ORGANIZING PRODUCTIONThis lecture explains the role of firms and the problems that all firms face

ObjectivesAfter studying this chapter, you will able toExplain what a firm is and describe the economic problems that all firms faceDistinguish between technological efficiency and economic efficiencyDefine and explain the principal-agent problem and describe how different types of business organizations cope with this problem

ObjectivesAfter studying this chapter, you will able toDescribe and distinguish between different types of markets in which firms operateExplain why markets coordinate some economic activities and firms coordinate others

The Firm and Its Economic ProblemA firm is an institution that hires factors of production and organizes them to produce and sell goods and services.The Firms GoalA firms goal is to maximize profit. If the firm fails to maximize profit, it is either eliminated or bought out by other firms seeking to maximize profit.

The Firm and Its Economic ProblemMeasuring a Firms ProfitAccountants measure a firms profit using rules laid down by the Internal Revenue Service and the Financial Accounting Standards Board.Their 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.Economists measure profit based on an opportunity cost measure of cost.

The Firm and Its Economic ProblemOpportunity CostA firms decisions respond to opportunity cost and economic profit.A firms opportunity cost of producing a good is the best, forgone alternative use of its factors of production.Opportunity cost includes both: Explicit costs Implicit costs

The Firm and Its Economic ProblemExplicit costs are costs paid directly in money.Implicit costs are costs incurred when a firm uses its own capital or its owners time for which it does not make a direct money payment.The firm can rent capital and pay an explicit rental cost reflecting the opportunity cost of using the capital. The firm can also buy capital and incur an implicit opportunity cost of using its own capital, called the implicit rental rate of capital.

The Firm and Its Economic ProblemThe implicit rental rate of capital is made up of: Economic depreciation Interest forgoneEconomic depreciation is the change in the market value of capital over a given period.Interest forgone is the return on the funds used to acquire the capital.

The Firm and Its Economic ProblemThe cost of the owners resources is his or her entrepreneurial ability and labor expended in running the business.The opportunity cost of the owners entrepreneurial ability is the average return from this contribution that can be expected from running another firm. This return is called a normal profit. 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.

The Firm and Its Economic ProblemEconomic ProfitEconomic profit equals a firms total revenue minus its opportunity cost of production. A firms opportunity cost of production is the sum of the explicit costs and implicit costs. Normal profit is part of the firms opportunity costs, so economic profit is profit over and above normal profit.

The Firm and Its Economic ProblemEconomic Accounting: A SummaryTo maximize profit, a firm must make five basic decisions:What goods and services to produce and in what quantitiesHow to producethe production technology to useHow to organize and compensate its managers and workersHow to market and price its productsWhat to produce itself and what to buy from other firms

The Firm and Its Economic ProblemThe Firms ConstraintsThe five basic decisions of a firm are limited by the constraints it faces. There are three constraints a firm faces: Technology Information Market

The Firm and Its Economic ProblemTechnology Constraints Technology is any method of producing a good or service. Technology advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output.

The Firm and Its Economic ProblemInformation Constraints A firm never possesses complete information about either the present or the future. It is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information limits profit.

The Firm and Its Economic ProblemMarket Constraints What a firm can sell and the price it can obtain are constrained by its customers willingness to pay and by the prices and marketing efforts of other firms. The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.

Technology and Economic EfficiencyTechnological EfficiencyTechnological 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. If it is impossible to maintain output by decreasing any one input, holding all other inputs constant, then production is technologically efficient.

Technology and Economic EfficiencyEconomic EfficiencyEconomic efficiency occurs when the firm produces a given level of output at the least cost.

The difference between technological and economic efficiency is that technological efficiency is concerned with the quantity of inputs used in production for a given level of output, whereas economic efficiency is concerned with the cost of the inputs used.

Technology and Economic EfficiencyAn economically efficient production process also is technologically efficient.\A technologically efficient process may not be economically efficient.Changes in the input prices influence the value of the inputs, but not the technological process for using them in production.

Information and OrganizationA firm organizes production by combining and coordinating productive resources using a mixture of two systems: Command systems Incentive systems

Information and OrganizationCommand SystemsA command system uses a managerial hierarchy.

Commands pass downward through the hierarchy and information (feedback) passes upward.

These systems are relatively rigid and can have many layers of specialized management.

Information and OrganizationIncentive SystemsAn incentive system uses market-like mechanisms to induce workers to perform in ways that maximize the firms profit.

Information and OrganizationMixing the SystemsMost firms use a mix of command and incentive systems to maximize profit. They use commands when it is easy to monitor performance or when a small deviation from the ideal performance is very costly. They use incentives whenever monitoring performance is impossible or too costly to be worth doing.

Information and OrganizationThe Principal-Agent ProblemThe 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.

