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ECON 208 (113)
Chapter 7

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Economics (Arts)
ECON 208
Wendy Dickinson

Chapter 7 – Producers in the Short Run 7.1 What are Firms? Organisation of Firms 1) Single proprietorship x Has one owner who is personally responsible for the firm’s actions and debts 2) Ordinary partnership x Has two or more joint owners, each of whom is personally responsible for the firm’s actions and debts 3) Limited partnership x Has two classes of owners: x General partners x Take part in managing the firm x Are personally liable for the firm’s actions and debts x Limited partners x Take no part in the management of the firm x Risk only the money that they have invested 4) Corporation x Has a legal existence separate from that of the owners x Owners not personally responsible x Private x Shares not traded on any stock exchange x Public x Shares traded on stock exchanges 5) State-owned enterprise x Owned by the government x Under the direction of a more or less independent state-appointed board x Organisation and legal status similar to corporation 6) Non-profit organisations x Provide goods and services with the objective of just covering their costs x Earn their revenues from sales and donations Multinational Enterprises (MNEs) x Firms that have operations in more than one country x Their growing number reveals an increasing role for these corporations in the ongoing process of globalisation Not all production in the economy takes place within firms. Many government agencies provide goods and services (financed by tax revenues) Financing of Firms Financial capital: the money a firm raises for carrying on its business basic types: equity & debt Real capital: the firm’s physical assets (factories, machinery, offices, finished goods) EQUITY x Individual proprietorships & partnerships x One or more owners provide much of the required funds x Corporations x Acquire funds from its owners in return for stocks, shares, orequities x Dividends x Profits that are paid out to shareholders x Retained Earnings x Retaining current profits rather than paying them out toshareholders x Way for an established for to raise money x Add value to the firm, raise market value of existing shares DEBT x Debt instruments x Loan agreements x Characteristics x They carry an obligation to: x repay the amount borrowed (aka, theprincipal of the loan) x make some form of payment to the lender (aka,interest) x Bonds x A debt instrument carrying a specified amount, a schedule of interest payments, and (usually) a date of redemption of its face value x Redemption date: the time at which the principal is to be repaid x Term: the amount of time between the issue of the debt and its redemption date Goals of Firms The desire to maximise 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 organisational structure in which they work x Assumptions 1) Firms are profit-maximisers 2) Each firm is a single, consistent decision-making unit x Allow x the theory to ignore the firm’s internal organisation and its financial structure x economists to predict behaviour of firms x the firm will select an alternative that produces the largest profits x Social responsibility a) Every firm has a responsibility to society that goes beyond the responsibility to its shareholders; VS b) By maximising profits, firms are providing a valuable service to society 7.2 Production, Costs, and Profits Production INPUTS x Intermediate products x All outputs that are used as inputs by other producers in afurther stage of production x Inputs that are provided directly by nature (Land) x Inputs that are provided directly by people (Labour) x Inputs that are provided by the factories and machines (Capital) PRODUCTION FUNCTION x Functional relation showing the maximum output that canbe produced by any given combination of inputs x Q = f (L, K) Q: flow of output K: flow of capital services L: flow of labour services f: production function itself x Changes in the firm’s technology, which alter the relationship between inputs and output, are reflected by changes in the functionf. Costs and Profits Firms arrive at profits by taking the revenues they obtainfrom selling their output by subtracting all the costs associated with their inputs. ECONOMIC VERSUS ACCOUNTING PROFITS x Accounting profits = Revenues –Explicit costs x Explicit costs: costs that actually involve a purchase of goods or services by the firm E.g.: hiring of workers, renting equipment, interest payments on debt, purchase of intermediate inputs x Economic Profits = Revenues – (Explicit costs +Implicit costs) = Accounting profits –Implicit costs x The difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the output. x Implicit costs: items for which there is no market transaction but for which there is still an opportunity cost for the firm x Opportunity cost of the owner’s TIME (over and above his salary) x In small and new firms, where owners spend a lot of time developing the business x They often pay themselves far less than they could earn elsewhere x E.g.: entrepreneur who pays herself $1,000/month instead of the $4,000/month from the best alternative job. Implicit cost = $3,000 Explicit cost = $1,000 x Opportunity cost of the owner’s CAPITAL (including a possible risk premium) x Applies to small business and to large corporations x Two questions to ask a) What could be earned by lending this amount to someone else in a riskless loan x E.g.: government bond with 6% return b) What could the firm earn in addition to this amountby lending its money to another firm where the risk of default is equalto the firm’s own risk of loss? x E.g.: risk premium of 4% x If the firm does not expect to earn this much in its own operations, it could close down and lend its money out to some equally risky firm and earn 10% x Negative economic profits are calledeconomic losses PROFITS AND RESOURCE ALLOCATION x Economic profits and losses play a crucial signalling rolein the workings of a free-market system x Economic profits in an industry are the signal that resources can profitably be moved into that industry x When the revenues of all the firms in some industry exceed opportunity cost, the firms in that industry will be earning pure economic profits. The owners will therefore want to move resources into the industry, because theearnings potentially available to them are greater there than in alternative uses. x Losses are the signal that the resources can profitably be moved elsewhere. x Only if there are zero economic profits is there no incentive for resources to move into or out of an industry Profit-Maximising Output x π = TR – TC π: the level of output that will maximise a firm’s profit TR: Total Revenue TC: Total Cost x What happens to profits as output varies depends on what happens to both revenues and cost Time Horizons for Decision Making THE SHORT RUN x Period of time in which the quantity of some inputs (fixed factors) cannot be increased beyond the fixed amount that is available x The length of time over which some of the firm’s factors of production are fixed x Fixed factor x an input whose quantity CANNOT be changed in the short run x usually an element of capital (e.g.: plant, equipment) x might be land, the services of management, supply of skilled labour x Variable factor x an input whose quantity CAN be changed over the time period under consideration THE LONG RUN x Period of time in which all inputs may be varied, but theexisting technology of production cannot be changed x The length of time over which all of the firm’s factors of production can be varied, but its technology is fixed x Corresponds to the situation the firm f
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