university of dayton · web viewchapter 17 covers the firm’s decisions in the resource and labor...

9 ORGANIZING PRODUCTION

C h a p t e r K e y I d e a sSpinning a Web

A. The number of business firms in the economy is vast and their scope diverse.1. Some firms are small operations and some are goliaths, like

General Electric, General Motors or Microsoft.2. Some firms are traditional “brick-and-mortar” businesses while

others are “cyberspace” businesses. Tim Berners-Lee’s idea, the World Wide Web, has provided a platform for creating thousands of profitable businesses from tiny owner-operated firms to giant multinationals.

3. Some firms operate in a market with high competitive pressures while others seemingly operate without direct competition.

B. This chapter explains why firms exist, what their roles are in the economy, and explores the various challenges facing the owners of firms.

O u t l i n eI. The Firm and Its Economic Problem

A. A firm is an institution that hires factors of production and organizes them to produce and sell goods and services.

2B. The Firm’s Goal

1. A firm’s goal is to maximize profit. 2. If the firm fails to maximize its profit, it is either eliminated or

bought out by other firms seeking to maximize profit.C. Opportunity Cost

1. A firm’s decisions respond to opportunity cost and economic profit.

2. A firm’s 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: a) Explicit costs that are paid directly in money, and b) Implicit costs that are incurred when a firm uses its capital,

or its owners’ time in production for which it does not make a direct money payment.

3. The firm can rent capital and pay an explicit rental cost reflecting the opportunity cost of using the capital.

4. The firm can also buy capital and incur an implicit opportunity cost of using its own capital, called the implicit rental rate of capital. The implicit rental rate of capital is made up of two components:a) Economic depreciation—the change in the market value of

capital over a given period.b) Interest forgone, which is the return on the funds used to

acquire the capital.5. There also is a cost for the resources the owner uses to operate

the business:a) The return to entrepreneurship is profit, and the return that

an entrepreneur can expect to receive on the average is called normal profit.

b) The opportunity cost of the owner’s labor spent running the business is the wage income forgone by not working in the next best alternative job.

E. Economic Profit1. Economic profit equals a firm’s total revenue minus its

opportunity cost of production. 2. A firm’s opportunity cost of production is the sum of its explicit

costs and implicit costs. 3. Normal profit is part of the

firm’s opportunity costs, so economic profit is profit over and above normal profit.

4. Table 9.1 illustrates the economic accounting concepts.

F. Economic Accounting: A Summary

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W H A T I S E C O N O M I C S ? 3To achieve its objective of profit maximization, the firm must make five basic decisions:1. What goods and services to produce and in what quantities2. How to produce—the production technology to use3. How to organize and compensate its managers and workers4. How to market and price its products5. What to produce itself and what to buy from other firms

G. The Firm’s ConstraintsThe five basic decisions of a firm are limited by the constraints it faces. There are three constraints a firm faces:1. Technology Constraints

a) Technology is any method of producing a good or service. b) Technology advances over time. c) 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.

2. Information Constraints a) A firm never possesses complete information about either

the present or the future. b) 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.

c) The cost of coping with limited information limits profit.3. Market Constraints

a) 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.

b) 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.

c) The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.

II. Technology and Economic EfficiencyA. Technological Efficiency

1. Technological efficiency occurs when a firm produces a given level of output by using the least amount of inputs.

2. Table 9.2 shows four ways of making a TV set, one of which (Method C, bench production) is technologically inefficient. Method C is technologically inefficient because it

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4uses the same quantity of capital as Method B but uses more labor than Method B.

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B. Economic Efficiency1. Economic efficiency occurs when the firm produces a given level

of output at the least cost. 2. Table 9.3 shows how the economically efficient method depends on

the relative prices of capital and labor.

3. An economically efficient production process is also technologically efficient. However, a technologically efficient production process is not necessarily economically efficient.a) The difference is that technological efficiency concerns

minimizing the quantity of inputs used in producing a specific level of output, whereas economic efficiency concerns the minimizing of the cost of the inputs used to produce that specific level of output.

b) Changes in the input prices influence the value of the inputs, but not the technological process for using them in production.

III. Information and OrganizationA. A firm organizes production by combining and coordinating productive

resources using a mixture of command systems and incentive systems.B. Command Systems

1. A command system organizes production using a managerial hierarchy.

2. Commands pass downward through the hierarchy and information (feedback) passes upward.

3. These systems are relatively rigid and can have many layers of specialized management.

C. Incentive Systems1. An incentive system is a method of organizing production that

uses a market-like mechanism inside the firm. These incentive systems, such a compensation schemes, induce workers to perform in ways that maximize the firm’s profit.

