1. Ch. 10: ORGANIZING PRODUCTION
Definition of a firm
The economic problems that all firms face
Technological vs. economic efficiency
The principal-agent problem
Different types of markets in which firms operate
Explain why markets coordinate some economic activities and firms coordinate others

2. The Firm and Its Economic Problem
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
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 of production includes
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
The firm can buy capital and incur an implicit opportunity cost of using its own capital, called the implicit rental rate of capital which includes
Economic depreciation
change in the market value of capital over a given period.
Differs from accounting depreciation.
Interest forgone
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. Economic Profits influence 5 Major Decisions for the Firm
What to produce and in what quantities
How to produce
How to compensate managers and workers
How to market and price products
What to produce itself and what to buy from other firms

8. Technological vs. Economic Efficiency
Technological efficiency
occurs when a firm produces a given level of output by using the least amount of inputs.
There may be different combinations of inputs to use for producing a given level of output.
Economic efficiency
occurs when the firm produces a given level of output at the least cost.
economically efficient method depends on the relative costs of capital and labor

9. Information and Organization
Command system
uses a managerial hierarchy.
Commands pass downward through the hierarchy and information (feedback) passes upward.
Problem: must monitor.
Incentive system
Rewards to induce workers to perform in ways that maximize the firm’s profit.
Problem:
Sometimes difficult to create proper incentives.
Principal agent problem.
Ownership
Incentive pay

10. Information and Organization
3 Types of Business Organization
Proprietorship
Partnership
Corporation

11. Information and Organization
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.

12. 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.

13. Information and Organization
Corporation
owned by one or more stockholders with limited liability,
The personal wealth of the stockholders is not at risk if the firm goes bankrupt.
The profit of corporations is taxed twice
corporate tax on firm profits
income taxes paid by stockholders on dividends.

14. 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

15. Pros and Cons of Different Types of Firms
Partnerships
Easy to set up
Employ diversified decision-making processes
Can survive the death or withdrawal of a partner
Profits are taxed only once
partnerships make attaining a consensus about managerial decisions difficult
Place the owners’ entire wealth at risk
The cost of capital can be high, and the withdrawal of a partner might create a capital shortage

16. Pros and Cons of Different Types of Firms
A corporation
Perpetual life
Easy to dissolve
Limited liability for its owners
Large-scale and low-cost access to financial capital
lead to slower and expensive decision-making
Profit is taxed twice—as corporate profit and shareholder income.

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

18. Types of Markets Perfect competition Monopolistic competition
Oligopoly
Monopoly

19. Name a business that you consider to be a monopoly (provide first 4 letters of name).

20. Perfect competition 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.

21. Monopolistic competition
Many firms
product differentiation
Each firm possesses an element of market power
No restrictions on entry of new firms to the industry

22. Oligopoly A small number of firms compete
The firms might produce almost identical products or differentiated products
Barriers to entry limit entry into the market.

23. 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

24. 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

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

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

27. Suppose there are 10 firms in an industry with market shares of 40%, 20%, and 8 firms with 5% each. What is the HHI? (Give answer to nearest integer – e.g. 1100)

28. Suppose there are 10 firms in an industry with market shares of 40%, 20%, and 8 firms with 5% each. If the two largest firms merge, how much will the HHI increase? (Give answer to nearest integer – e.g. 1100)

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

30. Markets and Firms Why Firms?
Firms coordinate production when they can do so more efficiently than a market.
Four key reasons might make firms more efficient than market.
Lower transactions costs
Economies of scale
Economies of scope
Economies of team production