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Chapter 10- Organizing Production

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ECON 101
Emanuel Carvalho

Chapter 10: Organizing Production The Firm and Its Economic Problem  Firm: An institution that hires factors of production and organizes those factors to produce and sell goods and services The Firm’s Goal  A firm’s goal is to maximize profit Accounting Profit  To measure profit, depreciation charge is subtracted from the cash surplus (revenue-expense)  Depreciation is the fall in value of a firm’s capital  To calculate depreciation, accountants use Revenue Canada rules based on standards established by the accounting profession Economic Accounting  Accountants measure a 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: Total revenue minus total cost, with total cost measured as the opportunity cost of production A Firm’s Opportunity Cost of Production  The opportunity cost of any action is the highest valued alternative forgone  The opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production  The opportunity cost of production is the value of real alternatives forgone  We express opportunity cost in monetary units so that we can compare and add up the value of the alternatives forgone  A firm’s opportunity cost of production is the sum of the cost of using resources 1. Bought in the market 2. Owned by the firm 3. Supplied by the firm’s owner Resources Bought in the Market  A firm incurs an opportunity cost when it buys resources in the market  The money spent on these resources is an opportunity cost of production because the firm could have bought different resources to produce some other good or service Resources Owned by the Firm  A firm incurs an opportunity cost when it uses its own capital  The cost of using capital owned by the firm is an opportunity cost of production because the firm could sell the capital that it owns and rent capital from another firm  When a firm uses its own capital, it implicitly rents the capital from itself.  In this case, the firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital  The implicit rental rate of capital has two components: 1. Economic depreciation 2. Foregone interest Economic Depreciation  Economic depreciation: The fall in the market value of a firm’s capital over a given period  Market price at the beginning of the period minus the market price of the capital at the end of the period Foregone Interest  The funds used to buy capital could have been used for some other purpose, and in their next best use, they would have earned interest. This foregone interest is an opportunity cost of production Resources Supplied by the Firm’s Owner  A firm’s owner might supply: 1. Entrepreneurship 2. Labour Entrepreneurship  The factor of production that organizes a firm and makes it decisions, entrepreneurship, might be supplied by the firm’s owner or by a hired entrepreneur  The return to entrepreneurship is profit, and the profit that an entrepreneur earns on average is called normal profit  Normal profit: The cost of entrepreneurship and is a cost production Owner’s Labour Services  The owner of a firm might supply labour but not take a wage  The opportunity cost of the owner’s labour is the wage income forgone by not taking the best alternative job Economic Accounting: A Summary  Refer to pg. 229 Decisions  To achieve the objective of maximum economic profit, a firm must make five 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 The Firm’s Constraints  Three features of a firm’s environment limit the maximum economic profit it can make. They are: 1. Technology constraints 2. Information constraints 3. Market constraints Technology Constraints  Technology: Any method of producing a good or service  At each point in time, to produce more output and gain more revenue, a firm must hire more resources and incur greater costs  The increase in profit that a firm can achieve is limited by the technology available Information Constraints  We never possess all the information we would like to have to make decisions  We lack information about both the future and the present  To make the best deal for a product, the opportunity cost of the comparison exceeds the cost of the computer  A firm is constrained by limited information about the quality and efforts of its workforce, the current and future buying plans of its customers, and the plans of its competitors  Workers might make too little effort, customers might switch to competing suppliers, and a competitor might enter the market and take some of the firm’s business  To address these problems:  Firms create incentives to boost workers’ efforts even when no one is monitoring them  Conduct market research to lower uncertainty about customers’ buying plans  “Spy” on each other to anticipate competitive challenges Technological and Economic Efficiency  There are two concepts of production efficiency: 1. Technological efficiency 2. Economic efficiency  Technological efficiency: Occurs when the firm produces a given output by using the least amount of inputs  Economic efficiency: Occurs when the firm produces a given output at the least cost Technology Efficiency Economic Efficiency  A technologically inefficient method is never economically efficient  Economic efficiency depends on the relative  The economically efficient method is the one that uses a smaller amount of the more expensive resource and a larger amount of the less expensive resource  A firm that is not economically efficient does not maximize profit  Natural selection favours efficient firms and inefficient firms disappear  Inefficient firms go out of business or are taken over by firms that produce at lower costs Information and Organization  Each firm organizes the production of goods and services by combining and coordinating the factors of production it hires. But the way firms organize production varies and they use a mixture of two systems 1. Command systems 2. Incentive systems Command Systems  Command system: A method of organizing production that uses a managerial hierarchy  Commands pass downward through the hierarchy, and information passes upward  