1. ORGANIZING PRODUCTION How firms make decisions 9 CHAPTER Dr. Gomis-Porqueras ECO 680

2. Residual Claimants In a market economy, firm owners are residual claimants. They have right to any revenue after costs have been paid. Provides a strong incentive for owners to keep costs of producing output low.

3. 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 Objective 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.

4. 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.

5. 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

6. 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.

7. 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.

8. 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.

9. The (opportunity) cost of producing the item indicates the desire of consumers for other goods. Economic Role of Costs The demand for a product indicates the intensity of consumer’s desires for an item.

10. 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.

11. 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

12. 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

13. 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.

14. 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.

15. 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.

16. Technology and Economic Efficiency Technological Efficiency Technological efficiency occurs when a firm produces a given level of output by using the least amount inputs. 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.

17. Technology and Economic Efficiency Economic Efficiency Economic efficiency occurs when the firm produces a given level of output at the least cost. 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.

18. 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.

19. Improving Inventory Control at Wal-Mart Better inventory controls have helped reduce firms’ costs.

20. In a price taker market, Marginal Revenue = market price. Marginal Revenue is the change in total revenue divided by the change in output. Marginal Revenue = (MR) the change in total revenue the change in output

21. MC will decline initially, reach a minimum, and then rise. Marginal Cost Marginal Cost (MC) is the increase in total cost associated with a one-unit increase in production.

22. MC Marginal Revenue (MR) Output Marginal Cost (MC) Profit (TR - TC) 0 1 2 8 9 10 11 12 13 14 15 16 17 18 19 20 21. Price and Cost Per Unit 1 3 7 9 ---- 5 5 5 5 5 $ 4.80 $ 3.95 $ 1.50 $ 1.25 $ 1.00 - 25.00 - 24.80 - 23.75 5 5 5 5 5 5 5 5 5 5 5 $ 1.25 $ 1.75 $ 2.50 $ 3.50 $ 4.75 $ 6.00 $ 7.25 $ 8.25 $ 9.50 $ 13.00 5 $ 17.00........ - 8.00 - 4.25 -.25 3.50 6.75 9.25 10.75 11.00 10.00 7.75 4.50 0.00 - 8.00 - 20.00 Below, low levels of output deliver marginal revenue to the firm greater than the marginal cost of increased output. After some point, though, additional units cost more than their marginal revenue. MR... Profit Maximum P = MR = MC Profit is maximized where P = MR = MC. 108 6 42 1214 16 18 20 Output Level 22

23. TFC TC TVC 0 Total Costs 4 2 Here we graph the general shape of the firm’s short-run total cost curves. 50 100 150 200 6 8 50 10 TC TVC TFC Output per day 1 2 3 4 5 6 7 8 9 10 0 15 25 34 42 52 64 79 98 122 152 Note that total fixed costs are flat and remain the same for 0 units or 11 units. Output Total Costs Curves = + 11 202 50 65 75 84 92 102 114 129 148 172 202 252 12 250 Note that total variable costs increase as more variable inputs are utilized. As total costs are the combination of TVC and TFC, they are everywhere positive and increase sharply with output

24. Information and Organization A firm organizes production by combining and coordinating productive resources using a mixture of two systems:  Command systems  Incentive systems

25. Information and Organization Command Systems A command system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management.

26. Information and Organization Incentive Systems An incentive system, uses market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.

27. Information and Organization Mixing the Systems Most firms use a mix of command and incentive systems to maximize profit. They use commands when it is easy to monitor performance or when a small deviation from the ideal performance is very costly. They use incentives whenever monitoring performance is impossible or too costly to be worth doing.

28. Information and Organization The Principal-Agent Problem The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. For example, the stockholders of a firm are the principals and the managers of the firm are their agents. Firm owners face this problem when dealing with workers.

29. Example: Long coffee break. Control with incentives and monitoring. Shirking With team production owners must reduce the problem of shirking.-employees working at less than normal rate of productivity.

30. Information and Organization Coping with the Principal-Agent Problem Three ways of coping with the principal-agent problem are:  Ownership  Incentive pay  Long-term contracts

31. Information and Organization Ownership, often offered to managers, gives the managers an incentive to maximize the firm’s profits, which is the goal of the owners, the principals. Incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal. Long-term contracts can tie managers’ or workers’ long- term rewards to the long-term performance of the firm. This arrangement encourages the agents work in the best long-term interests of the firm owners, the principals.

