ORGANIZING PRODUCTION How firms make decisions 9 CHAPTER Dr. Gomis-Porqueras ECO 680.

ORGANIZING PRODUCTION

How firms make decisions

9CHAPTER

Dr. Gomis-PorquerasECO 680

Residual Claimants

In a market economy, firm owners are residual claimants.

They have right to any revenue after costs have been paid.

•Provides a strong incentive for owners to keep costs of producing output low.

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 Objective

A firm’s goal is to maximize profit.

If the firm fails to maximize profits it is either eliminated or bought out by other firms seeking to maximize profit.


Measuring a Firm’s Profit

Accountants measure a firm’s profit using rules laid down by the Internal Revenue Service and the Financial Accounting Standards Board.

Their 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.

Economists measure profit based on an opportunity cost measure of cost.


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


Explicit costs are costs paid directly in money.

Implicit costs are costs incurred when a firm uses its own capital or its owners’ time for which it does not make a direct money payment.

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.


The implicit rental rate of capital is made up of:

Economic depreciation

Interest forgone

Economic depreciation is the change in the market value of capital over a given period.

Interest forgone is the return on the funds used to acquire the capital.


The cost of the owner’s resources is his or her entrepreneurial ability and labor expended in running the business.

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.

The (opportunity) cost of producing the item indicates the desire of consumers for other goods.

Economic Role of Costs

The demand for a product indicates the intensity of consumer’s desires for an item.


Economic Profit

Economic profit equals a firm’s total revenue minus its opportunity cost of production.

A firm’s opportunity cost of production is the sum of the explicit costs and implicit costs.

Normal profit is part of the firm’s opportunity costs, so economic profit is profit over and above normal profit.


Economic Accounting: A Summary

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


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


Technology Constraints

Technology is any method of producing a good or service.

Technology advances over time.

Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output.


Information Constraints

A firm never possesses complete information about either the present or the future.

It is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors.

The cost of coping with limited information limits profit.


Market Constraints

What a firm can sell and the price it can obtain are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms.

The resources that a firm can buy and the prices it must pay for them are limited by the willingness of people to work for and invest in the firm.

The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.

Technology and Economic Efficiency

Technological Efficiency

Technological efficiency occurs when a firm produces a given level of output by using the least amount inputs.

There may be different combinations of inputs to use for producing a given level of output.

If it is impossible to maintain output by decreasing any one input, holding all other inputs constant, then production is technologically efficient.


Economic Efficiency

Economic efficiency occurs when the firm produces a given level of output at the least cost.

The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the cost of the inputs used.


An economically efficient production process also is technologically efficient.

A technologically efficient process may not be economically efficient.

Changes in the input prices influence the value of the inputs, but not the technological process for using them in production.

Improving Inventory Control at Wal-Mart

Better inventory controls have helped reduce firms’ costs.

In a price taker market, Marginal Revenue = market price.

Marginal Revenue is the change in total revenue divided by the change in output.

Marginal Revenue

MarginalRevenue =(MR)

the change in total revenue

the change in output

MC will decline initially, reach a minimum, and then rise.

Marginal Cost

Marginal Cost (MC) is the increase in total cost associated with a one-unit increase in production.

MC

MarginalRevenue

(MR) Output

MarginalCost(MC)

Profit

(TR - TC)

0 1 2

8 9

10 11 12 13 14 15 16 17 18 19 20 21

.

Price and CostPer Unit

1

3

7

9

----5

5

5 5 5

----$ 4.80$ 3.95

$ 1.50 $ 1.25$ 1.00

- 25.00- 24.80- 23.75

5

5 5 5 5 5 5 5 5 5

5

$ 1.25$ 1.75$ 2.50$ 3.50$ 4.75$ 6.00$ 7.25$ 8.25$ 9.50

$ 13.00 5 $ 17.00

. . . . . . . .

- 8.00- 4.25- .25 3.50 6.75 9.25 10.75 11.00

10.00 7.75 4.50 0.00 - 8.00- 20.00

• Below, low levels of output deliver marginal revenue to the firm greater than the marginal cost of increased output.

• After some point, though, additional units cost more than their marginal revenue.

MR

. . .

Profit MaximumP = MR = MC

• Profit is maximized where P = MR = MC.

108642 12 14 16 18 20Output Level

22

TFC

TC

TVC

0

TotalCosts

42

• Here we graph the general shape of the firm’s short-run total cost curves.

50

100

150

200

6 8

50

10

TCTVCTFCOutputper day

1 2 3 4 5 6 7 8 9

10

01525344252

64 79 98

122152

• Note that total fixed costs are flat and remain the same for 0 units or 11 units.

Output

Total Costs Curves

=+

11 202

5050505050505050505050

5065758492

102114129148

172202252

12

250• Note that total variable costs increase as more variable inputs are utilized.• As total costs are the combination of TVC and TFC, they are everywhere positive and increase sharply with output

Information and Organization

A firm organizes production by combining and coordinating productive resources using a mixture of two systems:

Command systems

Incentive systems


Command Systems

A command system uses a managerial hierarchy.

Commands pass downward through the hierarchy and information (feedback) passes upward.

These systems are relatively rigid and can have many layers of specialized management.


Incentive Systems

An incentive system, uses market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.


Mixing the Systems

Most firms use a mix of command and incentive systems to maximize profit.

They use commands when it is easy to monitor performance or when a small deviation from the ideal performance is very costly.

