ORGANIZING PRODUCTION

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ORGANIZING PRODUCTION
CHAPTER
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Objectives

• After studying this chapter, you will able to
• Explain what a firm is and describe the economic
  problems that all firms face
• Distinguish between technological efficiency and
  economic efficiency
• Define and explain the principal-agent problem
  and describe how different types of business
  organizations cope with this problem

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Objectives

• After studying this chapter, you will able to
• Describe and distinguish between different types
  of markets in which firms operate
• Explain why markets coordinate some economic
  activities and firms coordinate others

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The Firm and Its Economic Problem

• A firm is an institution that hires factors of
  production and organizes them to produce and sell
  goods and services.
• The Firms Goal
• A firms goal is to maximize profit.
• If the firm fails to maximize profits it is
  either eliminated or bought out by other firms
  seeking to maximize profit.

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The Firm and Its Economic Problem

• Measuring a Firms Profit
• Accountants measure a firms profit using rules
  laid down by the Internal Revenue Service and the
  Financial Accounting Standards Board.
• Their goal is to report profit so that the firm
  pays the correct amount of tax and is open and
  honest about its financial situation with its
  bank and other lenders.
• Economists measure profit based on an opportunity
  cost measure of cost.

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The Firm and Its Economic Problem

• Opportunity Cost
• A firms decisions respond to opportunity cost
  and economic profit.
• A firms opportunity cost of producing a good is
  the best, forgone alternative use of its factors
  of production, usually measured in dollars.
• Opportunity cost includes both
• Explicit costs
• Implicit costs

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The Firm and Its Economic Problem

• Explicit costs are costs paid directly in money.
• Implicit costs are costs incurred when a firm
  uses its own capital or its owners time for
  which it does not make a direct money payment.
• The firm can rent capital and pay an explicit
  rental cost reflecting the opportunity cost of
  using the capital.
• The firm can also buy capital and incur an
  implicit opportunity cost of using its own
  capital, called the implicit rental rate of
  capital.

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The Firm and Its Economic Problem

• The implicit rental rate of capital is made up
  of
• Economic depreciation
• Interest forgone
• Economic depreciation is the change in the market
  value of capital over a given period.
• Interest forgone is the return on the funds used
  to acquire the capital.

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The Firm and Its Economic Problem

• The cost of the owners resources is his or her
  entrepreneurial ability and labor expended in
  running the business.
• The opportunity cost of the owners
  entrepreneurial ability is the average return
  from this contribution that can be expected from
  running another firm. This return is called a
  normal profit.
• The opportunity cost of the owners labor spent
  running the business is the wage income forgone
  by not working in the next best alternative job.

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The Firm and Its Economic Problem

• Economic Profit
• Economic profit equals a firms total revenue
  minus its opportunity cost of production.
• A firms opportunity cost of production is the
  sum of the explicit costs and implicit costs.
• Normal profit is part of the firms opportunity
  costs, so economic profit is profit over and
  above normal profit.
• Table 9.1summarizes the economic accounting
  concepts.

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The Firm and Its Economic Problem

• Economic Accounting A Summary
• To maximize profit, a firm must make five basic
  decisions
• What goods and services to produce and in what
  quantities
• How to producethe production technology to use
• How to organize and compensate its managers and
  workers
• How to market and price its products
• What to produce itself and what to buy from other
  firms

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The Firm and Its Economic Problem

• The Firms Constraints
• The five basic decisions of a firm are limited by
  the constraints it faces. There are three
  constraints a firm faces
• Technology
• Information
• Market

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The Firm and Its Economic Problem

• Technology Constraints
• Technology is any method of producing a good or
  service.
• Technology advances over time.
• Using the available technology, the firm can
  produce more only if it hires more resources,
  which will increase its costs and limit the
  profit of additional output.

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The Firm and Its Economic Problem

• Information Constraints
• A firm never possesses complete information about
  either the present or the future.
• It is constrained by limited information about
  the quality and effort of its work force, current
  and future buying plans of its customers, and the
  plans of its competitors.
• The cost of coping with limited information
  limits profit.

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The Firm and Its Economic Problem

• Market Constraints
• What a firm can sell and the price it can obtain
  are constrained by its customers willingness to
  pay and by the prices and marketing efforts of
  other firms.
• The resources that a firm can buy and the prices
  it must pay for them are limited by the
  willingness of people to work for and invest in
  the firm.
• The expenditures a firm incurs to overcome these
  market constraints will limit the profit the firm
  can make.

