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Chapter 6

Chapter 6


Department
Economics
Course Code
ECN 104
Professor
Halis Yildiz
Chapter
6

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Chapter 6: The Organization and Costs of Production
6.1 The Firm and The Business Sector
Plant: a physical establishment that performs one/more functions in producing, fabricating, distributing
goods & services (ie. factory, farm, mine, store, warehouse)
Firm: an organization that resources to produce goods or services for profit and operates one/more
plants
Multiplant firms: several plants performing much the same function (ie. multiple bottling
plants of coca-cola)
Vertically integrated: own plants that perform different functions in various stages of the
production process (ie. Petro Canada own oil fields, refineries, retail gasoline stations)
Conglomerates: have plants that produce products in several industries (ie. Power Corp. of
Montreal operates in communications and industrial, financial, energy services)
Industry: a group of firms that produce the same/similar products or services
Legal Forms of Business
Sole Proprietorship: an unincorporated firm owned and operated by one person
Partnership: an unincorporated firm owned and operated by two/more people
Corporation: a legal entity chartered by the federal/provincial government that operates as a distinct
and separate body from the individuals who own it
Stock (corporate): a share in the ownership of a corporation; purchaser has the right to vote for
corporate officers and to share in dividends
Bond: a financial device through which a borrower (a firm/government) is obligated to pay the
principal and interest on a loan at a specific date in the future; purchaser simply lending
money to corporation
Limited liability: corporations provided to owners (shareholders); restriction of maximum loss
to a predetermined amount for the owners (shareholders) of a corporation; the maximum loss
is the amount they paid for their shares
Creditors can sue corporation but can’t sue owners of corporations individually
Principal-Agent Problem
A conflict of interest that occurs when agents (workers/managers) pursue their own objectives to the
determinant of the principals’ (shareholders’) goods
Principals are shareholders who own the corporation and who hire executives as their agents to run the
business on their behalf
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6.2 Economic Costs
Economic (opportunity) cost: a value equal to the quantity of other products that cannot be produced
when resources are instead used to make a particular product
Economic goal of firms is to maximize profit
Profit = total revenue – total cost
Total revenue: the amount a firm receives for the sale of its output
Total cost: the market value of the inputs a firm uses in production
Costs as opportunity costs: a firm’s cost of production includes all the opportunity costs of
making its output of goods & services
Explicit costs: payments a firm must make to an outsider to obtain a resource (ie.
labour services, materials, fuel, transportation services); factors are revealed and
expressed
Ex.Total Sales Revenue $120000
Cost of T-Shirts$40000
Clerks Salary 15000
Utilities 5000
Total (explicit) Costs 63000
Accounting Profit 57000
Accounting profit: profit remaining after paying individuals and other firms for supply
**this accounting profit ignores implicit costs, thus overstated economic success
Implicit costs: (forgone income) income a firm sacrifices when it uses a resource it
owns rather than supplying the resource in the market; equals what the resource
could have earned in the best paying alternative employment (including normal
profit);
Present but not obvious (ie. using self-owned, self-employed resources)
Ex.Accounting Profit$57000
Forgone Interest$1000
Forgone Rent 5000
Forgone Wages 22000
Forgone Entrepreneurial Income 5000
Total (implicit) Costs 33000
Economic Profit 24000
Invest $20000 of savings earns $1000 per year interest
Renting out small store for $5000 per year
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Wages worth $22000
Entrepreneurial talent worth $5000 annually
**economic costs = $96000 (63000 + 33000)
Normal profit: payment made by a firm to obtain and retain entrepreneurial ability; cost of doing
business
Economic profit: firm’s total revenue exceeds all economic costs
Any residual goes to entrepreneur
Even if economic profit = 0, all explicit & implicit costs covered
**ECONOMIC PROFIT = TOTAL REVENUE ECONOMIC COST (EXPLICIT + IMPLICIT TOTAL)
Short run: (fixed plant) a period of time in which producers are able to change the quantities of some
but not all of the resources they employ
Can vary output by applying larger/smaller amounts of inputs to the plant, using plant
capacity more/less intensively
Ex. Hiring 100 extra workers for one plant or add an entire shift of workers
Long run: (variable plant) a period of time long enough to enable producers to change the quantities of
all the resources they employ
Includes enough time for existing firms to dissolve and leave the industry or new firms to be
created and enter the industry
Ex. Adds new production facility and installs more equipment
6.3 Short-Run Production Relationships
1.Total Product (TP): the total output of a particular good/service produced by a firm
2.Marginal Product (MP): the extra output associated with adding a unit of a variable factor to the
production process
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