Chapter 1: What is Economics? 11/12/2013 11:17:00 AM
Economics’ fundamental definition says that we as humans want
more than we can get. This is called scarcity.
Demands and needs are limited by the limited resources available.
Incentive: a reward that encourages an action or a penalty that encourages
Economics is the social science that studies the choices that
individuals, businesses, governments, and entire societies make as
they cope with scarcity and the incentives that influence and
reconcile those choices
Microeconomics: the study of the choices that individuals and businesses
make, the way these choices interact in markets, and the influence of
Macroeconomics: the study of the performance of the national economy
and the global economy.
Goods and services are the objects that people value and produce to satisfy
human wants. They are produced by using the four factors of production:
Land: Can also be known as natural resources such as oil, gas, coal,
water, air, forests and fish. Earns rent.
Labour: The work, time and effort that people devote to producing goods
and services. Earns wages.
Capital: The tools, instruments, machines, buildings, and other
constructions that businesses use to produce goods and services. Earns
Entrepreneurship: The human resource that organizes labour, land and
capital. Earns profit.
Self interest is a choice made that best suits you.
Social interest is a choice made that best suits the well being of society. Efficiency is achieved when the available resources are used to produce
goods and services at the lowest possible cost and in the quantities that give
the greatest possible value or benefit.
Can these be achieved equally? We can attempt to determine
whether they can or not by using four examples:
Globalization means the expansion of international trade, borrowing and
lending, and investment. It is in the self-interest of consumers who buy low
cost goods and services produced in other countries. This example isn‟t so
fair for workers in countries like Malaysia.
Information-Age Economy revolves around the ever changing technology.
Arguably, the self-interest of technology titans did not match the social-
Climate Change states that we all have a carbon footprint. Possible ways to
fix this would be riding a bike, planting a tree, or some sort of clean energy.
Economic Instability talks about banks , basically, stealing money from
their customers through interest rates and loans. When banks get into
financial trouble, they get loans from governments thus creating instability
within the economy.
In the end, the economic way of thinking something through will often end
in a tradeoff; an exchange of giving something up to gain something
else. A rational choice is one that compares costs and benefits and achieves
the greatest benefit over cost for the person making the choice.
The benefit of something is the gain or pleasure it brings and is determined
by preferences. Benefits can be measured by the most a person is willing
to give up to get something. How much you are willing to give up can be
measured by opportunity cost, which is the highest valued alternative that
must be given up to get something.
Marginal Benefit is the benefit that arises from increasing time spent doing
something. The marginal benefit of studying one more hour the night before
a test is a grade boost the next day.
Marginal Cost is the opportunity cost of increasing time spent doing the
same „something‟. The marginal cost of studying one more hour the night
before a test is a lost hour that could be spent playing WoW or CoD. If marginal benefit exceeds marginal cost, you study that extra hour. If
marginal cost exceeds marginal benefit, you don‟t study the extra hour. Chapter 2: The Economic Problem 11/12/2013 11:17:00 AM
In this chapter, expect to see economic models-the production possibility
frontier-that explains how factors that affect the production of some given
product can be examined, whether production is efficient or inefficient, and
how we can gain by trading with others.
A Production Possibility Frontier is the boundary between combinations
of goods and services that can be produced and those that cannot. Under
the line represents attainable quantities and outside represents unattainable.
We can examine the PPF for producers of pizza and cola:
Possibility Pizzas(millions) Cola(millions)
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
This chart shows that as we go up and down in the columns, we must give
up some of one product to gain some of the other product.
We can produce production efficiency if we produce goods and services at
the lowest possible cost. If we were to graph the points in the table above, it
would make a continuous down sloping line. Points on the graph are
efficient. If we were to drop a point anywhere inside the PPF, these amounts
would be inefficient because we are giving up or misallocating more goods
Every choice along the PPF signifies a tradeoff. At any given time, we have a
fixed amount of land, labour, capital and entrepreneurship. By using what
we have, we can employ these resources to product goods and services but
we are limited in production by what we have. To produce more coke, we
must give up pizza. Every tradeoff faces an opportunity cost.
