Microeconomics Week 9 Notes
Microeconomics Week 9 Notes ECON 2106
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This 8 page Class Notes was uploaded by Chapman Lindgren on Friday October 7, 2016. The Class Notes belongs to ECON 2106 at University of Georgia taught by Till Schreiber in Fall 2016. Since its upload, it has received 19 views. For similar materials see Principles of Microeconomics in Economics at University of Georgia.
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Date Created: 10/07/16
Economics (2106) Notes Week 9 The Firm and Its Economic Problems A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. The Firm’s Goal A firm’s goal is to maximize profit (while confirming to basic rules and laws of society) If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm that seeks to maximize profit Accounting Profit Accountants measure a firm’s profit to ensure that the firm pays the correct amount of tax and to show its investors how their funds are being used profit=totalrevenue−totalcost Accountants use IRS rules based on standards established by the Financial Accounting Standards Board to calculate a firm’s depreciation cost Economic Accounting Economists measure a firm’s profit to enable them to predict the firm’s decisions, and the goal of these decisions is to maximize economic profit Economic profit=totalrevenue−totalco(when total cost = the opportunity cost of production) A Firm’s Opportunity Cost of Production A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production (sum of implicit and explicit cost) A firm’s opportunity costs of production are the sum of the cost of using resources: o Bought in the market o Owned by the firm o Supplied by the firm’s owner Resources Bought in the Market The firm incurs an opportunity cost when it buys resources in the market The firm incurs an opportunity cost of production because the firm could have bought different resources to produce some other good or service Economics (2106) Notes Week 9 Resources Owned by the Firm If the firm owns capital and uses it to produce its output, then the firm incurs an opportunity cost The firm incurs an opportunity cost of production because it could have sold the capital and rented capital from another firm The firm implicitly rents the capital from itself The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital o The implicit rental rate of capital is made up of Economic depreciation: is the change in the market value of capital over a given period Forgone interest: the return on the funds used to acquire the capital Resources Supplied by the Firm’s Owner The owner might supply both entrepreneurship and labor The return to entrepreneurship is profit The profit an entrepreneur can expect to receive on average is called normal profit o Normal profit is the cost of entrepreneurship and is an opportunity cost of production In addition to supplying entrepreneurship, the owner might supply labor but not take a wage The opportunity cost of the owner’s labor is the wage income forgone by not taking the best alternative job Economic Accounting: A Summary' Economic profit=a fir m stotal revenue−total opportunity cost of production Economics (2106) Notes Week 9 Decisions: To maximize profits, a firm must make five basic decisions: o What to produce and in what quantities o How to produce o How to organize and compensate its managers and worker o How to market and price its products o What to produce itself and what to buy from other firms The Firm’s Constraints The firm’s profit is limited by three features of the environment: o Technology constraints o Information constraints o Market constraints 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 possess complete information about either the present or the future The firm 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 Economics (2106) Notes Week 9 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 that a firm incurs to overcome these market constraints limit the profit that the firm can make Technological and Economic Efficiency Technological efficiency occurs when a firm uses the least amount of inputs to produce a given quantity of output o Different combinations of inputs might be used to produce a given good, but only one of them is technologically efficient o If it is impossible to produce a given good by decreasing any one input, holding all other inputs constant, then production is technologically efficient Economic Efficiency occurs when the firm produces a given quantity of output at the least cost o The economically efficient method depends of the relative costs of labor and capital The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given quantity of output, whereas economic efficiency concerns the cost of inputs used o An economically efficient production process also is technologically efficient o 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 Information and Organization A firm organizes production by combing and coordinating productive resources using a mixture of two systems: o Command systems o Incentive systems Command Systems A command system uses a managerial hierarchy Commands pass downward through the hierarchy and information (feedback) passes upward Economics (2106) Notes Week 9 These systems are relatively rigid and can have many layers of specialized management Incentive Systems An incentive system is a method of organizing production that uses a market-like mechanism 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 profits 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 and agent to act in the best interests of a principal For example, stockholders of a firm are the principals and the managers of the firm are their agents For example, Mark Zuckerberg (a principal) must induce the designers who are working on the next generation Facebook (agents) to work efficiently Coping with the Principal-Agent Problem Three ways of coping with the principal agent problem are o Ownership o Incentive pay o 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 mangers’ and workers’ interest with those of the owners, the principals Long-term contracts can tie managers’ or workers’ long-term rewards to the long-term performance of the firm. This arrangement encourages the agents to work in the best long-term interests of the firm owners, the principals Types of Business Organization There are three types of business organization o Proprietorship Economics (2106) Notes Week 9 o Partnership o 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 proprietorship 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 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 Markets and the Competitive Environment Economists identify four market types: 1. Perfect competition 2. Monopolistic competition 3. Oligopoly 4. Monopoly Perfect Competition is a market structure with Many firms and many buyers All firms sell an identical product No restrictions on entry of new firms to the industry Both firms and buyers are all well informed about the prices and products of all firms in the industry Examples include world markets in wheat and corn Economics (2106) Notes Week 9 Monopolistic Competition is a market structure with Many firms Each firm produces similar but slightly different products – called market 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 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 To determine the structure of an industry, economists measure the extent to which a small number of firms dominate the market. Measures of Concentration Economists use two measures of market concentration: o The four-firm concentration ratio The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry o The Herfindahl-Hirschman Index (HHI) The HHI is the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all firms if fewer than 50) As market concentration increases, the amount of competition in the industry decreases Limits of Measures of Concentration The main limitations of only using concentration measures as determinants of market structure are o The geographical scope of the market o Barriers to entry and firm turnover o The correspondence between market and an industry To produce any good or service factors of production must be hired and their activities coordinated Economics (2106) Notes Week 9 Firm Coordination Firms hire labor, capital, and land, and by using a mixture of command systems and incentive systems they organize and coordinate their activities to produce goods and services Market Coordination Markets coordinate production by adjusting prices and making the decisions of buyers and sellers of factors of production and components consistent See chapter 3 to explain how demand and supply coordinate the plans of buyers and sellers Outsourcing – buying parts or products from other firms – is an example of market coordination of production Firms coordinate more production than do markets, but why? Why Firms Coordinate More Production Than Do Markets Firms coordinate production when they can do so more efficiently than a market Four key reasons make firms more efficient. Firms can achieve: o Lower transaction costs Transaction costs are the costs arising from finding someone with who to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled o Economies of scale Economies of scale occur when the cost of producing a unit of a good falls as its output rate increases o Economies of scope Economies of scope arise when a firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise o Economies of team production Firms can engage in team production, in which the individuals specialize in mutually supporting tasks
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