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Microeconomics – Chapter 10 & 11.docx

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ECON 1050
Eveline Adomait

Microeconomics – Chapter 10 & 11 Chapter 10 Firm – an institution that hires factors of production and organizes those factors to produce and sell goods and services -goal is to maximize profit Depreciation – fall in value of a firm’s capital Accountants measure firm’s profit to ensure that the firm pays the correct amount of income tax and to show its investors how their funds are being used. 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 – is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production Opportunity Cost of Production – value of best alternative use of resources that a firm uses in production A firm’s opportunity cost of production in the sum of the cost of using resources: -Bought in the market -Owned by the firm -when a firm uses its own capital, it implicitly rents from itself Implicit Rental Rate – firm’s opportunity cost of using the capital it owns IRR has two components: Economic Depreciation – fall in market value of a firm’s capital over the year (market price of capital at start of the year minus market price of the capital at the end of the year) Forgone Interest – funds used to buy capital could have been used for some other purpose, and in their next best use, they would have earned interest -Supplied by the firm’s owner Normal Profit – profit that entrepreneur earns on average -cost of entrepreneurship and is an OC of production -Owner’s Labour Service To achieve the objective of maximum economic profit, a firm must make 5 economic decisions: 1. What to produce and in what quantities 2. How to Produce 3. How to organize and compensate its managers and workers 4. How to market and price its products 5. What to produce itself and buy from others Constraints Three features of a firm’s environment limit the maximum economic profit they can make. 1. Technology Constraints 2. Information Constraints 3. Market Constraints (customer’s willingness to pay) Technology – any method of producing a good or service Technological and Economic Efficiency Technological Efficiency – occurs when firm produces a given output by using the least amount of inputs Economic Efficiency – occurs when firm produces a given output at the least cost Robot Production – one person monitors entire computer-driven process Production Line – workers specialize in small part of job as emerging product passes them on a production line Hand-tool Production – single worker uses a few hand tools to make product Bench Production – workers specialize in small part of job but walk from bench to bench to perform their tasks A technologically inefficient method is never economically efficient. Economically efficient method is one that uses a smaller amount of the more expensive resource and a larger amount of the less expensive resource. Information and Organization Firms use a mixture of two systems to organize production: 1. Command Systems -method of organizing production that uses managerial hierarchy 2. Incentive Systems -method of organizing production that uses a market-like mechanism inside the firm Principal-Agent Problem – problem of devising compensation rules that induce an agent to act in the best interest of a principal Each principal must create incentives that induce each agent to work in the interests of the principal. Three ways of attempting to cope with the Principal-Agent Problem: 1. Ownership -by assigning ownership of a business to managers or workers, it is sometimes possible to induce a job performance that increases a firm’s profits 2. Incentive Pay 3. Long-term Contracts -tie long-term fortunes of managers and workers to the success of the principals Types of Business Organization 1. Sole Proprietorship -firm with a single owner who has unlimited liability Unlimited Liability – legal responsibility for all the debts of a firm up to an amount equal to the entire wealth of the owner 2. Partnership -firm with two or more owners who have unlimited liability Joint Unlimited Liability – liability for full debts of the partnership 3. Corporation -firm owned by one or more limited liability stockholders Limited Liability – owners have legal liability only for the value of their initial Investment Markets and the Competitive Environment Economists identify four market types: 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 (Ex. corn, rice, other grain crops) 2. Monopolistic Competition -market structure in which a large number of firms compete by making similar but slightly different products (sole producer of one product, but is similar to others) Product Differentiation – making a product slightly different from the product of a competing firm 3. Oligopoly -market structure in which a small number of firms compete (computer software, airplanes, air transportation) -have companies with product differentiation 4. Monopoly -market structure in which there is only one firm and it produces a good or service that had no close substitutes, and the firm is protected by a barrier preventing the entry of new firms (Ex. Some places: phone, gas, electricity, water suppliers- local monopolies) (Ex. Microsoft Corporation- global monopoly) Measures of Concentration Economists use two measures of concentration: 1. The four-firm concentration ratio -percentage of the value of sales accounted for by the four largest firms in an industry -range of concentration ratio is from almost zero (perfect competition) to 100 percent (monopoly) -low concentration ratio = high degree of competition -four-firm concentration ratio that exceeds 60% is regarded as an indication of a market that is highly concentrated and dominated by a few firms in an oligopoly -ratio of less than 60% = competitive market 2. The Herfindahl-Hirschman Index (HHI) -square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market -HHI <1000 = competitive -HHI 1000 to 1800 = moderately competitive (monopolistic competition) -HHI >1800 = uncompetitive Limitations of a Concentration Measure Three main limitations of using only concentration measures as determinants of market structure are their failure to take proper account of: 1. The Geographical Scope of the Market -concentration measures take a national view of the market, and many goods are sold in a national market, but some are sold in a regional market, and some in a global one (cars may be in little competition nationally, but globally they may be in large competition) 2. Barriers to Entry and Firm Turnover -some markets are highly concentrated but entry can be easy and the turnover of firms is large (Ex. Opening a restaurant in a small town) 3. The Correspondence Between a Market and an Industry -governments classify each firm to a particular industry, but markets do not always correspond closely to industries -markets are often narrower than industries (Pharmacies are competitive, and they all sell the same drugs, which are Monopolies) -most firms make several products (Ex. West
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