Ch. 9: ORGANIZING PRODUCTION

Definition of a firm The economic problems that all firms face Technological vs. economic efficiency The principal-agent problem Different types of markets in which firms operate Explain why markets coordinate some economic

activities and firms coordinate others

The Firm and Its Economic Problem

• Firm – an institution that hires factors of production

and organizes them to produce and sell goods or services.

• Firm’s Goal– Maximize economic profit. – If the firm fails to maximize economic profits, it

is either eliminated or bought out by other firms seeking to maximize profit.

Accounting vs Economic Profits• Accounting profits

– measures a firm’s profit using rules established by the IRS and/or the Financial Accounting Standards Board.

– goal is to report profit so that the firm pays the correct amount of tax and is open and honest about its financial situation with its bank and other lenders.

• Economic profits– measure profit based on an opportunity cost measure

of cost.• Primary difference between accounting and

economic profits is in measurement of costs.

• Opportunity Cost– A firm’s opportunity cost of producing a good

is the best forgone alternative use of its factors of production, usually measured in dollars.

– Opportunity cost of production includes Explicit costs Implicit costs

– Explicit costs • costs paid directly in money

– wages, materials, utilities, rent, etc.

– Implicit costs • costs incurred when a firm uses the owners’ own

capital or time for which it does not make a direct money payment.

• Implicit costs of labor – The opportunity cost of the owner’s labor spent

running the business is the wage income forgone by not working in the next best alternative job.

• Cost of capital can be explicit or implicit – The firm can rent its capital and pay an explicit

rental rate– The firm can buy capital and incur an implicit

opportunity cost of using its own capital, called the implicit rental rate of capital.

• The implicit rental rate of capital is made up of: Economic depreciation

change in the market value of capital over a given period. Differs from accounting depreciation.

Interest forgone• the foregone return on the funds used to acquire the capital.

A firm pays $1 for a machine on 1/1/2008. Its market value drops to $800,00 by 12/31/2008. The interest rate is 10%. What’s the implicit annual rental rate on the capital?

$100,000 $200,000 $300,000 $400,000

25% 25%25%25%1. $100,0002. $200,0003. $300,0004. $400,000

A farmer owns 1000 acres of that he could rent to someone else for $100 per acre per year. The value of the land is currently $1000 per acre and is expected to rise at 3% per year. The farmer could earn an interest rate of 5% on any money he invests elsewhere. What is the opportunity cost of of using one acre of land in his own business?

$100 $300 $400 $500

25% 25%25%25%

1. $1002. $3003. $4004. $500

Economic vs. Accounting Profit

Accounting Profit = TR – Explicit Costs

Economic Profit = TR – Opportunity Costs of production = TR – Expl. Costs – Impl. Costs

= Acc. Profits – Implicit Costs

If Economic Profit > 0 Acc Profits > Implicit Costs Firms enter

If Economic Profit < 0 Acc Profits < Implicit Costs Firms exit

5 Decisions for the Firmto Maximize Profits

What to produce and in what quantities How to produce How to compensate managers and workers How to market and price products What to produce itself and what to buy from

other firms

Technological vs. Economic Efficiency

• Technological efficiency – occurs when a firm produces a given level of output

by using the least amount of inputs. – There may be different combinations of inputs to use

for producing a given level of output. • Economic efficiency

– occurs when the firm produces a given level of output at the least cost.

– economically efficient method depends on the relative costs of capital and labor

Information and OrganizationCommand system

• uses a managerial hierarchy. • Commands pass downward through the hierarchy and

information (feedback) passes upward. • Problem: must monitor.

Incentive system• Rewards to induce workers to perform in ways that

maximize the firm’s profit.• Problem:

Sometimes difficult to create proper incentives. Principal agent problem.

Ownership Incentive pay

• 3 Types of Business Organization– Proprietorship– Partnership– Corporation

Information and Organization

Information and Organization

• Proprietorship single owner unlimited liability proprietor makes management decisions and

receives the firm’s profit. profits are taxed the same as the owner’s

other income.