D. Mixing the Systems1. Most firms use a mix of command and incentive systems to

maximize profit. a) They use commands when it is easy to monitor performance or

when a small deviation from the ideal performance is very costly.

b) They use incentives whenever monitoring performance is impossible or too costly to be worth doing.

E. The Principal-Agent Problem1. The principal-agent problem is the problem of devising

compensation rules that induce an agent to act in the best interests of a principal. a) Agents work for principals. For example, the stockholders of a

firm are the principals and the managers of the firm are their agents.

F. Coping with the Principal-Agent ProblemThere are three ways of coping with the principal-agent problem:1. Ownership, often offered to managers, gives the managers an

incentive to maximize the firm’s profits, which is the goal of the owners, the principals.

2. Incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal.

3. Long-term contracts can tie managers’ or workers’ long-term rewards to the long-term performance of the firm. This encourages the agents work in the best long-term interests of the firm owners, the principals.

G. Types of Business OrganizationThere are three types of business organization:1. A proprietorship is a firm with a single owner who has unlimited

liability, or legal responsibility for all debts incurred by the firm—up to an amount equal to the entire wealth of the owner. The proprietor also makes management decisions and receives the firm’s profit. Profits are taxed as the personal income of the owner.

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2. 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.

3. 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. Corporate retained earnings are taxed twice, once at the corporate level and once again when they generate capital gains for the firm’s owners.

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H. Pros and Cons of Different Types of Firms1. Each type of business organization has advantages and

disadvantages. 2. Table 9.4 lists the pros and cons of different types of ownership.

a) Proprietorships are easy to set up, managerial decision making is simple, and profits are taxed only once. However, bad decisions made by the manager are not subject to review, the owner’s entire wealth is at stake, the firm dies with the owner, and acquiring capital and labor is expensive.

b) Partnerships are easy to set up, employ diversified decision-making processes, can survive the death or withdrawal of a partner, and profits are taxed only once. However, partnerships make attaining a consensus about managerial decisions difficult, place the owners’ entire wealth at risk, capital acquisition is expensive, and the withdrawal of a partner may create a capital shortage.

c) A corporation offers perpetual life, limited liability for its owners, large-scale and low-cost capital that is readily available, professional management that is not restricted by its owners’ abilities, and reduced costs from long-term labor contracts. However, a corporation’s complex management structure may

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lead to slow and expensive decision-making, and its retained earnings are taxed twice.


I. The Relative Proportions of Different Types and Firms1. There are a greater

number of proprietorships than other form of business, but corporations account for the majority of revenue received by businesses.

2. Figure 9.1a shows the overall frequency of each type of business organization and Figure 9.1b shows the dominant type of business organization for various industries, by percent of total industry revenues.

IV. Markets and the Competitive EnvironmentA. Economists identify four

market types:1. Perfect competition is a

market structure with many firms, each selling an identical product, many buyers, no restrictions on entry of new firms to the industry, and both firms and buyers are all well informed of the prices of the products of each firm in the industry.

2. Monopolistic competition is a market structure with many firms producing similar but slightly different products. This difference can be either tangible or merely perceived by the consumer. Making a product slightly different is called product differentiation and it gives the firm an element of market power.

3. Oligopoly is a market structure in which only a small number of firms compete. Oligopolies might produce almost identical goods or they might produce differentiated goods.

4. Monopoly is a market structure in which there is only one firm, which produces a good with no close substitutes and in which the firm is protected by a barrier that prevents the entry of new firms.

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B. Measures of Concentration1. Two measures of market concentration have been developed and

are in common use.a) The four-firm concentration ratio is the percentage of the

value of sales accounted for by the four largest firms in the industry.

b) The Herfindahl–Hirschman index (HHI) is the square of the percentage market share of each summed over the largest 50 firms in a market.

2. The larger the measure of market concentration, the less competition that exists in the industry. Table 9.5 shows an example calculation for each ratio.

C. Concentration Measures for the U.S. Economy1. The U.S. Justice Department uses the HHI to classify markets.

a) Markets with an HHI of less than 1,000 are regarded as highly competitive

b) Markets with an HHI between 1,000 and 1,800 are regarded as moderately competitive, and

c) Markets with an HHI above 1,800 regarded as concentrated.


