Transcript Slide 1

ORGANIZING PRODUCTION
How firms make decisions
9
CHAPTER
Dr. Gomis-Porqueras
ECO 680
Residual Claimants
In a market economy, firm owners are residual
claimants.
They have right to any revenue after costs have been
paid.
•Provides a strong incentive for owners to keep costs of
producing output low.
The Firm and Its Economic Problem
A firm is an institution that hires factors of production and
organizes them to produce and sell goods and services.
The Firm’s Objective
A firm’s goal is to maximize profit.
If the firm fails to maximize profits it is either eliminated or
bought out by other firms seeking to maximize profit.
The Firm and Its Economic Problem
Measuring a Firm’s Profit
Accountants measure a firm’s profit using rules laid down
by the Internal Revenue Service and the Financial
Accounting Standards Board.
Their 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.
Economists measure profit based on an opportunity cost
measure of cost.
The Firm and Its Economic Problem
Opportunity Cost
A firm’s decisions respond to opportunity cost and
economic profit.
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 includes both:
 Explicit costs
 Implicit costs
The Firm and Its Economic Problem
Explicit costs are costs paid directly in money.
Implicit costs are costs incurred when a firm uses its own
capital or its owners’ time for which it does not make a
direct money payment.
The firm can rent capital and pay an explicit rental cost
reflecting the opportunity cost of using the capital.
The firm can also buy capital and incur an implicit
opportunity cost of using its own capital, called the implicit
rental rate of capital.
The Firm and Its Economic Problem
The implicit rental rate of capital is made up of:
 Economic depreciation
 Interest forgone
Economic depreciation is the change in the market value
of capital over a given period.
Interest forgone is the return on the funds used to acquire
the capital.
The Firm and Its Economic Problem
The cost of the owner’s resources is his or her
entrepreneurial ability and labor expended in running the
business.
The opportunity cost of the owner’s entrepreneurial ability
is the average return from this contribution that can be
expected from running another firm. This return is called a
normal profit.
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.
Economic Role of Costs
The demand for a product indicates the intensity
of consumer’s desires for an item.
The (opportunity) cost of producing the item
indicates the desire of consumers for other goods.
The Firm and Its Economic Problem
Economic Profit
Economic profit equals a firm’s total revenue minus its
opportunity cost of production.
A firm’s opportunity cost of production is the sum of the
explicit costs and implicit costs.
Normal profit is part of the firm’s opportunity costs, so
economic profit is profit over and above normal profit.
The Firm and Its Economic Problem
Economic Accounting: A Summary
To maximize profit, a firm must make five basic decisions:
 What goods and services to produce and in what
quantities
 How to produce—the production technology to use
 How to organize and compensate its managers and
workers
 How to market and price its products
 What to produce itself and what to buy from other firms
The Firm and Its Economic Problem
The Firm’s Constraints
The five basic decisions of a firm are limited by the
constraints it faces. There are three constraints a firm
faces:
 Technology
 Information
 Market
The Firm and Its Economic Problem
Technology Constraints
Technology is any method of producing a good or service.
Technology advances over time.
Using the available technology, the firm can produce more
only if it hires more resources, which will increase its costs
and limit the profit of additional output.
The Firm and Its Economic Problem
Information Constraints
A firm never possesses complete information about either
the present or the future.
It is constrained by limited information about the quality
and effort of its work force, current and future buying plans
of its customers, and the plans of its competitors.
The cost of coping with limited information limits profit.
The Firm and Its Economic Problem
Market Constraints
What a firm can sell and the price it can obtain are
constrained by its customers’ willingness to pay and by the
prices and marketing efforts of other firms.
The resources that a firm can buy and the prices it must
pay for them are limited by the willingness of people to
work for and invest in the firm.
The expenditures a firm incurs to overcome these market
constraints will limit the profit the firm can make.
Technology and Economic Efficiency
Technological Efficiency
Technological efficiency occurs when a firm produces a
given level of output by using the least amount inputs.
There may be different combinations of inputs to use for
producing a given level of output.
If it is impossible to maintain output by decreasing any one
input, holding all other inputs constant, then production is
technologically efficient.
Technology and Economic Efficiency
Economic Efficiency
Economic efficiency occurs when the firm produces a
given level of output at the least cost.
The difference between technological and economic
efficiency is that technological efficiency concerns the
quantity of inputs used in production for a given level of
output, whereas economic efficiency concerns the cost of
the inputs used.
Technology and Economic Efficiency
An economically efficient production process also is
technologically efficient.
A technologically efficient process may not be
economically efficient.
Changes in the input prices influence the value of the
inputs, but not the technological process for using them in
production.
Improving Inventory Control at Wal-Mart
Better inventory controls
have helped reduce
firms’ costs.
Marginal Revenue
Marginal Revenue is the change in total revenue divided
by the change in output.
the change in total revenue
Marginal
(MR)
=
Revenue
the change in output
In a price taker market,
Marginal Revenue = market price.