We are able to use our resources efficiently. When goods and services are
produced at the lowest possible cost and in the quantities that provide the
greatest possible benefit, we have achieved allocative efficiency. The marginal cost of a good is the opportunity cost of producing one more
unit of it. We can calculate this from the slope of the PPF.
The marginal benefit of a good or service is the benefit received from
consuming one more unit of it.
In the past 30 years, production possibilities in Canada has doubled. This is
called economic growth. This, however, does not eliminate scarcity or
opportunity cost, but rather accelerate it. Technological change is the
development of new goods and of better ways of producing goods and
services. Capital accumulation is the growth of capital resources, including
Producing only one or few goods is called specialization. People can
specialize and gain from trade from finding themselves with a
A person has a comparative advantage in an activity if they can perform the
activity at a lower opportunity cost than anyone else.
A person has an absolute advantage if they can perform multiple activities at
a lower cost than anyone else.
Liz‟s Production Possibilities
Item Minutes to Produce 1 Quantity per hour
Smoothies 2 30
Salads 2 30
Liz‟s opportunity cost of producing 1 smoothie is 1 salad and the opportunity
cost of producing 1 salad is 1 smoothie
Joe‟s Production Possibilities
Item Minutes to Produce 1 Quantity per hour
Smoothies 10 6
Salads 2 30 Joe‟s opportunity cost of producing 1 smoothie is 5 salads and the
opportunity cost of producing 1 salad is 1/5 of a smoothie
From this, we can see that Liz has a comparative advantage in the
production of smoothies and Joe has a comparative advantage in the
production of salads.
So in the end:
a)Before trade Liz Joe
Smoothies 15 5
Salads 15 5
b)Specialization Liz Joe
Smoothies 30 0
Salads 0 30
c)Trade Liz Joe
Smoothies Sell 10 Buy 10
Salads Buy 20 Sell 20
d)After trade Liz Joe
Smoothies 20 10
Salads 20 10
e)Gains from trade Liz Joe
Smoothies +5 +5
Salads +5 +5
A market is any arrangement that enables buyers and sellers to get
information and to do business with each other. An example of this is the
world oil market. Markets can only work when property rights exist.
Property rights are the social arrangements that govern ownership, use
and disposal of anything that people value. Real property includes land and
buildings, financial property includes stocks and bonds and money in the
bank, and intellectual property is the intangible product of creative effort. Chapter 3: Supply and Demand 11/12/2013 11:17:00 AM
Competitive Market- A market that has many buyers and sellers, so no
single buyer or seller can influence the price
Price- The number of dollars that must be given up in exchange for an item,
also known as the Money Price
Opportunity Cost- The highest valued alternative forgone
Relative Price- The ratio of one price to another, also known as the
Demand- If you demand something, this entitles that you want it, can
afford it, and plan to buy it
Wants- are the unlimited desires or wishes that people have for goods and
Quantity Demanded- the amount of goods and services that consumers
plan to buy during a given time period at a particular price
The Law of Demand:
Other things remaining the same, the higher the price of a good, the smaller
the quantity demanded; the lower the price of a good, the higher the
Substitution Effect: When the price of a good rises, as does its opportunity
cost. As the opportunity cost rises, the economic solution would be to switch
to a substitute product of the same relation
Income Effect: As a products price rises, the income of some people
becomes too low to afford the product at its new price.
Demand- itself, refers to the entire relationship between the price of a good
and the quantity demanded of that good
Demand Curve- shows the relationship between the quantity demanded of
a good and its price when all other influences on consumers‟ planned
purchases remain the same Chapter 4: Elasticity 11/12/2013 11:17:00 AM
How do we tell which quantity(soft drinks or pizza) demanded is more
responsive to a price change? The question must be answered with a
measure of responsiveness that is independent of units of measurement.
