1.4 Organizing Production
** This note is summarized by Hui Wang.
Important reference Study Guides of Stalla Review for CFA Exams
Learning Outcomes
The candidate should be able to:
a. explain the types of opportunity cost and their relation to economic profit, and
calculate economic profit;
b. discuss a firm’s constraints and their impact on achievability of maximum profit;
c. differentiate between technological efficiency and economic efficiency, and calculate
economic efficiency of various firms under different scenarios;
d. explain command systems and incentive systems to organize production, the
principal-agent problem, and measures a firm uses to reduce the principal-agent
problem;
e. describe the different types of business organization and the advantages and
disadvantages of each;
f. characterize the four market types;
g. calculate and interpret the four-firm concentration ratio and the HerfindahlHischman Index, and discuss the limitations of concentration measures;
h. explain why firms are often more efficient than markets in coordinating economic
activity.
The measure of profit
The goal for most firms is to maximize profit. When talking about a firm’s profit, there
are two kinds of profit to be considered:
(1) Accounting profit: the difference between total revenue and explicit costs.
(2) Economic profit: the difference between the revenue received from the sale of an
output and the opportunity cost of the inputs used. Economic profit can be used as
another name for “economic value added” (EVA).
Opportunity cost
Opportunity cost is the value of the next best alternative forgone as the result of making a
decision.
A firms’ opportunity cost includes the following two parts:
(1) Explicit costs: explicit costs are money a firm pays. It represents clear cash outflows
from a firm.
(2) Implicit costs: a cost that is represented by lost opportunity in the use of a firm’s own
resources but the firm does not make an actual payment.
In general, implicit costs include the following two parts:
(1) Implicit rental rate: the opportunity costs that a firm incurs as a result of using their
own assets for ongoing operations instead of other alternative uses. This consists of:
a. Economic depreciation.
b. Forgone interest.
(2) The market value of the firm’s owners’ labor and entrepreneurship, which is
measured by:
a. Implicit wage.
b. Normal profit.
The firm’s constraints
When a firm seeks to maximize its profit, it faces three constraints:
1.
Te
chnology constraints
Although technology advances constantly, at a given point, the available
production technology for a firm is finite and predetermined. Technological
efficiency represents the situation where the production by a company of a
particular quantity of output using the minimum number of inputs. Economic
efficiency represents the situation where the resources are allocated to their
highest valued use and the production and distribution of goods and services at
the lowest possible cost.
A technological efficient production method is not necessarily economically
efficient. A firm that seeks to maximize its profit should consider the economic
efficiency of production method when conducting production.
2.
Inf
ormation constraints
Information constraints arise from incomplete information and uncertainty.
When organizing production, a firm usually adopts one of the following two
systems or a mixture of them:
a.
Co
mmand systems.
b.
Inc
entive systems.
c.
Mi
xture of the two.
The principal-agent problem
One issue caused by information constraints is principal-agent problem. The
principal employs an agent to perform in the principal’s interest and compensate
the agent by paying him or her. The principal-agent situation is one in which
effort cannot be perfectly monitored by the principal and therefore cannot be
directly rewarded.
The efficient solution for the principal-agent problem requires some alignment of
interests of the two parties. Three normal ways of coping with the principal-agent
problem are:
a.
O
wnership.
b.
Inc
entive pay.
c.
Lo
ng-term contracts.
3.
M
arket constraints
When a firm puts its products into the market, the quantity it can sell and the
price it can charge is determined collectively by the consumers’ willingness to
pay and its competitors’ reaction. Meanwhile, when a firm purchases raw
material from its suppliers, the quantity of resources it can get and the price it
needs to pay depends on its suppliers and other users’ of the same raw material.
Furthermore, when a firm plans to start a new project, the funds it can get
depends on the condition of the capital market and the attitude of its investors.
Types of business organization
Three main types of business organization are:
(1)
prietorship.
(2)
tnership.
(3)
rporation.