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Technology and Economic Efficiency

• Technological Efficiency
• Technological efficiency occurs when a firm
  produces a given level of output by using the
  least amount inputs.
• Table 9.2 shows four ways of making a TV set, one
  of which is technologically inefficient.
• There may be different combinations of inputs to
  use for producing a given level of output.
• If it is impossible to maintain output by
  decreasing any one input, holding all other
  inputs constant, then production is
  technologically efficient.

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Technology and Economic Efficiency

• Economic Efficiency
• Economic efficiency occurs when the firm produces
  a given level of output at the least cost.
• Table 9.3 shows how the economically efficient
  method depends on the relative costs of capital
  and labor.
• The difference between technological and economic
  efficiency is that technological efficiency
  concerns the quantity of inputs used in
  production for a given level of output, whereas
  economic efficiency concerns the cost of the
  inputs used.

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Technology and Economic Efficiency

• An economically efficient production process also
  is technologically efficient.\
• A technologically efficient process may not be
  economically efficient.
• Changes in the input prices influence the value
  of the inputs, but not the technological process
  for using them in production.

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Information and Organization

• A firm organizes production by combining and
  coordinating productive resources using a mixture
  of two systems
• Command systems
• Incentive systems

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Information and Organization

• Command Systems
• A command system uses a managerial hierarchy.
• Commands pass downward through the hierarchy and
  information (feedback) passes upward.
• These systems are relatively rigid and can have
  many layers of specialized management.

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Information and Organization

• Incentive Systems
• An incentive system, uses market-like mechanisms
  to induce workers to perform in ways that
  maximize the firms profit.

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Information and Organization

• Mixing the Systems
• Most firms use a mix of command and incentive
  systems to maximize profit.
• They use commands when it is easy to monitor
  performance or when a small deviation from the
  ideal performance is very costly.
• They use incentives whenever monitoring
  performance is impossible or too costly to be
  worth doing.

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Information and Organization

• The Principal-Agent Problem
• The principal-agent problem is the problem of
  devising compensation rules that induce an agent
  to act in the best interests of a principal.
• For example, the stockholders of a firm are the
  principals and the managers of the firm are their
  agents.

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Information and Organization

• Coping with the Principal-Agent Problem
• Three ways of coping with the principal-agent
  problem are
• Ownership
• Incentive pay
• Long-term contracts

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Information and Organization

• Types of Business Organization
• There are three types of business organization
• Proprietorship
• Partnership
• Corporation

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Information and Organization

• Proprietorship
• A proprietorship is a firm with a single owner
  who has unlimited liability, or legal
  responsibility for all debts incurred by the
  firmup to an amount equal to the entire wealth
  of the owner.
• The proprietor also makes management decisions
  and receives the firms profit.
• Profits are taxed the same as the owners other
  income.

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Information and Organization

• Partnership
• A partnership is a firm with two or more owners
  who have unlimited liability.
• Partners must agree on a management structure and
  how to divide up the profits.
• Profits from partnerships are taxed as the
  personal income of the owners.

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Information and Organization

• Corporation
• A corporation is owned by one or more
  stockholders with limited liability, which means
  the owners who have legal liability only for the
  initial value of their investment.
• The personal wealth of the stockholders is not at
  risk if the firm goes bankrupt.
• The profit of corporations is taxed twiceonce as
  a corporate tax on firm profits, and then again
  as income taxes paid by stockholders receiving
  their after-tax profits distributed as dividends.

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Information and Organization

• Pros and Cons of Different Types of Firms
• Each type of business organization has advantages
  and disadvantages.
• Table 9.4 lists the pros and cons of different
  types of ownership.

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Information and Organization

• Partnerships are easy to set up
• Employ diversified decision-making processes
• Can survive the death or withdrawal of a partner
• Profits are taxed only once
• But partnerships make attaining a consensus about
  managerial decisions difficult
• Place the owners entire wealth at risk
• The cost of capital can be high, and the
  withdrawal of a partner might create a capital
  shortage

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Information and Organization

• A corporation offers perpetual life
• Limited liability for its owners
• Large-scale and low-cost capital that is readily
  available
• Professional management
• Lower costs from long-term labor contracts
• But a corporations management structure may lead
  to slower and expensive decision-making
• Profit is taxed twiceas corporate profit and
  shareholder income.

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Information and Organization

• Figure 9.1(a) shows the frequency of each type of
  business organization.

