Lecture 8: Capitalist Production Reading: Chapter 10

Capitalist Production Q: What social institution is responsible for organizing the production of most commodities supplied to the market?  Firms Q: What is it that firms do?  Firms accomplish two social tasks:  1. Organize Production  2. Organize Distribution continued

Capitalist Production Q: What is involved in organizing production:  There are a number of related decisions:  technology decision:  factor input decisions:  1. Hiring workers and managers (L)  2. Financing and purchasing capital goods (K)  3. Purchasing intermediate inputs.

Capitalist Production Q: What is involved in organizing distribution?  This is often referred to as marketing:  1. Pricing decision.  2. Output decision.  3. Distribution decision.  4. Advertising decision.

Capitalist Production Q: How are firms themselves organized?  Two types of business organization  Unlimited Liability  sole proprietorship  Partnership  Limited Liability  Private Corporation  Public Corporation  Crown Corporation

Q: Why has limited liability been so important?  Limited liability was a legal innovation which enabled firms to attract a group of investors to cooperate on large projects. Q: What is the social significance of this legal innovation?  The ability to raise much larger investment funds made modern capitalism possible. Capitalist Production

Q: Large corporations have an advantage in financing projects that require large investments. How do corporations finance investments?  Firms finance investments by  selling stock (equity)  selling bonds  bank loans  retained earnings from cash-flow (borrowing from shareholders) continued

Capitalist Production Q: Firms play a social role of organizing and distributing production. This requires making decisions on output, input, and technology, etc. What guides firm decision- making?  Decisions are aimed at Maximizing Economic Profits  If the firm fails to maximize its profit, the firm is either eliminated or bought out by other firms seeking to maximize profit.  A manager who fails to pursue this objective loses his job.

Capitalist Production Q: What is profit?  The most common measure of profit is accounting profit: Accounting Profit = Revenue – Accounting Costs Q: What are Accounting Costs?  Accounting Costs = Explicit Costs + Conventional Depreciation  Explicit Costs = money costs of inputs  Conventional Depreciation = rate at which accountants cost wear and tear on Capital (i.e. buildings and equipment)

Capitalist Production Q: Is accounting profit the true economic profit?  Economic Profit = Revenue – Opportunity Cost Q: What is the Difference?  Opportunity Costs ≠ Accounting Costs

Q: What are a firm’s Opportunity Cost of Production?  A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.  A firm’s opportunity cost of production is the sum of the cost of using resources  Bought in the market (Explicit costs)  Owned by the firm (Implicit costs)  Supplied by the firm's owner (Implicit costs)

Resources Owned by the Firm  If the firm owns capital and uses it to produce its output, then the firm incurs an opportunity cost.  Instead of using the capital, the firm could have sold the capital and rented capital from another firm.  The firm implicitly rent the capital from itself.  The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital.

The implicit rental rate of capital is made up of 1.Economic depreciation: is the change in the market value of capital over a given period. 2.Interest forgone: is the return on the funds used to acquire the capital.

Resources Supplied by the Firm’s Owner  The owner might supply both entrepreneurship and labour.  The return to entrepreneurship is profit.  The profit that an entrepreneur can expect to receive on average is called normal profit.  Normal profit is the cost of entrepreneurship and is a cost of production.

 In addition to supplying entrepreneurship, the owner might supply labour but not take a wage.  The opportunity cost of the owner’s labour is the wage income forgone by not taking the best alternative job.  Economic Accounting: A Summary  Economic profit equals a firm’s total revenue minus its total opportunity cost of production.  The example in Table 10.1 on the next slide summarizes the economic accounting.

The Firm and Its Economic Problem

Capitalist Production Q: What is the relationship between accounting and economic costs and profits  Opportunity Costs > Accounting Costs  Economic Profits < Accounting Profits  Normal profit is considered a cost in the economic framework, while it is considered profit under the accounting framework.

Capitalist Production Q: If firms make decisions to maximize profits, what characterizes a good decision?  To maximize profits, decision-makers should focus on marginal revenue (MR) and marginal costs (MC) and follow this simple rule:  Increase an activity if MR>MC  Decrease an activity if MR<MC  Leave activity unchanged if MR = MC

Capitalist Production  For instance consider the decision on how much to produce and sell.  The MR will be the additional revenue from an additional unit produced and sold. The MC will be the additional opportunity cost of that unit.  The rule:  Increase Q if MR>MC  Decrease Q if MR<MC  Profit maximizing Q where MR=MC

Capitalist Production  For many firms the decision can be illustrated as

Capitalist Production Q: What determines the shape of the total revenue and total cost curves for a firm?  The shape of the total revenue curve depends on:  Market structure of the firm’s industry  The shape of the total cost curve depends on:  Input prices  Technology

Capitalist Production Economists identify four types of market structure: 1. Perfect competition 2. Monopolistic competition 3. Oligopoly 4. Monopoly The shape of the total revenue curve depends on the market structure for the firm’s sales.

Perfect competition is a market structure with  Many firms  Each sells an identical product  Many buyers  No restrictions on entry of new firms to the industry  Both firms and buyers are all well informed about the prices and products of all firms in the industry. Capitalist Production

Monopolistic competition is a market structure with  Many firms  Each firm produces similar but slightly different products—called product differentiation  Each firm possesses an element of market power  No restrictions on entry of new firms to the industry Capitalist Production

Oligopoly is a market structure in which  A small number of firms compete.  The firms might produce almost identical products or differentiated products.  Barriers to entry limit entry into the market. Capitalist Production

Monopoly is a market structure in which  One firm produces the entire output of the industry.  There are no close substitutes for the product.  There are barriers to entry that protect the firm from competition by entering firms. Capitalist Production

Economists use two measures of market concentration:  The four-firm concentration ratio  The Herfindahl–Hirschman index (HHI) Capitalist Production

Two measures of market concentration  The Four-Firm Concentration Ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry.  The Herfindahl–Hirschman Index (HHI) is the square of percentage market share of each firm summed over the largest 50 firms in the industry.  The larger the measure of market concentration, the less competition that exists in the industry. Capitalist Production

The main limitations of only using concentration measure as determinants of market structure are  The geographical scope of the market  Barriers to entry and firm turnover  The correspondence between a market and an industry Capitalist Production

Why do we have firms at all?  We have already learned that markets coordinate a great deal of the economy. Why not production as well? The market mechanism has many advantages:  Participation is voluntary  Market allocations are efficient  Markets are decentralized and automatically adjust to changing scarcity

Because of these advantages, Firms will coordinate production only when they can do so more efficiently than a market. When are firms more efficient? Firms can achieve  Lower transactions costs  Economies of scale  Economies of scope  Economies of team production Capitalist Production

Transactions costs are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled. Economies of scale occur when the cost of producing a unit of a good falls as its output rate increases. Economies of scope arise 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 specialize in mutually supporting tasks. Capitalist Production

End of Lecture