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ORGANIZING PRODUCTION

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Title: ORGANIZING PRODUCTION


1
ORGANIZING PRODUCTION How firms make decisions
9
CHAPTER
Dr. Gomis-Porqueras ECO 680
2
Residual Claimants
In a market economy, firm owners are residual
claimants.
  • They have right to any revenue after costs have
    been paid.
  • Provides a strong incentive for owners to keep
    costs of producing output low.

3
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 Objective
  • 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.

4
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.

5
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

6
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.

7
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.

8
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.

9
Economic Role of Costs
The demand for a product indicates the intensity
of consumers desires for an item.
The (opportunity) cost of producing the item
indicates the desire of consumers for other goods.
10
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.

11
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

12
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

13
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.

14
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.

15
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.

16
Technology and Economic Efficiency
  • Technological Efficiency
  • Technological efficiency occurs when a firm
    produces a given level of output by using the
    least amount inputs.
  • 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.

17
Technology and Economic Efficiency
  • Economic Efficiency
  • Economic efficiency occurs when the firm produces
    a given level of output at the least cost.
  • 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.

18
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.

19
Improving Inventory Control at Wal-Mart
Better inventory controls have helped reduce
firms costs.
20
Marginal Revenue
Marginal Revenue is the change in total revenue
divided by the change in output.
In a price taker market, Marginal Revenue
market price.
21
Marginal Cost
Marginal Cost (MC) is the increase in total cost
associated with a one-unit increase in production.
MC will decline initially, reach a minimum, and
then rise.
22
  • Below, low levels of output deliver marginal
    revenue to the firm greater than the
    marginal cost of increased output.

----
----
- 25.00
5
  • After some point, though, additional units
    cost more than their marginal revenue.

4.80
- 24.80
5
3.95
- 23.75
.
.
.
.
.
  • Profit is maximized where P MR MC.

1.50
- 8.00
5
- 4.25
5
1.25
Price and Cost Per Unit
- .25
5
1.00
9
5
1.25
3.50
5
6.75
1.75
7
5
9.25
2.50
MR
5
10.75
3.50
5
11.00
5
4.75
5
10.00
6.00
3
5
7.25
7.75
4.50
5
8.25
1
5
0.00
9.50
- 8.00
5
13.00
Output Level
- 20.00
17.00
5
10
8
4
2
6
12
14
16
18
20
22
23
Total Costs Curves
  • Here we graph the general shape of the
    firms short-run total cost curves.


Total Costs
  • Note that total fixed costs are flat and
    remain the same for 0 units or 11 units.
  • Note that total variable costs increase as
    more variable inputs are utilized.

250
  • As total costs are the combination of TVC and
    TFC, they are everywhere positive and increase
    sharply with output

200


Output per day

TC
TVC
TFC
150
50
0
0
1
15
50
2
25
50
3
34
50
100
4
42
50
5
52
50
6
64
50
50
7
79
50
98
8
50
9
122
50
4
2
8
10
12
6
10
152
50
11
50
202
Output
24
Information and Organization
  • A firm organizes production by combining and
    coordinating productive resources using a mixture
    of two systems
  • Command systems
  • Incentive systems

25
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.

26
Information and Organization
  • Incentive Systems
  • An incentive system, uses market-like mechanisms
    to induce workers to perform in ways that
    maximize the firms profit.

27
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.

28
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.
  • Firm owners face this problem when dealing with
    workers.

29
Shirking
  • With team production owners must reduce the
    problem of shirking.-employees working at less
    than normal rate of productivity.

Example Long coffee break. Control with
incentives and monitoring.
30
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

31
Information and Organization
  • Ownership, often offered to managers, gives the
    managers an incentive to maximize the firms
    profits, which is the goal of the owners, the
    principals.
  • Incentive pay links managers or workers pay to
    the firms performance and helps align the
    managers and workers interests with those of
    the owners, the principal.
  • Long-term contracts can tie managers or workers
    long-term rewards to the long-term performance of
    the firm. This arrangement encourages the agents
    work in the best long-term interests of the firm
    owners, the principals.

32
Empirical Evidence
  • Drago and Garvey (1997) use Australian survey
    data to show that when agents are placed on
    individual pay-for-performance schemes, they are
    less likely to help their coworkers.
  • This is particularly important in those jobs that
    involve strong elements of team production
    where output reflects the contribution of many
    individuals, and individual contributions cannot
    be easily identified, and compensation is
    therefore based largely on the output of the
    team.
  • Studies suggest that profit-sharing, for example,
    typically raises productivity by 3-5.

33
Empirical Evidence
  • Fernie and Metcalf (1996) find that British
    jockeys perform significantly better when offered
    prizes for winning races compared to being on
    fixed retainers.
  • McMillan, Whalley and Zhu (1989) and Groves et al
    (1994) look at Chinese agricultural and
    industrial data respectively and find significant
    incentive effects.
  • Kahn and Sherer (1990) find that better
    evaluations of white-collar office workers were
    achieved by those employees who had a steeper
    relation between evaluations and pay.

34
Information and Organization
  • Types of Business Organization
  • There are three types of business organization
  • Proprietorship
  • Partnership
  • Corporation

35
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.

36
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.

37
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.

38
Information and Organization
  • Proprietorships are easy to set up
  • Managerial decision making is simple
  • Profits are taxed only once
  • But bad decisions made by the manager are not
    subject to review
  • The owners entire wealth is at stake
  • The firm dies with the owner
  • The cost of capital and labor can be high

39
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

40
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.

41
Information and Organization
  • The Relative Importance of Different Types and
    Firms
  • There are a greater number of proprietorships
    than other form of business, but corporations
    account for the majority of revenue received by
    businesses.

42
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.
43
Markets and the Competitive Environment
  • Economists identify four market types
  • Perfect competition
  • Monopolistic competition
  • Oligopoly
  • Monopoly

44
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.

45
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

46
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.

47
Incentive to Collude
Oligopolists have a strong incentive to collude
and raise their prices.
Each firm has an incentive to cheat by lowering
price because the demand curve facing each firm
is more elastic than the market demand
curve. This conflict makes collusive agreements
difficult to maintain.
48
Oligopolies
  • A cartel is an organization through which members
    jointly make decisions about prices and
    production (OPEC).
  • In the United States, antitrust laws prevent
    firms from obvious collusion and from forming a
    cartel. However, there are legally sanctioned
    cartels in the United States.
  • The NCAA is an example. Participation is
    restricted to member colleges.
  • The American Medical Association (AMA). You may
    have a great remedy for colds, but you are not
    allowed to open a medical practice until you meet
    the requirements of the AMA.

49
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

50
Monopolies
  • Before "Ma Bell" or ATT was broken up in 1982,
    Bell controlled all of the local and long
    distance phone business in the U.S.A.
  • Prices were high, service was bad and Bell was
    using it's control of the local phone exchanges
    to restrict competitors access to the long
    distance market.
  • In an agreed settlement Bell was broken up into
    the regional baby bells which where given the
    local phone market and ATT which had the long
    distance market.

51
Markets and the Competitive Environment
  • Figure 9.2 shows the four-firm concentration
    ratio for various industries in the United
    States.

52
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.

53
Why Do Governments Allow Monopolies?
  • Examples
  • - Power to tax future generations
  • - Easier to borrow
  • - Easier to take long term projects
  • Longer time horizon than private firms
  • Introduce some standards
  • - Public safety

54
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.

55
Markets and 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

56
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.
57
Markets and Firms
  • 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.

58
Summary
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