Figure 9.1(b) shows the dominant type of business
organization for various industries.
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Markets and the Competitive Environment

• Economists identify four market types
• Perfect competition
• Monopolistic competition
• Oligopoly
• Monopoly

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Markets and the Competitive Environment

• Perfect competition is a market structure with
• Many firms
• Each sells an identical product
• Many buyers
• No restrictions on entry of new firms to the
  industry
• Both firms and buyers are all well informed of
  the prices and products of all firms in the
  industry.

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Markets and the Competitive Environment

• Monopolistic competition is a market structure
  with
• Many firms
• Each firm produces similar but slightly different
  productscalled product differentiation
• Each firm possesses an element of market power
• No restrictions on entry of new firms to the
  industry

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Markets and the Competitive Environment

• Oligopoly is a market structure in which
• A small number of firms compete
• The firms might produce almost identical products
  or differentiated products
• Barriers to entry limit entry into the market.

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Markets and the Competitive Environment

• Monopoly is a market structure in which
• One firm produces the entire output of the
  industry
• There are no close substitutes for the product
• There are barriers to entry that protect the firm
  from competition by entering firms

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Markets and the Competitive Environment

• Measures of Concentration
• Two measures of market concentration in common
  use are
• The four-firm concentration ratio
• The HerfindahlHirschman index (HHI)

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Markets and the Competitive Environment

• The four-firm concentration ratio is the
  percentage of the total industry sales accounted
  for by the four largest firms in the industry.
• The HerfindahlHirschman index (HHI) is the sum
  of the squared market shares of the 50 largest
  firms in the industry.
• The larger the measure of market concentration,
  the less competition that exists in the industry.
• Table 9.5 on page 202 shows an example
  calculation for each ratio.

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?????? 23.94 863,685
???????? 71.41 987
??? 26.53 154,675
????? 99.74 129
??? 23.11 48,149
???????? 16.68 447,052
???????? 62.42 62,670
????????? 59.92 15,953
????? 24.12 38,835
?????????? 32.31 95,235
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Markets and the Competitive Environment

• Concentration Measures for the U.S. Economy
• The U.S. Justice Department uses the HHI to
  classify markets.
• A market with an HHI of less than 1,000 is
  regarded as highly competitive
• A market with an HHI between 1,000 and 1,800 is
  regarded as moderately competitive
• A market with an HHI greater than 1,800 is
  uncompetitive

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Markets and the Competitive Environment

• Figure 9.2 shows the four-firm concentration
  ratio for various industries in the United States.

The figure also shows the HHI for these
industries.
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Markets and the Competitive Environment

• Limitations of Concentration Measures
• Concentration measures alone are not sufficient
  to identify the market structure of a given
  industry.
• Concentration ratios are based on the national
  market.
• For some goods, the relevant market is local
  (e.g., newspapers)
• For some goods, the relevant market is the world
  (e.g., automobiles).

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Markets and the Competitive Environment

• Concentration ratios convey no information about
  the extent of barriers to entry.
• For some industries, few firms may be currently
  operating in the market but competition might be
  fierce, with firms regularly entering and exiting
  the industry.
• Even potential entry might be enough to maintain
  competition.

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Markets and the Competitive Environment

• Table 9.6 on page 203 summarizes the range of
  other information used with the concentration
  ratio to determine market structure.

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Markets and the Competitive Environment

• Market Structures in the U.S. Economy
• Figure 9.3 shows the distribution of market
  structures in the U.S. economy.
• The economy is mainly competitive.

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Markets and Firms

• Market Coordination
• Markets both coordinate production.
• Chapter 3 explains how demand and supply
  coordinate the plans of buyers and sellers.
• Outsourcingbuying parts or products from other
  firmsis an example of market coordination of
  production.
• But firms coordinate more production than do
  markets.
• Why?

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Markets and Firms

• Why Firms?
• Firms coordinate production when they can do so
  more efficiently than a market.
• Four key reasons might make firms more efficient.
  Firms can achieve
• Lower transactions costs
• Economies of scale
• Economies of scope
• Economies of team production

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Markets and Firms

• Transactions costs are the costs arising from
  finding someone with whom to do business,
  reaching agreement on the price and other aspects
  of the exchange, and ensuring that the terms of
  the agreement are fulfilled.
• Economies of scale occur when the cost of
  producing a unit of a good falls as its output
  rate increases.
• Economies of scope arise when a firm can use
  specialized inputs to produce a range of
  different goods at a lower cost than otherwise.
• Firms can engage in team production, in which the
  individuals specialize in mutually supporting
  tasks.

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THE END