1. Organizing Production
Michael Parkin
ECONOMICS 5e
CHAPTER 10
Organizing Production 1

2. Learning Objectives
Explain what a firm is and describe the economic problems that all firms face
Distinguish between technical efficiency and economic efficiency
Define and explain the principal-agent problem 2

3. Learning Objectives (cont.)
Describe and distinguish between different types of business organization
Describe and distinguish between different types of markets in which firms operate
Explain why firms coordinate some economic activities and markets coordinate others 3

4. Learning Objectives
Explain what a firm is and describe the economic problems that all firms face
Distinguish between technical efficiency and economic efficiency
Define and explain the principal-agent problem

5. The Firm and Its Economic Problem
An institution that hires productive resources and that organizes those factors to produce and sell goods and services
A firm’s goal is to maximize profit. 5

6. The Firm and Its Economic Problem
Measuring a Firm’s Profit
Sidney makes sweaters.
We want to predict the decisions that a firm makes.
These decisions respond to opportunity cost and economic profit. 5

7. The Firm and Its Economic Problem
Opportunity Cost
Opportunity cost of producing — the best alternative action that the firm foregoes to produce a good or service.
A firm’s opportunity cost are:
Explicit costs
Implicit costs 30

8. The Firm and Its Economic Problem
Opportunity Cost (cont.)
Explicit costs (money costs)
The amount paid for factors of production.
The amount paid for a resource that could have been spent on something else, so it is the opportunity cost of using the resource. 31

9. The Firm and Its Economic Problem
Opportunity Cost (cont.)
Implicit costs (non-money costs)
The value of foregone opportunities.
A firm incurs implicit cost when it:
1. Uses its own capital
2. Uses its owner’s time or financial resources. 31

10. The Firm and Its Economic Problem
Opportunity Cost (cont.)
Implicit rental rate is the income that the firm forgoes by using the assets itself and not renting them to another firm
The rental income foregone is the opportunity cost of the firm using its own capital. 31

11. The Firm and Its Economic Problem
Opportunity Cost (cont.)
This opportunity cost is called the implicit rental rate of capital.
The implicit rental rate of capital is made up of:
1. Economic depreciation
2. Interest foregone 31

12. The Firm and Its Economic Problem
Opportunity Cost (cont.)
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. 32

13. The Firm and Its Economic Problem
Opportunity Cost (cont.)
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. 35

14. The Firm and Its Economic Problem
Opportunity Cost (cont.)
Economic Profit
A firm’s total revenue minus its opportunity costs.
The firm’s opportunity cost is the sum of its explicit costs and implicit costs.
Not the same as accounting profit. 36

15. The Firm and Its Economic Problem
Economic Accounting: A Summary
Sidney’s Sweaters’ total revenue is $400,000.
Its opportunity cost is $365,000.
Its economic profit is $35,000. 37

16. The Firm and Its Economic Problem
Economic Accounting: A Summary
A firm’s actions are limited by the constraints that it faces.
The next task is to learn about these constraints. 37

17. The Firm and Its Economic Problem
Economic Accounting
Item
Total revenue $400,000
Opportunity Costs
Wool $80,000
Utilities ,000
Wages paid ,000
Bank interest paid 10,000
Total Explicit Costs $230,000 38

18. The Firm and Its Economic Problem
Economic Accounting (cont.)
Sydney’s wages foregone 40,000
Sydney’s interest foregone 20,000
Economic depreciation $25,000
Normal profit $50,000
Total Implicit Costs $135,000
Total Cost $365,000
Economic Profit $35,000 38

19. The Firm and Its Economic Problem
The Firm’s Constraints
Three features of its environment limit the maximum profit a firm can make. They are:
Technology
Information
Market

20. The Firm and Its Economic Problem
Technology Constraints
Technology is any method of producing a good or service.
A firm’s resources and the available technology limit its production.
Hiring more resources means increasing costs. The increase in cost limits profit.

21. The Firm and Its Economic Problem
Information Constraints
The cost of coping with limited information itself limits profit.

22. The Firm and Its Economic Problem
Market Constraints
What each firm can sell and the price it can obtain is constrained by the willingness to pay of its customers and by the prices and marketing efforts of other firms.
The resources that a firm can buy and the prices it must pay are limited by the willingness of people to work for and invest in the firm.

23. Learning Objectives
Explain what a firm is and describe the economic problems that all firms face
Distinguish between technical efficiency and economic efficiency
Define and explain the principal-agent problem

24. Technical and Economic Efficiency
Technological efficiency
Occurs when the firm produces a given output by using the least inputs.
Economic efficiency
Occurs when the cost of producing a given output is as low as possible. 42

25. Technical and Economic Efficiency
Let’s use an example to illustrate technological and economic efficiency.
Suppose there are 4 different ways of making 10 TVs a day.
Let’s compare each way’s technological and economic efficiency. 44

26. Technical and Economic Efficiency
Quantities of inputs
Method Labor Capital
a Robot production ,000
b Production line
c Bench production
d Hand-tool production 1,
Instructor Notes:
1) Method c is technologically inefficient.
2) It requires the less workers and the same number of units of capital to produce the same number of sets.
3) All of the other methods are technologically efficient. They each require more of one input than each of the others. 45

