CHAPTER 10 Organizing Production. TM 10-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain what a firm is and describe the economic.

CHAPTER 10Organizing Production

CHAPTER 10Organizing Production

TM 10-2Copyright © 1998 Addison Wesley Longman, Inc.

Learning Objectives

• Explain what a firm is and describe the economic problems that all firms face

• Define and explain the principal-agent problem

• Describe and distinguish among different forms of business organizations


Learning Objectives (cont.)

• Explain how firms finance their operations

• Calculate a firm’s opportunity cost and economic profit

• Explain why firms coordinate some economic activities and markets coordinate others


Learning Objectives





The Firm and ItsEconomic Problem

• Firm

• An institution that hires productive resources and that organizes those factors to produce and sell goods and services

• Primary economic problem firms face:

• Organization — firms must organize production by combining and coordinating its productive resources


Command Systems

• Command systems are based upon a managerial hierarchy.

• Incentive systems are market-like mechanisms that firms create within their organizations.

• These systems are designed to strengthen incentives and raise productivity.


Learning Objectives





The Principal-Agent Problem

• Principal-agent problem

• The problem of devising compensation rules that induce an agent to act in the best interest of the principal

• Three methods of coping• Ownership

• Incentive pay

• Long-term contracts


Uncertainty About the Future

• Another fundamental problem is uncertainty about the future.• sales

• costs

• future competition


Learning Objectives





The Forms of Business Organization

• Proprietorship • a firm with a single owner

• Partnership • a firm with two or more owners who have

unlimited liability

• Corporation • a firm owned by one or more limited liability

stockholders


The Pros and Cons of the Different Types of Firms

• Proprietorship

• Pros

• Easy to set up

• Simple decision making

• Profits taxed only once as owner’s income



• Proprietorship

• Cons

• Bad decision not checked by need for consensus

• Owners entire wealth at risk

• Firm dies with owner

• Capital is expensive

• Labor is expensive



• Partnership

• Pros

• Easy to set up

• Diversified decision making

• Can survive withdrawal of partner

• Profits taxed only once as owners’ incomes



• Partnership

• Cons

• Achieving consensus may be slow and expensive

• Owners entire wealth at risk

• Withdrawal of partner may create capital shortage

• Capital is expensive



• Corporation

• Pros

• Owners have limited liability

• Large-scale, low-cost capital available

• Professional management not restricted by ability of owners

• Perpetual life

• Long-term labor contracts cut labor costs



• Corporation

• Cons

• Complex management structure can make decisions slow and expensive

• Profits taxed twice as company profit and as stockholders’ income


Relative Importance of theThree Main Types of Firms


Relative Importance of theThree Main Types of Firms

• Why do proprietorships and corporations dominate in certain sectors?

• Corporation dominate where a large amount of capital is necessary

• Proprietorships dominate where flexibility in decision making is critical







Business Finance

• How Firms Raise Funds

• Equity — the owners stake in a business

• Selling stock — shares of ownership

• Selling bonds — a legally enforceable debt obligation to pay specified amounts of money at specified future dates


Business Finance

• Discounting an Present Value

• Deciding whether to borrow and how much to borrow requires firms to compare money today with money in the future

• Present value calculations allow this to be done


Discounting and Present Value

• Present Value

• The amount of money that, if invested today, will grow to be as large as a given future amount when the interest that it will earn is taken into account.

• Discounting is the conversion of a future amount of money to its present value.



• Present Value

Future amount = Present value + Interest

Future amount = Present value + (r x Present value)

Future amount = Present value (1 + r)



• Present Value

Present value = Future amount/(1 + r)

• Present Value n years in the future

Present value = Future amount/(1 + r)n


$121Present value =

(1 + 0.1)2

$121 = 1.21

= $100

Discounting and Present Value• Suppose you wish to find the present value of $121 two

years in the future discounted at an interest rate of 10%.


Future amount = Present value + (r Present value)

Year 1 = $100 + (.1 $100) or $100 + $10 = $110

Year 2 = $110 + (.1 $110) or $110 + $11 = $121

Discounting and Present Value• Suppose you wish to check this calculation.


Present Value and Marginal Analysis

• Firms compare the marginal benefit to the marginal benefit of borrowing.

• Firms calculate the net present value of borrowing.







Opportunity Cost andEconomic Profit

• Firms incur opportunity costs when they produce goods.

• Opportunity cost of producing — the best alternative action that the firm foregoes to produce a good or service



• Components of a firm’s opportunity cost

• Explicit costs (money costs)

• The amount paid for factors of production

• Implicit costs (non-money costs)

• The value of foregone opportunities.



