PARKIN

ECONOMICS
Thirteenth Edition, Global Edition
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

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 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.

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 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.

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 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.

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 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

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 The Firm and Its Economic Problem

Resources Bought in the Market

The firm incurs an opportunity cost when it buys resources
in the market.
The firm incurs an opportunity cost of production because
the firm could have bought different resources to produce
some other good or service.

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 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.

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 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.

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 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.

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 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.

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The Firm and Its Economic Problem

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 The Firm and Its Economic Problem

The Firm’s 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

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 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

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 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.

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 The Firm and Its Economic Problem

Information Constraints
A firm never possesses complete information about either
the present or the future.
The firm 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.

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 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.

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 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 technologically
efficient.
If it is impossible to produce a given good by decreasing
any one input, holding all other inputs constant, then
production is technologically efficient.

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 Technological and
Economic Efficiency
Economic Efficiency
Economic efficiency occurs when the firm produces a
given quantity of output at the least cost.
The economically efficient method depends on the relative
costs of capital and labor.
The difference between technological and economic
efficiency is that technological efficiency concerns the
quantity of inputs used in production for a given quantity of
output, whereas economic efficiency concerns the cost of
the inputs used.

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 Technological and
Economic Efficiency
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.
Table 10.3 on the next slide illustrates.

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 Information and Organization

A firm organizes production by combining and coordinating

productive resources using a mixture of two systems:
 Command systems
 Incentive systems

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 Information and Organization

Command Systems
A command system uses a managerial hierarchy.
Commands pass downward through the hierarchy and
information (feedback) passes upward.
These systems are relatively rigid and can have many
layers of specialized management.

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 Information and Organization

Incentive Systems
An incentive system is a method of organizing production
that uses a market-like mechanism to induce workers to
perform in ways that maximize the firm’s profit.

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 Information and Organization

Mixing the Systems

Most firms use a mix of command and incentive systems
to maximize profit.
They use commands when it is easy to monitor
performance or when a small deviation from the ideal
performance is very costly.
They use incentives whenever monitoring performance is
impossible or too costly to be worth doing.

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 Information and Organization

The Principal–Agent Problem

The principal–agent problem is the problem of devising
compensation rules that induce an agent to act in the best
interests of a principal.
For example, the stockholders of a firm are the principals
and the managers of the firm are their agents.
For example, Mark Zuckerberg (a principal) must induce
the designers who are working on the next generation
Facebook (agents) to work efficiently.

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 Information and Organization

Coping with the Principal–Agent Problem

Three ways of coping with the principal–agent problem are
 Ownership
 Incentive pay
 Long-term contracts

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 Information and Organization

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.
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 principals.
Long-term contracts can tie managers’ or workers’ long-
term rewards to the long-term performance of the firm.
This arrangement encourages the agents to work in the
best long-term interests of the firm owners, the principals.

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 Information and Organization

Types of Business Organization

There are three types of business organization:
 Proprietorship
 Partnership
 Corporation

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 Information and Organization

Proprietorship
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.

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 Information and Organization

Partnership
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.

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 Information and Organization

Corporation
A corporation is owned by one or more stockholders with
limited liability, which means the owners have legal liability
only for the initial value of their investment.
The 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 after-tax profits
distributed as dividends.

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 Information and Organization

Pros and Cons of Different Types of Firms

Each type of business organization has advantages and
disadvantages.
Table 10.4 and the following slides summarize the pros
and cons of different types of firms.

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 Information and Organization

Proprietorships
 Are easy to set up
 Managerial decision making is simple
 Profits are taxed only once as owner’s income
 But 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
 The cost of capital and labor can be high

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 Information and Organization

Partnerships
 Are easy to set up
 Employ diversified decision-making processes
 Can survive the withdrawal of a partner
 Profits are taxed only once
 But achieving a consensus about managerial decisions
is difficult
 Owners’ entire wealth is at risk
 Capital is expensive and withdrawal may create a
shortage
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 Information and Organization

Corporation
 Limited liability for its owners
 Large-scale and low-cost capital that is readily available
 Professional management
 Lower costs from long-term labor contracts
 But complex management structure can make decisions
slow and expensive
 Profits taxed twice—as corporate profit and shareholder
income.

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 Markets and the
Competitive Environment
Economists identify four market types:
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly

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 Markets and the
Competitive Environment
Perfect competition is a market structure with
 Many firms and many buyers
 All firms sell an identical product
 No restrictions on entry of new
firms to the industry
 Both firms and buyers are all well
informed about the prices and
products of all firms in the industry.
Examples include world markets
in wheat, corn, and other grains.

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 Markets and the
Competitive Environment
Monopolistic competition is a market structure with
 Many firms
 Each firm produces similar but
slightly different products—called
product differentiation
 Each firm possesses an
element of market power
 No restrictions on entry of
new firms to the industry

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 Markets and the
Competitive Environment
Oligopoly is a market structure in which
 A small number of firms compete.
 The firms might produce almost
identical products or differentiated
products.
 Barriers to entry limit entry into the
market.

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 Markets and the
Competitive Environment
Monopoly is a market structure in which
 One firm produces the entire output of the industry.
 There are no close substitutes for the product.
 There are barriers to entry that protect the firm from
competition by entering firms.
 Monopolies can be local such
as gas and water suppliers or
global such as the wholesaler
of designer brand sunglasses.

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 Markets and the
Competitive Environment
To determine the market structure of an industry,
economists measure the extent to which a small number
of firms dominate the market.
Measures of Concentration
Economists use two measures of market concentration:
The four-firm concentration ratio
The Herfindahl–Hirschman index (HHI)

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 Markets and the
Competitive Environment
The Four-Firm Concentration Ratio
The four-firm concentration ratio is the percentage of the
total industry sales accounted for by the four largest firms
in the industry.
The Herfindahl–Hirschman Index
The Herfindahl–Hirschman Index (HHI) is the square of
percentage market share of each firm summed over the
largest 50 firms in the industry (or all firms if fewer than 50).
As market concentration increases, the amount of
competition in the industry decreases.

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 Markets and the
Competitive Environment
Limitations of a Concentration Measure
The main limitations of only using concentration measures
as determinants of market structure are
 The geographical scope of the market
 Barriers to entry and firm turnover
 The correspondence between a market and an industry

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 Produce or Outsource?
Firms and Markets
To produce any good or service factors of production must
be hired and their activities coordinated.
Firm Coordination
Firms hire labor, capital, and land, and by using a mixture
of command systems and incentive systems they organize
and coordinate their activities to produce goods and
services.

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 Produce or Outsource?
Firms and Markets
Market Coordination
Markets coordinate production by adjusting prices and
making the decisions of buyers and sellers of factors of
production and components consistent.
Chapter 3 explains how demand and supply coordinate
the plans of buyers and sellers.
Outsourcing—buying parts or products from other firms—
is an example of market coordination of production.
But firms coordinate more production than do markets.
Why?

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 Produce or Outsource?
Firms and Markets
Why Firms?
Firms coordinate production when they can do so more
efficiently than a market.
Four key reasons might make firms more efficient. Firms
can achieve
 Lower transactions costs
 Economies of scale
 Economies of scope
 Economies of team production

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 Produce or Outsource?
Firms and Markets
Transactions costs 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.
Economies of scale occur when the cost of producing a
unit of a good falls as its output rate increases.
Economies of scope arise when a firm can use
specialized inputs to produce a range of different goods at
a lower cost than otherwise.
Economies of team production arise when labor works
as a team, specializing in mutually supporting tasks.

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