The Firm and Its Economic Problem
Each firm is 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.
A firm that does not seek to maximize profit either fails or is taken over by a firm
that does seek that goal.
Depreciation is the fall in value of a firm’s capital.
Depreciation is calculated using standards established by Revenue Canada.
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 decision,
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.
A Firm’s Opportunity Cost of Production
The opportunity cost of any action is the highest value forgone.
The opportunity cost of production is the value of the best alternative use of
the resources that a firm uses in in production.
Therefore, the firm’s opportunity cost of production is the value of real
Opportunity cost is expressed in money units so that we can compare and add
up the value of alternatives forgone.
A firms opportunity cost is the sum of the cost of using resources
Bought in the market
Owned by the firm
Supplied by the firms owner
Resources Bought in the Market
Firms incur an opportunity cost when buying resources in the market.
The amount 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.
When a firm uses its own capital, it implicitly rents it 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: economic depreciation
and forgone interest. Economic depreciation is when accountants measure the fall in the value of a
firm’s capital, using formulas that are unrelated to the change in the market
value for capital.
Economic depreciation is the fall in the market value of a firm’s capital over the
year: the market price of the capital at the start of the year minus the market
value at the end of the year.
Forgone interest refers to the funds used to buy capital that could have been
used for some other purpose, and in their next best use, they would have
This forgone interest is an opportunity cost of production.
Resources Supplied By the Firm’s Owner
A firm’s owner might supply both entrepreneurship and labour.
Entrepreneurship refers to the factor of production that organizes a firm and
makes its decisions might be supplied by the firm’s owner or hired by an
The return to entrepreneurship is profit, and the profit that an entrepreneur earns
on average is called normal profit. Which is the cost of entrepreneurship and
is an opportunity cost of production.
Owner’s Labour Services
Owner may supply his or her labour and 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 table 10.1 on page 229 in textbook.
To achieve the objective maximum economic profit, a firm must make five
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
In all these decisions, a firm’s actions are limited by constraints that it faces.
A Firm’s Constraints
Three features of a firm’s environment limit the maximum economic profit it can
Technology is any method of producing a good or service.
Detailed design of machines Layout of the workplace
Organization of the firm
The increase in profit that a firm can achieve is limited by the technology
Technology advances over time. But at each point in time, to produce more
output and to gain more revenue, a firm must higher more resources and incur
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.
To address these problems, firms create incentives to boost worker’s efforts
even when no one is monitoring them, conduct market research to lower
uncertainty about customer’s buying plans.
These efforts do not eliminate incomplete information and uncertainty.
Quantity each firm can sell and the price it can obtain is limited by the customer’s
willingness to pay and by the prices and marketing efforts of other firms.
Similarly, the resources that a firm can buy and the prices that it must pay for
them are limited by the willingness of people to work for and invest in the firm.
market constraints and the expenditures firms make to overcome them limit the
profit a firm can make.
Technological and Economic Efficiency
There are two concepts of production efficiency:
Technological efficiency which occurs when the firm produces a given output
by using the least amount of inputs.
Economic efficiency occurs when a firm produces a given output at the least
Technological Efficiency and Economic Efficiency
Refer to exercise on page 231, and table 10.2
Economic efficiency depends on the relative costs of resources.
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
Information and Organization
Firms combine coordinate the productive resources it hires to organize
production of goods and services.
Firms use a mixture of two systems to do so: Command systems
A command system is a method of organizing production that uses a
Commands pass down through the hierarchy, and information passes upward.
The military is a perfect example.
Small firms have one or two layers while large firms have several layers.
An incentive system is 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.
Operate at all levels in a firm.
Mixing the Systems
Firms use command when it is easy to monitor performance or when a small
deviation from an ideal performance is very costly.
They use incentives when it is either not possible to monitor performance or too
costly to be worth doing.
The Principal-Agent Problem
The principal-agent problem is the problem devising compensation rules that
induce an agent to act in the best interest of a principal. For example, the
stockholders of RIM are principals, and the firm’s managers are agents.
Agents pursue their own goals and often impose cost on a principal.
Firm’s profit depends on actions of its managers.
A firm constantly strives to find ways of improving performance and increasing
Coping With Principal-Agent Problem
Each principal must create incentives that induce each agent to work in the
interests of the principal. There are three ways with attempting to cope with the
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.
For example WestJet offers its employees an Employee Share Purchase Plan,
so most of its employees are owners of the company.
Incentive pay Is pay related to performance, which is very common.
based on a variety of performance criteria such as profits, production, or sales
Prompting an employee for good performance is another example of the use of
Tie the long-term fortunes of ma