• Cost of Capital

• Economic depreciation is the change in the market price of a piece of capital over a given time period (not the same as accounting depreciation).

• Interest is the funds used to buy capital that could have been used for some other purpose.



• Cost of Capital

• Implicit rental rate is the income that the firm forgoes by using the assets itself and not renting them to another firm — the same as economic depreciation and interest costs.

• Sunk costs are costs that has been incurred and cannot be reversed.



• Cost of Inventories

• Inventories are stocks of raw materials, semi-finished goods, and finished goods held by a firm.

• The opportunity cost of using an item from inventory is it current market price.



• Cost of Owner’s Resources

• The income that the owner could have earned in the best alternative job.

• Normal profit is the expected return for supplying entrepreneurial ability.



• Economic Profit

• A firm’s total revenue minus its opportunity costs.

• Not the same as accounting profit.


Opportunity Cost and Economic Profit: An Example

• Rocky owns a shop that sells bikes.

• His accountant and economist calculate his profit — let’s compare the two.



Item AmountTotal revenue $300,000

Costs:

Wholesale cost of bikes 150,000

Utilities and other services 20,000

Wages 50,000

Depreciation 22,000

Bank Interest 12,000

Total cost $254,000

Accounting Profit $ 46,000


• The economist includes the following costs not counted by the accountant:

• The fall in the market value of the assets of the firm gives the opportunity cost of not selling them one year ago. That is part of the opportunity cost of using them for the year.

• Rocky could have worked elsewhere for $40 an hour, but he worked 1,000 hours on the firm’s business, which means that the opportunity cost of his time is $40,000




• Rocky has invested $115,000 in the firm. If the current interest rate is 10% a year, the opportunity cost of those funds is $11,500.

• Rocky could avoid the risk of running his own business, and he would be unwilling to take on the risk for a return of less than $6,000. This is his normal profit.



Item AmountTotal revenue $300,000

Costs:

Wholesale cost of bikes 150,000

Utilities and other services 20,000

Wages 50,000

Bank Interest 12,000

Fall in market value of assets 10,000

Rocky’s wages (implicit) 40,000

Interest on Rocky’s money 11,500

Normal Profit (implicit) 6,000

Total cost $299,500

Economic Profit $ 500


Economic Efficiency

• Technological efficiency

• Occurs when it is not possible to increase output without increasing inputs

• Economic efficiency

• Occurs when the cost of producing a given output is as low as possible


Economic Efficiency

• Economic efficiency

• A firm that does not use the economically efficient method of production does not maximize profit.


Four Ways of Making 10 TV Sets a Day

• Lets use an example to illustrate economic and technological efficiency.

• Suppose there are 4 different ways of making 10 TVs a day.

• Lets compare each way’s technological and economic efficiency.



Quantities of inputs Method Labor Capital

a Robot production 1 1,000

b Production line 10 10

c Bench production 100 10

d Hand-tool production 1,000 1



Four ways of making TVs Labor cost Capital cost

Method ($75 per day) ($250 per day) Total cost Cost per TV set

a $75 + $250,000 = $250,075 $25,007.50

b 750 + 2,500 = 3,250 325.00

c 7,500 + 2,500 = 10,000 1,000.00

d 75,000 + 250 = 75,250 7,525.00




Method ($150 per day) ($1 per day) Total cost Cost per TV set

a $150 + $1,000 = $1,150 $115.00

b 1,500 + 10 = 1,510 151.00

d 150,000 + 1 = 150,001 15,000.10




Method ($1 per day) ($1,000 per day) Total cost Cost per TV set

a $1 + $1,000,000 = $1,000,001 $100,000.10

b 10 + 10,000 = 10,010 1,001.00

d 1,000 + 1,000 = 2,000 200.00







Firms and Markets

• What determines whether markets or firms coordinate production?

• Answer: • Whichever is the economically efficient

method.


Why Firms?

• Why firms are sometimes more efficient coordinators of economic activity?

• Lower transactions costs

• Economies of scale

• Economies of scope

• Economies of team production


Why Firms?

• Transactions costs • The costs arising from finding someone with

whom to do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled.


Why Firms?

• Economies of scale exist when the cost of producing a unit of a good falls as output increases.

• Economies of scope exist when a firm uses specialized resources to produce a range of goods and services.


Why Firms?

• Team production • A production process in which the individuals

in a group specialize in mutually supportive tasks.

CHAPTER 10 Organizing Production. TM 10-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain what a firm is and describe the economic.

Documents

firms facedefine

organization firms

economic problems

expensivethe pros

economic profitexplain

firms opportunity cost

economic activities

owners incomethe pros