10 ORGANIZING PRODUCTION After studying this chapter you will be able to Explain the economic problem that all firms face Distinguish between technological efficiency and economic efficiency Define and explain the principal agent problem Distinguish among different types of markets Explain why markets coordinate some economic activities and why firms coordinate others 2014 Pearson Addison Wesley The invention of the World Wide Web has paved the way for the creation of thousands of profitable businesses such as Facebook Apple and Google Most of the firms don t make the things they sell They buy them from other firms For example Apple doesn t make the iPhone Intel makes its memory chip and Foxconn assembles the iPhone Why doesn t Apple make its iPhone How do firms decide what to make themselves and what to buy from other firms How do the millions of firms around the world make their business decisions 2014 Pearson Addison Wesley 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 Firm s Goal A firm s goal is to maximize profit If the firm fails to maximize its profit the firm is either eliminated or taken over by another firm that seeks to maximize profit 2014 Pearson Addison Wesley The Firm and Its Economic Problem Accounting Profit Accountants measure a firm s profit to ensure that the firm pays the correct amount of tax and to show it investors how their funds are being used Profit equals total revenue minus total cost Accountants use Internal Revenue Service rules based on standards established by the Financial Accounting Standards Board to calculate a firm s depreciation cost 2014 Pearson Addison Wesley The Firm and Its Economic Problem Economic Accounting Economists measure a firm s profit to enable them to predict the firm s decisions and the goal of these decisions is to maximize economic profit Economic profit is equal to total revenue minus total cost with total cost measured as the opportunity cost of production 2014 Pearson Addison Wesley The Firm and Its Economic Problem A Firm s Opportunity Cost of Production A firm s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production A firm s opportunity cost of production is the sum of the cost of using resources Bought in the market Owned by the firm Supplied by the firm s owner 2014 Pearson Addison Wesley The Firm and Its Economic Problem Resources Bought in the Market The amount spent by a firm on resources bought in the market is an opportunity cost of production because the firm could have bought different resources to produce some other good or service 2014 Pearson Addison Wesley The Firm and Its Economic Problem Resources Owned by the Firm If the firm owns capital and uses it to produce its output then the firm incurs an opportunity cost The firm incurs an opportunity cost of production because it could have sold the capital and rented capital from another firm The firm implicitly rents the capital from itself The firm s opportunity cost of using the capital it owns is called the implicit rental rate of capital 2014 Pearson Addison Wesley The Firm and Its Economic Problem The implicit rental rate of capital is made up of 1 Economic depreciation 2 Forgone interest Economic depreciation is the change in the market value of capital over a given period The interest forgone is the return on the funds used to acquire the capital 2014 Pearson Addison Wesley The Firm and Its Economic Problem Resources Supplied by the Firm s Owner The owner might supply both entrepreneurship and labor The return to entrepreneurship is profit The profit that an entrepreneur can expect to receive on average is called normal profit Normal profit is the cost of entrepreneurship and is an opportunity cost of production 2014 Pearson Addison Wesley The Firm and Its Economic Problem In addition to supplying entrepreneurship the owner might supply labor but not take a wage The opportunity cost of the owner s labor is the wage income forgone by not taking the best alternative job Figure Economic Accounting A Summary Economic profit equals a firm s total revenue minus its total opportunity cost of production The example in Table 10 1 on the next slide summarizes the economic accounting 2014 Pearson Addison Wesley The Firm and Its Economic Problem 2014 Pearson Addison Wesley The Firm and Its Economic Problem Decisions To maximize profit a firm must make five basic decisions 1 What to produce and in what quantities 2 How to produce 3 How to organize 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 2014 Pearson Addison Wesley The Firm and Its Economic Problem The Firm s Constraints The firm s profit is limited by three features of the environment Technology constraints Information constraints Market constraints 2014 Pearson Addison Wesley 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 2014 Pearson Addison Wesley 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 2014 Pearson Addison Wesley 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 that a firm incurs to overcome these market constraints limit the profit that the firm can make 2014 Pearson Addison Wesley Technological and Economic Efficiency Technological Efficiency Technological efficiency occurs when a firm uses the least amount of inputs to produce a given quantity of output Different combinations of inputs might be used to produce a given good but only one of them is