ECON 208 Chapter Notes -Technological Change, Production Function

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23 Mar 2012
Adrienne Pacini ECON 208 WEEK: October 13, 2009
Chapter 7
What are Firms?
Organization of Firms
- A firm can be organized in six different ways
o Single proprietorship: one owner
o Ordinary partnership: two or more owners
o Limited partnership: including general and limited partners
o Corporation: has an identity of its own; owners are not personally responsible
o State-owned enterprise: owned by the government
o Non-profit organization: established with the sole objective to provide goods and
services to customers
Financing of Firms
- Financial capital: the profit a firm raises for carrying on its business
o Including equity and debt
Equity: funds provided by the owners of the firm
Debt: funds borrowed from creditors outside the firm
- Dividends: profits paid out to shareholders of a corporation (sometimes called distributive
- Bonds: a debt instrument carrying a specified amount and schedule of interest payments
and usually a date for redemption of its face value
o Principle of the loan: obligation to repay the amount borrowed
o Redemption date: time at which it must be paid
o Term: time between the issue date and redemption date
Goals of Firms
- The desire to maximize profits motivates all decisions
- Need for firms to be socially responsible
o Every firm has a responsibility to society
Production, Costs, and Profits
- Firms use four types of inputs for production:
o Intermediate products: goods that firms produce not for consumption by
individuals but for purchase by other firms to help with production of other goods
o Inputs provided by nature: existing natural resources
o Inputs provided by people: including labour services, investments, human capital
o Inputs provided by the services of physical capital: by machines
- The production function relates inputs to outputs
o Describes the technological relationship between the inputs that a firm uses and the
output that it produces
o Function notation: Q = f(L, K)
o Production is a flow
Costs and Profits
- Economic profit includes implicit and explicit costs
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Adrienne Pacini ECON 208 WEEK: October 13, 2009
- Unlike the accounting definition of profit, economic profit includes the (implicit) opportunity
cost of the owner’s time and capital in the firm’s costs
o Profit = revenues costs opportunity costs
o Economic profits are less than accounting profits (since opportunity cost is
o If economic profit is positive, then the owner’s capital is earning more than it could
in its next best alternative use
- Economic profits: the difference between the revenues received from the sale of output
and the opportunity cost of the inputs used to make the output
o Negative economic profits are called economic losses
o It is possible for the accounting profits to be positive when the economic profits are
o Opportunity cost of owner’s time: owners spend lots of time developing their
business and pay themselves less than they would make elsewhere
o Opportunity cost of owner’s capital: what could be earned by lending a certain
amount to someone else in a riskless loan (this is the risk premium)
Profit-Maximizing Output
- Need to determine the level of output that will maximize a firm’s profit
- What happens to profits as output varies depends on what happens to both revenues and
- For a firm to increase its rate of output, it must increase the inputs of one or more factors of
- A firm’s economic profit is equal to total revenues minus total economic costs
o π = TR TC
Time Horizons for Decision Making
- The short run Is a length of time over which some of the firm’s factors of production are
o Fixed factor: an input whose quantity cannot be changed in the short-run (i.e.
o Variable factor: an input whose quantity can be changed over the time period under
- The long run is the length of time over which all of the firm’s factors of production can be
o Technology is fixed
o Planning decisions: considered to be long-run decisions
- The very long run is the length of time over which all the firm’s factors of production and its
technology can be varied
Production in the Short Run
Total, Average, and Marginal Products
- Total product (TP) is the total amount of output that is produced during a given period of
- Average product (AP) is the total product divided by the number of units of the variable
factor used to produce it
o AP = TP ÷ Labour
o As more labour is used, average product first rises and then falls
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