This measure is called Elasticity.
Price elasticity of demand- a units free measure of the responsiveness of
the quantity demanded of a good to a change in its price when all other
influences on buying plans remain the same
Calculating it: percentage change in quantity demanded
percentage change in price
We can express the change in price as a percentage of the average price and
the change in quantity demanded as a percentage of the average quantity.
By using the averages, this allows us to use a point exactly between the old
point and the new point.
With the old point being 20.50$ a pizza and the new price being 19.50$ a
pizza, the average price sits at 20.00$ a pizza. We call this %ΔP. Which
%ΔP= (ΔP/P ave) x 100 = ($1/$20) x 100 = 5%
With the old quantity of pizza demanded being 9 pizzas and the new
quantity demanded being 11 pizzas, we can call the average amount of
pizzas demanded 10. We call this %ΔQ. Which means…
%ΔQ= (ΔQ/Q ave x 100 = (2/10) x 100 = 20%
Price elasticity of demand= percentage change in quantity
percentage change in price
Percentages and Proportions- elasticity is the ratio of two percentage
changes. A percentage change is a proportionate change multiplied by 100. Minus sign and elasticity- When the price of a good rises, the quantity
demanded falls. This means that because a positive change in price occurs, a
negative change in quantity demanded occurs which makes the price
elasticity of demand a negative number. We ignore the negative sign and
just pay attention to the magnitude and the absolute value.
Perfectly inelastic demand- when the quantity demanded remains
constant with a change in price and the elasticity is zero.
Unit elastic demand- if the percentage change in quantity demanded
equals the percentage change in price then the price elasticity equals one.
Perfectly elastic demand- if the quantity demanded changes by an
infinitely large percentage in response to a tiny price change, then the price
elasticity of demand is infinity. Chapter 5: Efficiency and Equity 11/12/2013 11:17:00 AM
The goal for this chapter is to evaluate the ability of markets to allocate
resources efficiently and fairly.
Problems with Scarcity: We know that resources are scarce so they must be
allocated efficiently. These scarce resources are allocated through
First come, first served
Market Price – The people who are willing and able to pay that price get
that resource. There are two kinds of people: those who can afford to pay
but choose not to buy, and those who cannot afford to buy.
Command – Allocates resources by the command of someone in authority.
This is used within firms, and government departments. In a job context
labour would be allocated via command.
Majority Rule – allocates resources in a way that a majority of voters
choose. (i.e tax rates, allocating scarce resources, etc)
Contest – allocates resources to a winner or group of winners
First Come First Served – allocates resources to those who are first in line.
It is most optimal when there are fewer people in need of a resource.
Personal Characteristics – People with the “right” characteristics get the
resources. i.e who you chose for a marriage partner, or sometimes in
unacceptable ways i.e giving the promotion to a white Anglo-Saxon
protestant (w.a.s.p) male over a minority on the basis of “w.a.s.p” status.
Force – War and the use of military force by one nation against another is
one way that resources are allocated.
Benefit, Cost, and Surplus
Resources are allocated efficiently and in social interest when they are used
in the ways that people value most highly.
In a demand sense, value is what we get and price is what we pay.
The value of one more unit of a good or service is its marginal benefit. Marginal benefit is the maximum price that is willingly paid for another unit
of the good or service. A demand curve is a marginal benefit curve.
Individual Demand and Market Demand
The relationship between the price of a good and the quantity demanded by
one person is called individual demand. The relationship between the price
of a good and quantity demanded by all buyers is market demand.
Is the excess of the benefit received from a good over the amount paid for
it. Consumer surplus occurs when we buy something for less than it is worth
Supply Cost and Minimum Supply Price
Producers distinguish between cost and price like we consumers distinguish
between value and price.
Cost: What a firm gives up when it produces a good or service
Marginal Cost is the min price the producers must receive to induce them to
offer one more unit of a good or service for sale.
A Supply curve is a marginal cost curve.
