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Chapter 7

Chapter 7 Producers in the Short Run.docx

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Economics (Arts)
ECON 208
Mayssun El- Attar Vilalta

Chapter 7 Producers in the Short Run 7.1 What are Firms? (Basic unit of production) Organization of Firms 1. Single proprietorship: a firm that has one owner-manager who is personally responsible for the firm’s actions and debts 2. Ordinary partnership: a firm that has 2 or more joint owners, each of whom is personally responsible for the firm’s actions and debts 3. Limited partnership: a firm that has 2 classes of owners: general partners, who take part in managing the firm and are personally liable for the firm’s actions and debts, and limited partners, who take no part in the management of the firm and risk only the money that they have invested; less common than ordinary partnership 4. Corporation: a firm that has a legal existence separate from that of the owners; its owners aren’t personally responsible for anything that is done in the name of the firm, though its directors may be. The shares of a private corporation are not traded on any stock exchange (such as the Toronto or New York Stock Exchanges) but the shares of a public corporation are 5. State-owned enterprise: a firm that is owned by the govt but is usually under the direction of a more or less independent, state-appointed board. Although its ownership differs, the organization and legal status of a state-owned enterprise are similar to those of a corporation. In Canada, these are called Crown corporations 6. Non-profit organizations: firms that provide goods and services with the objective of just covering their costs. They are established with the explicit objective of providing goods/services to customers by having any profits that are generated remain with the organization and not claimed by individuals. Some goods/services are sold to consumers while others are provided free of charge. They earn their revenues from a combo of sales and donations. These are often called NGOs, for non-governmental organizations.  Multinational enterprises (MNEs): firms that have operations in more than one country; increasing in number and importance over time = ^role in globalization  A large amount of international trade represents business transactions of MNEs – between diff corporations, as well as between diff regional operations of the same corporation  Not all production in economy occurs in firms. Govt agencies provide goods/services (defense, roads, primary & secondary education, and health-care services) to citizens mostly w/o charging directly for their use; costs are financed thru the govt’s general tax revenues. Financing of Firms  Financial capital: the money a firm raises for carrying on its business o Equity: the funds provided by the owners of the firm o Debt: the funds borrowed from creditors outside the firm  Real capital: the firm’s physical assets like factories, machinery, offices, and sticks of materials and finished goods Equity  In individual proprietorships and partnerships, one or more of the owners provide much of the required funds. 1  A corporation acquires funds from its owners in return for stocks, shares, or equities = ownership certificates = money to company and the shareholders become owners of the firm, risking the loss of their money and gaining the right to share in the firm’s profits.  Dividends: profits paid out to shareholders of a corporation  Retained earnings: when firms raise money to retain current profits rather than paying them out to shareholders; important source of funding; reinvested profits add to the value of the firm = raise the market value of existing shares; they are funds provided by owners Debt  Firm creditors are not owners; just lent money in return for some form of loan agreement = debt instruments (in business world) = bonds (in economic theory)  Bonds: a debt instrument carrying a specified amount, a schedule of interest payments, and (usually) a date for redemption of its face value  Each has its own characteristics and its own name.  Common to all debt instruments issued by firms: o 1)Carry and obligation to repay the amount borrowed, called the principal of the loan o 2)They carry an obligation to make some form of payment to the lender called interest o The time at which the principal is to be repaid is called the redemption date of the debt o The amount of time between the issue of the debt and its redemption date is called its term Goals of Firms  Theory of firm based on 2 assumptions: o profit-maximizers, seeking to make as much profit for their owners as possible o each firm is assumed to be a single, consistent decision-making unit  The desire to maximize profits is assumed to motivate all decisions made within a firm, and such decisions are assumed to be unaffected by the peculiarities of the persons making the decisions and by the organizational structure in which they work.  