ORGANIZING PRODUCTION

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

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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 Firms Objective
• A firms 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.

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The Firm and Its Economic Problem

• Measuring a Firms Profit
• Accountants measure a firms 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.

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The Firm and Its Economic Problem

• Opportunity Cost
• A firms decisions respond to opportunity cost
  and economic profit.
• A firms 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

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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.

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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.

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The Firm and Its Economic Problem

• The cost of the owners resources is his or her
  entrepreneurial ability and labor expended in
  running the business.
• The opportunity cost of the owners
  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 owners labor spent
  running the business is the wage income forgone
  by not working in the next best alternative job.

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Economic Role of Costs
The demand for a product indicates the intensity
of consumers desires for an item.
The (opportunity) cost of producing the item
indicates the desire of consumers for other goods.
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The Firm and Its Economic Problem

• Economic Profit
• Economic profit equals a firms total revenue
  minus its opportunity cost of production.
• A firms opportunity cost of production is the
  sum of the explicit costs and implicit costs.
• Normal profit is part of the firms opportunity
  costs, so economic profit is profit over and
  above normal profit.

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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 producethe 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

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The Firm and Its Economic Problem

• The Firms 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

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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.

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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.

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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.

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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.

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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.

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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.

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Improving Inventory Control at Wal-Mart
Better inventory controls have helped reduce
firms costs.
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Marginal Revenue
Marginal Revenue is the change in total revenue
divided by the change in output.
In a price taker market, Marginal Revenue
market price.
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Marginal Cost
Marginal Cost (MC) is the increase in total cost
associated with a one-unit increase in production.
MC will decline initially, reach a minimum, and
then rise.
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• Below, low levels of output deliver marginal
  revenue to the firm greater than the
  marginal cost of increased output.

----
----
- 25.00
5

• After some point, though, additional units
  cost more than their marginal revenue.

4.80
- 24.80
5
3.95
- 23.75
.
.
.
.
.

• Profit is maximized where P MR MC.

1.50
- 8.00
5
- 4.25
5
1.25
Price and CostPer Unit
- .25
5
1.00
9
5
1.25
3.50
5
6.75
1.75
7
5
9.25
2.50
MR
5
10.75
3.50
5
11.00
5
4.75
5
10.00
6.00
3
5
7.25
7.75
4.50
5
8.25
1
5
0.00
9.50
- 8.00
5
13.00
Output Level
- 20.00
17.00
5
10
8
4
2
6
12
14
16
18
20
22
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Total Costs Curves

• Here we graph the general shape of the
  firms short-run total cost curves.

TotalCosts

• Note that total fixed costs are flat and
  remain the same for 0 units or 11 units.

• Note that total variable costs increase as
  more variable inputs are utilized.

250

• As total costs are the combination of TVC and
  TFC, they are everywhere positive and increase
  sharply with output

200


Outputper day

TC
TVC
TFC
150
50
0
0
1
15
50
2
25
50
3
34
50
100
4
42
50
5
52
50
6
64
50
50
7
79
50
98
8
50
9
122
50
4
2
8
10
12
6
10
152
50
11
50
202
Output
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Information and Organization

• A firm organizes production by combining and
  coordinating productive resources using a mixture
  of two systems
• Command systems
• Incentive systems

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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.

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Information and Organization

• Incentive Systems
• An incentive system, uses market-like mechanisms
  to induce workers to perform in ways that
  maximize the firms profit.

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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.

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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.

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Shirking

• With team production owners must reduce the
  problem of shirking.-employees working at less
  than normal rate of productivity.

Example Long coffee break. Control with
incentives and monitoring.
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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

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Information and Organization

• Ownership, often offered to managers, gives the
  managers an incentive to maximize the firms
  profits, which is the goal of the owners, the
  principals.
• Incentive pay links managers or workers pay to
  the firms 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.

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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.
• 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.
• Studies suggest that profit-sharing, for example,
  typically raises productivity by 3-5.

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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.

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Information and Organization

• Types of Business Organization
• There are three types of business organization
• Proprietorship
• Partnership
• Corporation

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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
  firmup to an amount equal to the entire wealth
  of the owner.
• The proprietor also makes management decisions
  and receives the firms profit.
• Profits are taxed the same as the owners other
  income.

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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.

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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 twiceonce as
  a corporate tax on firm profits, and then again
  as income taxes paid by stockholders receiving
  their after-tax profits distributed as dividends.

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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 owners entire wealth is at stake
• The firm dies with the owner
• The cost of capital and labor can be high

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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

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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 corporations management structure may lead
  to slower and expensive decision-making
• Profit is taxed twiceas corporate profit and
  shareholder income.

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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.

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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.
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Markets and the Competitive Environment

• Economists identify four market types
• Perfect competition
• Monopolistic competition
• Oligopoly
• Monopoly

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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.

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Markets and the Competitive Environment

• Monopolistic competition is a market structure
  with
• Many firms
• Each firm produces similar but slightly different
  productscalled product differentiation
• Each firm possesses an element of market power
• No restrictions on entry of new firms to the
  industry

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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.

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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.
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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.

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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

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Monopolies

• Before "Ma Bell" or ATT 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 ATT which had the long
  distance market.

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Markets and the Competitive Environment

• Figure 9.2 shows the four-firm concentration
  ratio for various industries in the United
  States.

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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.

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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

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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.

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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

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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.
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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.

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Summary