Organizing Production

After studying this chapter you will be able to
Explain what a firm is and describe the economic problems that all firms face
Distinguish between technological efficiency and economic efficiency
Define and explain the principal-agent problem and describe how different types of business organizations cope with this problem
Describe and distinguish between different types of markets in which firms operate
Explain why markets coordinate some economic activities and firms coordinate others

The invention of the World Wide Web has paved the way for the creation of thousands of profitable businesses, such as Google, Inc.
How do Google and the other 20 million firms in the United States make their business decisions?
Most of the firms don’t make things; they buy and sell things. For example, Apple doesn’t make the iPod. Toshiba makes the iPod’s hard drive and display module and Inventec assembles the iPod.
Why doesn’t Apple make its iPod?
How do firms decide what to make themselves and what to buy from other firms?

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 Goal
A firm’s goal is to maximize profit.
If the firm fails to maximize its profit, the firm is either eliminated or bought out by other firms seeking to maximize profit.

Accounting Profit
Accountants measure a firm’s profit to ensure that the firm pays the correct amount of tax and to show it investors how their funds are being used.
π=TR-TC=Profit equals total revenue minus total cost
Accountants use Internal Revenue Service rules based on standards established by the Financial Accounting Standards Board to calculate a firm’s depreciation cost.
The Firm and Its Economic Problem

Economic Profit
Economists measure a firm’s profit to enable them to predict the firm’s decisions, and the goal of these decisions in to maximize economic profit.
Economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production.
The Firm and Its Economic Problem

A Firm’s Opportunity Cost of Production
A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.
A firm’s opportunity cost of production is the sum of the cost of using resources
Bought in the market
Owned by the firm
Supplied by the firm's owner
The Firm and Its Economic Problem

Resources Bought in the Market
The amount spent by a firm on resources bought in the market is an opportunity cost of production because the firm could have bought different resources to produce some other good or service.
The Firm and Its Economic Problem

Resources Owned by the Firm
If the firm owns capital and uses it to produce its output, then the firm incur an opportunity cost.
The firm incurs an opportunity cost of production because it could have sold the capital and rented capital from another firm.
The firm implicitly rent the capital from itself.
The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital.
The Firm and Its Economic Problem

The implicit rental rate of capital is made up of
1. Economic depreciation
2. 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

Resources Supplied by the Firm’s Owner
The owner might supply both entrepreneurship and labor.
The return to entrepreneurship is profit.
The profit that an entrepreneur can expect to receive on average is called normal profit.
Normal profit is the cost of entrepreneurship and is a cost of production.
The Firm and Its Economic Problem

In addition to supplying entrepreneurship, the owner might supply labor but not take as wage.
The opportunity cost of the owner’s labor is the wage income forgone by not taking the best alternative job.
Economic Accounting: A Summary
Economic profit equals a firm’s total revenue minus its total opportunity cost of production.
The example in Table 10.1 on the next slide summarizes the economic accounting.
The Firm and Its Economic Problem

The Firm and Its Economic Problem

The Firm’s Decisions
To maximize profit, a firm must make five basic decisions:
1. What to produce and in what quantities
2. How to produce
3. How to organize and compensate its managers and workers
4. How to market and price its products
5. What to produce itself and what to buy from other firms
The Firm and Its Economic Problem

The Firm’s Constraints
The firm’s profit is limited by three features of the environment:
Technology constraints
Information constraints
Market constraints
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.
The Firm and Its Economic Problem

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 good, but only one of them is technologically inefficient.
If it is impossible to produce a given good by decreasing any one input, holding all other inputs constant, then production is technologically efficient.

Technology and Economic Efficiency
Table 10.2 sets out the labor and capital required to produce 10 TVs a day by four methods A, B, C, and D.
Which methods are technologically efficient?