2. Figure 9.2 shows the HHI for various industries in the United States.

D. Limitations of Concentration Measures1. Concentration measures

alone are not sufficient to identify the market structure of a given industry.a) The geographical scope

of the market. Concentration ratios are based on the entire nation as the market. For many goods, the relevant market may be much smaller than the whole nation (newspapers, for which the appropriate market is a city or metropolitan area) or even larger (automobiles, for which the pertinent market can be the entire world).

b) Barriers to entry and firm turnover. Concentration ratios convey no information about the extent of barriers to entry. For some industries, few firms may be currently operating in the market. Yet competition in these industries may be fierce, with firms regularly entering and exiting the industry. Additionally, if entry and exit were not observed, the potential for entry may be enough to keep profits lower than if entry were not a threat.

c) The correspondence between a market and an industry. Firms may be misclassified with respect to their markets. This can be true for firms that: either produce a product with very specific applications for which few competitors exist, but are classified in too broad of a market description to reveal it, or firms that have diversified into several distinct product lines and are subject to more effective competition than their market share in just one product might suggest.

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2. Table 9.6 summarizes the range of other information used with the concentration ratio to determine market structure.

E. Market Structures in the U.S. Economy1. Figure 9.3 shows the

distribution of market structures in the U.S. economy.

2. About three-quarters of the total value of goods and services produced in the United States is produced in markets that are perfectly competitive or monopolistically competitive.

V. Markets and FirmsA. Market Coordination

Firms and markets both coordinate production.

B. Why Firms?1. Firms coordinate production when they can do so more efficiently

than a market. This can occur for four different reasons:a) Firms might lower transactions costs, which 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.


b) Firms might better capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases.

c) Firms can capture economies of scope, whereby one firm can use specialized inputs to produce a range of goods and services.

d) Firms can engage in team production, in which the individuals specialize in mutually supporting tasks.

2. There are limitations to the economic efficiency advantage that firms might have over markets in coordinating resources:a) If a firm exploiting economies of scale becomes too big, or if a

firm exploiting economies of scope becomes too diversified, the cost of management and monitoring per unit of output can rise above that of the market.

b) Long-term contracts can blur the line between the internal activities of the firm and market transactions, making it unclear whether or not the activity of production and exchange is still being implemented by a firm.

R e a d i n g B e t w e e n t h e L i n e sA news article discusses the history of Enron with a focus on its top executives. The analysis concentrates on the various principal-agent problems in Enron and how they lead to its downfall.

N e w i n t h e S e v e n t h E d i t i o nThe chapter largely remains intact, with only subtle changes in text.

Te a c h i n g S u g g e s t i o n s1. The Firm and its Decisions: Emphasize the difference between

accounting profit and economic profit when a firm owner is using cost information to make business decisions. Point out that only economic profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Stress that accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated according to strict, generally accepted accounting procedures (GAAP). Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy financial picture for the firm—to the detriment of the firm owners. Enron and Arthur Andersen: When is a cost really a cost? The Enron fiasco brought the subject of accuracy and completeness in cost assessment to the attention of investors everywhere. Suddenly, the

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validity of financial information on any financial statement issued by any publicly held company was under scrutiny.The implicit cost shuffle: Some subversive tools of the accounting trade. A very useful news article, written by financial reporter Ken Brown, appeared in the Wall Street Journal on Feb. 2, 2002. He summarized many popular ways to use accounting costs to understate opportunity costs on a financial statement while technically satisfying generally accepted accounting procedures: For example, his list includes: i) Understating the capital asset depreciation by failing to record recent declines in the true market valuation of the capital (rather than from physical decay); ii) using off-the-books agreements to hide debt and credit risk by partnering with another company to share liabilities (which was a key element of Enron’s ill-fated ploy); iii) capitalizing operating expenses, which allows current operating costs to be allocated over future time periods as if it were a capital depreciation expense.

2. Technological Efficiency vs. Economic Efficiency: Minimizing the quantity of resources used in production is not the same as minimizing the value of the resources used. Point out that technological efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally productive), there will inevitably be a difference between technological and economical efficiency.

3. The Competitive Environment: What are the limits to a “Market”?Can the market be defined by geography? by demography? by substitutability? Emphasize that attempts by economists to identify the market for a particular firm’s product is not easy. Geography: the (expanding) market for beer. In the early 20th century, a market for any given brand of beer was largely limited to the geographic area within a days’ truck drive from the brewery—if the beer traveled for too long under too high an ambient temperature, the trip ruined the product. When technological advances in mobile refrigeration made transporting beer over the road economical, local monopoly brands suddenly felt the pain of competition from out-of-state brands that had never before been observed in the local market.Demography: the (hidden) market for cigarettes. Can you define the market for a cigarette manufacturer by looking only at the market among adults? What if mostly illegal, under-aged smokers favored the brand rather than adult smokers? The sales to minors would not likely be recorded, yet it represents market share.Substitutability: the (changing) market for personal transportation. Can you define the market for personal transportation? Twenty-five years ago it meant just the market for cars. Today, if we wanted to determine the market share for an auto manufacturer that happens to only sell cars, would the definition of the market for personal (as opposed to commercial) transportation include only cars? Or should trucks, mini-vans and SUVs be included as well? How about motorcycles?