The relationship between the price of a good and the quantity supplied by
one producer is called Individual Supply.
The relationship between the price of a good and the quantity supplied by all
producers is called Market Supply.
The Market Supply Curve is the horizontal sum of the individual supply
curves and is formed by adding the quantities supplied by all the producers
at each price.
Efficiency of Competitive Equilibrium
The market demand curve for a good or service tells us the marginal social
benefit from it. At equilibrium the marginal social benefit = marginal social
Competitive markets push the prices and quantity demanded to equilibrium
The sum of consumer surplus and producer surplus is called Total Surplus.
Market Failure occurs when a market delivers an inefficient allocation of
The scale of efficiency is measured by Deadweight Loss, which is the
decrease in total surplus that results in an inefficient level of production. An Example of Overproduction
A firm produces 15k pizzas a day, however at this quantity, consumers are
only willing to pay 10$ for pizzas that cost 20$ to produce. This means that
by producing the last pizza, $10 of resources are lost which reduces the total
surplus to less than it‟s max.
Sources of Market Failure
Price and Quantity regulation
Taxes and Subsidies
Public Goods and common resources
High Transaction costs
Price and Quantity Regulations
Price regulations occur when a cap is put on something like rent or
minimum wage. These can block price adjustments that the market would
normally make and lead to underproduction.
Quantity regulations that limit the amount that a firm is able to produce can
lead to underproduction as well.
Taxes & Subsidies
Taxes increase the prices paid by buyers and lower the prices received by
sellers. This means taxes decrease the quantity produced by sellers leading
Subsidies – are payments by the government to producers, they decrease
the prices paid by buyers and increase the prices received by sellers. As a
result firms produce too much and we have overproduction
A cost or benefit that affects someone other than the seller or the buyer.
External costs arise when we fail to consider elements such as pollution
costs. As a result we overproduce disregarding our heavy external costs.
External benefit can arise when a condo owner puts a fire alarm in your
neighbours apartment. As a result, you benefit from decreased fire risk.
Public Goods and Common Resources
A public good is a good or service that is consumed simultaneously by
everyone even if they don‟t pay for it. (i.e free health care, national defense
etc) Common Resources are owned by no one but available to everyone for use.
For Example Atlantic Salmon owned by nobody, so we over produce it at
the cost of the well being of the species. This results in an overused
Monopoly - A firm that is the sole provider of a good or service. Its goal is to
maximize profits. To achieve it‟s goal of maximum profit, it produces too
little and overcharges. This is an example of underproduction.
High Transaction Costs
Transaction costs are the costs of the services that enable a market to bring
buyers and sellers together.
Utilitarianism – we should strive to achieve the greatest happiness for the
greatest number. It was argued that wealth should be transferred from the
rich to the poor until there was a balance of marginal benefit per dollar. (the
2 millionth dollar a rich person has brings them little joy yet 1 dollar given to
a bum brings them significant happiness).
The problem with this approach is that is neglects to consider the effects of
transaction costs. This leads to a Big tradeoff where we are torn between
efficiency and fairness. The greater amount of income redistribution through
income taxes, the greater the inefficiency and the smaller the economic pie
A solution to this is to make the poorest as well off as possible. Rawls theory
takes into account transfer fees and finds the most efficient ways to provide
the poor with resources while not shrinking the pie.
The Symmetry Principle: the requirement that people in similar situations
be treated similarly.
Fairness obeys 2 rules
the state must enforce laws that establish and protect private property
private property may be transferred from one person to another only by
voluntary exchange. Chapter 6: Government Actions in Markets 11/12/2013 11:17:00 AM
Government regulation that makes it illegal to charge a price higher than a
specified level is called a price ceiling/price cap.
If a price ceiling is set above the equilibrium price, then there is no effect
Yet when the price ceiling is below the equilibrium price, there is a huge
effect on the market. There is a conflict between force of law and market
forces which often result in shortages.
