1. Chapter 5 The Firm: Production and Cost

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-2 Learning Objectives List the advantages and disadvantages of the sole proprietorship, partnership, and corporation. Distinguish between average and marginal product and relate this distinction to the law of diminishing returns. Define and distinguish between fixed and variable costs and explain why marginal costs are the most important guide to decisions. Explain how to calculate economic profits and why they differ from accounting profits.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-3 Types of Business Organizations The three main types of business organizations in the United States are: (1) the sole proprietorship, (2) the partnership, and (3) the corporation. There are also certain hybrid forms of these types of business organizations, which have become more popular in recent years.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-4 Sole Proprietorship This is a business owned by one person. Advantages: the proprietor answers to no one else when making decisions about how run the business, and the owner receives all of the profits. Disadvantage: the owner has unlimited liability, meaning that he or she has complete legal responsibility for all debts and damages arising from doing business.

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-5 Partnerships This is a business that two or more individuals own and operate. Advantages: more than one person is available for specialized management, partners can pool their financial capital in order to have a larger business base.

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-6 Partnerships (cont.) Disadvantages: partners have unlimited liability for debts incurred while in business—if one partner cannot pay his or her share of a debt, the other partner or partners have to ante up the rest; also, when a partner decides to leave the partnership or dies, the partnership normally ends—it must be reorganized.

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-7 Corporations A corporation is a legal entity that may conduct business in its own name just as an individual does. The owners of a corporation are called shareholders. Advantage: By law, shareholders enjoy limited liability—up to the value of their shares. Disadvantage: Double taxation of corporate income.

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-8 Table 5-1: Forms of Business Organization

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-9 Hybrids S Corporation—a corporation in which all of the net profits are passed directly to the individual owner or owners, and are taxed as their income. The Limited Liability Company, or LLC—in addition to avoiding double taxation, LLC’s also have the limited liabilities of a corporation.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-10 Businesses A business firm has a goal—profits. To make profits, business firms combine land, labor, capital, and entrepreneurship. A combination of these factors of production constitutes the inputs into the production process.

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-11 The Production Function A business takes all of its inputs and combines them to produce an output. Hence, output is some function of inputs. Assuming that all inputs are fixed except the labor input, there exists a production function that relates output per some specific time period with the amount of labor input used.

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-12 The Production Function The physical output of each worker is called physical product. Average Physical Product is equal to total output divided by the number of workers. Marginal Physical Product of labor is the change in total output that occurs when a worker joins an existing production process.

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-13 Law of Diminishing Marginal Returns As successive equal increases in a variable factor of production (such as labor) are added to fixed factors of production, there will be a point beyond which the extra, or marginal, product that can be attributed to each additional unit of the variable factor of production will decline.

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-14 The Firm Faces Its Costs All firms have costs. Businesses need to have a handle on what their costs are in order to determine whether they are producing the way they should and even whether they should stay in business. In order to analyze costs correctly, we must look at the different types of costs that each firm encounters.

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-15 Fixed Costs Some costs are fixed in the short run. Fixed costs are those cost that by definition cannot change. In other words, fixed costs to not vary with the rate of output. For example, monthly rent of an office space.

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-16 Variable Costs Variable costs change with the level of output. Labor costs normally are variable costs. Businesses can hire and fire without too much trouble. They can also have workers increase hours or decrease hours.

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-17 Total Costs When you add up all fixed costs and all variable costs, you end up with total costs. In Figure 5-2, next, we graph total costs, total variable costs, and total fixed costs. To do so, we put total costs in dollars on the vertical axis and output on the horizontal axis.

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-18 Figure 5-2: Total Cost Curves

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-19 Average Costs

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-20 Marginal Costs Firms are very interested in their marginal costs—costs that result from a one-unit change in the production rate. Typically, marginal costs of production fall as output increases up to a certain point and then start to rise.

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-21 The Short Run and the Long Run The short run is defined as the period during which the firm effectively cannot alter all of its inputs. The long run is defined as a period long enough that the firm can change all of these inputs.

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-22 In the Long Run, There Are No Fixed Costs In the long run, all costs are marginal costs and therefore all decisions are decisions made on the margin that considers the usage of all inputs.

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-23 Accounting Profits Explicit costs are expenses that business managers must take into account of because they must directly be paid by the firm such as taxes, rent, and workers’ salaries.

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-24 Economic Profits Economic Profits are calculated by considering not only explicit costs, but also the opportunity cost of all other inputs used by the firm. Economics profits total revenues total opportunity cost of all inputs used = –

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-25 Figure 5-5: Simplified View of Economic and Accounting Profits

26. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-26 Profits Are What Matters To be more accurate, we say that the firm wishes to maximize economic profits. This means that the firm is expected to try to make as great as possible the positive difference between total revenues and the total opportunity cost of all production inputs.

27. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-27 Key Terms and Concepts accounting profits average fixed costs average physical product average total cost average variable costs corporation costs economic profits explicit fixed costs law of diminishing returns limited liability limited liability company (LLC)

28. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.5-28 Key Terms and Concepts (cont.) marginal costs marginal physical product partnership production function S corporations short run sole proprietorship total costs unlimited liability variable costs