The World Wide Web of business. Conclude the discussion of market definition by mentioning how today, items can be produced anywhere in the world and can be discovered and ordered from anywhere else in the world using the World Wide Web. These items can be paid for through electronic accounts located only in cyber-space, and the product can be shipped literally overnight to nearly any city in any developed country around the world. Stress how difficult it is to discern even the relevance of the term “market” in today’s business climate.

5. Markets and FirmsRonald Coase is the classic on this topic. You might like to tell your students about this remarkable person. Born in England in 1910, be graduated with a bachelor of commerce degree in 1932, at the depth of the Great Depression. While still an undergraduate, he was puzzled by the fact that he was being taught that markets coordinate economic activity, yet all around him he could see firms that were also coordinating economic activity. “Why?” he wondered. The question was especially important at that time because Socialists (and the young Coase was one of them) thought that central planning by government was superior to the market.Quoting from Coase’s autobiography, http://www.nobel.se/economics/laureates/1991/coase-autobio.html:

I spent the academic year 1931-32 on my Cassel Travelling Scholarship in the United States studying the structure of American industries, with the aim of discovering why industries were organized in different ways. I carried out this project mainly by visiting factories and businesses. What came out of my enquiries was not a complete theory answering the questions with which I started but the introduction of a new concept into economic analysis, transaction costs, and an explanation of why there are firms. All this was achieved by the Summer of 1932, as the contents of a lecture delivered in Dundee in October 1932, make clear. These ideas became the basis for my article “The Nature of the Firm,” published in 1937, cited by the Royal Swedish Academy of Sciences in awarding me the 1991 Alfred Nobel Memorial Prize in Economic Sciences.

So, this amazing scholar had done his Nobel prize winning work at the age of 22!

T h e B i g P i c t u r eWhere we have been:

Chapter 9 introduces students to the firm as a decision making entity with an organizational structure and a specific goal. Key ideas in this chapter are recognizing the importance of having access to accurate cost and profitability information for making sound business decisions (learning the difference between economic versus accounting profit) and using the correct notion of efficiency as a criteria for making these decisions (understanding the difference between technological versus economic efficiency).

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Where we are going:Understanding the nature of the firm allows students to gain a better appreciation of the following chapters, which cover business decisions made by the firm under different market structures. Chapter 10 introduces the firm’s production function and cost functions. Chapter 11 examines firm performance in a competitive environment and Chapter 12 explores the firm as a monopoly. Chapter 13 looks at firm behavior under monopolistic competition and oligopoly. Chapter 17 covers the firm’s decisions in the resource and labor markets.

O v e r h e a d Tr a n s p a r e n c i e sTransparency Text figure Transparency title

54 Figure 9.1 The Proportions of the Three Types of Firms

55 Figure 9.3 The Market Structure of the U.S. Economy56 Figure 9.4 The Pros and Cons of Different Types of

Firms57 Figure 9.5 Concentration Ratio Calculations58 Table 9.6 Market Structure

E l e c t r o n i c S u p p l e m e n t sMyEconLabMyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help. Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book.

PowerPoint Lecture NotesPowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of the chapter.PowerPoint Electronic Lecture Notes for students are available in MyEconLab.

Instructor CD-ROM with Computerized Test BanksThis CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.


A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s1. The complexities of running your own business. Have the students

imagine starting up their own firm after graduation. Let them dream about pursuing their passion and trying to make a living at it, and get them to appreciate the complexities of organizing production and making a profit. Challenge them with the following business decision issues and open their eyes to how much risk must be endured and how much market perceptiveness is necessary to be a successful entrepreneur.Organizing your firm. Ask students if the initial capital requirements for their dream business would be extensive, such as starting up a high-performance car manufacturing firm (John DeLorean tried this, but his attempt to raise financial capital caused him to take a bit of a career detour!), or merely a modest capital outlay. Will the size and scope of their operation require a large management structure with a diversity of specialized managers, or a small, streamlined structure with only a few managers in multi-purpose roles? Will they want to spread out the risk of financial liability among stockholders in exchange for sharing a portion of their profit? Determining your firm’s financial reporting standards. What financial reporting standards will their firm practice? Ask the students how they will treat the wages paid to themselves, the owners of the firm? Mention that if their next best alternative job forgone has just experienced a significant increase in salary, the implicit cost of running their own business has just increased and their economic profitability has decreased. Point out that if they were to give themselves a raise to reflect the higher opportunity cost and transform that implicit cost into an explicit cost, their accounting profit then declines as well. Not only will a lower profit report for the period hurt their firm’s perceived stature in the industry, it will also make it more costly for their firm to raise financial capital in the future.Determining appropriate sources of information. Where will they receive the information regarding locating good workers and managers? Where can they find the market wages, salaries, and benefits that they must offer to their employees in order to attract quality people to work with them instead of other firms? How will they uncover all the business regulations, licensing, periodic tax filing procedures, and labor laws that must be strictly followed to remain in operation?