Information and Organization

• Partnership two or more owners unlimited liability. partners must agree on a management

structure and how to divide up the profits. profits are taxed as the personal income of

the owners.

Information and Organization

• Corporation owned by one or more stockholders with

limited liability, The personal wealth of the stockholders is not

at risk if the firm goes bankrupt. The profit of corporations is taxed twice

• corporate tax on firm profits• income taxes paid by stockholders on dividends.

Pros and Cons of Different Types of Firms

Proprietorships • easy to set up• Managerial decision making is simple• Profits are taxed only once• The owner’s entire wealth is at stake• The firm dies with the owner• The cost of capital and labor can be high

Pros and Cons of Different Types of Firms

Partnerships • Easy to set up• Employ diversified decision-making processes• Can survive the death or withdrawal of a partner• Profits are taxed only once• partnerships make attaining a consensus about

managerial decisions difficult• Place the owners’ entire wealth at risk• The cost of capital can be high, and the withdrawal of a

partner might create a capital shortage

Pros and Cons of Different Types of Firms

A corporation Perpetual life Easy to dissolve Limited liability for its owners Large-scale and low-cost access to financial capital lead to slower and expensive decision-making Profit is taxed twice—as corporate profit and shareholder

income.

Information and Organization• # of proprietorships

vs. share of revenue?

• Why does type of organization differ across industries?

Types of Markets: Perfect competition Monopolistic competition Oligopoly Monopoly

Perfect competition

Many firms Each sells an identical product Many buyers No restrictions on entry of new firms to the

industry Both firms and buyers are all well informed of

the prices and products of all firms in the industry.

Monopolistic competition

Many firms product differentiation Each firm possesses an element of market

power No restrictions on entry of new firms to the

industry

Oligopoly

A small number of firms compete The firms might produce almost identical

products or differentiated products Barriers to entry limit entry into the market.

Monopoly

One firm produces the entire output of the industry

There are no close substitutes for the product There are barriers to entry that protect the firm

from competition by entering firms

Name a local firm that you consider to be a monopoly.

Name a firm that sells its product nationally that you consider to be a monopoly.

Measures of ConcentrationTwo measures of market concentration in

common use are: The four-firm concentration ratio

Sum of market shares for 4 largest firms. The Herfindahl–Hirschman index (HHI)

Sum of squared market shares for all firms. DOJ uses the HHI to classify markets.

HHI<1,000 highly competitive 1000<HHI<1800 moderately competitive HHI>1800 not competitive

Measures of Concentration

• Limitations of Concentration Measures as Measures of Competition Geographic boundaries Product boundaries. Barriers to Entry Ability to Collude

Suppose there are 5 airlines that fly out of Cincinnati with market shares of 50%, 20%, 10%, 10% and 10%. What is the four firm concentration ratio?

Choice One

Choice Two

Choice Three

Choice Fo

ur

25% 25%25%25%

1. Choice One2. Choice Two3. Choice Three4. Choice Four

Suppose there are 5 airlines that fly out of Cincinnati with market shares of 50%, 20%, 10%, 10% and 10%. What is the four firm concentration ratio?

Suppose there are 5 airlines that fly out of Cincinnati with market shares of 50%, 20%, 10%, 10% and 10%. What is the HHI?

Suppose there are 5 airlines that fly out of Cincinnati with market shares of 50%, 20%, 10%, 10% and 10%. If two of the firms with 10% of the market merge, what would the HHI be?

Measures of Concentration

• 4 firm CR and HHI for various industries in the United States.

Markets and the Competitive Environment

• The economy is mainly competitive.

• Has become more competitive over time

Markets and Firms

• Why Firms?– Firms coordinate production when they can do

so more efficiently than a market.– Four key reasons might make firms more

efficient. Firms can achieve: Lower transactions costs Economies of scale Economies of scope Economies of team production