Dr. Mohammed Alwosabi
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Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Notes on Chapter 9 ORGANIZING PRODUCTION Firms differ in the size and in the type of business they are doing but all firms perform the same basic economic functions. A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. To predict a firm's behavior, we need to know the firm's goals and the constraints it faces.
The Firm's Main Goal 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. Profit is the difference between total revenue and total cost
π = TR – TC. To maximize profit, a firm must make five basic decisions: What goods and services to produce and in what quantities What to produce itself and what to buy from other firms How to produce—the production technology to use How to organize and compensate its managers and workers How to market and price its products
MEASURING A FIRM'S COSTS (OPPORTUNITY COST) Accountants typically count money costs only and ignore any resource use that does not result in an explicit money payment. Thus, Accounting cost = explicit cost When calculating costs, economists on the other hand, consider the opportunity cost of all resources used in production whether they are paid or not.
1
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Opportunity cost of any action – as you remember - is the highest-valued alternative forgone. For a firm, the opportunity cost of production is the value of the firm's best alternative use of resources. Opportunity cost includes both explicit and implicit cost. This is called economic cost. Economic Cost (also called resource cost) refers to the value of all resources used to produce a good or service, whether the resources are paid or unpaid. Economic Cost = opportunity cost = explicit cost + implicit cost Explicit cost is cost paid directly in money. Implicit cost is the value of resources used even when no direct monetary payments are made to these resources. It incurred when a firm gives up an alternative action. A firms incurs implicit costs when it uses its own capital, and/ or it uses its owner's resources
1. The cost of firm's own capital o If the firm rents capital from another firm, it incurs an explicit cost; the cost of rental payments. o If the firm buys the capital it uses, it incurs an implicit cost (or the implicit rental rate of capital) which is made up of i. Interest forgone: The funds used to buy the capital could have been used for some other purpose. They would have yielded a return - an interest income. This forgone interest is an implicit cost and it is part of the opportunity cost of using the capital ii. Rent forgone: The firm could rent its capital to another firm. The rental income forgone is the firm's opportunity cost of using its own capital. iii. Economic depreciation: is the decline in the market value of capital over a given period. It is calculated as the market price of the capital at the beginning of a period minus the market price of the capital at the end of the period. 2
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
2. The cost of the owner's resources A firm's owner could offer his resources in two ways: a. As an entrepreneur: The owner's skills and talent as an entrepreneur could be used in running another business and expect to receive a return called normal profit. o Normal profit Normal profit is the cost of forgone entrepreneurial abilities and talent in running another firm. It is the average return that could be obtained from running another business. It is an amount equal to what the owners of a business could have earned if their resources had been employed elsewhere. It is equivalent to the opportunity cost of running the firm. o It is the minimum return a firm's owner must earn in order to stay in operation. A lower rate would cause some of the established firms to leave; a higher one would cause new firms to enter. o It is part of economic cost (part of implicit cost) but it is part of accounting profit. b. As a labor: Wage is the return to labor. The opportunity cost of the owner's time spent on working for the firm is the wage income forgone by not working in the best alternative job.
3
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Measuring a Firm's Economic Profit Profit = Total Revenue – Total Cost. Economic Profit = Total Revenue - Total Economic Cost = Total Revenue – Opportunity Cost = Total Revenue – (Explicit Cost + Implicit cost) = Total Revenue – Explicit Cost - Implicit cost Economic Profit accounts for all resources. A firm earns an economic profit only if it earns more than its opportunity cost. Economic profits represent an extra profit over and above all costs including normal profit. Economic profit is regarded as a reward (compensation) to the entrepreneur for taking the risk of running a business that might reap profit or suffer loss. o If economic profit is zero ⇒ firm earns only normal profit (average rate of return) o If economic profit is positive ⇒ firm earns more than normal profit o If economic profit is negative ⇒ firm earns less than normal profit (economic loss) A firm that makes zero economic profit covers all its costs including a provision for normal profit. In other words, a firm making just a normal profit is making zero economic profit. Not every business has an equal chance to earn economic profit. There are many constraints in the market prevent the firm from maximizing its economic profit.
