Chapter 8 Costs and the Supply of Goods I The Organization of the Business a A business firm is an entity designed to organize raw materials labor and machines with the goal of producing goods services b Firms i Purchase productive resources from households and other firms ii Transform them into a different commodity iii Sell the new product to consumers c Incentives Cooperation and the Nature of the Firm i The property right of owners to the residual income of the firm plays a very important role It provides owners with a strong incentive to organize and operate their business in a manner that will maximize the value of their output to consumers while keeping the cost of producing output low ii Residual Claims individuals who personally receive the excess of revenues 1 These people gain if the firm s costs are reduced or revenues over costs increase 1 Contracting iii Two ways of organizing productive activity 2 Team production a Expanding rolls to people b Example a contractor has a house build by contracting with one person to pour the concrete another to construct the wooden part third to install the roof etc a Team Production a production process in which employees work together under the supervision of the owner or the owner s representative b The employment of workers operating under the supervision of the owner or their rep c Team members must be monitored and given incentives to avoid shirking productivity i Shirking working less than the expected rate of 1 Example taking long breaks not paying attention wasting time d Principal Agent Problems the incentive problem that occurs when the purchaser of services lacks full information about the circumstances i Example Going to a mechanic to get a car fixed The mechanic the agent typically knows more and it s hard for the customer to monitor what he is doing As a result the mechanic may not act in best interest of the customer the principal d Three Types of Business Firms i Proprietorship a business firm owned by an individual who possesses the ownership right to the firm s profits and is personally liable for the firm s debts 1 The owner usually works directly for the firm managerially and labor ii Partnership A business firm owned by two or more individuals who possess ownership rights to the firm s profits and are personally liable for them 1 Same liability as partnership iii Corporation a business firm owned by shareholders who possess ownership rights to the firm s profits but whose liability is limited to the amount of their investment in the firm 1 The limited liability makes it possible for corporations to attract investment funds from a large number of owners II Costs Competition and the Corporation a 3 major factors in a market economy promote cost efficiency and customer service i Competition among firms for investment funds and for customers ii Compensation and management incentives iii The threat of corporate takeover b How well does the corporation structure work i Corporation is generally a cost efficient consumer sensitive form of III The Economic Role of Costs a The demand for a product represents the voice of consumers instructing firms to organization produce the good b A firm s costs represent the desire of consumers not to sacrifice goods that could be produced if the same resources were employed elsewhere c Calculating Economic Costs Profits i profit fir m stotal revuene total costs 1 cost is NOTTTT the amount paid for raw materials 2 costs can be a Explicit payments by a firm to purchase the services of productive resources i Money that is going out ii Example money wages interest and rental payments b Implicit opportunity cost associated with the firm s use of resources that it owns i Money that could have come in ii Example foregone interest forgone wages ii Total Cost the cost of explicit and implicit of all resources 1 Includes a normal rate of return for the firm s equity capital iii Opportunity cost of equity capital the rate of return that must be earned by investors to induce them to supply financial capital to the firm 1 Example rate of return is 10 investors will not continue to supply equity capital unless they can earn this normal return d How Do Economic and Accounting Profit Differ i Economic Profit the difference between the firm s total revenues and its total costs including explicit and implicit costs 1 Economic Profit Total Revenues Total Cost ii Normal Profit Rate Zero economic profit just the competitive rate of return on the capital and labor of owners 1 Zero economic profit a Does NOT mean the business is failing 2 An above normal profit will draw more entry into the market whereas a below normal profit will lead to an exit of investors and capital 3 A higher rate would draw more competitors and their investors into their markets 4 A lower would cause them to exit iii Accounting Profits the sales revenues minus the expenses of a firm over a designated time period IV Short Run and Long Run Time Periods a Time plays an important role in production b Short run a time period so short that a firm is unable to vary some of its factors of production i Plant size cannot be altered ii Some assets are fixed others are variable 1 Applying larger or smaller amounts of variable resources can alter output iii Short run is that period of time during which at least one factor of production about the size of the plant cannot be changed 1 Example a trucking firm could hire more drivers or buy rent more trucks and double its hauling capacity in a few months c Long Run a time period long enough to allow the firm to vary all of its factors of production i a time period long enough for existing firms to alter the size of their plants and for new firms to enter exit the market ii ALL the firms resources are variable V Categories of Costs a Costs can be i Variable ii Fixed iii Average costs a firm s total costs and its per unit cost b Total Fixed Cost TFC the sum of the costs that do not vary with output i Will be incurred as long as firm continues in business and the assets have alternative uses ii Will be remain unchanged when output rises falls iii Example a firm s insurance premiums property taxes all are fixed costs won t rise with increase production and can only be avoided if firm goes out of business c Average Fixed Cost AFC total fixed cost divided by number of units produced i It always declines as output increases 1 Because the cost will spread out over more units d Total Variable Cost TVC the
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