D. Theory of the Firm

This section of the handbook covers the neoclassical theory of the firm. The theory has three main features. First, the firm's technology is represented mathematically by a production function. This function's inputs are the amounts of the various raw materials, labor, and capital that the firm utilizes in the production process. The production function's output is the amount of the good or service that the firm produces. Thus, the production function gives the amount of the output good or service that the firm can produce with any given bundle of inputs.

Second, the firm is assumed to be a price taker in the marketplace, meaning that the firm takes as given the prices of the various inputs and the output good. The firm is too small in the marketplace for its decisions to have an impact on prices. Further, market prices are per unit and the firm can buy and sell all that it wants at these prices. Third, we assume that the firm seeks to maximize its profit, which is defined as revenue minus the cost of production.

The first part of this section (The Firm and Production) begins with the analysis of production functions, starting with the definition of a production function and moving on to some key concepts such as average product, marginal product, isoquant, and marginal rate of technical substitution. The second part of this section (Cost Functions) characterizes the firm's optimal choice of inputs for a given level of output, which is to minimize the cost of production. We derive cost functions, which give the minimized cost of production as a function of the output level. An important consideration is the period of time under consideration, because the firm may not be able to adjust some of its inputs in a short length of time. The third part of this section (Optimal Supply in Competitive Markets) looks at the firm's choice of the number of units of the output good/service to produce. This leads to the notions of a supply function and a supply curve, which relate the price of the output good to the number of units optimally produced.