4
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Example: Calculating Economic Profit Total Revenue
400,000
Opportunity Cost Explicit costs: Cost of merchandise sold
80,000
Wages
120,000
Utilities
20,000
Interest paid
10,000
Taxes
10,000
Total explicit costs
240,000
Implicit costs: Owner's wage forgone
40,000
Interest forgone
20,000
Economic Depreciation*
25,000
Normal Profit
50,000
Total implicit costs
135,000
Total Economic Cost (Opportunity Cost) 375,000 Economic Profit
25,000
5
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
The Firm's Main Constrains There are three main constraints that limit the ability of the firm to achieve its goal of maximum profit. These three constraints are: Technology Constraint, Information Constraint, Market Constraint Technology Constraints o Technology is any method of producing a good or service. It includes the design of the machines, the lay out of the work place, the organization of the firm, etc. o At any point in time, the increase in profit that the firm can achieve is limited by the technology available. If there is an improvement in the technology or discovery of new technology the cost of production will decrease and profit will increase, everything else remaining the same o With a given technology, to produce more output and gain more revenue, a firm must hire more resources and incur higher costs Information Constraints o A firm is constrained by limited information about the quality and effort of its work force, the current and future buying of its customers, the plans of its competitors, and the changes that may occur in the local and global economies. o In addition, the cost of coping with the limited information itself limits profits Market Constraints What each firm can sell and prices it can obtain are constrained by 1. its customers' willingness to pay, 2. prices and marketing efforts of other firms, 3. the resources that a firm can buy and the prices it must pay for them, and 4. the willingness of people to work for and invest in the firm
6
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
TECHNOLOGICAL AND ECONOMIC EFFICIENCY To maximize profit, the firm must be efficient. To achieve production efficiency the firm must achieve both technological efficiency and economic efficiency Technological efficiency occurs when the firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output using the least cost methods; i.e., the cost of producing a given level of output is as low as possible. Input prices should be known first in order to calculate economic efficiency. A firm that is technologically efficient is not always economically efficient, but a firm that is economically efficient must always be technologically efficient. Example: Suppose we have 3 methods of producing 11 units of good X per day using only Labor (L) and capital (K) Method
L
K
A
10
20
B
30
5
C
10
25
o To know which method is technologically efficient, compare between the methods. You can see that methods A and C have the same quantity of labor but different quantities of capital. Method C uses more capital than method A. Because method C uses the same amount of labor but more capital than method A, method C is not technologically efficient. Firms prefer to use less capital with the same amount of labor. The other two methods are technologically efficient. Method A has less labor and more capital than method B; and method B has less capital and more labor than method A o The method that is technologically inefficient can never be economically efficient
7
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
o To know which method is economically efficient o Economic efficiency depends on input prices If P (L) = $1 per hour and P (K) = $ 5 per hour. Then TC of method A = (1*10) + (5*20) = 110, and per unit cost = 110/11 = 10 TC of Method B = (1*30) + (5*5) = 55, and per unit cost = 55/11 = 5 Hence, method B is economically efficient because it produces the 11 units of X at the least cost but method A is not. Now suppose P (L) = $5 per hour and P (K) = $1 per hour. Then TC of method A = (5*10) + (1*20) = 70, and the per unit cost = 70/11 = 6.36 TC of Method B = (5*30) + (1*5) = 155, and the per unit cost = 155/11 = 14.09 Hence, method A is economically efficient because it produces the 11 units of X at the least cost but method B is not. o The economically efficient method is the one that uses a smaller amount of the more expensive inputs and a large amount of the less expensive inputs A firm that is not economically efficient does not maximize profit Profit can be maximized only by firms that achieve technological efficiency an economic efficiency.