27. Technical and Economic Efficiency
(a) Four ways of making TVs
Labor cost Capital cost
Method ($75 per day) ($250 per day) Total cost Cost per TV set
a $ $250, = $250,075 $25,007.50
b , = ,
c , , = , ,000.00
d , = , ,525.00
Instructor Notes:
1) It should be noted that even though method c is technologically inefficient, it costs less to produce a TV set by using method c that it does by using methods a and d.
2) Since method c is not technologically efficient, there is always a method available that has a lower cost. We will ignore method c from now on.
3) Method b is economically efficient.
3) Let’s change the costs of labor and capital to see if another method might be more economically efficient. 46

28. Technical and Economic Efficiency
(b) Three ways of making TVs: High Labor Costs
Labor cost Capital cost
Method ($150 per day) ($1 per day) Total cost Cost per TV set
a $ $1, = $1, $115.00
b , = ,
d , = , ,000.10
Instructor Notes:
1) Now, method a is economically efficient.
2) Capital is now sufficiently cheap relative to labor that the method that uses the most capital is the economically efficient method.
3) Now, let’s change labor costs and capital costs, again. 47

29. Technical and Economic Efficiency
(c) Three ways of making TVs: High Capital Costs
Labor cost Capital cost
Method ($1 per day) ($1,000 per day) Total cost Cost per TV set
a $ $1,000,000 = $1,000, $100,000.10
b ,000 = , ,001.00
d , ,000 = ,
Instructor Notes:
1) Now, method d is economically efficient.
2) Firms that do not use the economically efficient method of production do not maximize profit.
3) Efficient firms are stronger and better able to survive temporary adversity than inefficient ones. 48

30. Technical and Economic Efficiency
While technological efficiency depends only on what is feasible, economic efficiency depends on the relative cost of resources.
The economically efficient method is the one that uses the smallest amount of a more expensive resource and a larger amount of a less expensive resource.

31. Technical and Economic Efficiency
A firm that is not economically efficient does not maximize profit.
Profit-maximizing firms are stronger and better able to survive temporary adversity than inefficient ones.

32. Information and Organization
Each firm organizes the production of goods and services by combining and coordinating the productive resources it hires.
Firms use a mixture of two systems:
Command systems
Incentive systems

33. Information and Organization
Command Systems
Command systems are based upon a managerial hierarchy.
Incentive systems
Incentive systems are market-like mechanisms that firms create within their organizations. 6

34. Information and Organization
Mixing the Systems
Firms use a mixture of commands and incentives.They choose the mixture to maximize profit.
They use commands when it is easy to monitor performance.
They use incentives when monitoring performance is too costly or not possible. 6

35. Learning Objectives
Explain what a firm is and describe the economic problems that all firms face
Distinguish between technical efficiency and economic efficiency
Define and explain the principal-agent problem

36. The 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 8

37. The Principal-Agent Problem
Ownership
By assigning a manager or worker ownership of a business, it is sometimes possible to induce a job performance that increases the firm’s profits.

38. The Principal-Agent Problem
Incentive pay
Pay related to performance - are very common.
Based on a variety of performance criteria such as profits or production or sales targets.

39. The Principal-Agent Problem
Long-term contracts
Long-term contracts tie the long-term fortunes of managers and workers (agents) to the success of the principle(s) - the owner(s) of the firm.
Case: the Japanese company’s culture for “life employment” combined with substantial economic stimuli

40. The Principal-Agent Problem
Each type of business organization is a different response to the principle-agent problem.

41. Learning Objectives
Describe and distinguish between different types of business organization
Describe and distinguish between different types of markets in which firms operate
Explain why firms coordinate some economic activities and markets coordinate others

42. Types of Business Organization
Proprietorship
A firm with a single owner.
Partnership, Ltd
A firm with two or more owners who have unlimited liability.
Partnership, Ltd – limited liability
Corporation (stockholding company) - Inc
A firm owned by one or more limited liability stockholders. 11

43. Types of Business Organization
Proprietorship
Pros
Easy to set up.
Simple decision making.
Profits taxed only once as owner’s income. 12

44. Types of Business Organization
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. 13

45. Types of Business Organization
Partnership
Pros
Easy to set up.
Diversified decision making.
Can survive withdrawal of partner.
Profits taxed only once as owners’ incomes. 14

46. Types of Business Organization
Partnership
Cons
Achieving consensus may be slow and expensive.
Owners entire wealth at risk.
Withdrawal of partner may create capital shortage.
Capital is expensive. 15

47. Types of Business Organization
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. 16

48. Types of Business Organization
Corporation
Cons
Complex management structure can make decisions slow and expensive.
Profits taxed twice as company profit and as stockholders’ income (tax on dividends). 17

49. Relative Importance of Three Main Types of Firms18

50. Types of Business Organization
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 19

51. Learning Objectives
Describe and distinguish between different types of business organization
Describe and distinguish between different types of markets in which firms operate
Explain why firms coordinate some economic activities and markets coordinate others

52. Markets and the Competitive Environment
Economists identify four market types:
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly

53. Markets and the Competitive Environment
1. Perfect competition
Arises when there are many firms each selling an identical product, many buyers, and no restrictions on the entry of new firms into the industry.

