9
ORGANIZING
PRODUCTION
Outline
Spinning a Web
A. Tim Berners-Lee’s idea, the World Wide Web, has provided a
platform for the creation of thousands of profitable businesses
from tiny owner-operated firms to giant multinationals.
B. This chapter explains the role of firms and the problems that
all firms face.
I.
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.
B. The Firm’s Goal
1. A firm’s goal is to maximize profit.
2. If the firm fails to maximize profits it is either eliminated
through 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. This implicit cost is made up of:
a) Economic depreciation—the change in the market value of
capital over a given period.
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b) Interest forgone, which is the return on the funds used to
acquire the capital.
5. The cost of the owner’s resources is his or her
entrepreneurial ability and labor expended in running the
business.
a) The opportunity cost of the owner’s entrepreneurial
ability is the average return from this contribution that
can be expected from running another firm. This return is
called a 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 Profit
1. 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 the
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 (page 193) summarizes the economic accounting
concepts.
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F. Economic Accounting: A Summary
To achieve profit maximization, the firm must make five basic
decisions:
1.
What goods and services to produce and in what quantities
2.
How to produce—the production technology to use
3.
How to reorganize and compensate its managers and workers
4.
How to market and price its products
5. What to produce itself and what to buy from other firms
G. The Firm’s Constraints
The 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 Efficiency
A. Technological Efficiency
1. Technological efficiency occurs when a firm produces a given
level of output by using the least amount inputs.
2. Table 9.2 (page 195) shows four ways of making a TV set, one
of which is technologically inefficient.
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3. There may be different combinations of inputs to use for
producing a given level of output.
4. If it is impossible to maintain output by decreasing any one
input, holding all other inputs constant, then production is
technologically efficient.
B. Economic Efficiency
1. Economic efficiency occurs when the firm produces a given level
of output at the least cost.
2. Table 9.3 (page 196) shows how the economically efficient
method depends on the relative costs of capital and labor.
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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 cost of the inputs
used.
4. 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.
III. Information and Organization
A. 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 uses 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 Systems
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1. An incentive system, uses market-like mechanisms to induce
workers to perform in ways that maximize the firm’s profit.
D. Mixing the Systems
1. 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 Problem
1. 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) For example, the stockholders of a firm are the principals
and the managers of the firm are their agents.
2. Command systems do not address the principal-agent problem,
since monitoring agent performance to principals is generally
very costly.
F. Coping with the Principal-Agent Problem
There 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 Organization
There 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
the same as the owner’s other income.
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
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personal wealth of the stockholders is not at risk if the
firm goes bankrupt. The profit of corporations is taxed
twice—once as a corporate tax on firm profits, and then again
as income taxes paid by stockholders receiving their aftertax profits distributed as dividends.
H. Pros and Cons of Different Types of Firms
1. Each type of business organization has advantages and
disadvantages.
2. Table 9.4 (page 199) 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
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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 lead to slow and
expensive decision-making, and its profit is taxed twice—
once as corporate profit and once as shareholder income.
I. The Relative Importance of Different Types and Firms
1. 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 (page 200) shows the overall frequency of each
type of business organization and Figure 9.1b (page 200)
shows the dominant type of business organization for various
industries, by percent of total industry revenues.
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IV. Markets and the Competitive Environment
A. 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 and products of all firms
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
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consumer. This is activity 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 may produce almost identical or
differentiated goods.
4. Monopoly is a market structure 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 by
entering firms.
B. Measures of Concentration
1. Two measures of market concentration have been developed and
are in common use.
a) The four-firm concentration ratio is the percentage of the total
industry sales accounted for by the four largest firms in
the industry.
b) The Herfindahl–Hirschman index (HHI) equals the sum of the
squared market shares of the 50 largest firms in the
industry.
2. The larger the measure of market concentration, the less
competition that exists in the industry. Table 9.5 (page 202)
shows an example calculation for each ratio.
C. Concentration Measures for the U.S. Economy
1. 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) between 1,000 and 1,800 as moderately competitive, and
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c) above 1,800 as concentrated.
2. Figure 9.2 (page 203) shows the HHI for various industries in
the United States.
D. Limitations of Concentration Measures
1. Concentration measures alone are not sufficient to identify
the market structure of a given industry.
a) 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 (e.g., newspapers, for which
the appropriate market is a city or metropolitan area) or
even larger (e.g., automobiles, for which the pertinent
market can be the entire world).
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b) 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) Firms may be misclassified with respect to their markets.
This is may be true for firms that: i) 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 ii) 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.
2. Table 9.6 (page 203) summarizes the range of other
information used with the concentration ratio to determine
market structure.
E. Market Structures in the U.S. Economy
1. Figure 9.3 (page 205) shows the distribution of market
structures in the U.S. economy.
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2. About three-quarters of the total value of goods and services
produced in the United States is produced in markets that
are characterized by perfect competition or monopolistic
competition.
V. Markets and Firms
A. 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 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.
b) Firms may 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 different
goods at a lower cost than otherwise.
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
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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.