2. The implicit cost of mediocre management is determined in part by forces outside the firm owner’s control. Ask students why the CEO of a large corporation that has not made an economic profit under his or her reign can still command a nice, seven-figure annual salary? Is the manager’s contribution to firm profit the only determinant of the salary for a corporate CEO? Emphasize that the salaries earned by high-level managers of large companies are determined by both demand (the value added to profitability) and supply (the availability of talent to run a large corporation). Even if a CEO’s ability to bring returns to a firm owner’s capital above the normal profit levels is mediocre (or worse), the supply of experienced managers capable of running large and complex companies is still relatively scarce. The firm must meet the manager’s opportunity cost (the salary and benefits from the next best alternative position forgone) to

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retain his or her services. Other firms are willing to bid generous salaries and benefits for CEOs, even ones with mediocre track records, because they cannot easily determine whether the poor financial performance of the firm is the responsibility of the CEO or a result of unusual circumstances constraining the effectiveness of the CEO.

3. Market structure and consumer welfare. Get the students to consider the economic implications for consumers under the different market structures. Ask the following questions: Which type of market would allow the consumers to buy the available

products at the lowest price? (Pure competition) Which type of market structure would give consumers the widest

variety of choices among the products offered? (Monopolistic competition)

Which type of market would give create the most product innovation through research and development in the long run? (Many economists think the presence of long-run profit must exist for firms to commit to significant research and development, implying the monopoly or oligopoly market)

So which of these market characteristic is the best for the consumer: lowest price, greatest variety, or consistent product innovation over time? (There is no positive answer, but there will be much discussion!)

4. The double taxation of corporate taxes. Ask the students to recall the deadweight loss of taxation analyzed in Chapter 6 and apply it to the double taxation of corporate profits. Get them to see that they can model the effects of the compounding deadweight losses by using the production possibilities frontier. Show them how the corporate tax causes movement of the economy to production combinations that are inefficient and closer to the interior of the production possibilities frontier.

5. The economic organization of new residential home markets. Mention to the students that if a market is more efficient at allocating resource among buyers and sellers than a firm, the market will be characterized by the presence of many different contractors or consultants, rather than with traditional companies. Ask the students to identify some of these kinds of markets and get them to consider what characteristics of the products or services do not lend themselves tot the organizational structure of the firm. Cookie Cutter houses on manicured streets. For example, ask the students what characteristics that describe the building of new residential homes that encourages a predominance of contractors rather than firms to supply new residential housing? In this market, independent, general construction contractors who deal with many sub-contractors are the entities that tend to build individual “spec” homes. Yet, in the same market there are also a few, large residential developments of “cookie cutter” homes built in a small geographic area by one firm. Perhaps the high cost of monitoring the progress in many off-site work areas, combined with a high degree of variation in the customer preferences for the product, prevents any economies of scale to be enjoyed by a firm trying to build “spec” homes. Perhaps the economies of scale can only be enjoyed


in a small geographic area with a high concentration of construction sites managed by one firm.

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A n s w e r s t o t h e R e v i e w Q u i z z e sPage 198

1. A firm’s goal is to maximize profit, which is the return on the firm owner’s investment in labor, entrepreneurial effort, and capital. If the firm fails to maximize profits it is either eliminated or bought out by other firms maximizing profit.

2. Accounting profits differ from economic profits because accounting profits include only explicit costs. Economic costs, however, include both explicit and implicit costs that reflect the full opportunity cost of production incurred by the firm. Economic profit will be equal to or less than accounting profits.

3. Opportunity cost includes all explicit costs incurred by the firm, such as wages paid to workers, expenses for raw materials, and rent paid to capital owners. Explicit costs such as these comprise an accountant’s measures. Opportunity cost also includes all implicit costs incurred by the firm, which makes an economist’s measure differ from an accountant’s. These implicit costs include the implicit rental rate of owner’s capital, labor, and entrepreneurial ability. The total opportunity cost incurred by a firm is the sum of all explicit and all implicit costs.

4. Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labor to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, like running another firm. This is an implicit cost for the firm and must be included in calculating the firm’s full opportunity cost of production.

5. The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it 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. Information is never complete, for the future or the present. A firm 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 itself limits profit. What each 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.

Page 2001. Technological efficiency occurs when a firm produces a given level of

output by using the least amount inputs. Adopting the latest available technology does not necessarily imply that a firm’s production process is technologically efficient. As long as the firm is getting the maximum


possible output for a given combination of inputs, it is technologically efficient.

2. Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.

3. 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 value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.

4. The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods.

Page 2041. A command system uses a managerial hierarchy, where commands pass

downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.

2. The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal; long-term contracts tie managers’ or workers’ long-term rewards to the long-term performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.

3. The three main ways of organizing a firm have both advantages and disadvantages:

Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. DISADVANTAGES—bad decisions on the part of the owner are not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive.

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Partnership. ADVANTAGES—easy to set up; has diversified decision-making so that more than one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. DISADVANTAGES—all the owners’ wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; and capital costs can be high.

Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available, large-scale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. DISADVANTAGES—potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.

4. All three types of firms survive since each may have a superior advantage for the unique characteristics of the industry in which the firm operates. For example, there are more proprietorships in industries where flexibility in decision-making is important. This is why we see most agriculture firms are single-family owned farms. For industries where a large amount of capital is used, we see mostly corporations. This is true of the capital-intensive manufacturing industries. Partnerships are seen most prominently in mining. This suggests mining firms benefit from the diversified decision-making of a partnership as well as profits being taxed only once.

Page 2091. Economists identify four market types:

1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry.

2. Monopolistic competition is a market with many firms that produce similar but slightly different goods.

3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods.

4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist’s product and there are barriers to entry that protect the firm from competition of entering firms.

2. Two measures of concentration have been developed and are in common use: the four-firm concentration ratio and the Herfindahl–Hirschman index (HHI).

1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry.

2. The Herfindahl–Hirschman index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.


3. Concentration measures give a good indication of the degree of competition in a market if the following characteristics of the industry market are correct:

1. The industry market is national in scope, rather than local or international.

2. There are no concerns about over-stating or under-stating the extent of barriers to entry.

3. Firms are not misclassified with respect to their markets.4. The U.S. economy would be considered competitive since three-quarters

of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.

Page 2111. Firms and markets both coordinate resources.2. Firms coordinate resources when they can do so more efficiently than a

market.1. Firms may reduce transactions costs, which 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.

2. Firms may better capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases.

3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise.

4. Firms can engage in team production, in which the individuals specialize in mutually supporting tasks.

3. Firms can often coordinate production at a lower cost than markets can because they lower transactions costs and achieve economies of scale, scope, and team production.

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A n s w e r s t o t h e P r o b l e m s1. Explicit costs are $30,000. Explicit costs are all the costs for which there is

a payment. Explicit costs are the sum the wages paid ($20,000) and the goods and services bought from other firms ($10,000).Implicit costs are the sum of the costs that do not involve a payment. Implicit costs are the sum of the interest forgone on the $50,000 put into the firm; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is the value of 500 hours of Jill’s leisure (10 hours a week for 50 weeks); and the economic depreciation of $2,000 ($30,000 minus $28,000).

2. Explicit costs are $23,000. Explicit costs are all the costs for which there is a payment. Explicit costs are the sum the wages paid ($18,000) and the goods and services bought from other firms ($5,000).Implicit costs are the sum of the costs that do not involve a payment. Implicit costs are the sum of the interest forgone on the $70,000 put into the firm; the $22,000 income forgone by Moffat not working at her previous job; $20,000, which is the value of 1,000 hours of Spieder's leisure (20 hours a week for 50 weeks); and the economic depreciation of $3,000 ($40,000 minus $37,000).

3. a. All methods other than “pocket calculator with paper and pencil” are technologically efficient.To use a pocket calculator with paper and pencil to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a pocket calculator but it uses more capital.

b. The economically efficient method is to use (i) a pocket calculator, (ii) a pocket calculator, (iii) a PC.The economically efficient method is the technologically efficient method that allows the task to be done at least cost.When the wage rate is $5 an hour: Total cost with a PC is $1,005, total cost with a pocket calculator is $70, and total cost with paper and pencil is $81. Total cost is least with a pocket calculator.When the wage rate is $50 an hour: Total cost with a PC is $1,050, total cost with a pocket calculator is $610, and the total cost with paper and pencil is $801. Total cost is least with a pocket calculator.When the wage rate is $500 an hour: Total cost with a PC is $1,500, total cost with a pocket calculator is $6,010, and total cost with pencil and paper is $8,001. Total cost is least with a PC.

