CHAPTER 10 Organizing Production

1. CHAPTER10Organizing Production

2. Learning Objectives • Explain what a firm is and describe the economic problems that all firms face • Define and explain the principal-agent problem • Describe and distinguish among different forms of business organizations

3. Learning Objectives (cont.) • Explain how firms finance their operations • Calculate a firm’s opportunity cost and economic profit • Explain why firms coordinate some economic activities and markets coordinate others

4. Learning Objectives • Explain what a firm is and describe the economic problems that all firms face • Define and explain the principal-agent problem • Describe and distinguish among different forms of business organizations

5. The Firm and ItsEconomic Problem • Firm • An institution that hires productive resources and that organizes those factors to produce and sell goods and services • Primary economic problem firms face: • Organization — firms must organize production by combining and coordinating its productive resources

6. Command Systems • Command systems are based upon a managerial hierarchy. • Incentive systems are market-like mechanisms that firms create within their organizations. • These systems are designed to strengthen incentives and raise productivity.

7. Learning Objectives • Explain what a firm is and describe the economic problems that all firms face • Define and explain the principal-agent problem • Describe and distinguish among different forms of business organizations

8. The Principal-Agent Problem • 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

9. Uncertainty About the Future • Another fundamental problem is uncertainty about the future. • sales • costs • future competition

10. Learning Objectives • Explain what a firm is and describe the economic problems that all firms face • Define and explain the principal-agent problem • Describe and distinguish among different forms of business organizations

11. The Forms of Business Organization • Proprietorship • a firm with a single owner • Partnership • a firm with two or more owners who have unlimited liability • Corporation • a firm owned by one or more limited liability stockholders

12. The Pros and Cons of the Different Types of Firms • Proprietorship • Pros • Easy to set up • Simple decision making • Profits taxed only once as owner’s income

13. The Pros and Cons of the Different Types of Firms • 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

14. The Pros and Cons of the Different Types of Firms • Partnership • Pros • Easy to set up • Diversified decision making • Can survive withdrawal of partner • Profits taxed only once as owners’ incomes

15. The Pros and Cons of the Different Types of Firms • Partnership • Cons • Achieving consensus may be slow and expensive • Owners entire wealth at risk • Withdrawal of partner may create capital shortage • Capital is expensive

16. The Pros and Cons of the Different Types of Firms • 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

17. The Pros and Cons of the Different Types of Firms • Corporation • Cons • Complex management structure can make decisions slow and expensive • Profits taxed twice as company profit and as stockholders’ income

18. Relative Importance of theThree Main Types of Firms

19. Relative Importance of theThree Main Types of Firms • 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

20. Learning Objectives (cont.) • Explain how firms finance their operations • Calculate a firm’s opportunity cost and economic profit • Explain why firms coordinate some economic activities and markets coordinate others

21. Business Finance • How Firms Raise Funds • Equity — the owners stake in a business • Selling stock — shares of ownership • Selling bonds — a legally enforceable debt obligation to pay specified amounts of money at specified future dates

22. Business Finance • Discounting an Present Value • Deciding whether to borrow and how much to borrow requires firms to compare money today with money in the future • Present value calculations allow this to be done

23. Discounting and Present Value • Present Value • The amount of money that, if invested today, will grow to be as large as a given future amount when the interest that it will earn is taken into account. • Discounting is the conversion of a future amount of money to its present value.

24. Discounting and Present Value • Present Value Future amount = Present value + Interest Future amount = Present value + (r x Present value) Future amount = Present value ´ (1 + r)

25. Discounting and Present Value • Present Value Present value = Future amount/(1 + r) • Present Value n years in the future Present value = Future amount/(1 + r)n

26. Discounting and Present Value • Suppose you wish to find the present value of $121 two years in the future discounted at an interest rate of 10%. $121 Present value = (1 + 0.1)2 $121 = 1.21 = $100

27. Discounting and Present Value • Suppose you wish to check this calculation. Future amount = Present value + (r ´ Present value) Year 1= $100 + (.1 ´ $100) or $100 + $10 = $110 Year 2= $110 + (.1 ´ $110) or $110 + $11 = $121

28. Present Value and Marginal Analysis • Firms compare the marginal benefit to the marginal benefit of borrowing. • Firms calculate the net present value of borrowing.

29. Learning Objectives (cont.) • Explain how firms finance their operations • Calculate a firm’s opportunity cost and economic profit • Explain why firms coordinate some economic activities and markets coordinate others

30. Opportunity Cost andEconomic Profit • Firms incur opportunity costs when they produce goods. • Opportunity cost of producing — the best alternative action that the firm foregoes to produce a good or service

31. Opportunity Cost andEconomic Profit • Components of a firm’s opportunity cost • Explicit costs (money costs) • The amount paid for factors of production • Implicit costs (non-money costs) • The value of foregone opportunities.