When rent ceilings are put into effect below the equilibrium we experience a
shortage of houses available and increased demand. This leads to more
search activity, which is the time, spent looking for someone to do
business with. It can also lead to a black market, which is an illegal market
where the equilibrium price surpasses the imposed price ceiling. It is
inefficient because the marginal social benefit is exceeding the cost meaning
we will have an underproduction of housing.
Labour Markets – Minimum Wage
Minimum wage is a price floor applied to labour markets. At a wage rate
above the equilibrium wage, there is a surplus of labour because the
quantity of people willing to supply is higher than the amount of positions in
The demand curve measures the marginal social benefit from labour. This
benefit is the value of goods and services produced. Unregulated labour
markets allocate resources to the jobs in which they are valued most highly.
The market is efficient.
Inefficient labour markets are the product of more people willing to work for
a wage than firms are willing to supply. As a result 20 million people are
employed but now an extra 2 million people don‟t have jobs, which would
have existed had the minimum wage not increased.
Tax Incidence – the division of the burden of a tax between buyers and
A tax on sellers leads to an increased cost which causes them to reduce their
A tax on buyers reduces demand.
Regardless of who pays the tax, the outcome is the same. Demand will be
reduced and so will the resulting suppy.
Tax Incidence and Elasticity of Demand Perfectly inelastic demand – Buyers pay
Perfectly elastic demand – sellers pay
Taxes and Fairness
The Benefits Principle
The proposition that people should pay taxes equal to the benefits they
receive from them.
The Ability To Pay Principle – the proposition that people should pay
taxes according to how easily they can bear the burden of the tax. (high
income tax on high incomes)
Production Quota’s and Subsidies
A Production Quota is an upper limit to the quantity of a good that may be
produced in a specified period.
The effects of a Production Quota below the equilibrium quantity are
Decrease in supply
Rise in price
Decrease in marginal cost
Incentive to cheat and overproduce
A Subsidy is a payment made by the government to a producer.
The effects of a subsidy are similar to the effects of a tax but they go in the
These effects are
an increase in supply
a fall in price with increased quantity produced
an increase in marginal cost
payments by government
Markets for Illegal Goods
A free market for a drug – the cheaper the drug, the more bought. (think
marijuana sticks in Colorado)
When the drug becomes illegal, the cost of trading is increased. Larger
penalties and heavy policing on both the seller and or buyer will influence
Penalties on Sellers – Rises the price of the drugs and decreases the
Penalties on buyers – Lowers the price, decreases quantity supplied Penalties on both buyers and sellers – both supply and demand decrease Chapter 7: Global Markets in Action 11/12/2013 11:17:00 AM
Comparative Advantage drives international trade. National Comparative
advantage refers to a nations ability to produce a good or service at a lower
opportunity cost than any other nation.
Comparative advantages are how countries decide what they will produce
(export), and what they will import. Essentially we produce what we can
most efficiently and import what we produce least efficiently. i.e Canada
produces fighter jets inexpensively, China produces clothes inexpensively.
So we trade and all parties win.
This is advantageous because we can now sell more of our products at an
increased price due to a larger world market. By introducing global trade we
now sell our products at a universal world price.
International trade lowers the price of imported goods and raises the price of
exported goods. As a result buyers of imported goods benefit from cheaper
prices (think of cheaper clothing prices), and exporters get to sell their
products for more! (China buys our jets for more than we would charge if we
just sold them domestically).
Governments use tariffs, import quotas, export subsidies and other import
barriers to control how much we import and export. These measures are
used to protect domestic suppliers.
Tariff: a tax on a good that is imposed by the importing country. When a
tariff is put into effect, the price of the good goes up by the amount of the
tariff. This decreases demand, and takes away some of the competitive
$2 tariff raises price in Canada to
Canada imports decrease by 1
mill per year
Canadian government collects the
tax revenue of 2 mill a year
(purple box) Winners & Losers from Tariffs
Canadian Consumers Lose (have to pay more for the product)
Canadian Producers Gain (Imported competition have less of a price
The consumers lose more than producers gain so we now have a
Area C and E are the deadweight
loss due to the tariffs.