8
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
MARKET STRUCTURE The opportunity of the firm to maximize its profit may be limited by the structure of the industry. Market structure refers to the number and the relative size of the firms in an industry There are four main types of market structure: perfect competition, monopolistic competition, oligopoly and monopoly. It is important to note that: (1) these markets may change over time from one structure to another, and (2) some real life markets may not fit well in any of these four structures Perfect Competition o Perfect competition refers to a market in which there are many firms selling an identical product and many buyers. None of the buyers or sellers has market power. Each firm is a price taker. No barriers to enter or exit this type of market. Information is available to all. In the long run, economic profit of any firm in this type of market is zero. o Market Power refers to the ability to influence the market price of a good or service o Examples: the markets for agricultural product (corn, wheat, coffee), financial instruments (stocks, bonds, foreign exchange), precious metals (gold, silver, platinum) and the global petroleum industry o In each of these markets, the products are standardized commodities, and supply and demand are the primary determinants of their market price. Monopolistic Competition o Monopolistic competition is a market in which large number of relatively small firms produce similar but different product (differentiated products). Each firm maintains some control of its own price. It is easy to enter or exit this market. In the long run, economic profit of any firm in this type of markets is zero. 9
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
o There are many of monopolistic competitive firms in any given city or area of the city. The start-up capital is relatively low, so it is fairly easy to start these types of business. Each one tries its best to stand out among its many competitors by differentiating its product. o Examples: Small industries such as retail and service establishments (restaurants, boutiques, luggage stores, shoe stores, stationary stores, repair shops, laundries, beauty parlors) Oligopoly o Oligopoly is a market in which a small number of firms producing all or most of the market supply of a particular good or service. The product may be identical or differentiated. This market is generally considered to be for large firms. It is difficult to enter this market. Firms in this market can make positive economic profit based on whether they compete with each other severely or they have some kind of mutual agreements regarding prices, market share and products. o Examples: manufacturing sector, oil refining, certain types of computer hardware and software, chemical and plastics, steel, automobile, soft drinks, airline travel, banking industry, insurance companies, telecommunications, etc Monopoly o Monopoly refers to the firm that produces the entire market supply of a particular unique good or service (no close substitutes for this product). It has market power. It is a price maker. It is very difficult or impossible for any other firm to enter this market. This firm makes high economic profit subject to regulations. o Examples of pure monopoly are not easy to find. Electricity and water industry in some countries, patent laws sometimes provide companies with temporary monopolies, a company that is so dominant might be said to exhibit monopolistic status (such as Microsoft) 10
ECON 140 – Ch. 9
Notes on Chapter 9 ORGANIZING PRODUCTION Firms differ in the size and in the type of business they are doing but all firms perform the same basic economic functions. A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. To predict a firm's behavior, we need to know the firm's goals and the constraints it faces.
The Firm's Main Goal 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. Profit is the difference between total revenue and total cost
π = TR – TC. To maximize profit, a firm must make five basic decisions: What goods and services to produce and in what quantities What to produce itself and what to buy from other firms How to produce—the production technology to use How to organize and compensate its managers and workers How to market and price its products
MEASURING A FIRM'S COSTS (OPPORTUNITY COST) Accountants typically count money costs only and ignore any resource use that does not result in an explicit money payment. Thus, Accounting cost = explicit cost When calculating costs, economists on the other hand, consider the opportunity cost of all resources used in production whether they are paid or not.
1
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Opportunity cost of any action – as you remember - is the highest-valued alternative forgone. For a firm, the opportunity cost of production is the value of the firm's best alternative use of resources. Opportunity cost includes both explicit and implicit cost. This is called economic cost. Economic Cost (also called resource cost) refers to the value of all resources used to produce a good or service, whether the resources are paid or unpaid. Economic Cost = opportunity cost = explicit cost + implicit cost Explicit cost is cost paid directly in money. Implicit cost is the value of resources used even when no direct monetary payments are made to these resources. It incurred when a firm gives up an alternative action. A firms incurs implicit costs when it uses its own capital, and/ or it uses its owner's resources
1. The cost of firm's own capital o If the firm rents capital from another firm, it incurs an explicit cost; the cost of rental payments. o If the firm buys the capital it uses, it incurs an implicit cost (or the implicit rental rate of capital) which is made up of i. Interest forgone: The funds used to buy the capital could have been used for some other purpose. They would have yielded a return - an interest income. This forgone interest is an implicit cost and it is part of the opportunity cost of using the capital ii. Rent forgone: The firm could rent its capital to another firm. The rental income forgone is the firm's opportunity cost of using its own capital. iii. Economic depreciation: is the decline in the market value of capital over a given period. It is calculated as the market price of the capital at the beginning of a period minus the market price of the capital at the end of the period. 2
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
2. The cost of the owner's resources A firm's owner could offer his resources in two ways: a. As an entrepreneur: The owner's skills and talent as an entrepreneur could be used in running another business and expect to receive a return called normal profit. o Normal profit Normal profit is the cost of forgone entrepreneurial abilities and talent in running another firm. It is the average return that could be obtained from running another business. It is an amount equal to what the owners of a business could have earned if their resources had been employed elsewhere. It is equivalent to the opportunity cost of running the firm. o It is the minimum return a firm's owner must earn in order to stay in operation. A lower rate would cause some of the established firms to leave; a higher one would cause new firms to enter. o It is part of economic cost (part of implicit cost) but it is part of accounting profit. b. As a labor: Wage is the return to labor. The opportunity cost of the owner's time spent on working for the firm is the wage income forgone by not working in the best alternative job.
