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Ch. 9: ORGANIZING PRODUCTION

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Ch. 9: ORGANIZING PRODUCTION Definition of a firm The economic problems that all firms face Technological vs. economic efficiency The principal-agent problem – PowerPoint PPT presentation

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Title: Ch. 9: ORGANIZING PRODUCTION


1
Ch. 9 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
  • Firm
  • an institution that hires factors of production
    and organizes them to produce and sell goods or
    services.
  • Firms 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
  • measures a firms profit using rules established
    by the IRS and/or the Financial Accounting
    Standards Board.
  • 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.
  • Economic profits
  • measure profit based on an opportunity cost
    measure of cost.
  • Primary difference between accounting and
    economic profits is in measurement of costs.

4
  • Opportunity Cost
  • 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 of production includes
  • Explicit costs
  • Implicit costs

5
  • Explicit costs
  • costs paid directly in money
  • wages, materials, utilities, rent, etc.
  • Implicit costs
  • costs incurred when a firm uses the owners own
    capital or time for which it does not make a
    direct money payment.
  • Implicit costs of labor
  • 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.

6
  • 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.
  • The implicit rental rate of capital is made up
    of
  • 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.

7
A firm pays 1 for a machine on 1/1/2008. Its
market value drops to 800,00 by 12/31/2008. The
interest rate is 10. Whats the implicit
annual rental rate on the capital?
  1. 100,000
  2. 200,000
  3. 300,000
  4. 400,000

8
A farmer owns 1000 acres of that he could rent to
someone else for 100 per acre per year. The
value of the land is currently 1000 per acre and
is expected to rise at 3 per year. The farmer
could earn an interest rate of 5 on any money he
invests elsewhere. What is the opportunity cost
of of using one acre of land in his own business?
  1. 100
  2. 300
  3. 400
  4. 500

9
  • 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 gt 0 ? Acc Profits gt Implicit
    Costs ? Firms enter
  • If Economic Profit lt 0 ? Acc Profits lt Implicit
    Costs ? Firms exit

10
5 Decisions for the Firmto Maximize Profits
  • 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

11
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

12
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 firms profit.
  • Problem
  • Sometimes difficult to create proper incentives.
  • Principal agent problem.
  • Ownership
  • Incentive pay

13
Information and Organization
  • 3 Types of Business Organization
  • Proprietorship
  • Partnership
  • Corporation

14
Information and Organization
  • Proprietorship
  • single owner
  • unlimited liability
  • proprietor makes management decisions and
    receives the firms profit.
  • profits are taxed the same as the owners other
    income.

15
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.

16
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.

17
Pros and Cons of Different Types of Firms
  • Proprietorships
  • easy to set up
  • Managerial decision making is simple
  • Profits are taxed only once
  • The owners entire wealth is at stake
  • The firm dies with the owner
  • The cost of capital and labor can be high

18
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

19
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 twiceas corporate profit and
    shareholder income.

20
Information and Organization
  • of proprietorships vs. share of revenue?
  • Why does type of organization differ across
    industries?

21
  • Types of Markets
  • Perfect competition
  • Monopolistic competition
  • Oligopoly
  • Monopoly

22
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.

23
Monopolistic competition
  • Many firms
  • product differentiation
  • Each firm possesses an element of market power
  • No restrictions on entry of new firms to the
    industry

24
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.

25
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

26
Name a local firm that you consider to be a
monopoly.







27
Name a firm that sells its product nationally
that you consider to be a monopoly.







28
Measures of Concentration
  • Two measures of market concentration in common
    use are
  • The four-firm concentration ratio
  • Sum of market shares for 4 largest firms.
  • The HerfindahlHirschman index (HHI)
  • Sum of squared market shares for all firms.
  • DOJ uses the HHI to classify markets.
  • HHIlt1,000 ? highly competitive
  • 1000ltHHIlt1800? moderately competitive
  • HHIgt1800 ? not competitive

29
Measures of Concentration
  • Limitations of Concentration Measures as Measures
    of Competition
  • Geographic boundaries
  • Product boundaries.
  • Barriers to Entry
  • Ability to Collude

30
Suppose there are 5 airlines that fly out of
Cincinnati with market shares of 50, 20, 10,
10 and 10. What is the four firm
concentration ratio?
  1. Choice One
  2. Choice Two
  3. Choice Three
  4. Choice Four

31
Suppose there are 5 airlines that fly out of
Cincinnati with market shares of 50, 20, 10,
10 and 10. What is the four firm
concentration ratio?







32
Suppose there are 5 airlines that fly out of
Cincinnati with market shares of 50, 20, 10,
10 and 10. What is the HHI?







33
Suppose there are 5 airlines that fly out of
Cincinnati with market shares of 50, 20, 10,
10 and 10. If two of the firms with 10 of
the market merge, what would the HHI be?







34
Measures of Concentration
  • 4 firm CR and HHI for various industries in the
    United States.

35
Markets and the Competitive Environment
  • The economy is mainly competitive.
  • Has become more competitive over time

36
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.
    Firms can achieve
  • Lower transactions costs
  • Economies of scale
  • Economies of scope
  • Economies of team production
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