Area D is tariff revenue claimed by
The Consumer surplus shrinks and
the producer claims area B.
An Import quota is a restriction that limits the max quantity of a good that
may be imported in a given period.
With the Quota (t-shirt supply
becomes S + Quota)
The price rises to $7
The quantity produced in Canada
increases and the quantity bought
Winners and Losers from Import Quota’s.
Canadian consumers of t-shirts lose
Canadian producers of t-shirts gain Importers of t-shirts gain and society loses because the markets are not
running at max efficiency.
Import quota raises the price of a
t-shirt to $7 and decreases
Area B is transferred from
consumer surplus to producer
Importers profit the sum of areas
C+E is the deadweight loss.
*in free trade C, E and D‟s +B
would all be consumer surplus and
we‟d have no deadweight loss
Other import barriers are regulations such as health and safety which
restrict international trade.
Export subsidies are payments made by the government to a domestic
producer of an exported good. They bring gains to domestic producers but
often result in overproduction in the domestic economy and underproduction
for the rest of the world leading to a deadweight loss.
2 Arguments against Protection
The Infant Industry argument 2) The dumping argument
Infant industry argument – it is important to protect a new industry from
import competition allowing it to grow and compete in world markets.
It has been argued that these firms would learn by doing which would not
warrant protection from competition.
Dumping occurs when foreign firm sells it‟s exports for a lower price than its
cost of production.
We cannot protect these firms because it is impossible to determine a firms
Even if they drove out all domestic firms, new ones would pop up thus
preventing a global monopoly
If a global monopoly did occur, we could simply just regulate it rather than
restrict it. Arguments for protection include Saving jobs, allows us to compete with
cheap foreign labour, penalize lax environmental standards, prevents rich
countries from exploiting developing countries.
Free trades destroys some jobs but creates new better jobs. Free trade also
increases foreign income and allows them to buy domestic production.
Free trade allows poorer countries to acquire wealth allowing them to have
enough money to take the environment into consideration.
Hire Canadian labor and produce in Canada.
Hire foreign labour and produce in another country
Buy finished goods, components, or services from firms in Canada
Buy finished goods, components, or services from other countries.
Outsourcing: occurs when a firm in Canada buys finished goods,
components or services from firms in Canada or buys finished goods,
components, or services from firms in other countries.
Offshoring – occurs when a firm in Canada hires foreign labour and
produces in another country. Or buys goods components and or services
from firms in other countries.
Offshoring Outsourcing – occurs when a firm in Canada buys finished
goods, components, or services from firms in other countries.
Rent Seeking – lobbying and other political activity that seeks to capture
the gains from trade. Chapter 8: Utility and Demand 11/12/2013 11:17:00 AM
Consumption choices are broken into 2 categories Consumption
Possibilities, and Preferences.
Consumption Possiblities are all the things that you can afford to buy.
Budget Line – shows the limits of her consumption possibilities.
Utility – the benefit or satisfaction attained by consuming a good or service
Total Utility – the total benefit a person gets from the consumption of
goods. Generally, more consumption gives more total utility.
Marginal Utility – The change in total utility that results from a one unit
increase in the quantity of the good consumed.
Total utility increases as more of a product is consumed however it‟s
marginal utility diminishes significantly.
The direct way to find the utility maximizing choice is to make a table and
calculate. We want to find the just affordable combinations, the total utility
for each just affordable combination, and the utility maximizing one is the
Consumer Equilibrium occurs
when someone has allocated all of
their available income in the way
that maximizes their total utility.
In the table this occurs when total
utility is at 315.
To calculate the marginal utility per dollar we take the marginal utility from
(movies) MU M and the price of a movie P M.We now know the marginal utility
per dollar from movies is MU M P M .he same could be down with another
product and you could compare the two marginal utilities per dollar to help
achieve maximum utility.
