CHAPTER 10 Organizing Production

TM 10-2 Copyright © 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

TM 10-3 Copyright © 1998 Addison Wesley Longman, Inc. 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

TM 10-4 Copyright © 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

TM 10-5 Copyright © 1998 Addison Wesley Longman, Inc. The Firm and Its Economic 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

TM 10-6 Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM 10-7 Copyright © 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

TM 10-8 Copyright © 1998 Addison Wesley Longman, Inc. 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

TM 10-9 Copyright © 1998 Addison Wesley Longman, Inc. Uncertainty About the Future Another fundamental problem is uncertainty about the future. sales costs future competition

TM Copyright © 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. The Pros and Cons of the Different Types of Firms 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

TM Copyright © 1998 Addison Wesley Longman, Inc. The Pros and Cons of the Different Types of Firms Partnership Pros Easy to set up Diversified decision making Can survive withdrawal of partner Profits taxed only once as owners’ incomes

TM Copyright © 1998 Addison Wesley Longman, Inc. The Pros and Cons of the Different Types of Firms Partnership Cons Achieving consensus may be slow and expensive Owners entire wealth at risk Withdrawal of partner may create capital shortage Capital is expensive

TM Copyright © 1998 Addison Wesley Longman, Inc. The Pros and Cons of the Different Types of Firms 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

TM Copyright © 1998 Addison Wesley Longman, Inc. The Pros and Cons of the Different Types of Firms Corporation Cons Complex management structure can make decisions slow and expensive Profits taxed twice as company profit and as stockholders’ income

TM Copyright © 1998 Addison Wesley Longman, Inc. Relative Importance of the Three Main Types of Firms

TM Copyright © 1998 Addison Wesley Longman, Inc. Relative Importance of the Three 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Discounting and Present Value Present Value Future amount = Present value + Interest Future amount = Present value + (r x Present value) Future amount = Present value  (1 + r)

TM Copyright © 1998 Addison Wesley Longman, Inc. Discounting and Present Value Present Value Present value = Future amount/(1 + r) Present Value n years in the future Present value = Future amount/(1 + r) n

TM Copyright © 1998 Addison Wesley Longman, Inc. $121 Present value = ( ) 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%.

TM Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Present Value and Marginal Analysis Firms compare the marginal benefit to the marginal benefit of borrowing. Firms calculate the net present value of borrowing.

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic 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

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit Economic Profit A firm’s total revenue minus its opportunity costs. Not the same as accounting profit.

TM Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit: An Example ItemAmount Total 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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 Opportunity Cost and Economic Profit: An Example

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit: An Example 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Opportunity Cost and Economic Profit: An Example ItemAmount Total 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. Economic Efficiency Economic efficiency A firm that does not use the economically efficient method of production does not maximize profit.

TM Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Four Ways of Making 10 TV Sets a Day Quantities of inputs Method Labor Capital aRobot production 1 1,000 bProduction line cBench production dHand-tool production 1,000 1

TM Copyright © 1998 Addison Wesley Longman, Inc. Four Ways of Making 10 TV Sets a Day 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, b ,500 = 3, c 7, ,500 = 10,000 1, d 75, = 75,250 7,525.00

TM Copyright © 1998 Addison Wesley Longman, Inc. Four Ways of Making 10 TV Sets a Day Four ways of making TVs Labor cost Capital cost Method ($150 per day) ($1 per day) Total cost Cost per TV set a $150 + $1,000 = $1,150 $ b 1, = 1, d 150, = 150,001 15,000.10

TM Copyright © 1998 Addison Wesley Longman, Inc. Four Ways of Making 10 TV Sets a Day Four ways of making TVs Labor cost Capital cost Method ($1 per day) ($1,000 per day) Total cost Cost per TV set a $1+ $1,000,000 = $1,000,001 $100, b ,000 = 10,010 1, d 1,000+ 1,000 = 2,

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. Firms and Markets What determines whether markets or firms coordinate production? Answer: Whichever is the economically efficient method.

TM Copyright © 1998 Addison Wesley Longman, Inc. 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

TM Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. 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.

TM Copyright © 1998 Addison Wesley Longman, Inc. Why Firms? Team production A production process in which the individuals in a group specialize in mutually supportive tasks.