They use incentives whenever monitoring performance is impossible or too costly to be worth doing.


The Principal-Agent Problem

The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal.

For example, the stockholders of a firm are the principals and the managers of the firm are their agents.

Firm owners face this problem when dealing with workers.

Example: Long coffee break.

Control with incentives and monitoring.

Shirking

With team production owners must reduce the problem of shirking.-employees working at less than normal rate of productivity.


Coping with the Principal-Agent Problem

Three ways of coping with the principal-agent problem are:

Ownership

Incentive pay

Long-term contracts


Ownership, often offered to managers, gives the managers an incentive to maximize the firm’s profits, which is the goal of the owners, the principals.

Incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal.

Long-term contracts can tie managers’ or workers’ long-term rewards to the long-term performance of the firm. This arrangement encourages the agents work in the best long-term interests of the firm owners, the principals.

Empirical Evidence

Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers.

This is particularly important in those jobs that involve strong elements of ‘team production” where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team.

Studies suggest that profit-sharing, for example, typically raises productivity by 3-5%.

http://en.wikipedia.org/wiki/Australia

http://en.wikipedia.org/w/index.php?title=Team_production&action=edit

Empirical Evidence

Fernie and Metcalf (1996) find that British jockeys perform significantly better when offered prizes for winning races compared to being on fixed retainers.

McMillan, Whalley and Zhu (1989) and Groves et al (1994) look at Chinese agricultural and industrial data respectively and find significant incentive effects.

Kahn and Sherer (1990) find that better evaluations of white-collar office workers were achieved by those employees who had a steeper relation between evaluations and pay.


Types of Business Organization

There are three types of business organization:

Proprietorship

Partnership

Corporation


Proprietorship

A proprietorship is a firm with a single owner who has unlimited liability, or legal responsibility for all debts incurred by the firm—up to an amount equal to the entire wealth of the owner.

The proprietor also makes management decisions and receives the firm’s profit.

Profits are taxed the same as the owner’s other income.


Partnership

A partnership is a firm with two or more owners who have unlimited liability.

Partners must agree on a management structure and how to divide up the profits.

Profits from partnerships are taxed as the personal income of the owners.


Corporation A corporation is owned by one or more stockholders with limited liability, which means the owners who have legal liability only for the initial value of their investment.

The personal wealth of the stockholders is not at risk if the firm goes bankrupt.

The profit of corporations is taxed twice—once as a corporate tax on firm profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.


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


Partnerships are 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


A corporation offers perpetual life

Limited liability for its owners

Large-scale and low-cost capital that is readily available

Professional management

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.


The Relative Importance of Different Types and Firms

There are a greater number of proprietorships than other form of business, but corporations account for the majority of revenue received by businesses.


Figure 9.1(a) shows the frequency of each type of business organization.

Figure 9.1(b) shows the dominant type of business organization for various industries.

Markets and the Competitive Environment

Economists identify four market types:

Perfect competition

Monopolistic competition

Oligopoly

Monopoly


Perfect competition is a market structure with:

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.


Monopolistic competition is a market structure with:

Many firms

Each firm produces similar but slightly different products—called product differentiation

Each firm possesses an element of market power

No restrictions on entry of new firms to the industry


Oligopoly is a market structure in which:

A small number of firms compete

The firms might produce almost identical products or differentiated products

Barriers to entry limit entry into the market.

Incentive to Collude

Oligopolists have a strong incentive to collude and raise their prices.

Each firm has an incentive to cheat by lowering price because the demand curve facing each firm is more elastic than the market demand curve.

This conflict makes collusive agreements difficult to maintain.

Oligopolies

A cartel is an organization through which members jointly make decisions about prices and production (OPEC).

In the United States, antitrust laws prevent firms from obvious collusion and from forming a cartel. However, there are legally sanctioned cartels in the United States.

The NCAA is an example. Participation is restricted to member colleges.

The American Medical Association (AMA). You may have a great remedy for colds, but you are not allowed to open a medical practice until you meet the requirements of the AMA.


Monopoly is a market structure in which

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

Monopolies

Before "Ma Bell" or AT&T was broken up in 1982, Bell controlled all of the local and long distance phone business in the U.S.A.

Prices were high, service was bad and Bell was using it's control of the local phone exchanges to restrict competitors access to the long distance market.

In an agreed settlement Bell was broken up into the regional baby bells which where given the local phone market and AT&T which had the long distance market.


Figure 9.2 shows the four-firm concentration ratio for various industries in the United States.


Market Structures in the U.S. Economy

Figure 9.3 shows the distribution of market structures in the U.S. economy.

The economy is mainly competitive.

Why Do Governments Allow Monopolies?

Examples:

- Power to tax future generations

- Easier to borrow

- Easier to take long term projects- Longer time horizon than private firms- Introduce some standards

- Public safety


Market Structures in the U.S. Economy

Figure 9.3 shows the distribution of market structures in the U.S. economy.

The economy is mainly competitive.

Markets and 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

Markets and Firms

Transactions costs are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled.

Economies of scale occur when the cost of producing a unit of a good falls as its output rate increases.

Markets and Firms

Economies of scope arise when a firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise.

Firms can engage in team production, in which the individuals specialize in mutually supporting tasks.

Summary

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ORGANIZING PRODUCTION How firms make decisions 9 CHAPTER Dr. Gomis-Porqueras ECO 680.

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