Transcript 6 2015-6 How Firm is the Firm

How Firm is The Firm?
The firm is a business activity that is organized as:
a)
A depository for capital (Marx)
b)
A reservoir of labor (Ricardo)
c)
An incomplete transaction awaiting a buyer
(Robinson)
d)
An instrument of public policy (Keynes)
The firm is the basis for the private sector
economy and the theory of the firm sets up
the nature of supply in the free market. It is
governed by the forces of supply and demand
(Smith) and it is governed in turn by the
nature of competition. Its objective is to earn a
profit which is determined in turn by its cost
structure.
Forms of Competition determine
the nature of the Firm.
• Perfect competition is a market form in which no single
supplier can affect the market price.
• Monopoly is a form in which the supplier sets the market
price.
• Oligopoly is a form in which a few suppliers set the
market price either by collusion (illegal) or market
reactions (legal).
• Monopolistic Competition is a form in which few
suppliers set the market price through contesting market
share directly but who face a downward sloping demand
curve and therefore can practice price discrimination,
market chain domination, and or vertical integration but
who inevitably face a competitive result in the market.
How Costs Determine Profit
• Profit is the residual of total revenue less total costs and
as costs are determined outside of any particular market
and demand is also dictated outside of the control of the
firm, it is costs that the firm attempts to control in any
number of ways:
– by using market structures in other markets to control final costs
which may include buying up suppliers (Vertical Integration) or
by buying out competitors (Horizontal Integration)
– by investing in cost reducing technology through design of
products, marketing of products (warehousing and distribution) ,
and financing of products
– by standardizing unit variable costs through supplier
specifications (detailed requirements), organization of delivery,
and unionization formal or informal.
Firms maximize profits when costs are predictable
and stablized.
Cost Structures
Costs are either fixed or variable. Fixed costs are the same
regardless of output while variable costs increase as output
increases.
Costs include opportunity costs which include all other potential
ways of making money that are given up to undertake the
enterprise.
Sunk costs are those that have been spent in the past and are no
longer of value to the firm except that they may earn a place in a
market because of them. Sunk costs are capitalized and are
therefore fully depreciated.
Average costs are costs per unit of output for total costs, variable
costs and fixed costs.
Marginal costs are costs associated with last unit of output
produced. This will cut the average variable cost and the
average total costs curves at their lowest point for an constant
returns to scale technology.
Marginal revenues are revenues associated with the last unit of
output produced and will be less steep than the demand curve.
When Marginal Cost is equal to Marginal Revenue
the profit will be maximized.
Cost Structures
Profit is Maximized when Marginal Revenue is equal to Marginal Cost. (Price Received minus Cost Incurred )
times Quantity Sold is Profit Earned. A is market exit point because revenue would not cover fixed costs. B
is plant shut down point because revenue would not cover variable costs. C is profit minimization point
because marginal revenue would be equal to average total cost.
Price
Average Total Cost
Average Variable Costs
Price Received
Marginal Cost
C
Cost Incurred
B
A
Quantity Sold
Demand
Average Fixed Costs
Marginal Revenue
Quantity
Perfect Competition
• Complete knowledge of the market.
• Homogeneous product throughout.
• Ease of entry and exit from the market
usually characterized by a singular
planning point in time or space.
• Ability to carry over product from one time
period to the next at minimal active cost
• No Profit available.
Perfect Competition Analytics
•
There is no profit in perfect competition [total costs include opportunity costs].
Price
Marginal Cost
Average Total Cost
Demand =
Marginal Revenue
Price Received =
Costs Incurred
Quantity
Quantity Sold
Imperfect Competition
• Complete knowledge of the market is known
only to the firm.
• Non-homogeneous product throughout.
• No ease of entry and exit from the market
usually characterized by continuous planning
points in time or space.
• No Ability to carry over product from one time
period to the next without major active costs.
• Profit available.
Imperfect Competition Analytics
Monopoly
•
Imperfect Competition leads to a deadweight loss [A:D:E:C] because in the perfectly competitive case average
total cost would have been equal to average revenue [demand] and we would have produced more quantity but
profit would be given up.
Marginal Cost
Price
A
Price Received
Average Total Cost
Perfectly Competitive
[Price Received =
Cost Incurred]
B
C
D
Marginal Revenue
Cost Incurred
Quantity Sold
Demand
E
Quantity that could
have been sold
Quantity
Deadweight Loss Issues
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If we have deadweight loss issues because of imperfect competition it may be
possible to compensate and improve welfare.
If the deadweight loss is significant and wasteful the government has remedies that
can compete with the monopolist, open up the market to competition, regulate
conduct of the monopolist or tax the profits away.
Not all monopolies are ‘bad’ and the government may accept some welfare loss :
– Natural monopolies come about due to single sources of product or geographic
necessity.
– Policy monopolies come about due to government efforts to encourage research
[patent monopolies] , to preserve local industries [tariff monopolies] , to
encourage investment [offset monopolies] or to establish cultural, health , safety
and environmental standards.
– Structural monopolies exist because of business preferences for single service
provision which minimize transactions costs.
Competition Policy
•
•
•
•
Competition is encouraged by governments in order to maximize welfare by
minimizing deadweight losses due to monopoly.
Competition is welcomed by consumers and valued by business but relative losses
have tended to favor business over consumer surpluses.
Competition policy is civil law in Canada based on tort laws.
The remedies include:
–
–
–
–
Competition with the monopoly and pricing at the competitive solution thereby dragging down the market to
the welfare maximizing position (automobile insurance)
Opening up the market to competition by funding alternative options with grants and subsidies in order to
expand options on a regional or functional basis (food retailing)
Regulating the conduct of the monopolist through licensing and compliance rules (securities and exchange
regulations)
Taxing the profits away with targeted taxation based on the relative balance between tax revenues and
deadweight losses.
The Organization of the Firm
•
The Organization of the firm is the key to its stability because it minimizes the
business risks that the firm is exposed to:
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–
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A sole proprietorship is the business that is owned by an individual. It has the “status” of a person under the
law. This is typical for consulting companies and holding companies and is found in professional services.
A partnership is a firm organized with a formal agreement between a number of people who provide funds
according to a set plan and agree upon initiation and also dissolution of the company. This is typical of
clinics.
A limited partnership is similar but is registered, usually with a professional society that is self regulating and
therefore sets standards amongst it members on matters of conduct. This is typical of professional agencies
that have large public liability exposure.
A corporation that is incorporated under the laws of a province or country and has set prescriptions
regarding the nature of the affairs that the company can undertake and limits corporation liabilities to the
capital invested in the company. This is usually identified as an “incorporated” firm and usually has
ownership distributed through shares and funding derived from bonds that are regulated under securities
legislation. The corporation may be public or private . Going from private to public involves an IPO [Initial
Public Offering] and going from public to private involves the exercise of executive share options.
Firming Firms
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The more stable the structure of business, the greater is the reliability of the
market for the company in terms of planning, marketing and finance.
The stability of the firm is reflected in price stability and efficient market
information in which prices are publicly posted.
The parameters of the market are stable when the boundaries of who
supplies to the market and how can be set and projected into investments.
The projection of markets allows for anticipation of research and
development needs and the further stability of government planning and
policy management.
• The more stable the firm the more stable the
economy.