Information and OrganizationCoping with the Principal-Agent ProblemThree ways of coping with the principal-agent problem are: Ownership Incentive pay Long-term contracts

Information and OrganizationOwnership, often offered to managers, gives the managers an incentive to maximize the firms profits, which is the goal of the owners, the principals. Incentive pay links managers or workers pay to the firms performance and helps align the managers and workers interests with those of the owners, the principals.Long-term contracts can tie managers or workers long-term rewards to the long-term performance of the firm. This arrangement encourages the agents to work in the best long-term interests of the firm owners, the principals.

Information and OrganizationTypes of Business OrganizationThere are three types of business organization: Proprietorship Partnership Corporation

Information and OrganizationProprietorshipA proprietorship is a firm with a single owner who has unlimited liability, or legal responsibility for all debts incurred by the firmup to an amount equal to the entire wealth of the owner.

The proprietor also makes management decisions and receives the firms profit.

Profits are taxed the same as the owners other income.

Information and OrganizationPartnershipA partnership is a firm with two or more owners who have unlimited liability.

Partners must agree on a management structure and how to divide up the profits.

Profits from partnerships are taxed as the personal income of the owners.

Information and OrganizationCorporation A corporation 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.The personal wealth of the stockholders is not at risk if the firm goes bankrupt.The profit of corporations is taxed twiceonce as a corporate tax on firm profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.

Information and OrganizationPros and Cons of Different Types of Firms

Each type of business organization has advantages and disadvantages.

Information and OrganizationProprietorships are easy to set upManagerial decision-making is simpleProfits are taxed only onceBut bad decisions made by the manager are not subject to reviewThe owners entire wealth is at stakeThe firm dies with the owner

Information and OrganizationPartnerships are easy to set upEmploy diversified decision-making processesCan survive the death or withdrawal of a partnerProfits are taxed only onceBut partnerships make attaining a consensus about managerial decisions difficultPlace the owners entire wealth at riskThe withdrawal of a partner might create a capital shortage

Information and OrganizationA corporation offers everlasting lifeLimited liability for its ownersLarge-scale and low-cost capital that is readily availableProfessional managementLower costs from long-term labor contractsBut a corporations management structure may lead to slower and expensive decision-makingProfit is taxed twiceas corporate profit and shareholder income.

Markets and the Competitive EnvironmentEconomists identify four market types:Perfect competitionMonopolistic competitionOligopolyMonopoly

Markets and the Competitive EnvironmentPerfect competition is a market structure with:Many firmsEach sells an identical productMany buyersNo restrictions on entry of new firms to the industryBoth firms and buyers are all well-informed of the prices and products of all firms in the industry

Markets and the Competitive EnvironmentMonopolistic competition is a market structure with:Many firmsEach firm produces similar but slightly different productscalled product differentiationEach firm possesses an element of market powerNo restrictions on entry of new firms to the industry

Markets and the Competitive EnvironmentOligopoly is a market structure in which:A small number of firms competeThe firms might produce almost identical products or differentiated productsBarriers to entry limit entry into the market

Markets and the Competitive EnvironmentMonopoly is a market structure in which:One firm produces the entire output of the industryThere are no close substitutes for the productThere are barriers to entry that protect the firm from competition by entering firms

*****Another day, another dollar profitor 15 cents, after implicit costs. Emphasize the difference between accounting profit and economic profit when a firm owner is using cost information to make business decisions. Point out that only economic profit reflects the full opportunity cost of making a business decision and that it is vital for assessing the true financial health of a firm. Stress that 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). Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy financial picture for the firmto the detriment of the firm owners.Enron and Arthur Andersen: When is a cost really a cost? The Enron fiasco brought the subject of accuracy and completeness in cost assessment to the attention of investors everywhere. Suddenly, the validity of financial information on any financial statement issued by any publicly held company was under scrutiny.The implicit cost shuffle: Some subversive tools of the accounting trade. A very useful news article, written by financial reporter Ken Brown, appeared in the Wall Street Journal on Feb. 2, 2002. He summarized many popular ways to use accounting costs to understate opportunity costs on a financial statement while technically satisfying generally accepted accounting procedures: For example, his list includes: i) Understating the capital asset depreciation by failing to record recent declines in the true market valuation of the capital (rather than from physical decay); ii) using off-the-books agreements to hide debt and credit risk by partnering with another company to share liabilities (which was a key element of Enrons ill-fated ploy); iii) capitalizing operating expenses, which allows current operating costs to be allocated over future time periods as if it were a capital depreciation expense. **********Minimizing the quantity of resources used in production is not the same as minimizing the value of the resources used. Be sure that students appreciate the difference between technological efficiency and economic efficiency. Point out that technological 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 economic efficiency.********Why do professional golfers/tennis players, etc., get paid in prize money? Get your students to think about this question and to think about the idea of a rank tournament inside a firm.**************