The assumptions allow the theory to ignore the firm’s internal organization and its financial structure. They allow economists to predict the behaviour of firms by first studying the choices open to the firm, establishing the effect that each choice would have on the firm’s profit. Then they predict that the firm will select the alternative that produces largest profits  Some ppl argue that every firm has responsibility to society that goes well beyond the responsibility to its shareholders; others argue that by profit-maximizing, firms are providing a valuable service to society 7.2 Production, Costs, and Profits Production  Each firm needs inputs to produce goods/services that it sells = outputs o Inputs that are outputs from some other firm (steel) o Inputs provided directly by nature (land) o Inputs provided directly by people (services of workers/managers) o Inputs provided by the factories and machines used for manufacturing 2  Intermediate products: all outputs that are used as inputs by other producers in a further stage of production  Factors of production: land = nature (raw materials); labour = physical/mental efforts provided by people; capital = factories, machines, and other human-made aids to production  Productions function: a functional relation showing the maximum output that can be produced by any given combination of inputs; describes the technological relationship between the inputs that a firm uses and the output that it produces.  Q = f (L, K) Q is the flow of output, K is the flow of capital services, and L is the flow of labour services (ignore the role of land); changes in the firm’s technology alter the relationship between inputs and output, and are reflected by changes in the f Costs and Profits  Firms arrive at profits by taking the revenues they obtain from selling their output and subtracting all the costs associated with their inputs. Profits are the return to the owners’ capital Economic Vs. Accounting Profits  Accounting profits = Revenues – Explicit costs  ^Explicit costs involve a purchase of goods or services by the firm (hiring of workers, equipment rental, interest payments on debt, purchase of intermediate inputs, depreciation (not involved in market transaction) cost due to wearing out of physical capital)  Economic profits = Revenues – (Explicit costs + Implicit Costs) = Accounting Profits – Implicit Costs  ^Implicit costs are items for which there is no market transaction by for which there is still an opportunity cost for the firm that should be included in the complete measure of costs. 2 most important implicit costs are opportunity cost of the owner’s time (over and above his/her salary) and opp. cost of the owner’s capital (including the possible risk premium)  Economic/pure profits: the difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the output. Negative economic profits are called economic losses. Opportunity Cost of Time  Small and new firms = owners spend a lot of time developing the business.  Implicit cost to owner’s firm [$3000/month] is the difference between [how much owner could earn by offering their labour services to other firms $4000/month] minus [how much the owner pays himself in own firm $1000/month]; this may be missed by the accountant who measures only the $1000/month Opportunity Cost of Capital  Small and big firms  What else could be earned by lending this amount to someone else in a riskless loan? The owners could have purchased a govt bond (no risk). This is opp. cost since the firm could close down operations, lend its money, and earn the risk-free rate of return on capital from this.  What could the firm earn in addition to this amount by lending its money to another firm where risk default was equal to the firm’s own risk of loss? Additional earned is the risk premium and is 3 also a cost. If firm doesn’t think can earn total from its own operations, can close and lend to another equally risky firm and earn pure return plus risk premium.  Economists include both implicit and explicit costs in their measurements of profits, whereas accounting profits include only explicit costs. Economic profits are therefore less than accounting profits  If a firm’s accounting profits represent a return just equal to what is available if the owner’s capital and time were used elsewhere, then opportunity costs are just being covered and there are zero economic profits, even tho the firm’s accountant will record positive profits  Firms are interested in profits; economists are interested in how profits affect resource allocation Profits and Resource Allocation  When resources are valued by the opportunity-cost principle, their costs show how much these resources would earn if used in their best alternative uses. If the revenues of all firms in some industry exceed opportunity cost, the firms will earn pure/economic profits = owners of factors of production move resources into the industry b/c greater potential earnings than alternatives  Economic profits and losses play a crucial signalling role in the workings of a free-market system  Economic profits in an industry are the signal that resources can profitably be moved into that industry. Losses signal move resources elsewhere. Zero economic profits = no incentive for resources to move into or out of an industry. Profit-Maximizing Output  Level of output that will maximize a firm’s output (π) = Total Revenue (TR) – Total Cost (TC)  REST OF NOTES PROFIT = ECONOMIC (including both explicit and implicit) Time Horizons for Decision Making  Types of decisions made by firms 1. How to best use existing plant and equipment – short run 2. What new plant and equipment and production processes to select, given known technical possibilities – long run 3. How to encourage, or adapt to, the development of new techniques – very long run The Short Run  Short run: a period of time in which the quantity of some inputs (fixed factors) can’t be increased beyond the fixed amount that is available  Fixed factor: an input whose quantit
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