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Chapter 7

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ECON 110
Ian James Cromb

Producers in the Short Run What are firms? Organization of Firms  A single proprietorship has one owner-manager who is personally responsible for all aspects of the business, including its debts  An ordinary partnership has two or more joint owners, each of whom is personally responsible for all the partnership debts  The limited partnership provides for two types of partners o General: Take part in running the business and are liable for business debts o Limited: Take no part in running business & liability is limited to their investment  A corporation is a firm regarded in law as being a separate identity from the owners o Private: Shares are not traded on the stock exchange/available for public purchase o Public: Shares are traded on the stock exchange/available for public purchase  A state-owned enterprise is owned by the gov’t but is usually under the direction of a more or less independent, state-appointed board. Although its ownership differs, the org and legal status of a state-owned enterprise are similar to those of a corporation.  Non-profit organizations are established with the explicit objective of providing goods or services to customers but having any profits that are generated remain with the org and are not claimed by individuals – some goods sold, some given away for free o Earn revenue through from sales and donations  Multinational Enterprises are companies that have locations in more than one country Financing of Firms  The money a firm raises for carrying on its own business is sometimes called it financial capital, as distint from its real capital, which is the firms physical assets  The two basic types of financial capital are equity and debt Equity  Sole proprietorships and partnerships provide mush of their required funds  A corporation aquires funds from its owners in return for stocks, shares, or equities  People buy a corporation’s shares and become partial owners of the business, the money goes to the corporation and is a part of its financial capital  Profits that are paid out to shareholders are called dividends Debt  The firm’s creditors are not owners; they have lent money in return for some for some form of loan agreement – debt agreements in the bus world, bonds in economics  A bond is a debt instrument carring a specified amount, schedule of interest payments, and a maturity date Goals of Firms  The theory we study in the text is based off two key assumptions o All firms are assumed to be profit-maximizers o The firm is assumed to be a single, consistent making unit o 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 org structure in which they work  These assumptions allow the theory to ignore the firm’s internal org & financial structure  Using these assumptions, economists can predicts the behaviour of firms  To do this, they first study the choices open to the firm, establishing the effect that each choice would have on the firm’s profits  Then they predict that the firm will select the alternative that produces the largest profits Production, Costs, and Profits Production  To make products, businesses need to use hundreds of inputs – these inputs can be grouped into broad categories o Inputs to the firm that are outputs from another firm o Inputs from nature – land o Inputs provided from people – services from workers and managers o Inputs from factories and machines used  Intermediate Products: All outputs that are used as inputs by other producers in a further stage of production (aka the first group) – iron ore from mining to input in steel plant  Factors of Production: Resources used to produce goods and services; frequently divided into the basic categories of land, labour, and capital  The Production Function describes the technological relationship between the inputs that a firm uses and the outputs it produces o Shows maximum output that can be produced by any given combination of inputs Costs and Profits  Firms arrive at profits by taking revenues they obtain by selling their outputs and subtracting all of the costs associated with their inputs – resulting profits is the ROE Economic vs. Accounting Profits  Economists use somewhat different concepts of costs and profits  When accounts measure profits, they start with profit then subtract all explicit costs o Explict costs: Costs that actually involve a purchase of g/s by the firm – hiring worker, buying equipment, interest payments, the purchase of inputs  Economists also subtract implicit costs – the result is called economic or pure profit o No market cost but there is still an opp cost for the firm – two most important ones are owner’s time and capital Opportunity Cost of Time  Especially in small and relatively new firms, owners spend a tremendous amount of their time developing the business but often pay themselves far less than they could be paid at an alternative job  Ex. May pay themselves $1000, even though they could get $4000 at the next best alternative – implicit cost of $3000 for economists, $1000 explicit cost for accountants Opportunity Cost of Capital  Applies equally to small and large firms – opportunity cost is broken into two parts  Ask what could be earned by lending this amount to someone else in a risk-less loan o The owners would have purchased a gov’t bond, little risk of default o If the return is 6% annually, that shows the risk-free return on capital  Then ask what the firm could earn in addition to this amount by lending money to another firm where risk default is equal to the firm’s own risk of loss – suppose an additional 4% o If the firm does not expect to earn this much in its own operations, it should close down and lend its money and earn a 10% return  Since economists include both explicit and implicit costs in calculating profits, economic profits are less than accounting profits Profits and Resource Allocation  When resources are valued by the opportunity-cost principle, their costs show how much these resources would earn if used to their next best alternative uses  If revenues of all the firms in some industry exceed opportunity cost, the firms in that industry will be pure or economic profits o The owners of the factors of production will want to move resources into that industry, because the earnings potentially available to them are greater there than in alternative uses  Economic profits in an industry are the signal that resources can profitably be moved into that industry – losses are a sign they should be moved elsewhere Profit-Maximizing Output  To develop a theory of supply, we need to determine the level of output that will maximize a firm’s profit – difference between total rev and total cost per unit of output o Thus, what happens to profits as output varies depends on what happens to both revenues and costs (explicit and implicit) Time Horizon’s For Decision Making 1. Short Run: How to best use existing plants and equipment 2. Long Run: What new plants, equipment, and production processes to select – given known technical possibilities 3. Very Long Run: How to encourage, or adapt to, the development of new techniques The Short Run  This is a short period of time in which the quantity of some inputs (fixed factors) cannot be increased beyond the fixed amount that is available  Fixed Factor: An input whose quantity cannot be changed in the short run  Variable Factors: An input whose quantity can be changed in the short run  The short run does not correspond to a specific number of months or years depending on the industry – “short run” depends on how long the factors of production remain fixed The Long Run  This is a time period in which all inputs may be varied but in which the basic technology of production cannot be changed – does not correspond to a specific length of time  The long run corresponds to the situation the firm faces when it is planning to go into business, to expand the scale of its operations, to branch out into new p/s  The firm’s planning decisions are long run decisions because they are made from given technological possibilities but with freedom to choose from a variety of production processes that will use the factor inputs in different proportions  “Long Run” refers to the length of time over which inputs are varied, but tech is fixed The Very Long Run  A period of time in which
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