32. Empirical Evidence Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-for- performance schemes, they are less likely to help their coworkers.Australian This is particularly important in those jobs that involve strong elements of ‘team production” where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team.team production Studies suggest that profit-sharing, for example, typically raises productivity by 3-5%.

33. Empirical Evidence Fernie and Metcalf (1996) find that British jockeys perform significantly better when offered prizes for winning races compared to being on fixed retainers. McMillan, Whalley and Zhu (1989) and Groves et al (1994) look at Chinese agricultural and industrial data respectively and find significant incentive effects. Kahn and Sherer (1990) find that better evaluations of white-collar office workers were achieved by those employees who had a steeper relation between evaluations and pay.

34. Information and Organization Types of Business Organization There are three types of business organization:  Proprietorship  Partnership  Corporation

35. Information and Organization Proprietorship A proprietorship is a firm with a single owner who has unlimited liability, or legal responsibility for all debts incurred by the firm—up to an amount equal to the entire wealth of the owner. The proprietor also makes management decisions and receives the firm’s profit. Profits are taxed the same as the owner’s other income.

36. Information and Organization Partnership A partnership is a firm with two or more owners who have unlimited liability. Partners must agree on a management structure and how to divide up the profits. Profits from partnerships are taxed as the personal income of the owners.

37. Information and Organization Corporation A corporation is owned by one or more stockholders with limited liability, which means the owners who have legal liability only for the initial value of their investment. The personal wealth of the stockholders is not at risk if the firm goes bankrupt. The profit of corporations is taxed twice—once as a corporate tax on firm profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.

38. Information and Organization  Proprietorships are easy to set up  Managerial decision making is simple  Profits are taxed only once  But bad decisions made by the manager are not subject to review  The owner’s entire wealth is at stake  The firm dies with the owner  The cost of capital and labor can be high

39. Information and Organization  Partnerships are easy to set up  Employ diversified decision-making processes  Can survive the death or withdrawal of a partner  Profits are taxed only once  But 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

40. Information and Organization  A corporation offers perpetual life  Limited liability for its owners  Large-scale and low-cost capital that is readily available  Professional management  Lower costs from long-term labor contracts  But a corporation’s management structure may lead to slower and expensive decision-making  Profit is taxed twice—as corporate profit and shareholder income.

41. Information and Organization The Relative Importance of Different Types and Firms There are a greater number of proprietorships than other form of business, but corporations account for the majority of revenue received by businesses.

42. Information and Organization Figure 9.1(a) shows the frequency of each type of business organization. Figure 9.1(b) shows the dominant type of business organization for various industries.

43. Markets and the Competitive Environment Economists identify four market types:  Perfect competition  Monopolistic competition  Oligopoly  Monopoly

44. 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.

45. 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

46. 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.

47. Incentive to Collude Oligopolists have a strong incentive to collude and raise their prices. Each firm has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand curve. This conflict makes collusive agreements difficult to maintain.

48. Oligopolies A cartel is an organization through which members jointly make decisions about prices and production (OPEC). In the United States, antitrust laws prevent firms from obvious collusion and from forming a cartel. However, there are legally sanctioned cartels in the United States. The NCAA is an example. Participation is restricted to member colleges. The American Medical Association (AMA). You may have a great remedy for colds, but you are not allowed to open a medical practice until you meet the requirements of the AMA.

49. 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

50. Monopolies Before "Ma Bell" or AT&T was broken up in 1982, Bell controlled all of the local and long distance phone business in the U.S.A. Prices were high, service was bad and Bell was using it's control of the local phone exchanges to restrict competitors access to the long distance market. In an agreed settlement Bell was broken up into the regional baby bells which where given the local phone market and AT&T which had the long distance market.

51. Markets and the Competitive Environment Figure 9.2 shows the four-firm concentration ratio for various industries in the United States.

52. Markets and the Competitive Environment Market Structures in the U.S. Economy Figure 9.3 shows the distribution of market structures in the U.S. economy. The economy is mainly competitive.

53. Why Do Governments Allow Monopolies? Examples: - Power to tax future generations - Easier to borrow - Easier to take long term projects - Longer time horizon than private firms - Introduce some standards - Public safety

54. Markets and the Competitive Environment Market Structures in the U.S. Economy Figure 9.3 shows the distribution of market structures in the U.S. economy. The economy is mainly competitive.

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

56. Markets and Firms Transactions costs are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled. Economies of scale occur when the cost of producing a unit of a good falls as its output rate increases.

57. Markets and Firms Economies of scope arise when a firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise. Firms can engage in team production, in which the individuals specialize in mutually supporting tasks.

58. Summary