Marginal Cost
Marginal Cost (MC) is the increase in total
cost associated with a one-unit increase in
production.
MC will decline initially, reach a minimum,
and then rise.
Marginal Marginal
Revenue Cost
Profit
Output (MR)
(MC) (TR - TC)
0
1
2
..
.
8
9
10
11
12
13
14
15
16
17
18
19
20
21
---5
5
..
.
5
5
5
5
5
5
5
5
5
5
5
5
5
5
---$ 4.80
$ 3.95
..
.
$ 1.50
$ 1.25
$ 1.00
$ 1.25
$ 1.75
$ 2.50
$ 3.50
$ 4.75
$ 6.00
$ 7.25
$ 8.25
$ 9.50
$ 13.00
$ 17.00
- 25.00
- 24.80
- 23.75
..
.
- 8.00
- 4.25
- .25
3.50
6.75
9.25
10.75
11.00
10.00
7.75
4.50
0.00
- 8.00
- 20.00
• Below, low levels of output deliver
marginal revenue to the firm greater than
the marginal cost of increased output.
• After some point, though, additional units
cost more than their marginal revenue.
• Profit is maximized where P = MR = MC.
Price and Cost
Per Unit
9
7
5
MC
Profit Maximum
P = MR = MC
MR
3
1
Output Level
2 4 6 8 10 12 14 16 18 20 22
• Here we graph the general shape of the
firm’s short-run total cost curves.
• Note that total fixed costs are flat and
remain the same for 0 units or 11 units.
• Note that total variable costs increase as
more variable inputs are utilized.
• As total costs are the combination of
TVC and TFC, they are everywhere
positive and increase sharply with output
Output
per day
0
1
2
3
4
5
6
7
8
9
10
11
TFC + TVC = TC
50
50
50
50
50
50
50
50
50
50
50
50
0
15
25
34
42
52
64
79
98
122
152
202
50
65
75
84
92
102
114
129
148
172
202
252
Total Costs Curves
Total
Costs
TC
250
TVC
200
150
100
TFC
50
2
4
6
8
10 12
Output
Information and Organization
A firm organizes production by combining and coordinating
productive resources using a mixture of two systems:
 Command systems
 Incentive systems
Information and Organization
Command Systems
A command system uses a managerial hierarchy.
Commands pass downward through the hierarchy and
information (feedback) passes upward.
These systems are relatively rigid and can have many
layers of specialized management.
Information and Organization
Incentive Systems
An incentive system, uses market-like mechanisms to
induce workers to perform in ways that maximize the firm’s
profit.
Information and Organization
Mixing the Systems
Most firms use a mix of command and incentive systems
to maximize profit.
They use commands when it is easy to monitor
performance or when a small deviation from the ideal
performance is very costly.
They use incentives whenever monitoring performance is
impossible or too costly to be worth doing.
Information and Organization
The Principal-Agent Problem
The principal-agent problem is the problem of devising
compensation rules that induce an agent to act in the best
interests of a principal.
For example, the stockholders of a firm are the principals
and the managers of the firm are their agents.
Firm owners face this problem when dealing with workers.
Shirking
With team production owners must reduce the
problem of shirking.-employees working at less than
normal rate of productivity.
Example: Long coffee break.
Control with incentives and monitoring.
Information and Organization
Coping with the Principal-Agent Problem
Three ways of coping with the principal-agent problem are:
 Ownership
 Incentive pay
 Long-term contracts
Information and Organization
Ownership, often offered to managers, gives the
managers an incentive to maximize the firm’s profits,
which is the goal of the owners, the principals.
Incentive pay links managers’ or workers’ pay to the firm’s
performance and helps align the managers’ and workers’
interests with those of the owners, the principal.
Long-term contracts can tie managers’ or workers’ longterm rewards to the long-term performance of the firm.
This arrangement encourages the agents work in the best
long-term interests of the firm owners, the principals.
Empirical Evidence
Drago and Garvey (1997) use Australian survey data to
show that when agents are placed on individual pay-forperformance schemes, they are less likely to help their
coworkers.
This is particularly important in those jobs that involve
strong elements of ‘team production” where output reflects
the contribution of many individuals, and individual
contributions cannot be easily identified, and compensation
is therefore based largely on the output of the team.
Studies suggest that profit-sharing, for example, typically
raises productivity by 3-5%.
Empirical Evidence
Fernie and Metcalf (1996) find that British jockeys perform
significantly better when offered prizes for winning races
compared to being on fixed retainers.
McMillan, Whalley and Zhu (1989) and Groves et al (1994)
look at Chinese agricultural and industrial data respectively
and find significant incentive effects.
Kahn and Sherer (1990) find that better evaluations of
white-collar office workers were achieved by those
employees who had a steeper relation between evaluations
and pay.
Information and Organization
Types of Business Organization
There are three types of business organization:
 Proprietorship
 Partnership
 Corporation
Information and Organization
Proprietorship
A proprietorship is a firm with a single owner who has
unlimited liability, or legal responsibility for all debts
incurred by the firm—up to an amount equal to the entire
wealth of the owner.
