Transcript The Economics of Business Firms

THE ECONOMICS OF
BUSINESS FIRMS
Chapter 4
ORGANIZING A BUSINESS
Sole Proprietorship
Partnership
Corporation
3 MAIN GROUPS OF AMERICAN
BUSINESS
 Sole Proprietor
Mom & Pop Store
Barbershop
Web design
 Partnership
Attorneys
Accountants
Professional Groups
 Corporations
General Motors
Microsoft
IBM
SOLE PROPRIETOR
A business owned by just one person
individual initiative, self-reliance, hard-work
 Most common form and simplest to form.
 Over 78% of all business in U.S.
 Financial investment need not be large.
 Limited amount of red tape.
 Owner has satisfaction of working for himself.
 Flexibility of organization (hours, pay, etc)
 Pays taxes only on personal income from
business.
 Can put money into private pensions.
DISADVANTAGES TO
SOLE PROPRIETOR
Only 24 hours in a day- can’t work 24/7.
Prosperity depends on talent of one person and no one
contains all necessary skills.
Often too close to trees to see the forest.
Often difficult to borrow money from the banks.
Unlimited liability.
Limited Life.
PARTNERSHIP
A legal association of two or more persons
in a business as co-owners.
More complicated than S.P.
Each partner agrees to contribute some
portion of funding and labor used by the
business and to receive some proportion
of the profits or losses.
Could be a “silent” partner (put up
money,but nothing to say about
operations.
Common formation for professional groups.
PARTNERSHIP ADVANTAGES
Easy to form.
Usually has legal standing
Combines skills of several people which enhances ability to
create wealth.
Easier to get funding and backing.
Taxed only on personal income.
Limited amount of red tape.
PARTNERSHIP
DISADVANTAGES
Unlimited liability (each member of partnership is legally liable
for debts of business and other partners in name of
business.
Conflicts among partners
Too many chiefs- not enough Indians.
Inside partnership very competitive.
Lifespan somewhat limited.
CORPORATION
A BODY THAT IS AUTHORIZED BY LAW TO ACT AS A
PRIVATE PERSON
Legally endowed with various rights and duties
 To receive, own, and transfer property.
 To make contracts
 To sue and be sued.
CORPORATIONS INCLUDE:
EXXON, IBM, GENERAL MOTORS,
MICROSOFT,
Characteristics:
 Shareholders share in the wealth.
 Limited Liability (responsibility of shareholders of
a corporation is held only to their investment in
same)
 May own tremendous wealth.
 Increased management skills
 Ownership divided into equal parts called shares
 Can raise large amounts of money
 Can borrow money through sale of bonds.
MERGERS
Horizontal
Vertical
Conglomerate
MERGERS
horizontal – two firms that serve the same set of customers
vertical – two firms operating at different stages of the
production/distribution process
conglomerate – two firms operating in unrelated industries
MERGERS/CONGLOMERATES
Merger= acquisition through sale of one company to another with the
purchasing company remaining dominant.
example: General Motors absorbed Chevrolet Corporation
In 1919- General Motors remained dominant- This is called a
Horizontal Merger
General Motors
Chevrolet Corporation
Amalgamation = Outsider brings together 2 companies minimum
And forms a new company
.
Pontiac
Oldsmobile
Buick
Cadillac
General
Motors
1917
VERTICAL MERGER
A company in one phase of the business
absorbs or joins a company involved in
another phase in order to guarantee a
supplier or customer.
Retailer
Distributor
Trucking
Refinery
Pipeline
Oil fields
CONGLOMERATE
Saw a lot of this type after
1961- union of two
corporations whose
operations were
unrelated…
ITT = 250 operations-
Taxi, motel chain, Madison
Square gardens, paper mill,
Food products,cosmetic,
Pharmaceutical.
Phillip Morris is huge!
Coca Cola is huge!
INCOME STATEMENT
Revenues – costs = profits (TR-TC)
•
•
•
•
Revenues – money coming into the firm
Costs – money and non-money costs, also called expenses
Profits – revenues exceed costs
Losses – revenues are less than costs
TOTAL REVENUE (TR)
Sales revenue received by the firm
TR = P x Q
MARGINAL REVENUE
(MR)
Additional revenue received when the firm sells one more
unit of the product.
