Economics by David Begg, Gianluigi Vernasca, Stanley Fischer & Rudiger Dornbusch TENTH EDITION ©McGraw-Hill Companies, 2010 Chapter 6 Introducing supply decisions

Forms of business organization Sole trader –owned by an individual; entitled to income and responsible for losses Partnership –jointly owned by two or more people –unlimited liability Company –ownership divided among shareholders –legal entitlement to produce and trade –limited liability –shares of public companies resold on the stock exchange ©McGraw-Hill Companies, 2010

Some key terms Revenues –the amount a firm earns by selling goods and services in a given period Costs –the expenses incurred in producing goods and services during the period Profits –the excess of revenues over costs ©McGraw-Hill Companies, 2010

Limited liability Shareholders of a company have limited liability. The most they can lose is the money they spent buying shares. Unlike sole traders and partners, shareholders cannot be forced to sell their personal possessions if the business goes bust. At worst, the shares become worthless. ©McGraw-Hill Companies, 2010

Some accounting terms Cash flow –the net amount of money received (by the firm) during the accounting period Physical capital –machinery, equipment and buildings used in production Depreciation –the loss in value of a capital good during the accounting period Inventories –goods held in stock by the firm for future sales ©McGraw-Hill Companies, 2010

A firm’s balance sheet Assets –what the firm owns Liabilities –what the firm owes Balance sheet –lists a firm’s assets and liabilities at a point in time ©McGraw-Hill Companies, 2010

Costs and the economist Accounting cost –actual payments made by a firm in a period Opportunity cost –amount lost by not using a resource in its best alternative use Economists include opportunity cost in a firm’s total costs ©McGraw-Hill Companies, 2010

Supernormal profits – Economic costs relate to all the costs incurred by the firm. They include the opportunity costs of all resources used in production. –They thus include the opportunity cost of financial capital used in the firm. – Supernormal profit is the pure profit accruing to the owners after allowing for all economic costs. ©McGraw-Hill Companies, 2010

The production decision For any output level, the firm attempts to minimize costs. Assume the firm aims to maximize profits. Profits depend on both COSTS and REVENUE, –each of which varies with the level of output. Marginal cost (MC) is the rise in total cost if output increases by 1 unit. Marginal revenue (MR) is the rise in total revenue if output increases by 1 unit. ©McGraw-Hill Companies, 2010

Table 6.3 Cost, revenue, profit (weekly)

©McGraw-Hill Companies, 2010 Table 6.4 Total and marginal cost Finding Marginal Cost

©McGraw-Hill Companies, 2010 (1)(2) OutputTRMR 00 _ Finding Marginal Revenue Total and marginal revenue

©McGraw-Hill Companies, 2010

Maximizing profits Output Q1Q1 E MC, MR 0 If MR > MC, an increase in output will increase profits. If MR < MC, a decrease in output will increase profits. So profits are maximized when MR = MC at Q 1 (as long as the firm covers variable costs). ©McGraw-Hill Companies, 2010

Table 6.6 Using marginal revenue and marginal cost to choose output

©McGraw-Hill Companies, 2010 Table 6.7 The firm’s output choice

©McGraw-Hill Companies, 2010

Figure 6.4 An increase in marginal cost reduces output (K)

©McGraw-Hill Companies, 2010 Figure 6.5 An upward shift in marginal revenue increases output A shift in demand (K)

A shift in demand Output Q1Q1 E MC, MR 0 E' Q2Q2 A shift of marginal revenue from MR to MR' Optimal output increases from Q 1 to Q 2, This shift in the MR curve could come from an increase in the number of customers in the market Leads the interaction point between MR and MC to shift from E to E' ©McGraw-Hill Companies, 2010

Will firms try to maximize profits? Large firms are not run by their owners –there is separation of ownership and control Managers may pursue different objectives –e.g. size, growth But firms not maximizing profits may be vulnerable to takeover –or managers may be given share options to influence their incentive to maximize profits ©McGraw-Hill Companies, 2010

Sources of finance Borrowing from banks Borrowing by selling pieces of paper (corporate bonds) whereby the firm promises to pay interest for a specified period and then repay the debt Using the stock market for selling new shares in the firm ©McGraw-Hill Companies, 2010