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Chapter 7 The Firm. Business Firm. Employs factors of production Produces goods and services Sells to consumers, other firms, or the government We work for and buy from firms. Market. Two sides Buyers Utility is major decision making device Sellers How do they make decisions.
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Business Firm • Employs factors of production • Produces goods and services • Sells to consumers, other firms, or the government • We work for and buy from firms
Market • Two sides • Buyers • Utility is major decision making device • Sellers • How do they make decisions
How do the two sides come together? • Market Coordination • Invisible Hand (Adam Smith) • Market guides individuals into activities at which they are the most efficient • Pushes sellers to produce certain things and buyers to instruct what to produce • Equates supply and demand
How does the firm decide what to produce? • Managerial Coordination • Guides individual firm production decisions • Thus…invisible hand of the firm
Why follow this invisible hand? • Firms are formed because greater benefits of working as a team than working as individuals
Problem with teamwork • Shirking • Putting forth less effort than your originally agreed to • Problem because shirker gains ALL benefits from shirking but costs are spread over the entire team
Can shirking increase or decrease? • Yes!! • As the benefits of shirking increase so does the amount • If the shirker must bear the full cost of shirking then shirking will decrease
How can we decrease shirking? • Manager’s duty or MONITORING • Reward productive workers and punish shirkers • Preserves the benefit of team production • Reduces the benefits of shirking
Who monitors the monitor? • Salary usually tied into production • Called Residual Claimant • Person who shares in the profits of the firm • More shirkers?? Less Production…so less pay for monitor
Another way to ward off shirking? • Pay higher than equilibrium wages • Decreases shirking because cost of losing job is greater. • Don’t need monitor because high wage makes worker monitor themselves • Called efficiency wage theory
Why do people submit to being monitored?? • Monitoring decreases shirking • Monitoring increases benefits of teamwork • Monitoring maximizes benefits that can be achieved
Objective of the firm • Profit Maximization • Now…want to move to the Firm to see how they achieve this objective
Chapter 8Production and Costs © South-Western College Publishing 1998
Cost Side • Explicit Cost • Actual money is exchanged • COST • Implicit Cost • Value of resources used in the production or acquisition of a good • No monetary payment • OPPORTUNITY COST
Sacrifice • In order to have a cost, sacrifice must have taken place • Forfeited something else • No money must change hands for sacrifice to take place
Profit • Two types • Accounting • Difference between total revenue and explicit costs • Acct Profit = TR – EXPLICIT COSTS • Economic • Difference between total revenue and total cost (implicit and explicit) • Econ Profit = TR – Explicit Cost – Implicit Cost
Which do you think is lower?? • Economic Profit • Usually lower but never higher • How can it be “usually” lower? • Implicit cost can equal 0 so accounting and economic profit would be equal
Zero Economic Profit • Total Revenue-explicit cost-implicit costs = 0 • Also called NORMAL PROFIT • Equilibrium of profit for the firm • Would we want zero accounting profit? • NO!!! Implicit costs would not be covered
Sunk versus Fixed Costs • Sunk • Incurred in the past • Cannot be changed by a current decision • Cannot be recovered • Example: Time spent in school • Can’t recover so let it go…Release it • Fixed • Possibility of recovering some money for selling the good • Example: Land, equipment…
Production • Takes time to produce • Costly to produce • Direct link between production, costs, and time
Two types of time • Short Run • Fixed and variable inputs • Long Run • All inputs are variable
Short Run • Fixed input • Quantity can not be changed • Independent of output produced • Example: Building, land… • Variable input • Quantity can be changed as output changes • Example: Labor
Costs • Fixed Cost (FC) • Associated with fixed inputs • Do not change with output • Example: Insurance premiums • Variable Costs (VC) • Associated with variable inputs • Changes as output changes • Example: Hire more people and must pay more wages
Total Costs • Variable Cost + Fixed Cost
Other costs of importance… • Average Variable Cost (AVC) • Average Fixed Cost (AFC) • Average Total Cost (ATC)
Marginal Cost • Change in TC that results from a change in output • Additional cost of producing an additional unit of output
Why Change in Total Cost or Total Variable Cost???? • Since total fixed cost doesn’t change the “additional” total fixed cost is zero
Shapes of Curves • Law of diminishing marginal returns • As larger amounts of a variable input are combined with fixed inputs eventually the Marginal Physical Product (MPP) declines
Marginal Physical Product (MPP) • What is the variable input? • What is the variable cost?
So… • As more labor (VARIABLE INPUT) are added to land (FIXED INPUT) the variable inputs would yield smaller and smaller additions to output
Crowding Problem • The point at which MPP declines • Shows the law of diminishing returns
Average Physical Productivity • Output divided by Inputs (usually labor) • Good for comparing firms or countries.
So find that… • MC and MPP are related • What is the relationship?
Does this relationship make sense? • Yes.. • If productivity increases what would happen to costs?? • Decrease (MPP increase & MC decrease) • Productivity decreases?? • Increase (MPP decreases & MC increases)
MPP determines shape of MC • MPP must have a declining part because of diminishing returns • Can also define MC as:
