Chapter 4

THE ECONOMICS OF BUSINESS FIRMS

ORGANIZING A BUSINESS

Sole Proprietorship

Partnership

Corporation

3 MAIN GROUPS OF AMERICAN BUSINESS

Sole ProprietorMom & Pop StoreBarbershopWeb design

PartnershipAttorneysAccountants

Professional Groups Corporations

General MotorsMicrosoftIBM

SOLE PROPRIETORA business owned by just one person

individual initiative, self-reliance, hard-work

Most common form and simplest to form.

Over 78% of all business in U.S.

Financial investment need not be large.

Limited amount of red tape.

Owner has satisfaction of working for himself.

Flexibility of organization (hours, pay, etc)

Pays taxes only on personal income from business.

Can put money into private pensions.

DISADVANTAGES TO SOLE PROPRIETOROnly 24 hours in a day- can’t work 24/7.

Prosperity depends on talent of one person and no one contains all necessary skills.

Often too close to trees to see the forest.

Often difficult to borrow money from the banks.

Unlimited liability.

Limited Life.

PARTNERSHIPA legal association of two or more persons in a

business as co-owners.

More complicated than S.P.

Each partner agrees to contribute some portion of funding and labor used by the business and to receive some proportion of the profits or losses.

Could be a “silent” partner (put up money,but nothing to say about operations.

Common formation for professional groups.

PARTNERSHIP ADVANTAGES

Easy to form.

Usually has legal standing

Combines skills of several people which enhances ability to create wealth.

Easier to get funding and backing.

Taxed only on personal income.

Limited amount of red tape.

PARTNERSHIP DISADVANTAGES

Unlimited liability (each member of partnership is legally liable for debts of business and other partners in name of business.

Conflicts among partners

Too many chiefs- not enough Indians.

Inside partnership very competitive.

Lifespan somewhat limited.

CORPORATION

A BODY THAT IS AUTHORIZED BY LAW TO ACT AS A PRIVATE PERSON

Legally endowed with various rights and duties

To receive, own, and transfer property.

To make contracts

To sue and be sued.

CORPORATIONS INCLUDE:EXXON, IBM, GENERAL MOTORS, MICROSOFT,

Characteristics:

Shareholders share in the wealth.

Limited Liability (responsibility of shareholders of a corporation is held only to their investment in same)

May own tremendous wealth.

Increased management skills

Ownership divided into equal parts called shares

Can raise large amounts of money

Can borrow money through sale of bonds.

MERGERS

Horizontal

Vertical

Conglomerate

MERGERS

horizontal – two firms that serve the same set of customers

vertical – two firms operating at different stages of the production/distribution process

conglomerate – two firms operating in unrelated industries

MERGERS/CONGLOMERATESMerger= acquisition through sale of one company to another with thepurchasing company remaining dominant.

example: General Motors absorbed Chevrolet CorporationIn 1919- General Motors remained dominant- This is called aHorizontal Merger

General Motors Chevrolet Corporation

Amalgamation = Outsider brings together 2 companies minimumAnd forms a new company

.Pontiac Oldsmobile Buick Cadillac

GeneralMotors1917

VERTICAL MERGERA company in one phase of the business

absorbs or joins a company involved in another phase in order to guarantee a supplier or customer.

Oil fields

Pipeline

Refinery

Distributor

Retailer

Trucking

CONGLOMERATESaw a lot of this type after 1961- union of two corporations whose operations were unrelated…

ITT = 250 operations-

Taxi, motel chain, Madison Square gardens, paper mill,

Food products,cosmetic,

Pharmaceutical.

Phillip Morris is huge!

Coca Cola is huge!

INCOME STATEMENT

Revenues – costs = profits (TR-TC)

• Revenues – money coming into the firm• Costs – money and non-money costs, also called expenses• Profits – revenues exceed costs• Losses – revenues are less than costs

TOTAL REVENUE (TR)

Sales revenue received by the firm

TR = P x Q

MARGINAL REVENUE (MR)

Additional revenue received when the firm sells one more unit of the product.

