Microeconomics Homework

Chapter 10: Organizing Production

· Firms must organize their production so that it is as efficient as possible.

· Firms operate in markets that differ according to the competition within the market.

· Firms organize some economic activities while markets are used for other economic activity.

I. The Firm and Its Economic Problem

· The number and scope of business firms in the economy is vast and diverse. A firm is an institution that hires factors of production and organizes those factors to produce and sell goods and services.

The Firm’s Goal

· The firm’s goal is to maximize its profit. If a firm fails to maximize profit it is either eliminated through competition or bought out by other firms seeking to maximize profit.

Do firms really maximize profit? Sometimes firms state they are willing to bear lower profits to expand market share. Other firms claim to utilize only the “greenest” technology in their production process. You should see that maximizing market share or using the latest green technology is an effort to gain greater market power and consumer loyalty in the long run.

Accounting Profit and Economic Profit

· A firm’s accounting profit is the firm’s revenues minus expenses and depreciation.

· A firm’s economic profit is equal to total revenue minus total opportunity cost.

A Firm’s Opportunity Cost of Production

· A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.

· Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner.

· For example, renting capital means the firm is paying a rental cost reflecting the opportunity cost to the owner of the capital when someone else using the capital. However, if the firm buys capital it incurs an opportunity cost of using its own capital, which is called the implicit rental rate of capital. The implicit rental rate includes economic depreciation, which is the change in the market value of capital over a given period, and the interest forgone, which is the lost potential return on the funds that were used to acquire the capital.

· The return to the owner for the owner’s entrepreneurial ability is profit. The return for this input that an entrepreneur can expect to receive on the average is called normal profit. The normal profit is part of the firm’s opportunity cost. Economic profit is a firm’s total revenue minus its opportunity cost. Because normal profit is part of the firm’s opportunity costs, economic profit is profit over and above normal profit.

Is economic profit a “better” measure of profit than accounting profit? Economic profit and accounting profit really have different purposes, so one is not universally better or worse than the other. Economic profit is a better measure of whether a firm is using its resources efficiently and is a better measure for predicting a firm’s actions, but accounting profit may be a better measure of whether the firm is earning enough revenue to pay its expenses. Only economic profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated according to strict, generally accepted accounting procedures (GAAP).

Decisions

· In order to maximize economics profit, a firm must decide:

· What to produce and in what quantities.

· How to produce.

· 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 others.

The Firm’s Constraints

· A firm faces three basic constraints that limit its maximum profit:

· Technology Constraints: A technology is any method of producing a good or service. At the existing level of technology, a firm can produce more output only if it hires more resources, which increases its costs and limits its profits.

· Information Constraints: A firm has only limited information about the quality and effort of its work force, about the current and future buying plans of its customers, and about the plans of its competitors.

· Market Constraints: What a firm can sell and the prices it sets are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms.

II. Technological and Economic Efficiency

· There typically are many different combinations of inputs that can produce a specific level of output. Technological efficiency occurs when a firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output at the least possible cost. An economically efficient production process is always technologically efficient. But, a technologically efficient process might not be economically efficient.

· The table has 4 different methods of producing a unit of output. The columns show the number of units of labor and capital needed to produce 1 unit of output.

· Method 2 is technologically inefficient because it uses the same amount of capital but more labor than does Method 1.

· Which method is economically efficient depends on the prices of labor and capital. If labor is $10 per unit and capital is $1, then Method 1 is economically efficient (with a cost of $60 per unit of output). If labor is $1 per unit and capital is $10 per unit, then Method 4 is economically efficient (with a cost of $30 per unit of output).

Does technological efficiency imply economic efficiency (or vice versa)? Ttechnological efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally productive), there will inevitably be a difference between technological and economical efficiency.

III. Information and Organization

A firm organizes production by combining and coordinating productive resources using a mixture of command systems and incentive systems.

· A command system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward.

· An incentive system uses a market-like mechanism inside the firm.

· 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. Stockholders wish to provide incentives to the managers to bring the manager’s decisions in line with profit maximization. Firms cope with the principal-agent problem in many ways:

· Ownership: Firms’ owners often offer managers partial ownership of the firm to give the managers an incentive to maximize the firm’s profits, which is the goal of the owners.

· Incentive pay: Firms’ owners can links managers’ or workers’ pay to the firm’s performance, such as its sales, to help align the managers’ and workers’ interests with those of the owners.

· Long-term contracts: Firms’ owners can tie managers’ or workers’ long-term rewards to the long-term performance of the firm.

Types of Business Organization

· A proprietorship is a firm with a single owner. This owner has unlimited legal liability, which means the owner has legal responsibility for all debts incurred by the firm up to an amount equal to the entire wealth of the owner. The proprietor is the only one who makes management decisions and is the sole claimant of the firm’s profit. Profits are taxed the same as the owner’s other income.

· A partnership is a firm with two or more owners. Each partner has unlimited legal liability. The partners must agree upon a management structure and agree how to divide up the profits from the firm. Profits from partnerships are taxed as the personal income of the owners.