Economic Efficiency
Economic efficiency occurs when the firm produces a given level of output at the least cost.
The economically efficient method depends on the relative costs of capital and labor.
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.
Table 10.3 on the next slide illustrates how the economically efficient method depends on the relative costs of resources.
Technology and Economic Efficiency

Technology and Economic Efficiency
When the wage rate is $75 a day and the rental rate is $250 a day, Method B is the economically efficient method.
When the wage rate is $150 a day and the rental rate is $1 a day, Method A is the economically efficient method.
When the wage rate is $1 a day and the rental rate is $1,000 a day, Method C is the economically efficient method.

Information and Organization
A firm organizes production by combining and coordinating productive resources using a mixture of two systems:
Command systems
Incentive systems

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 is a method of organizing production that uses a market-like mechanism 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.
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 principals.
Long-term contracts can tie managers’ or workers’ long-term 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.
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

Pros and Cons of Different Types of Firms
Each type of business organization has advantages and disadvantages.
Table 10.4 summarizes the pros and cons of different types of firms.
Information and Organization

Proprietorships
Are easy to set up
Managerial decision making is simple
Profits are taxed only once as owner’s income
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 withdrawal of a partner
Profits are taxed only once
But achieving a consensus about managerial decisions difficult
Owners’ entire wealth is at risk
Capital is expensive
Information and Organization

Corporation
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 complex management structure may lead to slow and expensive
Profits taxed twice—as corporate profit and shareholder income.
Information and Organization

Markets and the Competitive Environment
Economists identify four market types:
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly

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 about 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.
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.
Markets and the Competitive Environment

Measures of Concentration
Economists use two measures of market concentration:
The four-firm concentration ratio
The Herfindahl–Hirschman index (HHI)
The larger the measure of market concentration, the less competition that exists in the industry.
Markets and the Competitive Environment

The Four-Firm Concentration Ratio
The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry.
Table 10.5 on the next slide shows two calculations of the four-firm concentration ratio.
Markets and the Competitive Environment

Markets and the Competitive Environment

The Herfindahl–Hirschman Index
The Herfindahl–Hirschman index (HHI) is the square of percentage market share of each firm summed over the largest 50 firms in the industry.
For example, if there are four firms in a market and the market shares are 50 percent, 25 percent, 15 percent, and 10 percent,
HHI = 502 + 252 + 152 + 102 = 3,450.
Markets and the Competitive Environment

Markets and the Competitive Environment
Concentration Measures for the U.S. Economy
Figure 9.2 shows some concentration ratios and HHIs for the United States.
Concentration measures are a useful indicator of the degree of competition in a market.
A market with an HHI of less than 1,000 is regarded as being highly competitive.
A market with an HHI between 1,000 and 1,800 is regarded as being moderately competitive.
A market with an HHI greater than 1,800 is regarded as being uncompetitive.

Markets and the Competitive Environment
Figure 10.2 shows the four-firm concentration ratio for various industries in the United States.

Limitations of Concentration Measures
The main limitations of only using concentration measure as determinants of market structure are
The geographical scope of the market
Barriers to entry and firm turnover
The correspondence between a market and an industry
Markets and the Competitive Environment

Markets and the Competitive Environment
Market Structures in the U.S. Economy
Figure 9.3 shows the distribution of market structures in the North American economy.
The economy is mainly competitive.

Markets and Firms
Market Coordination
Markets both coordinate production.
Chapter 3 explains how demand and supply coordinate the plans of buyers and sellers.
Outsourcing—buying parts or products from other firms—is an example of market coordination of production.
But firms coordinate more production than do markets.
Why?

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
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.
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.
Markets and Firms

Terms Along the Way
firm
corporation
stock
bond
profit (economic profit)
total revenue
total cost
explicit cost
implicit opportunity cost (implicit cost)
normal profit
excess profit
loss
breakeven
principal – agent problem

Test Yourself
1.Which is not a legal form of business?
Sole proprietorship.
Partnership.
Corporation.
Limited liability.

Test Yourself
2. The stock exchanges are an example of a
primary market.
secondary market.
sole proprietorship.
mutual fund.