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Chapter 10
The Firm, Production and Cost
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Forms of Business Organization
Sole ProprieitorshipPartnershipCorporation (Joint-Stock Company)Public CorporationGovernment
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Sole Proprieitorship
Advantages
Easy to OrganizeNo Legal Red TapeProfit Depends on one’s own effortIncentive to Manage Business Efficiently
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Sole Proprieitorship
Disadvantages
Financial resources are limited.Commercial banks are unwilling to lend.Carry out many tasks and functions (buying,
selling, training personnel etc) UNLIMITED LIABILITY
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Partnership
Advantages
Easy to Organize but still requires a written agreement.
Greater specialization in management.Financial resources are greater than
proprietorship
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Partnership
Disadvantages
Division of authorityFinances are still limited to partners’ capital.Continuity is precarious, after withdrawal or
death of a partner.Unlimited Liability
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Corporation
Separate Legal EntityDistinct from Its Owners.Can acquire or sell assets, incur debts,
extend credit, sue and be sued.TWO TYPES
Private Limited Company (shares cannot be traded on stock exchange)
Public Limited Company (shares are traded on some public exchange
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ADVANTAGES OF CORPORATION
Can sell stocks and bonds. Easier access to bank credit
Most effective for raising capital.
Limited LiabilityOwners risk only what they paid for stockPersonal assets are not at stake in case of
bankruptcy.
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ADVANTAGES OF CORPORATION
Easier to expand size and scope of operations.
Greater Specialization in use of human and capital resources.
Relative permanence to other forms of business organization.
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PUBLIC CORPORATION
Setup to run a nationalized industry
Owned by state
Organization and legal status similar to a joint-stock company.
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Government
Government agencies providing for various services.Health (Mayo Hospital, Jinnah Hospital,
National Health Service in England, Medicare in U.S.)
Education (public schools)Defence
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Financing of Firms
Financial CapitalSharesBondsLong-Term Loans
Physical CapitalFactoriesMachineryOfficesOffice Equipment
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Financial Capital
EquityAcquire fund by selling stocks and shares.Retain Current profits and finance investment
from undistributed profits.
Debt InstrumentsBonds (Long-Term, Specified Time of
Maturity and interest rate)Loans Between financial institutionsBills and Notes (for short-term loans,
specified principal and time of maturity)
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Theory of the Firm
Firm as the Unit of Analysis
Firm Makes Decisions regarding production
OBJECTIVE OF FIRMProfit Maximization
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Production, Costs and Profits
Total Revenue=Price× Quantity
Total Profit=Total Revenue –Total Cost
Increase in cost, decreases profit.
What determines the costs of production of a firm?
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PRODUCTION FUNCTION
Inputs – the factors of production classified as:1. Land – all natural resources of the
earthPrice paid to acquire land = Rent
2. Labour – all physical and mental human effort involved in productionPrice paid to labour = Wages
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INPUTS AND PRODUCTION
3. Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to productionPrice paid for capital = Interest
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Intermediate Products
Output of one firm, could be an input for another. These inputs are called “intermediate products”.
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INPUTS AND COST
Increase in inputs will lead to higher cost in the form of wages, rent, interest.
Which costs to consider, as a firm hires or purchases an input?
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Opportunity Cost
The cost of using something in a particular use is the benefit foregone by not using it in its best alternative use.
For hired inputs, opportunity cost is easy to measure.
If firm pays $10,000 for electricity, it has sacrificed its claims to whatever else $10,000 could buy.
Purchase price as reasonable measure of opportunity cost.
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IMPUTED COSTS
How to assign a cost to factors that the firm “already owns”.
Costs of using such factors are called “imputed costs”.
These costs will reflect what the firm could have earned if it shifted these factors, to their next best use.
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IMPUTED COSTS
Firm’s Own Capital EquipmentLoss in Value of Asset, called
depreciation.Buys machine for $12,000 and intends to
use for 6 years. Depreciation of $2000 per year.But after 1 year, car is worth $9,000 only.Charge $3000, as she can buy 1 year old
car and operate it for 5 years.
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SUNK COSTS
EXAMPLEFirm buys a set of machines for $100,000.Machines can be used to make only one
product and cannot be leased to anyone else.
Life of 10 years. Depreciation =$10000/year.Cost of all other factors utilized in produciton
of output is $25,000After purchasing machines, firm realizes that
output can be sold for only $29,000 per year, instead of $35,000.
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SUNK COSTS
Total Cost=$25,000+ 10000=$35,000
Revenue=$29,0000
Profit=29000-35000=-$6000 (i.e. LOSS)
Should product be made???
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SUNK COSTS
The depreciation charge is a sunk cost.Firms cannot use machines anywhere
else, as they have no alternative use.Net Profit =29,000-25,000=$4,000i.e. if firm did not produce goods, it would
earn $4000 per year less, than if it carried on with production.
(-$10000 vs$ -6,000)
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Resource Allocation and Profits
If firms are earning profits in one industry, owners of factors of production (f.o.p) will move their resources into that industry.
If losses are being earned, owners of f.o.p. will take resources out of that industry.
Crucial role of profits, in the working of a free-market system.
Profits encourage efficiency.