Chapter 10 The Firm, Production and Cost

Forms of Business Organization Sole Proprieitorship Partnership Corporation (Joint-Stock Company) Public Corporation Government

Sole Proprieitorship Advantages  Easy to Organize  No Legal Red Tape  Profit Depends on one’s own effort  Incentive to Manage Business Efficiently

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

Partnership Advantages  Easy to Organize but still requires a written agreement.  Greater specialization in management.  Financial resources are greater than proprietorship

Partnership Disadvantages  Division of authority  Finances are still limited to partners’ capital.  Continuity is precarious, after withdrawal or death of a partner.  Unlimited Liability

Corporation Separate Legal Entity Distinct 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

ADVANTAGES OF CORPORATION Can sell stocks and bonds. Easier access to bank credit  Most effective for raising capital. Limited Liability  Owners risk only what they paid for stock  Personal assets are not at stake in case of bankruptcy.

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.

PUBLIC CORPORATION Setup to run a nationalized industry Owned by state Organization and legal status similar to a joint-stock company.

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

Financing of Firms Financial Capital  Shares  Bonds  Long-Term Loans Physical Capital  Factories  Machinery  Offices  Office Equipment

Financial Capital Equity  Acquire fund by selling stocks and shares.  Retain Current profits and finance investment from undistributed profits. Debt Instruments  Bonds (Long-Term, Specified Time of Maturity and interest rate)  Loans Between financial institutions  Bills and Notes (for short-term loans, specified principal and time of maturity)

Theory of the Firm Firm as the Unit of Analysis Firm Makes Decisions regarding production OBJECTIVE OF FIRM  Profit Maximization

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?

PRODUCTION FUNCTION Inputs – the factors of production classified as: 1. Land – all natural resources of the earth Price paid to acquire land = Rent 2. Labour – all physical and mental human effort involved in production Price paid to labour = Wages

INPUTS AND PRODUCTION 3. Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to production Price paid for capital = Interest

Intermediate Products Output of one firm, could be an input for another. These inputs are called “intermediate products”.

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?

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.

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.

IMPUTED COSTS Firm’s Own Capital Equipment Loss 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.

SUNK COSTS EXAMPLE  Firm 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 $25,000  After purchasing machines, firm realizes that output can be sold for only $29,000 per year, instead of $35,000.

SUNK COSTS Total Cost=$25, =$35,000 Revenue=$29,0000 Profit= =-$6000 (i.e. LOSS) Should product be made???

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=$4,000 i.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)

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.