Chapter 8- Costs and the Supply of GoodsChapter 8- Costs and the Supply of GoodsI. The Organization of the Businessa. A business firm is an entity designed to organize raw materials, labor and machines with the goal of producing goods/servicesb. Firms…i. Purchase productive resources from households and other firmsii. Transform them into a different commodityiii. Sell the new product to consumersc. Incentives, Cooperation, and the Nature of the Firmi. 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 over costs1. These people gain if the firm’s costs are reduced or revenues increase.iii. Two ways of organizing productive activity:1. Contractinga. Expanding rolls to peopleb. 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.2. Team productiona. Team Production: a production process in which employees work together under the supervision of the owner or the owner’s representativeb. The employment of workers operating under the supervisionof the owner or their rep. c. Team members must be monitored and given incentives to avoid shirkingi. Shirking: working less than the expected rate of productivity. 1. Example: taking long breaks, not paying attention, wasting timed. 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. Asa result, the mechanic may not act in best interest of the customer (the principal)d. Three Types of Business Firmsi. 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 debts1. The owner usually works directly for the firm- managerially and laborii. 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 partnershipiii. 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 Corporationa. 3 major factors in a market economy promote cost efficiency and customer servicei. Competition among firms for investment funds and for customersii. Compensation and management incentives. iii. The threat of corporate takeoverb. How well does the corporation structure work?i. Corporation is generally a cost-efficient, consumer-sensitive form of organizationIII. The Economic Role of Costsa. The demand for a product represents the voice of consumers instructing firms toproduce the good. b. A firm’s costs represent the desire of consumers not to sacrifice goods that couldbe produced if the same resources were employed elsewhere. c. Calculating Economic Costs & Profitsi.profit=fir m'stotal revuene−totalcosts1. 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 resourcesi. Money that is going outii. Example: money wages, interest and rental paymentsb. Implicit: opportunity cost associated with the firm’s use of resources that it ownsi. Money that could have come inii. Example: foregone interest, forgone wagesii. Total Cost: the cost of explicit and implicit of all resources1. Includes a normal rate of return for the firm’s equity capitaliii. Opportunity cost of equity capital: the rate of return that must be earned by investors to induce them to supply financial capital to the firm1. Example: rate of return is 10% investors will not continue to supply equity capital unless they can earn this normal returnd. 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 costs1.Economic Profit=Total Revenues−Total Costii. Normal Profit Rate: Zero economic profit, just the competitive rate of return on the capital (and labor) of owners1. Zero economic profita. 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 capital3. A higher rate would draw more competitors and their investors into their markets4. A lower would cause them to exitiii. Accounting Profits: the sales revenues minus the expenses of a firm over a designated time period. IV. Short-Run and Long-Run Time Periodsa. Time plays an important role in productionb. Short run: a time period so short that a firm is unable to vary some of its factors of productioni. Plant size cannot be alteredii. Some assets are fixed, others are variable1. Applying larger or smaller amounts of variable resources can alter outputiii. Short run is that period of time during which at least one factor of production (about the size of the plant) cannot be changed1. Example: a trucking firm could hire more drivers or buy/rent more trucks and double its hauling capacity in a few monthsc. Long Run: a time period long enough to allow the firm to vary all of its factors of productioni. a time period long enough for existing firms to alter the size of their plants and for new firms to enter/exit the marketii. ALL the firms resources are variableV. Categories of Costsa. Costs can be…i. Variableii. Fixediii. Average costs: a firm’s total costs and its per-unit costb. 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/fallsiii. 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 businessc. Average Fixed Cost (AFC):
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