4. a. All methods are technologically efficient.To use paper and pencil to complete the accounting assignment takes 30 hours and $5 of capital. To use a pocket calculator, it takes fewer hours (15 hours) and more capital ($20). To use a pocket calculator and paper and pencil, it takes fewer hours (7 hours) and more capital ($25). To use a PC, it takes fewer hours (1 hour) and more capital ($1,000). No method uses more of both resources (time and capital) than any other method. So all methods are technologically efficient.


b. The economically efficient method is to use (i) a pocket calculator and paper and pencil, (ii) a pocket calculator and paper and pencil, (iii) a pocket calculator.The economically efficient method is the technologically efficient method that allows the task to be done at least cost.When the wage rate is $10 an hour: Total cost with a PC is $1,010, total cost with a pocket calculator is $170, total cost with pocket calculator and paper and pencil is $95, and total cost with paper and pencil is $305. Total cost is least with a pocket calculator and paper and pencil.When the wage rate is $20 an hour: Total cost with a PC is $1,020, total cost with a pocket calculator is $320, total cost with pocket calculator and paper and pencil is $165, and the total cost with paper and pencil is $605. Total cost is least with a pocket calculator and paper and pencil.When the wage rate is $250 an hour: Total cost with a PC is $1,250, total cost with a pocket calculator is $3,770, and total cost with pocket calculator and paper and pencil is $1,775, and the total cost with pencil and paper is $7,505. Total cost is least with a PC.

5. a. Methods A, B, C, and D are technologically efficient. Compare the amount of labor and capital used by the four methods. Start with method A. Moving from A to B to C to D, the amount of labor increases and the amount of capital decreases in each case.

b. The economically efficient method in (i) is method D, in (ii) is methods C and D, and in (iii) is method A.The economically efficient method is the technologically efficient method that allows the 100 shirts to be washed at least cost.

(i) Total cost with method A is $1,001, total cost with method B is $805, total cost with method C is $420, and total cost with method D is $150. Method D has the lowest total cost.

(ii) Total cost with method A is $505, total cost with method B is $425, total cost with method C is $300, and total cost with method D is $300. Methods C and D have the lowest total cost.

(iii) Total cost with method A is $100, total cost with method B is $290, total cost with method C is $1,020, and total cost with method D is $2,505. Method A has the lowest total cost.

6. a. Methods A, C, and D are technologically efficient. Compare the amount of labor and capital used by the four methods. Start with method A. Moving from A to B, the amount of labor is the same and the amount of capital increases. Method B is not technologically efficient. The same amount of labor can produce 10 surfboards with less capital by using method A. Moving from A to C to D, the amount of labor increases and the amount of capital decreases in each case.

b. The economically efficient method in (i) is method A, in (ii) is method A, and in (iii) is method D.The economically efficient method is the technologically efficient method that allows the 100 surfboards to be made at least cost.

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(i) Total cost with method A is $1,040, total cost with method C is $3,020, total cost with method D is $4,010. Method A has the lowest total cost.

(ii) Total cost with method A is $700, total cost with method C is $1,600, and total cost with method D is $2,050. Method A has the lowest total cost.

(iii) Total cost with method A is $2,050, total cost with method C is $1,150, and total cost with method D is $700. Method D has the lowest total cost.

7. a. The four-firm concentration ratio is 60.49.The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $450 + $325 + $250 + $200, which equals $1,225. Total industry sales equal $1,225 + $800, which equals $2,025. The four-firm concentration ratio equals ($1,225/$2,025) 100, which is 60.49 percent.

b. This industry is highly concentrated because the four-firm concentration ratio exceeds 60 percent.

8. a. The four-firm concentration ratio is 26.83.The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $15,000 + $25,000 + $30,000 + $40,000, which equals $110,000. Total industry sales equal $110,000 + $300,000, which equals $410,000. The four-firm concentration ratio equals ($110,000/$410,000) 100, which is 26.83 percent.

b. This industry is competitive because the four-firm concentration ratio is less than 40 percent.

9. a. The Herfindahl-Hirschman Index is 1,800.The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl-Hirschman Index equals 152 + 102 + 202 + 152 + 252 + 152, which equals 1,800.

b. This industry is moderately competitive because the Herfindahl-Hirschman Index lies in the range 1,000 to 1,800.