• MR = (change in revenue)/(change in output)
In most markets, MR slopes downward twice as fast as the
demand curve
FIGURE 4-1. DEMAND AND
MARGINAL REVENUE
TR = P x Q
MR = increase in TR/
P
increase in Q
MR
D
Q
Q
0
1
2
3
4
5
6
P
10
9
8
7
6
5
4
TR
0
9
16
21
24
25
24
MR
+9
+7
+5
+3
+1
-1
COSTS
Fixed costs (FC)
Variable costs (VC)
Total costs (TC)
• TC = FC + VC
COSTS
Fixed costs (FC) – payment for the fixed inputs
Variable costs (VC) – payment for the variable inputs
Total costs (TC) = FC + VC
FIGURE 4-2. FC, VC, AND TC
As output (Q) increases:
Fixed Costs (FC) do not change.
Variable Costs (VC) increase at an irregular rate.
Total Costs (TC) = FC + VC.
Q
VC
0
10
20
30
40
50
FC
0
85
150
240
350
550
TC
120
120
120
120
120
120
120
205
270
360
470
670
AVERAGE FIXED COSTS (AFC)
AFC = FC/Q
If no other costs but fixed, average costs will decline
FIGURE 4-4. AVERAGE
FIXED COSTS (AFC)
AFC = FC/Q
Q
FC
0
10
20
30
40
50
$
AFC
120
120
120
120
120
120
12.00
6.00
4.00
3.00
2.40
AFC
Q
AVERAGE VARIABLE COSTS
(AVC)
AVC = VC/Q
As Q increases, AVC falls to a minimum, then rises rapidly as
the firm approaches maximum capacity
FIGURE 4-5. AVERAGE
VARIABLE COSTS (AVC)
AVC = VC/Q
Q
VC
0
10
20
30
40
50
$
AVC
0
85
150
240
350
550
8.50
7.50
8.00
8.75
11.00
AVC
7.50
20
Q
AVERAGE TOTAL COSTS (ATC)
ATC = TC/Q = AFC + AVC
As Q increases, ATC falls to a minimum, then rises rapidly as
the firm approaches maximum capacity.
ATC is always higher than AVC
FIGURE 4-6. AVERAGE
TOTAL COSTS (ATC)
ATC = TC/Q = AFC + AVC
Q
TC
0
10
20
30
40
50
ATC
120
205
270
360
470
670
$
ATC
20.50
13.50
12.00
11.75
13.40
11.75
40
Q
MARGINAL COST (MC)
MC = (change in TC/change in Q)
MC falls at first, then rises rapidly through the range of normal
production
FIGURE 4-7. MARGINAL COSTS
(MC)
MC = (change in TC/change in Q)
Q
TC
0
10
20
30
40
50
MC
120
205
270
360
470
670
$
MC
8.50
6.50
9.00
11.00
20.00
Q
$24
20
GRAPH
ATC/AVC/AFC
Costs (dollars per pair)
I
ATC
J
16
K
12
L
M
8
AVC
4
0
O
N
AFC
10
20
30
Rate of Output (pairs per day)
40
50
SUMMARY OF THE BASIC COST
CURVES
21-32
FIGURE 4-10. MR, MC AND
PROFIT MAXIMIZATION
MC = MR
Produce the Q, labeled Qm
where MR = MC and profit
will be maximized.
The demand curve tells you
that the price must be Pm.
P
MC
Pm
MR
Qm
MR>MC
D
Q
MR<MC
PROFIT
MAXIMIZATION RULES
Produce the Q where MR = MC and
profit will be maximized.
Price determined from that point
also.
Loss minimization occurs.
EXPLICIT AND IMPLICIT
COSTS
Explicit costs – actual out-of-pocket payments by the firm,
plus depreciation.
Implicit costs – the opportunity costs of the owner’s assets,
time and effort.
Total costs = explicit costs + implicit costs
PROFITS
Accounting profit = TR – explicit costs
Economic profit = TR – both explicit costs and implicit costs
Normal profit is the minimum return on investment necessary
for the owner to continue to operate the business.
DECISION MAKING
Economic Profit > 0
• Expand the firm.
Economic Profit < 0
• Shrink or close the firm.
Economic Profit = 0
• Keep operating at this level.
MARKET STRUCTURE AND
MARKET POWER
Ability to manipulate the market price.
• perfect competition – no market power
• monopoly – complete market power
• monopolistic competition – some market power at
times
• oligopoly – considerable market power at times
PERFECT COMPETITION
Many small firms
Identical products sold at the same price
Easy to enter into and exit from the industry.
Each firm must accept the market price.
Each firm can only choose the quantity to
produce (they choose the profit-maximizing
quantity).
Economic profit quickly goes to zero or
normal.
