1. Ch. 10: ORGANIZING PRODUCTION  Definition of a firm  The economic problems that firms face  Technological vs. economic efficiency  Different types of markets in which firms operate

2. The Firm and Its Economic Problem Firm –an institution that hires factors of production and organizes them to produce and sell goods or services. Firm’s Goal –Maximize economic profit. –If the firm fails to maximize economic profits, it is either eliminated or bought out by other firms seeking to maximize profit.

3. Accounting vs Economic Profits Accounting profits –uses rules established by the IRS and/or the Financial Accounting Standards Board. –Goals are to report profit so that the firm pays the correct amount of tax Truthful representation of financial situation Economic profits –Measure based on an opportunity cost measure of cost. Primary difference between accounting and economic profits is in measurement of costs.

4. Opportunity Cost –best forgone alternative use of its factors of production, usually measured in dollars. –Two parts  Explicit costs  costs paid directly in money  Implicit costs  Opportunity cost of owner’s resources for which no direct money payment is made.

5. Cost of capital can be explicit or implicit –The firm can rent its capital and pay an explicit rental rate –If firm buys capital, the implicit rental rate of capital includes –Economic depreciation  change in the market value of capital over a given period.  Differs from accounting depreciation.  Foregone Interest »the foregone return on the funds used to acquire the capital.

6. Economic vs. Accounting Profit Accounting Profit = TR – Explicit Costs Economic Profit = TR – Opportunity Costs of production = TR – Expl. Costs – Impl. Costs = Acc. Profits – Implicit Costs If Economic Profit > 0  Acc Profits > Implicit Costs  Firms enter If Economic Profit < 0  Acc Profits < Implicit Costs  Firms exit

7. Technological vs. Economic Efficiency Technological efficiency –when a firm produces a given level of output by using the least amount of inputs. –different combinations of inputs can achieve technological efficiency Economic efficiency –when the firm produces a given level of output at the least cost. –requires technological efficiency –depends on the relative costs of capital and labor

8. 3 Types of Business Organization –Proprietorship – Partnership – Corporation Information and Organization

9. Proprietorship  single owner  unlimited liability  proprietor makes management decisions and receives the firm’s profit.  profits are taxed the same as the owner’s other income.

10. Information and Organization Partnership  two or more owners  unlimited liability.  partners must agree on a management structure and how to divide up the profits.  profits are taxed as the personal income of the owners.

11. Information and Organization Corporation  owned by one or more stockholders  limited liability  Profits are taxed twice corporate tax on firm profits income taxes paid by stockholders on dividends.

12. Pros and Cons of Different Types of Firms Proprietorships Easy to set up Managerial decision making is simple Profits are taxed only once The owner’s entire wealth is at stake The firm dies with the owner The cost of capital and labor can be high

13. Pros and Cons of Different Types of Firms Partnerships easy to set up diversified decision-making processes survives the death or withdrawal of a partner profits taxed only once attaining a consensus about managerial decisions difficult owners’ entire wealth at risk cost of capital can be high, and the withdrawal of a partner might create a capital shortage

14. Pros and Cons of Different Types of Firms Corporations  Perpetual life  Easy to dissolve  Limited liability  Large-scale and low-cost access to financial capital  Slower and expensive decision-making  Profits taxed

15. Information and Organization # of proprietorships vs. share of revenue? Why does type of organization differ across industries?

16.  Perfect competition  Monopolistic competition  Oligopoly  Monopoly Types of Markets

17. Perfect competition  Many firms  Homogeneous products  No single firm can control price  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.

18. Monopolistic competition  Many firms  Product differentiation  Each firm possesses an element of market power (i.e. can control price)  No restrictions on entry of new firms to the industry

19. Oligopoly  A small number of firms compete  The firms might produce homogeneous or differentiated products  Barriers to entry limit entry into the market.  Firms anticipate how other firms will respond to a change in price, quality, or advertising.

20. Monopoly  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

21. Measures of Concentration The four-firm concentration ratio  Sum of market shares for 4 largest firms. The Herfindahl–Hirschman index (HHI)  Sum of squared market shares for all firms.  DOJ uses the HHI to classify markets.  HHI<1,000  highly competitive  1000<HHI<1800  moderately competitive  HHI>1800  not competitive (oligopoly, monopoly)

22. Measures of Concentration 4 firm CR and HHI for various industries in the United States.

23. Measures of Concentration Limitations of Concentration Measures as measures of competition.  Geographic boundaries  Product boundaries.  Barriers to Entry  Ability to Collude

24. Markets and the Competitive Environment The economy is mainly competitive. Has become more competitive over time

25. Markets and Firms Why Firms? –Firms coordinate production when they can do so more efficiently than a market. –Reasons firms could be more efficient than market Lower transactions costs Economies of scale Economies of scope Principal-Agent problem can make firms less efficient.