• MR = (change in revenue)/(change in output)

In most markets, MR slopes downward twice as fast as the demand curve

FIGURE 4-1. DEMAND AND MARGINAL REVENUE

Q0

P10

TR 0

MR

12

9 8

916

+9+7

34

7 6

2124

+5+3

56

5 4

2524

+1 -1

P

DMR

Q

TR = P x QMR = increase in TR/ increase in Q

COSTS

Fixed costs (FC)

Variable costs (VC)

Total costs (TC)

• TC = FC + VC

COSTS

Fixed costs (FC) – payment for the fixed inputs

Variable costs (VC) – payment for the variable inputs

Total costs (TC) = FC + VC

FIGURE 4-2. FC, VC, AND TC

Q VC FC TC0 0 120 120

10 85 120 20520 150 120 27030 240 120 36040 350 120 47050 550 120 670

As output (Q) increases:Fixed Costs (FC) do not change.Variable Costs (VC) increase at an irregular rate.Total Costs (TC) = FC + VC.

AVERAGE FIXED COSTS (AFC)

AFC = FC/Q

If no other costs but fixed, average costs will decline

FIGURE 4-4. AVERAGE FIXED COSTS (AFC)

Q FC AFC0 120

10 120 12.0020 120 6.0030 120 4.0040 120 3.0050 120 2.40

AFC = FC/Q

$

Q

AFC

AVERAGE VARIABLE COSTS (AVC)

AVC = VC/Q

As Q increases, AVC falls to a minimum, then rises rapidly as the firm approaches maximum capacity

FIGURE 4-5. AVERAGE VARIABLE COSTS (AVC)

Q VC AVC0 0

10 85 8.5020 150 7.5030 240 8.0040 350 8.7550 550 11.00

AVC = VC/Q

$

Q

AVC

20

7.50

AVERAGE TOTAL COSTS (ATC)

ATC = TC/Q = AFC + AVC

As Q increases, ATC falls to a minimum, then rises rapidly as the firm approaches maximum capacity.

ATC is always higher than AVC

FIGURE 4-6. AVERAGE TOTAL COSTS (ATC)

Q TC ATC0 120

10 205 20.5020 270 13.5030 360 12.0040 470 11.7550 670 13.40

ATC = TC/Q = AFC + AVC

ATC

40

11.75

$

Q

MARGINAL COST (MC)

MC = (change in TC/change in Q)

MC falls at first, then rises rapidly through the range of normal production

FIGURE 4-7. MARGINAL COSTS (MC)

Q TC MC0 120

10 205 8.5020 270 6.5030 360 9.0040 470 11.0050 670 20.00

MC = (change in TC/change in Q)

$

Q

MC

GRAPH ATC/AVC/AFC$24

20

16

12

8

4

0 10 20 30 40 50Rate of Output (pairs per day)

Cos

ts (

dolla

rs p

er p

air)

I

J

KL M N

O

ATC

AVC

AFC

SUMMARY OF THE BASIC COST CURVES

21-32

FIGURE 4-10. MR, MC AND PROFIT MAXIMIZATION

P

Q

DMR

MC

Pm

Qm

MC = MR Produce the Q, labeled Qm

where MR = MC and profit will be maximized.The demand curve tells you that the price must be Pm.

MR>MC MR<MC

PROFIT MAXIMIZATION RULES

Produce the Q where MR = MC and profit will be maximized.

Price determined from that point also.

Loss minimization occurs.

EXPLICIT AND IMPLICIT COSTS

Explicit costs – actual out-of-pocket payments by the firm, plus depreciation.

Implicit costs – the opportunity costs of the owner’s assets, time and effort.

Total costs = explicit costs + implicit costs

PROFITS

Accounting profit = TR – explicit costs

Economic profit = TR – both explicit costs and implicit costs

Normal profit is the minimum return on investment necessary for the owner to continue to operate the business.

DECISION MAKING

Economic Profit > 0

• Expand the firm.

Economic Profit < 0

• Shrink or close the firm.

Economic Profit = 0

• Keep operating at this level.

MARKET STRUCTURE AND MARKET POWER

Ability to manipulate the market price.

• perfect competition – no market power• monopoly – complete market power• monopolistic competition – some market power at

times• oligopoly – considerable market power at times

PERFECT COMPETITION

Many small firms

Identical products sold at the same price

Easy to enter into and exit from the industry.

Each firm must accept the market price.

Each firm can only choose the quantity to produce (they choose the profit-maximizing quantity).

Economic profit quickly goes to zero or normal.