3
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Measuring a Firm's Economic Profit Profit = Total Revenue – Total Cost. Economic Profit = Total Revenue - Total Economic Cost = Total Revenue – Opportunity Cost = Total Revenue – (Explicit Cost + Implicit cost) = Total Revenue – Explicit Cost - Implicit cost Economic Profit accounts for all resources. A firm earns an economic profit only if it earns more than its opportunity cost. Economic profits represent an extra profit over and above all costs including normal profit. Economic profit is regarded as a reward (compensation) to the entrepreneur for taking the risk of running a business that might reap profit or suffer loss. o If economic profit is zero ⇒ firm earns only normal profit (average rate of return) o If economic profit is positive ⇒ firm earns more than normal profit o If economic profit is negative ⇒ firm earns less than normal profit (economic loss) A firm that makes zero economic profit covers all its costs including a provision for normal profit. In other words, a firm making just a normal profit is making zero economic profit. Not every business has an equal chance to earn economic profit. There are many constraints in the market prevent the firm from maximizing its economic profit.
4
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
Example: Calculating Economic Profit Total Revenue
400,000
Opportunity Cost Explicit costs: Cost of merchandise sold
80,000
Wages
120,000
Utilities
20,000
Interest paid
10,000
Taxes
10,000
Total explicit costs
240,000
Implicit costs: Owner's wage forgone
40,000
Interest forgone
20,000
Economic Depreciation*
25,000
Normal Profit
50,000
Total implicit costs
135,000
Total Economic Cost (Opportunity Cost) 375,000 Economic Profit
25,000
5
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
The Firm's Main Constrains There are three main constraints that limit the ability of the firm to achieve its goal of maximum profit. These three constraints are: Technology Constraint, Information Constraint, Market Constraint Technology Constraints o Technology is any method of producing a good or service. It includes the design of the machines, the lay out of the work place, the organization of the firm, etc. o At any point in time, the increase in profit that the firm can achieve is limited by the technology available. If there is an improvement in the technology or discovery of new technology the cost of production will decrease and profit will increase, everything else remaining the same o With a given technology, to produce more output and gain more revenue, a firm must hire more resources and incur higher costs Information Constraints o A firm is constrained by limited information about the quality and effort of its work force, the current and future buying of its customers, the plans of its competitors, and the changes that may occur in the local and global economies. o In addition, the cost of coping with the limited information itself limits profits Market Constraints What each firm can sell and prices it can obtain are constrained by 1. its customers' willingness to pay, 2. prices and marketing efforts of other firms, 3. the resources that a firm can buy and the prices it must pay for them, and 4. the willingness of people to work for and invest in the firm
6
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
TECHNOLOGICAL AND ECONOMIC EFFICIENCY To maximize profit, the firm must be efficient. To achieve production efficiency the firm must achieve both technological efficiency and economic efficiency Technological efficiency occurs when the firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output using the least cost methods; i.e., the cost of producing a given level of output is as low as possible. Input prices should be known first in order to calculate economic efficiency. A firm that is technologically efficient is not always economically efficient, but a firm that is economically efficient must always be technologically efficient. Example: Suppose we have 3 methods of producing 11 units of good X per day using only Labor (L) and capital (K) Method
L
K
A
10
20
B
30
5
C
10
25
o To know which method is technologically efficient, compare between the methods. You can see that methods A and C have the same quantity of labor but different quantities of capital. Method C uses more capital than method A. Because method C uses the same amount of labor but more capital than method A, method C is not technologically efficient. Firms prefer to use less capital with the same amount of labor. The other two methods are technologically efficient. Method A has less labor and more capital than method B; and method B has less capital and more labor than method A o The method that is technologically inefficient can never be economically efficient
