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Chapter 7

Chapter 7 Reading Notes.docx

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Michael H O

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Chapter 7 Reading Notes • firms can be organized in 6 diff ways: single proprietor, ordinary partnership, limited partnership, corporation, state-owned enterprise (owned by the government. Also called crowned corporations), and non-profit organizations. • goals of firms are to maximize profits. It motivates 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 organizational structure in which they work Production • intermediate products: all outputs that are used as inputs by other producers in a further stage of production. This is what makes up the first group of inputs. Ex: the firm mines iron ore and sells it to a manufacturer. the gifts of nature • labour is the physical and mental effort provided by people • capital: the factories, machines and human-made aids to production • the production function describes the technologival relationship between the inputs that a firm uses and the output that it produces. Q=f(L,K) • Q is the flow of output, K is the flow of capital and L is the flow of labour services. Costs and profits • profits is taking revenues they obtain from selling their output and subtracting all costs associated with their inputs. When all costs have been deducted, the resulting profits are the return to the owner's capital • economists use a different concept of costs and profits. When accountants measure profits, they begin with the firm's revenues and then subtract all of the explicit costs incurred by the firm. • explicit costs are costs that actually involve a purchase of goods and services by the firm • these costs are the hiring of workers, rental of equipment, interest payments on debt, purchase of intermediate inputs. ACCOUNTING PROFITS = REVENUES - EXPLICIT COSTS • economists subtract explicit and implicit costs from revenues. implicit costs are items for which there is no market transaction but there is still an opportunity cost for the firm that should be included in the complete measuer of costs. • two most imp implicit costs are opportunity costs of the owner's capital and time. • When this more complete set of costs are subtracted from the firm's revenues, the result is called economic profit or pure profit. ECONOMIC PROFIT = REVENUE - (EXPLICIT+IMPLICIT COSTS) = ACCOUNTING PROFITS -IMPLICIT COSTS. • opportunity cost of time: owners spend a lot of time developing their business. They would often pay themselves less than they could earn. EX: an entrepreneur who opens a restaurant may pay herself only $1000/month when she could be earning $4000/month. Therefore her implicit cost is $3000/month that would be missed by the accountant who measure only the explicit cost of $1000/month. • opportunity cost of capital: is the opportunity cost of making an investment. EXAMPLE: ask what could be earned by lending this amount to someone else in a riskless loan. The owners could have purchased a gov't bond, which has no significant risk. Suppose the return on this is 6% per year. This amount is the risk free rate of return on capital; this is an opportunity cost. Next, ask what the firm could earn in addition to this amount by lending its money to another firm where risk of default was equal to the firm's own risk of loss. Suppose this is an additional 4%. This is the risk premium, and it is clearly also a cost. If the firm doesn't 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% (6%+4%) • when resources are valued by the opportunity-cost-principle, their costs show how much these resources would earn if used in their best alternative uses. • If revenues of all the firms in the industry exceed opportunity cost, the firms in that industry will be earning pure/economic profits. • If there are 0 economic profits, there is no incentive for resources to move into or out of an industry Profit Maximizing Output • profit is symbolized by the pi symbol btwwwww!!!!!!!! • in order to develop a theory of supply, we need to determine the level of output that will maximize a firm's profit. PROFIT IS TOTAL REVENUE (TR) each firm derives from the sale of its output - TOTAL COST (TC) of producing an output. Short Run • short run is a time period in which the quantity of somme inputs, called fixed factors, can't be changed. Like capital. Labour can be changed. but not capital. because there isn't enough time to change your capital. Labour would be called the variable factor • the short run is the length of time over which some of the firm's factors of production are fixed. Long run • long run is a time period in which all inputs may be varied but in which the basic technology of production can't be changed • all inputs may be varied but the basic technology of production can't be changed. • the long run is the length of time over which all of the firm's factors of production can be varied, but its technology is fixed. the very long run • the length of time over
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