DEMAND CURVE FOR A
PRODUCER OF SECURE
DIGITAL CARDS
FIGURE 24-2 PROFIT
MAXIMIZATION, PANEL
(A)
PROFIT MAXIMIZATION
$18
Marginal cost
Price or Cost (per bushel)
16
14
p = MC
MRB
Profits decreasing
Price (= MR)
12
10
Profits increasing
8
Profit-maximizing
rate of output
6
4
2
0
MCB
1
2
3
4
5
Quantity (bushels per day)
6
7
MONOPOLY
Only one firm produces the product.
• They control the supply curve.
There is a total barrier to other firms entering the
industry.
Monopolist will choose to produce its profitmaximizing quantity. (MC = MR)
• The demand curve will then identify the market
price.
• Marginal Revenue falls faster than price.
PROFIT MAXIMIZATION
$14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
Average
total cost
D
Profits
d
Demand
Marginal
cost
1
2
Marginal
revenue
3
4
5
6
7
Quantity (baskets per hour)
8
9
PRICE AND MARGINAL REVENUE
Unlike competitive firms, marginal revenue
for a monopolist is not equal to price.
So long as the demand curve is downwardsloping, MR will always be less than price.
Quantity
1
2
3
4
5
6
7
Price
$13
12
11
10
9
8
7
Total
Revenue
$13
24
33
40
45
48
49
Marginal
Revenue
—
$11
9
7
5
3
1
MONOPOLIES NOT
PERMITTED IN U.S.
WAIT!!!!!!!!!!!!
Don’t we have them anyway?
Sure – (natural and companies with
large percentage of market.
MONOPOLISTIC COMPETITION
Many intensely competitive firms
Each sells a slightly different version of the
product at slightly different prices
Easy entry and exit
One firm’s product innovation captures the
customers’ imagination; that firm becomes a
short term monopolist
• Earns normal profits
BRAND LOYALTY
 Will compete with other firms but offer substitutes
 makes the demand curve facing the firm less price-elastic.
 implies that consumers shun substitute goods even when
they are cheaper.
 Example: the price differences between computers which
are essentially the same.
NON-PRICE
COMPETITION
Advertising.
http://www.youtube.com/watch?v=xffOCZYX6F8
http://www.youtube.com/watch?v=xffOCZY
X6F8
FIGURE 26-2 COMPARISON OF
THE PERFECT COMPETITOR WITH
THE MONOPOLISTIC COMPETITOR
OLIGOPOLY
A few large firms dominate the industry.
Significant price-setting power.
Significant barriers to entry.
Name brand producers.
Nation-wide and world-wide distributors.
MARKET POWER
Tom Thumb wants to gain
market share from
Albertsons.
Wal-Mart wants market
share from Kmart… boy
did they get it!
Central Market wants
market share from Whole
Foods
Google wants market
share from Facebook.
MARKET SHARE-NORTH
TEXAS JULY 2013 % of market share
Grocery Store
Walmart
27.8
Kroger
Tom Thumb
14.5
10.1
Albertsons
Target ,super
6.9
6.7
Sam’s
Costco
5.2
5.2
HEB Central Market
Whole Foods
2.5
1.2
Market Street
1.0
OLIGOPOLY (CONT'D)
Oligopoly
• A market situation in which there are very few sellers.
• Each seller knows that the other sellers will react to its
changes in prices and quantities.
OLIGOPOLY (CONT'D)
Why oligopoly occurs
• Economies of scale
• Barriers to entry
• Mergers
• Vertical mergers
• Horizontal mergers
Price or Cost (dollars per unit)
Maximizing Oligopoly Profits
Industry
marginal
cost
Profitmaximizing
price
Industry
average
cost
Market
demand
Profits
Average cost
at profitmaximizing
output
J
Industry marginal
revenue
Profit-maximizing output
0
Quantity (units per period)
ECONOMIES OF SCALE
Increase the capacity to produce and costs are lowered.
• …achieve economies of scale.
• …up to a point.
How?
• switch from batch mode to assembly line.
• employees specialize to task.
• buy inputs in bulk at lower prices.
DISECONOMIES OF SCALE
Continued increase in production capacity leads, after a point,
to rising costs.
How?
• multiple assistant managers needed.
• create a costly bureaucracy.
• move decision making authority away from the production line.
IDEAL SIZED PLANT
Build a facility that:
• is big enough to achieve all economies of scale.
• operates at lowest cost.
• does not get big enough to experience diseconomies of scale.
Economies of Scale
Economies of scale
COST (dollars per unit)
Constant returns to scale
Diseconomies of scale
ATC3
ATC1
ATCS
ATCS
m1
c
c
0
QM
RATE OF OUTPUT
(units per period)
0
ATCS
ATC2
m2
QM
RATE OF OUTPUT
(units per period)
m3
c
0
QM
RATE OF OUTPUT
(units per period)
QUESTIONS?