The proprietor also makes management decisions and
receives the firm’s profit.
Profits are taxed the same as the owner’s other income.
Information and Organization
Partnership
A partnership is a firm with two or more owners who have
unlimited liability.
Partners must agree on a management structure and how
to divide up the profits.
Profits from partnerships are taxed as the personal income
of the owners.
Information and Organization
Corporation
A corporation is owned by one or more stockholders with
limited liability, which means the owners who have legal
liability only for the initial value of their investment.
The personal wealth of the stockholders is not at risk if the
firm goes bankrupt.
The profit of corporations is taxed twice—once as a
corporate tax on firm profits, and then again as income
taxes paid by stockholders receiving their after-tax profits
distributed as dividends.
Information and Organization
 Proprietorships are easy to set up
 Managerial decision making is simple
 Profits are taxed only once
 But bad decisions made by the manager are not subject
to review
 The owner’s entire wealth is at stake
 The firm dies with the owner
 The cost of capital and labor can be high
Information and Organization
 Partnerships are easy to set up
 Employ diversified decision-making processes
 Can survive the death or withdrawal of a partner
 Profits are taxed only once
 But 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
Information and Organization
 A corporation offers perpetual life
 Limited liability for its owners
 Large-scale and low-cost capital that is readily available
 Professional management
 Lower costs from long-term labor contracts
 But a corporation’s management structure may lead to
slower and expensive decision-making
 Profit is taxed twice—as corporate profit and shareholder
income.
Information and Organization
The Relative Importance of Different Types and Firms
There are a greater number of proprietorships than other
form of business, but corporations account for the majority
of revenue received by businesses.
Information and Organization
Figure 9.1(a) shows the
frequency of each type of
business organization.
Figure 9.1(b) shows the
dominant type of business
organization for various
industries.
Markets and the Competitive
Environment
Economists identify four market types:
 Perfect competition
 Monopolistic competition
 Oligopoly
 Monopoly
Markets and the Competitive
Environment
Perfect competition is a market structure with:
 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.
Markets and the Competitive
Environment
Monopolistic competition is a market structure with:
 Many firms
 Each firm produces similar but slightly different
products—called product differentiation
 Each firm possesses an element of market power
 No restrictions on entry of new firms to the industry
Markets and the Competitive
Environment
Oligopoly is a market structure in which:
 A small number of firms compete
 The firms might produce almost identical products or
differentiated products
 Barriers to entry limit entry into the market.
Incentive to Collude
Oligopolists have a strong incentive to collude and
raise their prices.
Each firm has an incentive to cheat by lowering price
because the demand curve facing each firm is more
elastic than the market demand curve.
This conflict makes collusive agreements difficult to
maintain.
Oligopolies
A cartel is an organization through which members jointly make
decisions about prices and production (OPEC).
In the United States, antitrust laws prevent firms from obvious
collusion and from forming a cartel. However, there are legally
sanctioned cartels in the United States.
The NCAA is an example. Participation is restricted to member
colleges.
The American Medical Association (AMA). You may have a great
remedy for colds, but you are not allowed to open a medical
practice until you meet the requirements of the AMA.
Markets and the Competitive
Environment
Monopoly is a market structure in which
 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
Monopolies
Before "Ma Bell" or AT&T was broken up in 1982, Bell
controlled all of the local and long distance phone business
in the U.S.A.
Prices were high, service was bad and Bell was using it's
control of the local phone exchanges to restrict competitors
access to the long distance market.
In an agreed settlement Bell was broken up into the
regional baby bells which where given the local phone
market and AT&T which had the long distance market.
Markets and the Competitive
Environment
Figure 9.2 shows the
four-firm concentration
ratio for various
industries in the United
States.
Markets and the Competitive
Environment
Market Structures
in the U.S.
Economy
Figure 9.3 shows
the distribution of
market structures
in the U.S.
economy.
The economy is
mainly competitive.
Why Do Governments Allow Monopolies?
Examples:
- Power to tax future generations
- Easier to borrow
- Easier to take long term projects
- Longer time horizon than private firms
- Introduce some standards
- Public safety
Markets and the Competitive
Environment
Market Structures in
the U.S. Economy
Figure 9.3 shows the
distribution of market
structures in the U.S.
economy.
The economy is
mainly competitive.
Markets and 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
Markets and Firms
Transactions costs are the costs arising from
finding someone with whom to do business,
reaching agreement on the price and other
aspects of the exchange, and ensuring that
the terms of the agreement are fulfilled.
Economies of scale occur when the cost of
producing a unit of a good falls as its output
rate increases.
Markets and Firms
Economies of scope arise when a firm can use
specialized inputs to produce a range of different
goods at a lower cost than otherwise.
Firms can engage in team production, in which
the individuals specialize in mutually supporting
tasks.
Summary