Managers spend most of their time collecting and processing information about the performance of the people under their control and making decisions about what commands to issue and how best to get those commands implemented  CEO: top of the command system  Senior executives: Report to and receive commands from the CEO specialize in managing production, marketing, finance, personnel, and perhaps other aspects of the firm’s operations Middle management ranks: Stretch downward to the managers who supervise the day-to-day operations of the business Operators: People who operate the firm’s machines and who make and sell the firm’s goods and services  Small firms have one or two layers of managers, while large firms have several layers  As production processes have become ever more complex, management ranks have swollen  Today, more people have management jobs that ever before, even though the information revolution of the 1990s slowed the growth of management  In some industries, the information revolution reduced the number of layers of managers and brought a shakeout of middle managers  Managers make enormous efforts to be well informed  They try hard to make good decisions and issue commands that end up using resources efficiently  But managers always have incomplete information about what is happening in the divisions of the firm for which they are responsible  For this reason, firms use incentive systems as well as command systems to organize production Incentive Systems  Incentive system: A method of organizing production that uses a market-like mechanism inside the firm  Senior managers create compensation schemes to induce workers to perform in ways that maximize the firm’s profit  Selling organizations use incentive systems most extensively  Sales representatives who spend most of their working time alone and unsupervised are induced to work hard by being paid a small salary and a large performance-related bonus  Incentive systems operate at all levels in a firm  The compensation plan of a CEO includes a share in the firm’s profit, and factory floor workers sometimes receive compensation based on the quantity they produce Mixing the Systems  Firms use a mixture of commands and incentives, and they choose the mixture that maximizes profit  Firms use commands when it is easy to monitor performance or when a small deviation from an ideal performance is very costly  They use incentives when monitoring performance is either not possible or too costly to be worth doing The Principal-Agent Problem  Principal-agent problem: The problem of devising compensation rules that induce an agent to act in the best interest of a principal  Principal (e.g. stockholders, Steve Jobs) induce Agents (e.g. managers, designers)  Agents, whether they are managers or workers, pursue their own goals and often impose costs on a principal  Firm’s goal is to maximize profit; however, this depends on the actions of its managers (agents)  E.g. Manager takes customer to a hockey game on the pretense that she is building customer loyalty, when in fact she is simply enjoying on-the-job leisure  Managers can also be a principal, and her tellers are agents  E.g. Workers enjoy conversations with each other and take on-the-job leisure Coping with the Principal-Agent Problem  Issuing commands does not address the principal-agent problem  In most firms, the shareholders can’t monitor the mangers and often the managers can’t monitor the workers  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 is: 1. Ownership 2. Incentive pay 3. Long-term contracts 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  Part-ownership is quite common for senior managers but less common for workers Incentive Pay  Incentive pay-pay related to performance-is very common  Incentives are based on a variety of performance criteria such as profits, production, or sales targets  Promoting an employee for good performance is another example of the use of incentive pay Long-Term Contracts  Long-term contracts tie the long-term fortunes of managers and workers (agents) to the success of the principals(s)- the owners(s) of the firm Types of Business Organization  The three main types of business organization are: 1. Sole proprietorship 2. Partnership 3. Corporation Sole proprietorship  A sole proprietorship is a firm with a single owner-a proprietor-who has unlimited liability  Unlimited liability is the legal responsibility for all the debts of a firm up to an amount equal to the entire wealth of the owner  If a sole proprietorship cannot pay its debts, those to whom the firm owes money can claim the personal property of the owner  Makes management decisions, receives the firm’s profits, and is responsible for tis losses  Profits form a sole proprietorship are taxed at the same rate as other sources of the proprietor’s personal income  Examples: Businesses of some farmers, computer programmers, and artists Partnership  A partnership is a firm with two or more owners who have unlimited liability  Partners must agree on an appropriate management structure and on how to divide the firm’s profits among themselves  The profits of a partnership are taxed as the personal income of the owners, but each partner is legally liable for all the debts of the partnership  Liability for the full debts of the partnership is called joint unlimited liability  Example: Law firms Corporation  A corporation is a firm owned by one or more limited liability stockholders  Limited liability means that the owners have legal liability only for the value of their initial investment  This limitation of liability means that if the corporation becomes bankrupt, its owners are not required to use their personal wealth to pay the corporation’s debts  Corporations’ profits are taxed independently of stockholders’ incomes  Stockholders pay tax on dividends and a capital gains tax on the profit they earn when they sell a stock for a higher price than they paid for it  Corporate stocks generate capital gains when a corporation retains some of its profit and reinvests it in profitable activities  So retained earnings are taxed twice
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