profit is reduced to $40,000. But wait: the farmer's own wages
must be subtracted to. If he could have earned $30,000 working
for someone else, that too is an implicit cost, a wage. So we
have $10,000 left. But what about the capital goods? He could
have hired them out for $6,000 that year. Subtract this
implicit yield on capital goods, and we are left with a $4,000
economic profit. This is also called an entrepreneurial profit.

But since wealth is divided into a first distribution of
wages, rent, and capital yields, where does this economic profit
fit in? Since entrepreneurs are also workers, this
entrepreneurial profit is really a type of wage.

But it is a special type of wage. Foundational
proposition #15 states that the future is uncertain.
Entrepreneurs are innovators, but they can't be sure whether
they will earn a profit from trying or organize factors in what
they expect to be better ways. Uncertainty cannot be insured

against, unlike ordinary risk. Normal risks such as fires occur

with some regularity in a larger-number environment, and
insurance companies can measure how much loss there has been in
an average year and provide insurance against it. But, as
economist Frank Knight pointed out, uncertainty does not have
probability distributions. New products are unique in time and
circumstance, we cannot know what the probability of success is.
So entrepreneurs and their fellow investors take a chance, and
if they are right, their reward is entrepreneurial or economic
profits. If they are wrong, they take losses.

Profits and losses are important signals in a market
economy. Consistently high profits in an industry indicate that
more resources can be devoted to this product. Losses indicate
that too much production has taken place in that industry.
Hence, taxes on profits skew these signals, reducing the
potential investment and entrepreneurship in an economy,
reducing output, efficiency, and employment.

We see then, that profits induce firms to produce,
innovate, and employ factors. How this is done by the economy
as a whole will be the subject of the next chapter.

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