· A corporation is a firm that is owned by one or more stockholders with limited liability, which means the owners have legal liability only for the initial value of their investment, so 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 the firm’s profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.

· Proprietorships are the most common form of business organization but corporations account for the majority of revenue received by all types of business organization.

IV. Markets and the Competitive Environment

· Perfect competition is a market structure when there are many firms, each selling an identical product, many buyers, and with no restrictions on entry of new firms to the industry. Both firms and buyers are well informed of the prices of the products of all firms in the industry.

· Monopolistic competition is a market structure in which a large number of firms compete by making similar but slightly different products. Making a product slightly different from the product of a competitor is called product differentiation and it gives the firm an element of market power.

· Oligopoly is a market structure in which a small number of firms compete. Oligopolies might produce almost identical or differentiated goods.

· Monopoly arises when there is one firm, which produces a good or service that has no close substitutes and in which the firm is protected by a barrier preventing the entry of new firms.

Measures of Concentration

There are two measures of market concentration:

· The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry. The four-firm concentration ratio ranges between near 0 (extremely competitive) to 100 (not very competitive).

· The Herfindahl–Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. The HHI ranges between near 0 (extremely competitive) to 10,000 (a monopoly).

· The U.S. Justice Department uses the HHI to classify markets:

· Markets with an HHI of less than 1,000 are regarded as highly competitive.

· Markets with an HHI of between 1,000 and 1,800 are regarded as moderately competitive.

· Markets with an HHI above 1,800 are regarded as concentrated.

· Concentration measures fail to take account of:

· Geographic Scope of the Market: Concentration ratios define the market as the entire United States, but the relevant market might be smaller than the entire nation (newspapers, for which the market is a city) or larger than the entire nation (automobiles, for which the market is the entire world).

· Barriers to Entry and Firm Turnover: For some industries, a few firms might be currently operating in the market but competition in these industries might be fierce, with firms regularly entering and exiting the industry.

· Market and Industry Correspondence: Some firms produce a product with very specific applications for which few competitors exist, but are classified in too broad of a market (specific pharmaceutical drugs) while other firms have diversified into several distinct product lines and are subject to more effective competition than what their market share for just one product might suggest.

How do economists identify the market for a product? Examples:

Geography: the (expanding) market for beer. In the early 20th century, a market for any given brand of beer was largely limited to the geographic area within a days’ truck drive from the brewery—if the beer traveled for too long under too high an ambient temperature, the trip ruined the product. When technological advances in mobile refrigeration made transporting beer over the road economical, local monopoly brands suddenly felt the pain of competition from out-of-state brands that had never before been observed in the local market.

Demography: the (hidden) market for cigarettes. Can you define the market for a cigarette manufacturer by looking only at the market among adults? What if mostly illegal, under-aged smokers favored the brand rather than adult smokers? The sales to minors would not likely be recorded, yet it represents market share.

Substitutability: the (changing) market for personal transportation. Can you define the market for personal transportation? Twenty-five years ago it meant just the market for cars. Today, if we wanted to determine the market share for an auto manufacturer that happens to only sell cars, would the definition of the market for personal (as opposed to commercial) transportation include only cars? Or should trucks, mini-vans and SUVs be included as well? How about motorcycles and scooters?

The World Wide Web of business. T today, items can be produced anywhere in the world and can be discovered and ordered from anywhere else in the world using the World Wide Web. These items can be paid for through electronic accounts located only in cyber-space, and the product can be shipped literally overnight to nearly any city in any developed country around the world. It is difficult to discern even the relevance of the term “market” in today’s business climate.

What is the relevant market for Ford Motor Company? Ford Motor Company advertises that it is the largest seller of pickup trucks in the United States. Should we be concerned that Ford might have too much market power in that area of the market? What would be an appropriate definition for the “market” such that a proper market concentration measure might be calculated? Should only pickup trucks be included? Or should all cars and trucks be considered as possible substitutes? How about minivans and/or SUVs?

V. Produce or Outsource? Firms and Markets

· Factors of production can be coordinated by firms or by markets.

· Firms coordinate production when they can do so more efficiently than a market.

· Markets coordinate production by adjusting prices and making the decisions of buyers and sellers of factors of production consistent.

· Outsourcing, buying parts or products from other firms, is an example of market coordination.

Why might firms be more efficient at coordinating production than markets?

· Firms can reduce transactions costs, which are the costs that arise 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.

· Firms can capture economies of scale, which occurs when the cost of producing a unit of a good falls as its output rate increases.

· Firms can capture economies of scope, which occurs 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 can coordinate to specialize in mutually supporting tasks.

· Because of these advantages, firms rather than markets coordinate most of our economic activity.

Economics in Action: Apple doesn’t produce the iPhone by itself. Global supply chains, high degrees of specialization and competition, and other innovations have made it possible for a company to design and market a product, collect most of the profit from it, and yet not produce it.

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