Utility maximizing rules
Spend all available income 2) Equalize the marginal utility per dollar for all
goods In Row C MU /P = MU /P
P p M M
This maximizes total utility.
The price of one good changes the
demand for another good. If the
price falls for a good the
consumer changes quantities
In this instance the price of
movies has fallen and so now Lisa
is seeing more movies and
drinking less pop to get her
consumer equilibrium. When income increases the demand for a normal good increases (pop,
The Paradox of Value
Why is water which is essential to life, far cheaper than diamonds which are
not essential? We can answer this by using the concepts of total utility and
We use so much water that the marginal utility from water consumed is very
small but the total utility is huge.
We buy very few diamonds so the marginal utility from diamonds is large
with a small total utility.
Behavioural Economics studies the ways in which limits on the human brain‟s
ability to compute and implement rational decisions influences economic
behaviour –both the decisions that people make and the consequences of
those decisions for the way markets work.
There are 3 impediments to rational choice
Bounded Rationality – Rely on listening to others views‟ or gut instincts
Bounded Willpower –less than perfect willpower that prevents us from
making a decision that we know we will later regret
Bounded Self-Interest – Suppressing our own interests to help others.
The Endowment Effect – the tendency for people to value something more
highly simple because they own it. (i.e owning a Volkswagon Golf ;) Chapter 10: Organizing Production 11/12/2013 11:17:00 AM
A firm is an institution that hires factors of production and organizes those
factors to produce and sell goods and services. A firm‟s goal is to maximize
profits. If this isn‟t a firms main priority then they will either end up going
under or getting taken over by a more healthy firm.
Economic Profit is equal to total revenue minus total cost, with total cost
measured as the opportunity cost of production.
Accounting Profit on the other hand is the dollar amount.
A firm‟s opportunity cost of production is the value of the best alternative
use of resources that a firm uses in production. A firm‟s opportunity
cost of production is the sum of the cost of using resources either
A) bought in the market firms incur an opportunity cost when it buys
resources in the market. The purchasing of these resources can be
considered an opportunity cost because they could have bought a different
resource to create a different good or service.
B) owned by the firm firms incur an opportunity cost when it uses its own
capital. This is an opportunity cost because instead of using it, they could
sell it and rent capital from another firm. The implicit rental rate of capital
is when a firm rents its capital from itself. This has two parts.
I) Economic Depreciation – is the fall in the market price of capital at the
start of the year minus the market price of capital at the end of the year.
II) Forgone Interest – the funds used to buy capital could have been used
for some other interest gaining purpose.
C) supplied by the firm‟s owner a firm‟s owner might supply both
entrepreneurship and labour.
I) Entrepreneurship – the organizing and decision making of the firm. The
average profit that the firm earns through entrepreneurship is called a
normal profit which is the cost of entrepreneurship which is an opportunity
cost of production.
II) Owner’s Labour Services – the owner might supply labour without a
wage. The opportunity cost of the owner choosing to do this is the labour
forgone by not taking a good alternative job.
In order to maximize profits, the 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 what to buy from other firms
The Firm’s Constraints
Technology Constraints – any method of producing a good or service. It
advances over time and firms must hire more resources.
Information Constraints – firms will never be able to possess full
information about the present or the future therefore it is limited by not
knowing buying plans and such. This will, in the end, limit profits.
Market Constraints – firms are limited because they cannot predict their
customers‟ willingness-to-pay and they have no say on other firm‟s
Efficiencies in the Firm
Technological Efficiency – occurs when the firm uses the least amount of
input to produce a large number of output.
Economic Efficiency – occurs when the firm produces a given amount of
output at the lowest cost. This depends on the relative costs of capital and
The difference in the two is that technological efficiency considers
the quantity of input whereas economic efficiency considers the
price of input.
Information and Organization
Command System uses a managerial hierarchy. Comman