Firm an institution that hires factors of production and organizes those factors to produce and sell goods and services The firm s goal to maximize profit Depreciation the fall in the value of a firm s capital Economic profit equal to total revenue minus total cost measured as the opportunity cost of production Accounting profit total revenue minus explicit cost Normal profit average profit return made by similar firms Opportunity cost of production 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 Resources owned by the firm o The opportunity cost comes from the amount spent on resources i e wool and thread o Firm could sell capital it owns but instead uses it which creates opportunity cost o Implicit rental rate of capital the firm s opportunity cost of using the capital it owns Economic depreciation the fall in the market value of a firm s capital over a given period equals the market price of the capital at the beginning minus the market price of the capital at the end Forgone interest the funds used to buy capital which could have been used for some other purpose which would have earned interest Resources supplied by the firm s owner o Firm s owner might supply both entrepreneurship and labor o Entrepreneurship organizes a firm and makes its decisions Normal profit the cost of entrepreneurship and is an opportunity cost of production o Owner s Labor Services opportunity cost of the owner s labor is the wage income forgone by not taking the best alternative job Decisions A firm must make five decisions to maximize economic profit 1 What to produce and in what quantities 2 How to produce 3 How to organize and compensate its manager and workers 4 How to market and price its products 5 What to produce itself and buy from others The firm s constraints Technology constraints o Technology any method of producing a good or service o Increase in profit that a firm can achieve is limited by the technology available Information constraints o A firm is constrained by limited information about the quality and efforts of its workforce the current and future buying plans of its customers and the plans of its competitors Market constraints o The quantity each 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 Technological efficiency occurs when the firm produces a given output by using the least amount of inputs Economic efficiency occurs when the firm produces a given output at the least cost Depends on the relative costs of resources uses a smaller amount of the more expensive resource and a larger amount of the less expensive resource A technologically inefficient method is never economically efficient Each firm organizes the production of goods and services by combining and coordinating the productive resources it hires using a mixture of two systems Command systems hierarchy Incentive systems o Command system a method of organizing production that uses a managerial o Commands pass downward through the hierarchy and information passes upwards o Incentive system a method of organizing production that uses a market like mechanism inside the firm o Instead of issuing commands senior managers create compensation schemes to induce workers to perform in ways that maximize the firm s profit Firms use a mixture of commands and incentives and they choose the mixture that maximizes profit Firms use commands when it is easy to monitor performance or when a small deviation from an ideal performance is very costly Firms use incentives when it is either not possible to monitor performance or too costly to be worth doing Principal agent problem the problem of devising compensation rules that induce an agent to act in the best interest of a principal i e Steve jobs a principal must induce the designers who work on the next generation iPhone agents to work efficiently agents pursue their own goals and often impose costs on a principal Coping with the principal agent problem Ownership o Making employees owners of a business sometimes induces more productive job performance Incentive pay Long term contracts o Pay related to performance i e a promotion for good performance o Encourages employers to take a long term view of how to maximize company s profit Types of business organization to avoid principal agent problem Proprietorship o Proprietorship a firm with a single owner proprietor who has unlimited liability Unlimited liability the legal responsibility for all the debts of a firm up to an amount equal to the entire wealth of the owner o The proprietor makes management decisions receives the firm s profits and is responsible for its losses Partnership o Partnership a firm with two or more owners who have unlimited liability o Profits of a partnership are taxed as the personal income of the owners but each partner is legally liable for all the debts of the partnership Joint unlimited liability liability for the full debts of the partnership Corporation o Corporation a firm owned by one or more limited liability stockholders many owners Limited liability the owners have legal liability only for the value of their initial investment If the corporation goes bankrupt its owners are not required to use their personal wealth to pay the corporation s debts Type of Firm Proprietorship Pros Partnership Easy to set up Simple decision making Profits taxed only once as owner s income Easy to set up Diversified decision making Can survive withdrawal of partner Profits taxed only once as owner s income Bad decisions not checked Cons Owner s entire wealth at risk Firm dies with owner Cost of capital and labor is higher Achieving consensus may be slow and expensive Owners entire wealth at risk Withdrawal of partner may create capital shortage Corporation Owners have limited liability Large scale low cost capital available Professional management not restricted by ability of owners Perpetual life Long term labor contracts cut labor costs Markets and Competitive Environment Cost of capital and labor is relatively high Complex management structure can make decisions slow and expensive Retained profits taxed twice as company profit and as stockholders capital gains Perfect competition most extreme form of competition o Arises when there are many firms each selling an identical product