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Chapter 7

Economics 101: Chapter 7

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ECON 101
Robert Gateman

Economics 101: Principles of Economics Chapter 7 7.1 What are Firms? Organization of Firms:  Sole proprietorship: one owner responsible for all aspects of the business, including liability  Partnership: two or more owners responsible for all partner's debts  Limited Partnership: two types of partners within the same business o General partners that are responsible for all the firm's debt o Limited partners have no control of the business and liabilities limited to ownership %  Corporation: owners own shares, and are not responsible for the firm's actions  State-Owned Enterprise: government owned, under control of state appointed board o Also known in Canada as Crown Corporations o Organization and legal status are similar to that of a corporation  Non-Profit Organization: provides goods or services to consumers without distributing profits o Profits generated stay within the organization and go back into the firm's objectives o Earns revenues from a combination of sales and donations  Multinational Enterprises: firms that have locations in more than one country o Growing number of MNEs shows the importance and development of globalization  Governments also provide services to population through tax funding Financing of Firms  Money a firm raises in order to continue to run the business (financial capital) o Two types of financial capital financings used by firms are equity and debt  Equity Financing: investments of capital from one or more investors in return for shares or equity (% of the firm) o Capital goes to the firm, and owners gain rights to profits (through dividends) o Firms may retain profits to finance instead of distributing profits to shareholders o Reinvested profits increased the value of the firm, thus the market value of shares  Debt Financing: creditors that lend money to a firm in return for interest + the principle o Creditors do not receive an equity stake for debt financing o Several types of debt financing: bonds, convertible debt etc. o Carry the obligation to repay the borrowed amount, called the principle o Creditor is paid back the principle + the interest to the lender/creditor o Redemption date: time at which the principle is repaid o Term: time between the issue of the debt and redemption date Goals of Firms:  All firms are assumed to be profit-maximizers, try to make as much profit for owners  Each firm is assumed to be a single, consistent decision making unit  Desire to maximize profits is assumed to motivate all decision made by a firm o Decisions are assumed to be unaffected by particular interests of a firm's leadership  In reality firms do not always maximize profit, often owners make self interest decisions Economics 101: Principles of Economics o These assumption are made to help economists predict most firms 7.2 Production, Costs and Profits Production:  Several inputs are often needed to create an output (end product, good)  Four types of inputs: to the firm, from nature, from people, and from factories/machinery  Intermediate products: outputs that are used as inputs in further stages of production  Production Function: describes the technological change between inputs and outputs o Specifies the maximum amount of output that from the given amount of inputs o Production is a flow, and therefore a rate of time (100 units/hour etc.) o  Q = flow of output  K = flow of capital services  L = flow of labour services Economics Versus Accounting Profits  Accountants find profits by finding revenue and subtracting all explicit costs o Explicit costs: costs that involve the purchase of a good or service by the firm o Workers, rental equipment, interest payment on debt, input costs etc. o Accounting Profits = Revenues - Explicit Costs  Economists find profit from revenues minus explicit and implicit costs o Implicit costs: no market transaction, but still creates an opportunity costs  Two important implicit costs are owner's time and owner's capital  Economic Profit = Revenues - (Explicit costs + Implicit costs) Opportunity Cost of Time:  In small or new firms, owners spend large amount of time developing the business  Often owners pay themselves less than what could be earned elsewhere  This is an implicit costs for owners that could be making more $ at another firm  Accounting profits do not measure this implicit cost Opportunity Cost of Capital:  Owners of small companies and corporations have other opportunities to invest their money o Owners could have invested in less risk (government bond) o Owners could also invest in equally risky business (another business, stock market etc.)  As economic profits include implicit costs, profits are less than accounting profits Profits and Resource Allocation:  If revenues exceed opportunity cost, a firm is earning pure economic profit o Owners will want to move resources into the industry as earnings potential is high  Economic profits and losses play crucial signalling role in the free market system o Economic profits signal resources profitably be moved into a particular industry o Economic loss signal resources can be moved to other industries Economics 101: Principles of Economics o Zero economic profits signal no incentive to move resources Profit Maximizing Output:  To develop the supply theory, the level of output to maximize profits must be determined o  π = firm's output that maximizes profits  TR = total revenue  TC = total cost (of producing that output)  Total output changes with revenues and costs that both fluctuate with production Time Horizons for Decision Making:  Short run: how best to use existing plant and equipment o Length of time over which some of the fir
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