In studying decision making by consumers and businesses, microeconomics gives rise to the theory of the consumer and theory of the firm as two branches of study.

The theory of the consumer is the study of consumption—the demand for goods and services—by utility-maximizing individuals. The theory of the firm, the subject of this reading, is the study of the supply of goods and services by profit-maximizing firms. Conceptually, profit is the difference between revenue and costs. Revenue is a function of selling price and quantity sold, which are determined by the demand and supply behavior in the markets into which the firm sells/provides its goods or services. Costs are a function of the demand and supply interactions in resource markets, such as markets for labor and for physical inputs. The main focus of this reading is the cost side of the profit equation for companies competing in market economies under perfect competition. A subsequent reading will examine the different types of markets into which a firm may sell its output.

The study of the profit-maximizing firm in a single time period is the essential starting point for the analysis of the economics of corporate decision making. Furthermore, with the attention given to earnings by market participants, the insights gained by this study should be practically relevant. Among the questions this reading will address are the following:

• How should profit be defined from the perspective of suppliers of capital to the firm?

• What is meant by factors of production?

• How are total, average, and marginal costs distinguished, and how is each related to the firm’s profit?

• What roles do marginal quantities (selling prices and costs) play in optimization?

This reading is organized as follows:

Section 2 discusses the types of profit measures, including what they have in common, how they differ, and their uses and definitions.

Section 3 covers the revenue and cost inputs of the profit equation and the related topics of breakeven analysis, shutdown point of operation, market entry and exit, cost structures, and scale effects. In addition, the economic outcomes related to a firm’s optimal supply behavior over the short run and long run are presented in this section.