10. a. The Herfindahl-Hirschman Index is 5,838.The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl-Hirschman Index equals 752 + 102 + 82 + 72, which equals 5,838.

b. This industry is not competitive because the Herfindahl-Hirschman Index exceeds 1,800.


A d d i t i o n a l P r o b l e m s1. Sue can do her accounting assignment by using: a personal computer; a

pocket calculator; a pocket calculator and a pencil and paper; or a pencil and paper. With a PC, Sue completes the job in half an hour; with a pocket calculator, it takes 4 hours; with a pocket calculator and with a pencil and paper, it takes 5 hours; and with a pencil and paper, it takes 14 hours. The PC and its software cost $2,000, the pocket calculator costs $15, and the pencil and paper cost $3.a. Which, if any, of the methods is technologically efficient?b. Which methods is economically efficient if Sue’s wage rate is(i) $10 an hour?(ii) $20 an hour?(iii) $50 an hour?

2. Alternative ways of making 100 shirts a day are:Labor Capital

Method (hours) (machines)A 10 50B 20 40C 50 20D 100 10

a. Which methods are technologically efficient?b. Which method is economically efficient if:(i) The wage rate is $1 an hour and the rental cost of a machine is $100

an hour?(ii) The wage rate is $5 an hour and the rental cost of a machine is $50 an

hour?(iii) The wage rate is $50 an hour and the rental cost of a machine is $5 an

hour?3. Sales of the firms in the pet food industry are:

SalesFirm (thousands of dollars)Big Collar, Inc. 50Shiny Coat, Inc. 75Friendly Pet, Inc. 60Nature's Way, Inc. 65Other 8 firms 400a. Calculate the four-firm concentration ratio.b. What is the structure of the industry?

4. Market shares of mat makers are:Market share

Firm (percent)Made-to-Last, Inc. 20Big Wheel, Inc. 17Magic Carpet, Inc. 22

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Supreme, Inc. 17Copra, Inc. 24a. Calculate the Herfindahl-Hirschman Index.b. What is the structure of the industry?


S o l u t i o n s t o A d d i t i o n a l P r o b l e m s1. a. All methods other than “pocket calculator with paper and pencil” are

technologically efficient.To use a pocket calculator with paper and pencil to complete the accounting assignment is not a technologically efficient method because it takes more hours than it would with a pocket calculator and it uses more capital.

b. The economically efficient method is to use (i) a pocket calculator, (ii) a pocket calculator, (iii) a pocket calculator.The economically efficient method is the technologically efficient method that allows the task to be done at least cost.When the wage rate is $10 an hour: Total cost with a PC is $2,005, total cost with a pocket calculator is $55, and total cost with paper and pencil is $143. Total cost is least with a pocket calculator.When the wage rate is $20 an hour: Total cost with a PC is $2,010, total cost with a pocket calculator is $95, and the total cost with paper and pencil is $283. Total cost is least with a pocket calculator.When the wage rate is $50 an hour: Total cost with a PC is $2,025, total cost with a pocket calculator is $215, and total cost with pencil and paper is $703. Total cost is least with a pocket calculator.

2. a. Methods A, B, C, and D are technologically efficient. Compare the amount of labor and capital used by the four methods. Start with method A. Moving from A to B to C to D, the amount of labor increases and the amount of capital decreases in each case.

b. The economically efficient method in (i) is method D, in (ii) is method D, and in (iii) is method A.The economically efficient method is the technologically efficient method that allows the 100 shirts to be made at least cost.

(i) Total cost with method A is $5,010, total cost with method B is $4,020, total cost with method C is $2,050, and total cost with method D is $1,100. Method D has the lowest total cost.

(ii) Total cost with method A is $2,550, total cost with method B is $2,100, total cost with method C is $1,250, and total cost with method D is $1,000. Method D has the lowest total cost.

(iii) Total cost with method A is $750, total cost with method B is $1,200, total cost with method C is $2,600, and total cost with method D is $5,050. Method A has the lowest total cost.

3. a. The four-firm concentration ratio is 38.46.The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $50,000 + $75,000 + $60,000 + $65,000, which equals $250,000. Total industry sales equal $250,000 + $400,000, which equals $650,000. The four-firm concentration ratio equals ($250,000/$650,000) 100, which is 38.46 percent.

b. This industry is competitive because the four-firm concentration ratio is less than 40 percent.

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4. a. The Herfindahl-Hirschman Index is 2,038.The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The Herfindahl-Hirschman Index equals 202 + 172 + 222 + 172 + 242, which equals 2,038.

b. This industry is not competitive because the Herfindahl-Hirschman Index exceeds 1,800.


university of dayton · web viewchapter 17 covers the firm’s decisions in the resource and labor...

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