32. Opportunity Cost andEconomic Profit • Cost of Capital • 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.

33. Opportunity Cost andEconomic Profit • Cost of Capital • Implicit rental rate is the income that the firm forgoes by using the assets itself and not renting them to another firm — the same as economic depreciation and interest costs. • Sunk costs are costs that has been incurred and cannot be reversed.

34. Opportunity Cost andEconomic Profit • Cost of Inventories • Inventories are stocks of raw materials, semi-finished goods, and finished goods held by a firm. • The opportunity cost of using an item from inventory is it current market price.

35. Opportunity Cost andEconomic Profit • 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.

36. Opportunity Cost andEconomic Profit • Economic Profit • A firm’s total revenue minus its opportunity costs. • Not the same as accounting profit.

37. Opportunity Cost and Economic Profit: An Example • Rocky owns a shop that sells bikes. • His accountant and economist calculate his profit — let’s compare the two.

38. Opportunity Cost and Economic Profit: An Example Item Amount Total revenue $300,000 Costs: Wholesale cost of bikes 150,000 Utilities and other services 20,000 Wages 50,000 Depreciation 22,000 Bank Interest 12,000 Total cost $254,000 Accounting Profit $ 46,000

39. Opportunity Cost and Economic Profit: An Example • The economist includes the following costs not counted by the accountant: • The fall in the market value of the assets of the firm gives the opportunity cost of not selling them one year ago. That is part of the opportunity cost of using them for the year. • Rocky could have worked elsewhere for $40 an hour, but he worked 1,000 hours on the firm’s business, which means that the opportunity cost of his time is $40,000

40. Opportunity Cost and Economic Profit: An Example • Rocky has invested $115,000 in the firm. If the current interest rate is 10% a year, the opportunity cost of those funds is $11,500. • Rocky could avoid the risk of running his own business, and he would be unwilling to take on the risk for a return of less than $6,000. This is his normal profit.

41. Opportunity Cost and Economic Profit: An Example Item Amount Total revenue $300,000 Costs: Wholesale cost of bikes 150,000 Utilities and other services 20,000 Wages 50,000 Bank Interest 12,000 Fall in market value of assets 10,000 Rocky’s wages (implicit) 40,000 Interest on Rocky’s money 11,500 Normal Profit (implicit) 6,000 Total cost $299,500 Economic Profit $ 500

42. Economic Efficiency • Technological efficiency • Occurs when it is not possible to increase output without increasing inputs • Economic efficiency • Occurs when the cost of producing a given output is as low as possible

43. Economic Efficiency • Economic efficiency • A firm that does not use the economically efficient method of production does not maximize profit.

44. Four Ways of Making 10 TV Sets a Day • Lets use an example to illustrate economic and technological efficiency. • Suppose there are 4 different ways of making 10 TVs a day. • Lets compare each way’s technological and economic efficiency.

45. Four Ways of Making 10 TV Sets a Day Quantities of inputs Method Labor Capital a Robot production 1 1,000 b Production line 10 10 c Bench production 100 10 d Hand-tool production 1,000 1

46. Four Ways of Making 10 TV Sets a Day Four ways of making TVs Labor cost Capital cost Method ($75 per day) ($250 per day) Total cost Cost per TV set a $75 + $250,000 = $250,075 $25,007.50 b 750 + 2,500 = 3,250 325.00 c 7,500 + 2,500 = 10,000 1,000.00 d 75,000 + 250 = 75,250 7,525.00

47. Four Ways of Making 10 TV Sets a Day Four ways of making TVs Labor cost Capital cost Method ($150 per day) ($1 per day) Total cost Cost per TV set a $150 + $1,000 = $1,150 $115.00 b 1,500 + 10 = 1,510 151.00 d 150,000 + 1 = 150,001 15,000.10

48. Four Ways of Making 10 TV Sets a Day Four ways of making TVs Labor cost Capital cost Method ($1 per day) ($1,000 per day) Total cost Cost per TV set a $1 + $1,000,000 = $1,000,001 $100,000.10 b 10 + 10,000 = 10,010 1,001.00 d 1,000 + 1,000 = 2,000 200.00

49. Learning Objectives (cont.) • Explain how firms finance their operations • Calculate a firm’s opportunity cost and economic profit • Explain why firms coordinate some economic activities and markets coordinate others

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