Lecture: Organizing Production

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2 Apr 2012
Lecture #15 ECON*1050 Page 1
Organizing Production
- firm: institution that hires and organizes factors of production to produce goods
and services
o goal is to maximize profit; failure to do so leads to elimination or buy-out
- factors affecting output quantity: capital (human and physical), labour, natural
resources, and technology
o Q = F (KP+H, L, N, T)
Accounting Profit
- accountants: measure firms’ profit to ensure firms pay correct tax and show
investors how funds are used
o profit = total revenue – cost
- Internal Revenue Service Rules used to calculate firms’ depreciation cost
Economic Profit
- economists: measure a firm’s profit to predict the firm’s decisions; goal of these
decisions is to maximize economic profit
o economic profit: total revenue - total cost
total cost = opportunity cost of production
A Firm’s Opportunity Cost of Production
- firm opportunity cost: value of the best alternative use of the resources used in
A. Resources bought in the market
- firm could buy other resources to produce other goods
B. Resources owned by the firm
- firm could sell the capital and rent capital from another firm
o would free up money to invest in other things
- firm implicitly rents capital it owns from itself
o implicit rental rate = OC of owning capital
economic depreciation: change in the market value of capital over
a given period
interest foregone: return on the funds used to acquire the capital
C. Resources supplied by the firm’s owner
- owner might suppy both entrepreneurship
o return on entrepreneurship is profit
normal profit: profit expected to receive on average
excess profit
- owner might supply labour without taking a wage
o OC = wage income forgone by not taking the best alternative job
Note: Human capital differs from
labour; human capital is highly
skilled labourers (management,
research and development, etc.)
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Lecture #15 ECON*1050 Page 2
Firm Decisions
- to maximize profit, five decisions must be made
o what and how much to produce
o how to produce
o how to organize and how to compensate managers and workers
o how to market and how to price products
o what to produce itself and what to buy from other firms
Firm Constraints
A. Technology Constraints
- technology: any method of producing a good or service
o advances over time
- using available technology, production can only occur with resources
o causes costs and limits profits on additional output
B. Information Constraints
- limited information is possessed about both the present and the future
o quality and efforts of the work force
o current and future buying plans of customers
o plans of competitors
- cost of coping with limited information limits profits
C. Market Constraints
- selling plans are constrained by:
o customers’ willingness to pay
o marketing efforts of other firms
- price and selection of resources are limited by:
o the willingness of people to work for and invest in the firm
- expenditures incurred to overcome market constraints limit profit
A. Technological Efficiency
- technological efficiency: given level of output achieved using the least inputs
o efficiency occurs when it is impossible to produce a given good by
decreasing any one input while holding all other inputs constant
- different combinations of inputs can be used to produce a good; only one is
technologically inefficient
- technological efficiency does not imply economic effiency
B. Economic Efficiency
- economic efficiency: given level of ouput achieved at the lowest cost
o depends on the relative costs of capital and labour
- economic efficiency implies technological efficiency
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