FIGURE 24-1 THE DEMAND CURVE FOR A PRODUCER OF SECURE DIGITAL CARDS

FIGURE 24-2 PROFIT MAXIMIZATION, PANEL (A)

PROFIT MAXIMIZATION

Quantity (bushels per day)0 1 2 3 4 5 6 7

2

4

6

8

10

12

14

16

$18

Pric

e or

Cos

t (p

er b

ushe

l)

Marginal cost

Price (= MR)

Profit-maximizing rate of output

MCB

MRB

p = MC Profits decreasing

Profits increasing

MONOPOLY

Only one firm produces the product.

• They control the supply curve.There is a total barrier to other firms entering the industry.

Monopolist will choose to produce its profit-maximizing quantity. (MC = MR)

• The demand curve will then identify the market price.• Marginal Revenue falls faster than price.

PROFIT MAXIMIZATION

0 1 2 3 4 5 6 7 8 9

123456789

10111213

$14

Quantity (baskets per hour)

d

Demand

Marginal revenue

Marginal cost

Average total cost

D

Profits

PRICE AND MARGINAL REVENUE

Unlike competitive firms, marginal revenue for a monopolist is not equal to price.

So long as the demand curve is downward-sloping, MR will always be less than price.

MONOPOLIES NOT PERMITTED IN U.S.

WAIT!!!!!!!!!!!!

Don’t we have them anyway?Sure – (natural and companies with large percentage of market.

MONOPOLISTIC COMPETITION

Many intensely competitive firms

Each sells a slightly different version of the product at slightly different prices

Easy entry and exit

One firm’s product innovation captures the customers’ imagination; that firm becomes a short term monopolist

• Earns normal profits

BRAND LOYALTY Will compete with other firms but offer substitutes

makes the demand curve facing the firm less price-elastic.

implies that consumers shun substitute goods even when they are cheaper.

Example: the price differences between computers which are essentially the same.

NON-PRICE COMPETITION

Advertising.

http://www.youtube.com/watch?v=xffOCZYX6F8http://www.youtube.com/watch?v=xffOCZYX6F8http://www.youtube.com/watch?v=xffOCZYX6F8

FIGURE 26-2 COMPARISON OF THE PERFECT COMPETITOR WITH THE MONOPOLISTIC COMPETITOR

OLIGOPOLY

A few large firms dominate the industry.

Significant price-setting power.

Significant barriers to entry.

Name brand producers.

Nation-wide and world-wide distributors.

MARKET POWER

Tom Thumb wants to gain market share from Albertsons.

Wal-Mart wants market share from Kmart… boy did they get it!

Central Market wants market share from Whole Foods

Google wants market share from Facebook.

MARKET SHARE-NORTH TEXAS JULY 2013Grocery Store % of market share

Walmart 27.8

Kroger 14.5

Tom Thumb 10.1

Albertsons 6.9

Target ,super 6.7

Sam’s 5.2

Costco 5.2

HEB Central Market 2.5

Whole Foods 1.2

Market Street 1.0

OLIGOPOLY (CONT'D)

Oligopoly

• A market situation in which there are very few sellers.

• Each seller knows that the other sellers will react to its changes in prices and quantities.

OLIGOPOLY (CONT'D)

Why oligopoly occurs

• Economies of scale

• Barriers to entry

• Mergers

• Vertical mergers

• Horizontal mergers

Pric

e or

Cos

t (d

olla

rs p

er u

nit)

Quantity (units per period)0

Maximizing Oligopoly Profits

Industrymarginal

cost

Industry average

cost

Marketdemand

Industry marginalrevenue

Profits

J

Profit-maximizing

price

Average costat profit-

maximizingoutput

Profit-maximizing output

ECONOMIES OF SCALE

Increase the capacity to produce and costs are lowered.

• …achieve economies of scale.• …up to a point.

How?

• switch from batch mode to assembly line.• employees specialize to task.• buy inputs in bulk at lower prices.

DISECONOMIES OF SCALE

Continued increase in production capacity leads, after a point, to rising costs.

How?

• multiple assistant managers needed.• create a costly bureaucracy.• move decision making authority away from the production line.

IDEAL SIZED PLANT

Build a facility that:

• is big enough to achieve all economies of scale.• operates at lowest cost.• does not get big enough to experience diseconomies of scale.

Economies of Scale

QM0

CO

ST

(do

llars

per

uni

t)

Constant returns to scale

c

ATC1

m1

RATE OF OUTPUT (units per period)

ATCS

QM0

Economies of scale

c

ATC2

m2

ATCS

RATE OF OUTPUT (units per period)

QM0

Diseconomies of scale

c

ATC3

m3ATCS

RATE OF OUTPUT (units per period)

QUESTIONS?