CHAPTER 6 Introducing supply decisions ©McGraw-Hill Education, 2014

Forms of business organization Sole trader – owned by an individual; entitled to income and responsible for losses Partnership – jointly owned by two or more people – unlimited liability Company – ownership divided among shareholders – legal entitlement to produce and trade – limited liability – shares of public companies traded on the stock exchange ©McGraw-Hill Education, 2014

Some key terms Revenues – the amount a firm earns by selling goods and services in a given period Costs – the expenses incurred in producing goods and services during the period Profits – the excess of revenues over costs ©McGraw-Hill Education, 2014

Limited liability Shareholders of a company have limited liability. The most they can lose is the money they spent buying shares. Unlike sole traders and partners, shareholders cannot be forced to sell their personal possessions if the business goes bust. At worst, the shares become worthless. ©McGraw-Hill Education, 2014

Some accounting terms Cash flow – the net amount of money received (by the firm) during the accounting period Physical capital – machinery, equipment and buildings used in production Depreciation – the loss in value of a capital good during the accounting period Inventories – goods held in stock by the firm for future sales ©McGraw-Hill Education, 2014

A firm’s balance sheet Assets – what the firm owns Liabilities – what the firm owes Balance sheet – lists a firm’s assets and liabilities at a point in time ©McGraw-Hill Education, 2014

Shark's balance sheet at 31 December 2009 ©McGraw-Hill Education, 2014

Costs and the economist Accounting cost – actual payments made by a firm in a period Opportunity cost – amount lost by not using a resource in its best alternative use Economists include opportunity cost in a firm’s total costs ©McGraw-Hill Education, 2014

Supernormal profits – Economic costs relate to all the costs incurred by the firm. They include the opportunity costs of all resources used in production. – They thus include the opportunity cost of financial capital used in the firm. – Supernormal profit is the pure profit accruing to the owners after allowing for all economic costs. ©McGraw-Hill Education, 2014

The production decision For any output level, the firm is assumed to attempt to minimize costs and maximise profits. Profits depend on both costs and revenue, – each of which varies with the level of output. Marginal cost (MC) is the rise in total cost if output increases by 1 unit. Marginal revenue (MR) is the rise in total revenue if output increases by 1 unit. ©McGraw-Hill Education, 2014

Maximizing profits If MR > MC, an increase in output will increase profits. If MR < MC, a decrease in output will increase profits. So profits are maximized when MR = MC at Q 1 (as long as the firm covers variable costs). ©McGraw-Hill Education, 2014

A shift in demand Output Q1Q1 E MC, MR 0 E' Q2Q2 A shift of marginal revenue from MR to MR' Optimal output increases from Q 1 to Q 2, This shift in the MR curve could come from an increase in the number of customers in the market Leads the interaction point between MR and MC to shift from E to E' ©McGraw-Hill Education, 2014

Will firms try to maximize profits? Large firms are not run by their owners. – There is separation of ownership and control; this leads to a principal-agent problem. Different managers may decide to pursue different objectives - e.g. size, growth But firms not maximizing profits may be vulnerable to takeover, – or managers may be given share options to influence their incentive to maximize profits ©McGraw-Hill Education, 2014

Sources of finance (1) Borrowing from banks Retained earnings Borrowing by selling pieces of paper (corporate bonds) whereby the firm promises to pay interest for a specified period and then repay the debt Using the stock market for selling new shares in the firm – initial public offering (IPO). ©McGraw-Hill Education, 2014

Sources of finance (2) The US and the UK have market-based or outsider systems, relying on active stock markets trading existing shares and debt, and available to issue new shares and debt. Japan and much of continental Europe, notably Germany, have traditionally had an insider system, in which financial markets play only a small role. German companies got long-term loans from banks, who then sat on company boards with access to inside information about how the firm was doing. ©McGraw-Hill Education, 2014

Some maths Give a linear demand function: Total Revenue: TR(Q) = P x Q The marginal revenue function (MR) can be found by taking the derivative of the total revenue function with respect to Q : ©McGraw-Hill Education, 2014

Concluding comments (1) The theory of supply is the theory of how much output firms choose to produce. Revenue is what the firm earns from sales. Costs are the expenses incurred in producing and selling. Profits are the excess of revenue over costs. Opportunity cost is the amount an input could obtain in its next-highest-paying use. Economic costs also include the opportunity cost of financial capital used in the firm. ©McGraw-Hill Education, 2014

Concluding comments (2) Supernormal profit is the pure profit accruing to the owners after allowing for all economic and opportunity costs. Firms are assumed to aim to maximize profits. Profits are maximized at the output at which marginal cost equals marginal revenue. ©McGraw-Hill Education, 2014