54. Markets and the Competitive Environment
2. Monopolistic competition
A market structure in which a large number of firms compete by making similar buy slightly different products.
Product differentiation gives a monopolistically competitive firm an element of monopoly power.

55. Markets and the Competitive Environment
3. Oligopoly
A market structure in which a small number of firms compete.
Case: OPEC (1960) Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Qatar (1961), Indonesia and Libya (1962), Abu Dhabi (1967; membership transferred to the United Arab Emirates, 1974), Algeria (1967), Nigeria (1971), and Angola (2007)

56. Markets and the Competitive Environment
4. Monopoly
An industry that produces a good or service for which no close substitutes exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

57. Markets and the Competitive Environment
Measures of Concentration
1. The four-firm concentration ratio
2. The Herfindahl-Hirschman Index 6

58. Markets and the Competitive Environment
The Four Firm Concentration Ratio
Measures the percentage of the value of sales accounted for by the four largest firms
Range from 0 percent to 100 percent 6

59. Measures of Concentration
Herfindahl-Hirschman Index (HHI)
The square of the percentage market share of each firm summed over the largest 50 firms (or the number of firms if there are less than 50)
Range from approximately 0.5 percent to 10,000.
In perfect competition the HHI is small. 7

60. Concentration Ratio Calculations
Tiremakers
Sales
Firm (millions of dollars)
Top, Inc. 200
ABC, Inc. 250
Big, Inc. 150
XYZ, Inc. 100
Top 4 sales 700
Other 10 firms sales 175
Industry sales 875
Four-firm concentration ratios:
Tiremakers: 700/875 100 = 80% 8

61. Concentration Ratio Calculations
Printers
Sales
Firm (millions of dollars)
Fran’s 2.5
Neda’s 2.0
Tom’s 1.8
Jill’s 1.7
Top 4 sales 8.0
Other 1,000 firm’s sales 1,592.0
Industry sales 1,600.0
Four-firm concentration ratios:
Printers makers: 8/1,600  100 = 0.5% 9

62. Market Structure Perfect Monopolistic
Characteristics competition competition Oligopoly Monopoly
Number of firms Many Many Few One
in industry
Product Identical Differentiated Either identical No close or differentiated substitute
Barriers
to entry None None Moderate High
Firm’s control None Some Considerable Considerable
over price or regulated
Concentration ratio 0 Low High 100
HHI Less than 1,000 1,000 to 1,800 More than 1,800 10,000
Examples Wheat, corn Food, clothing Automobiles, Local phone s cereals service, electric & gas utilities 10

63. Markets and the Competitive Environment
Limitations of Concentration Measures
Geographical Scope of Market
Regional markets versus global markets
Barriers to entry and turnover
Do not measure the barriers to entry 11

64. Markets and the Competitive Environment
Limitations of Concentration Measures (cont.)
The correspondence between a market and an industry
Markets are narrower than industries
Firms make many different products
Firms switch from one market to another 12

65. Concentration Measures in the United States
Instructor Notes:
1) Measured by the four-firm concentration ratio and the Herfindahl-Hirschman Index, the industries producing chewing gum, household laundry equipment, and lightbulbs are highly concentrated, while those producing commercial printing, ice-cream, and milk are highly competitive.
2) The industries producing food and cookies and crackers have an intermediate degree of concentration. 13

66. Market Structures in the U.S. Economy
In 1998, three-fourths of the value of goods came from either perfectly competitive or monopolistically competitive markets.
The economy became more competitive between 1939 and 1998.
During the past decade, the U.S. economy has become much more exposed to competition from the rest of the world. 14

67. The Market Structure of the U.S. Economy
Instructor Notes:
1) The market structure of three quarters of the U.S. economy is effectively competitive (perfect competition or monopolistic competition), one fifth is oligopoly, and the rest is monopoly.
2) The economy became more competitive between 1939 and 1980.
3) Professor William G. Shepherd, whose 1982 study remains the latest word on this topic, suspects that although some industries have become more concentrated, others have become less concentrated, so the net picture has probably not changed much since 1980) 15

68. Learning Objectives
Describe and distinguish between different types of business organization
Describe and distinguish between different types of markets in which firms operate
Explain why firms coordinate some economic activities and markets coordinate others

69. Firms and Markets
What determines whether markets or firms coordinate production?
Answer:
Whichever is the economically efficient method. 50

70. Firms and Markets
Why firms are sometimes more efficient coordinators of economic activity?
Lower transactions costs
Economies of scale
Economies of scope
Economies of team production 51

71. Firms and Markets 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. 52

72. Firms and Markets
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. 53

73. Firms and Markets Team production
A production process in which the individuals in a group specialize in mutually supportive tasks. 54