MGEA01 - Ch.7.pdf

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University of Toronto Scarborough
Economics for Management Studies
Michael Ho

MGEA01 – Ch. 7 1 Chapter 7: Producers in the Short Run 7.1: WHAT ARE FIRMS? Organization of Firms - Single Proprietorships o A firm that has one owner who is personally responsible for the firm’s actions and debts - Ordinary Partnerships o A firm that has two or more joint owners, each of whom is personally responsible for the firms actions and (all the partnership’s) debts - Limited Partnerships o Less common than ordinary ownership o Two types of partners ▯ General Partners: take part in the running of the business and are liable for all the firm’s debts ▯ Limited Partners: take no part in the running of the business, and their liability is limited to the amount they actually invest in the enterprise - Corporations o A firm that has a legal existence separate from that of the owners o Its owners are not responsible for anything that is done in the name of the firm (although its directors might be) o Private Corporation: shares are not traded in any stock exchange o Public Corporation: shares are traded in stock exchange - State-owned (“Crown”) Enterprise o A firm that is owned by the government, but is usually under the direction of a more or less independent, state-appointed board o Ownership differs, but its organization and legal status are similar to those of a corporation - Non-Profit Organizations (NGOs) o Firms that provide goods and services with the objective of just covering their costs o Any profits generated will remain in the organization and will not be claimed by any individuals - Multinational Enterprises (MNEs) o Firms that have operations in more than one country Financing of Firms - Real Capital o The firm’s physical assets, such as factories, machinery, materials and finished goods - Financial Capital o The money a firm raises for carrying on its business o Equity and debt 2 MGEA01 – Ch. 7 - Equity o Funds provided by the owners of the firm o In individual proprietorships and partnerships, one or more owners provide much of the required funds o A corporation acquires funds from its owners in return for stocks, shares, or equity (ownership certificates). o The money goes to the firm and the shareholders become owners of the firm, gaining the right to share in the firm’s profits, paid out as dividends - Debts o The firm’s creditors are not owners – they simply lend money in return for some form of loan agreement (collectively called debt instruments) o Bonds – a debt instrument carrying a specified amount, a scheduled of interest payments, and (usually) a date for redemption of its face value o Principal – an obligation to repay the amount borrowed o Interest – an obligation to make some form of payment to the lender o Redemption Date – time at which the principal is to be repaid o Term – amount of time between the issue of the debt and its redemption date Goals of Firms - Economists usually make two key assumptions about firms o Firms are assumed to be profit-maximizers o Each firm is assumed to be a single, consistent, decision-making unit - In recent years, some people argue that every firm has a responsibility to society that goes well beyond the responsibility to its shareholders - Some argue that by maximizing profits, firms are providing a valuable service to society 7.2: PRODUCTION, COSTS, AND PROFITS Production - To produce the foods and services that it sells, each firm needs inputs that can be grouped into four broad categories: - Intermediate Products o All outputs that are used as inputs by other producers in a further stage of production - Inputs provided directly by nature (land) o Soil and raw materials - Inputs provided by people (labour) Factors of Production o Managers, accountants - Inputs provided by the services of physical capital (capital) o Factories, machines, and other human made aids to production MGEA01 – Ch. 7 3 - Production Function o A functional relation describing the technological relationship between the inputs that a firm uses and the output that it produces (ignoring the role of land) ▯ = ▯ ▯,▯ ▯ ▯ = ▯▯▯▯ ▯▯ ▯▯▯▯▯▯,▯ = ▯▯▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯ ▯ = ▯ℎ▯ ▯▯▯▯ ▯▯ ▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯,▯ = ▯ℎ▯ ▯▯▯▯ ▯▯ ▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯ o Note that production is a flow – it is a number of units per period of time o Changes in the firm’s technology, which alter the relationship between inputs and outputs, are reflected by changes in the function f Cost - Explicit Cost: o Costs that actually involve a purchase of goods and services by the firm o Hiring for workers, rental of equipment, interest payment on debt, purchase of intermediate inputs - Implicit Cost: o Items for which there is no market transaction but for which there is still an opportunity cost for the firm that should be included in the complete measure of costs o Opportunity cost for the owner’s time (over or above his or her salary) ▯ Usually seen in small and relatively new firms o Opportunity cost for the owner’s capital (including a possible risk premium) ▯ Applicable in both small business and large corporations Profits - Accounting Profits ▯▯▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯ = ▯▯▯▯▯▯▯▯ − ▯▯▯▯▯▯▯▯ ▯▯▯▯ - Economic Profits o The difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the outputs. Also called pure profits ▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯ = ▯▯▯▯▯▯▯▯ − ▯▯▯▯▯▯▯▯ ▯▯▯▯ + ▯▯▯▯▯▯▯▯ ▯▯▯▯ ▯ = ▯▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯ − ▯▯▯▯▯▯▯▯ ▯▯▯▯▯ o Negative economic profits are called economic losses - Economic profits are always less than accounting profits - When economic profits are: o Positive - means that the owner’s capital is earning more than it could in its next best alternative use. Resources can profitably be moved into that industry o Negative – signals that resources can profitably be moved elsewhere o Zero – there is no incentive to move into or out of an industry 4 MGEA01 – Ch. 7 Profit Maximizing Output - What happens to profits as output changes depends on what happens to both revenues and costs ▯ = ▯▯ − ▯▯ ▯ = ▯▯▯▯▯ ▯▯ ▯▯▯▯▯▯ ▯ℎ▯▯ ▯▯▯▯ ▯▯▯▯▯▯▯▯ ▯ ▯▯▯▯ ▯ ▯▯▯▯▯▯ ▯▯ = ▯▯▯▯▯ ▯▯▯▯▯▯▯,▯▯ = ▯▯▯▯▯ ▯▯▯▯ Time Horizons for Decision Making - Economists classify the decisions that firms make into three types: o How best to use existing plants and equipment (the short run) o What new plant and equipment and production processes to select, given known technological possibilities (the long run) o How to encourage ,or adapt to, the development of new technologies (the very long run) - Fixed factors o Inputs whose quantity cannot be changed in the short run o Usually an element of capital – plant, equipment, land, supply of skilled labour - Variable factors o Inputs whose quantity can be changes over the time period under consideration - The Short Run o The length of time over which some of the firm’s factors of production are fixed - The Long Run o The length of time over which all of the firm’s factors of production can be varied, but its existing technology of production is fixed - The Very Long Run o Is the length of time over whi
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