1. Ch. 9: ORGANIZING PRODUCTION
Definition of a firm
The economic problems that all firms face
Technological efficiency vs. economic efficiency
The principal-agent problem and methods for coping with the problem.
Different types of markets in which firms operate
Explain why markets coordinate some economic activities and firms coordinate others

2. The Firm and Its Economic Problem
A firm is an institution that hires factors of production and organizes them to produce and sell goods and services.
The Firm’s Goal
Maximize economic profit.
If the firm fails to maximize economic profits, it is either eliminated or bought out by other firms seeking to maximize profit.

3. Measuring a Firm’s Profit
Accounting profits
measures a firm’s profit using rules laid down by the IRS and the Financial Accounting Standards Board.
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.
Economic profits
measure profit based on an opportunity cost measure of cost.
Primary difference between accounting and economic profits is in measurement of costs.

4. Opportunity Cost
A firm’s decisions respond to opportunity cost and economic profit.
A firm’s opportunity cost of producing a good is the best forgone alternative use of its factors of production, usually measured in dollars.
Opportunity cost includes both:
Explicit costs
Implicit costs
Another day; another dollar profit—or 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 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 firm—to 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, 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 Enron’s 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.

5. Explicit vs. implicit cost of capital:
Explicit costs
costs paid directly in money.
Implicit costs
costs incurred when a firm uses the owners’ own capital or time for which it does not make a direct money payment.
Explicit vs. implicit cost of capital:
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.

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

7. Implicit costs of labor
The opportunity cost of the owner’s 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 owner’s labor spent running the business is the wage income forgone by not working in the next best alternative job.

8. Economic vs. Accounting Profit
Accounting Profit = TR – Explicit Costs
Economic Profit = TR – Opportunity Costs of production
= TR – Expl. Costs – Impl. Costs
= Acc. Profits – Implicit Costs
If Economic Profit > 0  Acc Profits > Implicit Costs  Firms enter
If Economic Profit < 0  Acc Profits < Implicit Costs  Firms exit

9. 5 Decisions for the Firm
To maximize profit, a firm must make five basic decisions:
What goods and services to produce and in what quantities
How to produce—the production technology to use
How to organize and compensate its managers and workers
How to market and price its products
What to produce itself and what to buy from other firms

10. The Firm’s Constraints
The five basic decisions of a firm are limited by the constraints it faces. There are three constraints a firm faces:
Technology
Information
Market

11. Technology vs. Economic Efficiency
Technological 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.
Economic efficiency
occurs when the firm produces a given level of output at the least cost.
economically efficient method depends on the relative costs of capital and labor
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 economical efficiency.

12. Information and Organization
Command system
uses a managerial hierarchy.
Commands pass downward through the hierarchy and information (feedback) passes upward.
Problem: must monitor.
Incentive system
Uses market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.
Problem:
Sometimes difficult to create proper incentives.
Principal agent problem.
Ownership
Incentive pay
Long-term contracts

13. Information and Organization
3 Types of Business Organization
OrganizationProprietorship
Partnership
Corporation

14. Information and Organization
Proprietorship
single owner
unlimited liability
proprietor makes management decisions and receives the firm’s profit.
profits are taxed the same as the owner’s other income.

15. Information and Organization
Partnership
two or more owners who have unlimited liability.
partners must agree on a management structure and how to divide up the profits.
profits are taxed as the personal income of the owners.

16. Information and Organization
Corporation
owned by one or more stockholders with limited liability,
The personal wealth of the stockholders is not at risk if the firm goes bankrupt.
The profit of corporations is taxed twice
corporate tax on firm profits
income taxes paid by stockholders on dividends.

17. Pros and Cons of Different Types of Firms
Proprietorships
are easy to set up
Managerial decision making is simple
Profits are taxed only once
But bad decisions made by the manager are not subject to review
The owner’s entire wealth is at stake
The firm dies with the owner
The cost of capital and labor can be high

18. Pros and Cons of Different Types of Firms
Partnerships
Easy to set up
Employ diversified decision-making processes
Can survive the death or withdrawal of a partner
Profits are taxed only once
But partnerships make attaining a consensus about managerial decisions difficult
Place the owners’ entire wealth at risk
The cost of capital can be high, and the withdrawal of a partner might create a capital shortage

19. Pros and Cons of Different Types of Firms
A corporation
Perpetual life
Easy to dissolve
Limited liability for its owners
Large-scale and low-cost access to financial capital
Lower costs from long-term labor contracts
But a corporation’s management structure may lead to slower and expensive decision-making
Profit is taxed twice—as corporate profit and shareholder income.

