9 ORGANIZING PRODUCTION CHAPTER

Objectives After studying this chapter, you will 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

Objectives After studying this chapter, you will able to Describe and distinguish between 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 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 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 Another day; another dollar profit—or 15 cents, after implicit costs. Emphasize the difference between accounting profit and economic profit when a firm owner is using cost information to make business decisions. Point out that only economic profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Stress that accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated according to strict, generally accepted accounting procedures (GAAP). Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy financial picture for the firm—to the detriment of the firm owners. Enron and Arthur Andersen: When is a cost really a cost? The Enron fiasco brought the subject of accuracy and completeness in cost assessment to the attention of investors everywhere. Suddenly, the validity of financial information on any financial statement issued by any publicly held company was under scrutiny. The implicit cost shuffle: Some subversive tools of the accounting trade. A very useful news article, written by financial reporter Ken Brown, appeared in the Wall Street Journal on Feb. 2, 2002. He summarized many popular ways to use accounting costs to understate opportunity costs on a financial statement while technically satisfying generally accepted accounting procedures: For example, his list includes: i) Understating the capital asset depreciation by failing to record recent declines in the true market valuation of the capital (rather than from physical decay); ii) using off-the-books agreements to hide debt and credit risk by partnering with another company to share liabilities (which was a key element of Enron’s ill-fated ploy); iii) capitalizing operating expenses, which allows current operating costs to be allocated over future time periods as if it were a capital depreciation expense.

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.

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. Table 9.1summarizes the economic accounting concepts.

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. Table 9.2 shows four ways of making a TV set, one of which is technologically inefficient. 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. Minimizing the quantity of resources used in production is not the same as minimizing the value of the resources used. Be sure that students appreciate the difference between technological efficiency and economic efficiency. Point out that technological efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally productive), there will inevitably be a difference between technological and economical efficiency.

Technology and Economic Efficiency Economic efficiency occurs when the firm produces a given level of output at the least cost. Table 9.3 shows how 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. Changes in the input prices influence the value of the inputs, but not the technological process for using them in production.

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.

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