Pro
Par
Co
Each type of business organization has its own advantages and disadvantages:
Firm Type
Proprietorship
Advantages
easy to start, simple
decision making, profits
are only taxed once
Partnership
easy to start, diversified
decision making helps to
avoid mistakes, firm’s life
Disadvantages
bad decisions are not
checked, owner’s entire
wealth is tied up in the
business, firm dies with
owner, higher cost of
capital and labor, relative
to that of a corporation
Achieving consensus can
be slow and expensive,
owner’s entire wealth is
is independent of the life
of any single owner,
profits are taxed once
Corporation
Limited liability of
owners, large amount of
low-cost capital is
available, professional
management not restricted
by ability of owners,
unlimited life, lower cost
of labor through long-term
contracts
tied up in the business,
withdrawal of partner may
create capital shortage,
higher cost of capital and
labor relative to that of a
corporation
Complicated management
can slow decision-making
and increase costs, Profits
are taxed twice: as
company earnings and as
shareholders’ capital gain
Market and the competitive environment
Economists identify the following four market types by the differences in their
degrees of competition: perfect competition, monopolistic competition, oligopoly
and monopoly.
Market
Number
Type of
Power of
Barrier
Nonprice
Type
of
Product
Firms over
s to
competition
Producer
Price
Entry
s
Perfect
Many
Standardized None
Low
None
Competition
Monopolisti Many
Differentiate Some
Low
Differentiatio
c
d
n
Competition
Oligopoly
Few
Standardized Some
High
Advertising &
or
Differentiatio
differentiated
n
Monopoly
One
Unique
Considerabl Very
Advertising
product
e
high
Four-firm concentration ratio
The four-firm concentration ratio is used as an indicator of the relative size of firms
in relation to the industry as a whole. It is calculated as the sum of the percent market
share of the top four firms. The range of the concentration ratio is from almost zero
for perfect competition to 100% for monopoly. The lower the concentration ratio, the
higher degree is the competition in the market. If the concentration ratio is less than
60% in a market, the market is regarded as a competitive market.
Herfindahl-Hirschman Index
Herfindahl-Hirschman Index: also called the HHI, is a commonly accepted measure
of market concentration. It is calculated by summing up the squares of the market
shares of the 50 largest firms (or summed over all the firms if there are fewer than 50)
within the industry. The range of the HHI is from almost zero to 10,000, moving
from a huge number of very small firms to a single monopolistic producer.
HHI
Less than 1,000
Between 1,000 and 1,800
More than 1,800
Market Characteristic
Competitive
Moderately competitive
uncompetitive
Limitations of Industry concentration measures
There are three major limitations of using concentration measures as the only
indicators of market competitive structure:
(1)
Th
e geographical scope of the market: concentration measures can only deal with
national market while many goods are traded in regional market or even
international market.
(2)
Ba
rriers to entry and firm turnover: concentration measures pay no attention to the
entry barrier of a market and the firm turnover in the market.
(3)
Th
e correspondence between a market and an industry: concentration ratios are
calculated according to the industry classification by the Department of
Commerce. But firms classified in one industry may operate in many different
markets. Firms that are classified in a certain industry may produce several goods
which are traded in separate markets. In addition, firms may switch from one
market to another.
Markets and firms
Whether markets or firm is used to coordinate production depends on the economic
efficient of each method:
(1)
Ma
rket coordination: ongoing and spontaneous coordination of separate economic
activities by the price signals generated by the interaction of demand and supply
in a market. Market coordination occurs when a firm employs resources outside
the firm more efficiently than if they relied only on internal resources.
(2)
Fir
m coordination: firm coordination occurs when a firm produces its product using
resources within the firm. Firms can often coordinate economic activity more
efficiently than markets because firms can reduce the costs of market transactions,
and they can achieve economies of scale, scope, and team production:
a.
Tra
nsaction costs, the costs that arise from finding trading partners, reaching an
agreement about trading terms and ensuring the agreement will be fulfilled. A
firm can lower such transaction costs by coordinating production in which
they specialize and thus reducing the number of individual transactions
undertaken.
b.
Ec
onomies of scale, the increase in efficiency of production as the number of
goods being produced increases. A firm can lower the average cost per unit
output through mass production since fixed costs are shared over an increased
number of goods.
c.
Ec
onomies of scope, the reduction in costs that results from having two or more
productions utilize the same resources.
d.
Ec
onomies of team production, occurs when a group of people that specialize in
different part of the production work together for a mutual task.
Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)
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EXPLANATION
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