20. Information and Organization
There are a greater number of proprietorships than other form of business, but corporations account for the majority of revenue received by businesses.
The dominant type of business organization differs across industries. Why?

21. Four types of Markets: Perfect competition Monopolistic competition
Oligopoly
Monopoly

22. Perfect competition 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 of the prices and products of all firms in the industry.

23. Monopolistic competition
Many firms
product differentiation
Each firm possesses an element of market power
No restrictions on entry of new firms to the industry

24. Oligopoly A small number of firms compete
The firms might produce almost identical products or differentiated products
Barriers to entry limit entry into the market.

25. Monopoly 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

26. Measures of Concentration
Two measures of market concentration in common use are:
The four-firm concentration ratio
The Herfindahl–Hirschman index (HHI)
DOJ uses the HHI to classify markets.
A market with an HHI of less than 1,000 is regarded as highly competitive
A market with an HHI between 1,000 and 1,800 is regarded as moderately competitive
A market with an HHI greater than 1,800 is uncompetitive

27. Measures of Concentration
The four-firm concentration ratio for various industries in the United States.
The figure also shows the HHI for these industries.

28. Measures of Concentration
Limitations of Concentration Measures as Measures of Competion
Geographic boundaries
Product boundaries.
Barriers to Entry
Ability to Collude
Can the market be defined by geography? by demography? by substitutability? Emphasize that attempts by economists to identify the market for a particular firm’s product is not at all easy.
Geography: the (expanding) market for beer. In the early 20th century, a market for any given brand of beer was largely limited to the geographic area within a days’ truck drive from the brewery—if the beer traveled for too long under too high an ambient temperature, the trip ruined the product. When technological advances in mobile refrigeration made transporting beer over the road economical, local monopoly brands suddenly felt the pain of competition from out-of-state brands that had never before been observed in the local market.
Demography: the (hidden) market for cigarettes. Can you define the market for a cigarette manufacturer by looking only at the market among adults? What if mostly illegal, under-aged smokers favored the brand rather than adult smokers? The sales to minors would not likely be recorded, yet it represents market share.
Substitutability: the (changing) market for personal transportation. Can you define the market for personal transportation? Twenty-five years ago it meant just the market for cars. Today, if we wanted to determine the market share for an auto manufacturer that happens to only sell cars, would the definition of the market for personal (as opposed to commercial) transportation include only cars? Or should trucks, mini-vans and SUVs be included as well? How about motorcycles?
The World Wide Web of business. Conclude the discussion of market definition by mentioning how today, items can be produced anywhere in the world and can be discovered and ordered from anywhere else in the world using the World Wide Web. These items can be paid for through electronic accounts located only in cyber-space, and the product can be shipped literally overnight to nearly any city in any developed country around the world. Stress how difficult it is to discern even the relevance of the term “market” in today’s business climate.

29. Markets and the Competitive Environment
Market Structures in the U.S. Economy
The distribution of market structures in the U.S. economy.
The economy is mainly competitive.

30. Markets and Firms Why Firms?
Firms coordinate production when they can do so more efficiently than a market.
Four key reasons might make firms more efficient. Firms can achieve:
Lower transactions costs
Economies of scale
Economies of scope
Economies of team production
Ronald Coase is the classic on this topic. You might like to tell your students about this remarkable person. Born in England in 1910, be graduated with a bachelor of commerce degree in 1932, at the depth of the Great Depression. While still an undergraduate, he was puzzled by the fact that he was being taught that markets coordinate economic activity, yet all around him he could see firms that were also coordinating economic activity. “Why?” he wondered. The question was especially important at that time because Socialists (and the young Coase was one of them) thought that central planning by government was superior to the market.
Quoting from Coase’s autobiography,
“I spent the academic year on my Cassel Travelling Scholarship in the United States studying the structure of American industries, with the aim of discovering why industries were organized in different ways. I carried out this project mainly by visiting factories and businesses. What came out of my enquiries was not a complete theory answering the questions with which I started but the introduction of a new concept into economic analysis, transaction costs, and an explanation of why there are firms. All this was achieved by the Summer of 1932, as the contents of a lecture delivered in Dundee in October 1932, make clear. These ideas became the basis for my article "The Nature of the Firm", published in 1937, cited by the Royal Swedish Academy of Sciences in awarding me the 1991 Alfred Nobel Memorial Prize in Economic Sciences.”
So, this amazing scholar had done his Nobel prize winning work at the age of 22!