7
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
o To know which method is economically efficient o Economic efficiency depends on input prices If P (L) = $1 per hour and P (K) = $ 5 per hour. Then TC of method A = (1*10) + (5*20) = 110, and per unit cost = 110/11 = 10 TC of Method B = (1*30) + (5*5) = 55, and per unit cost = 55/11 = 5 Hence, method B is economically efficient because it produces the 11 units of X at the least cost but method A is not. Now suppose P (L) = $5 per hour and P (K) = $1 per hour. Then TC of method A = (5*10) + (1*20) = 70, and the per unit cost = 70/11 = 6.36 TC of Method B = (5*30) + (1*5) = 155, and the per unit cost = 155/11 = 14.09 Hence, method A is economically efficient because it produces the 11 units of X at the least cost but method B is not. o The economically efficient method is the one that uses a smaller amount of the more expensive inputs and a large amount of the less expensive inputs A firm that is not economically efficient does not maximize profit Profit can be maximized only by firms that achieve technological efficiency an economic efficiency.
8
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
MARKET STRUCTURE The opportunity of the firm to maximize its profit may be limited by the structure of the industry. Market structure refers to the number and the relative size of the firms in an industry There are four main types of market structure: perfect competition, monopolistic competition, oligopoly and monopoly. It is important to note that: (1) these markets may change over time from one structure to another, and (2) some real life markets may not fit well in any of these four structures Perfect Competition o Perfect competition refers to a market in which there are many firms selling an identical product and many buyers. None of the buyers or sellers has market power. Each firm is a price taker. No barriers to enter or exit this type of market. Information is available to all. In the long run, economic profit of any firm in this type of market is zero. o Market Power refers to the ability to influence the market price of a good or service o Examples: the markets for agricultural product (corn, wheat, coffee), financial instruments (stocks, bonds, foreign exchange), precious metals (gold, silver, platinum) and the global petroleum industry o In each of these markets, the products are standardized commodities, and supply and demand are the primary determinants of their market price. Monopolistic Competition o Monopolistic competition is a market in which large number of relatively small firms produce similar but different product (differentiated products). Each firm maintains some control of its own price. It is easy to enter or exit this market. In the long run, economic profit of any firm in this type of markets is zero. 9
Dr. Mohammed Alwosabi
ECON 140 – Ch. 9
o There are many of monopolistic competitive firms in any given city or area of the city. The start-up capital is relatively low, so it is fairly easy to start these types of business. Each one tries its best to stand out among its many competitors by differentiating its product. o Examples: Small industries such as retail and service establishments (restaurants, boutiques, luggage stores, shoe stores, stationary stores, repair shops, laundries, beauty parlors) Oligopoly o Oligopoly is a market in which a small number of firms producing all or most of the market supply of a particular good or service. The product may be identical or differentiated. This market is generally considered to be for large firms. It is difficult to enter this market. Firms in this market can make positive economic profit based on whether they compete with each other severely or they have some kind of mutual agreements regarding prices, market share and products. o Examples: manufacturing sector, oil refining, certain types of computer hardware and software, chemical and plastics, steel, automobile, soft drinks, airline travel, banking industry, insurance companies, telecommunications, etc Monopoly o Monopoly refers to the firm that produces the entire market supply of a particular unique good or service (no close substitutes for this product). It has market power. It is a price maker. It is very difficult or impossible for any other firm to enter this market. This firm makes high economic profit subject to regulations. o Examples of pure monopoly are not easy to find. Electricity and water industry in some countries, patent laws sometimes provide companies with temporary monopolies, a company that is so dominant might be said to exhibit monopolistic status (such as Microsoft) 10
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