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Household and Firm Behavior in the...
Firms: Investment and Employment Decisions

Now that we have examined the consumption behavior of households, let us turn to the investment behavior of firms. In an earlier lecture we learned that planned investment depends on interest rates. Now we will look at some of the other determinants of investment. In addition, we will look at the decision by firms to hire labor.

A firm's decisions to make investments and hire labor are decisions regarding inputs. In order to produce goods and services, firms need factories, machinery, labor, and other inputs. Recall that planned investment consists of purchases of plants and equipment, termed plant-and-equipment investment, as well as planned inventory investment, in which firms produce more output than they sell in order to increase their inventory stock. Unplanned investment, on the other hand, consists of unplanned changes in inventories.

Firms hire labor and make investments in physical capital in order to produce goods and services. Economists assume that decisions regarding the amount of output a firm produces, and the mix of capital and labor, are based on the objective of profit maximization. In order to produce a given level of output, a firm can use various combinations of labor and capital. Its choice will depend, to a large degree, on the relative prices of labor and capital. If labor is cheap relative to capital, firms may choose to employ a lot of labor.

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