ORGANIZATION OF THE BUSINESS FIRM

What do firms (like GM) do?
1. Purchase inputs from households and other firms (labor, materials, etc.)
2. Transform economic inputs into outputs (finished goods)
3. Sell the output to consumers (or other firms)

Firms in a market economy are privately owned and guided by the price system and the profit-los system (3 Ps of a market economy: Private property, Prices and Profit/loss).  Goal of the firm: Maximize Profits or Maximize Shareholder Wealth.

Owners (shareholders) of a firm are called "residual claimants."  Owners have a "residual" claim to the net income, only after all other expenses are paid: wages, cost of goods sold, interest, taxes, etc.  They get what is left over.  Also, if a firm is liquidated, the owners are last on the list in the order of payment priority, a residual claim to the assets of the firm after all other parties have been paid: workers, IRS, banks, suppliers, bondholders, etc.

Wealth of the owner is tied to costs.  The more efficiently the business operates, the more productive the firm is, the greater the profits.  Owners have an incentive to produce as efficiently/productively as possible, use resources as efficiently as possible.  Max Output and Min Inputs = Max Efficiency.

Two ways to produce: 1) Contracting (Outsourcing) or 2) Team Production (permanent workers are hired to work together under the supervision of the owner).  Firms typically use a combination of Contracting and Team Production, based on comparing the cost of Internal Production vs External Production (outsourcing).   Examples: Advertising, Accounting, Legal Services.  Is it cheaper for a firm to have its own advertising dept, accounting dept, legal dept, or is it cheaper to contract (outsource) these services?

Building Contractor?  Should he/she hire a full-time staff of carpenters, plumbers, painters, drywall workers, cement workers, electricians?  Or should some or all of these be contracted out?  Requires a comparison of the costs.

Costs of contracting/outsourcing?
1. Determine what services are needed.
2. Search out potential suppliers (set up a bidding process)
3. Negotiate and enforce the contracting contract.

Are these costs of contracting more or less than the costs of team production?

Costs of team production?  In team production, it might not be possible to accurately assess individual production.  Possible employee "shirking" - loafing, not working hard, taking long breaks, wasting materials, making personal phone calls on company time, etc. Owners want to minimize shirking, requires: 1) monitoring of employees and 2) incentive system to minimize shirking.  Examples of incentive compatible contracts, to align the interests of workers and owners???   Since perfect monitoring and perfect incentives are not possible, there is always a cost to team production.

Shirking is part of more general problem called the "Principal-Agent Problem."  We are principals when we hire someone, an agent,  to do something for us, e.g. you hire a lawyer, accountant, realtor, mechanic, headhunter to work for you as an agent.  Their interests may not always be perfectly aligned with yours.  In business, the principal-agent problem may arise due to the "separation of ownership and control" of large corporations.  The owners (principals/shareholders) hire the managers (agents) to run the company, and there is a separation between those who own the company (thousands of shareholders) and those who run the company (managers) in a team production format.  Managers may shirk, and take advantage of the shareholders/owners/agents.  How to motivate the managers and minimize shirking???
 

THREE TYPES OF BUSINESS FIRM ORGANIZATION

To start a business, you would have to operate as one of three legal organizations: Proprietorship, Partnership and Corporation.

PROPRIETORSHIP - 74% of all firms in U.S. are sole proprietorships.  Self- employed workers: piano tuners, small business owners, small family business, plumbers, attorneys, accountants, consultants, farms, barbershops, etc.  Advantage: easy to set up a business this way.  Disadvantage: Unlimited liability, Hard to raise large amounts of capital to expand.  Many firms start this way, and eventually become partnerships or corporations to expand.

PARTNERSHIP - Two or more partners acting as co-owners.  Partners have unlimited liability for business debts, lawsuits, etc.  7% of firms are organized as partnerships.  Common for physicians, accounts, lawyers, consultants, etc.

CORPORATION - Less than 20% of the number of firms, but corporations have 90% of Sales Revenue.  See page 183.  Advantages of corporations:

1. Limited liability, makes it easy to raise large amts of capital.  Example: you own 100 shares of GM, and GM gets sued.  You could lose your entire investment, but your personal assets are not at stake.

2. Easy to transfer ownership, just sell shares of stock if you are unhappy with company.

3. Unlimited Life of a corporation.

Possible Disadvantages of Corporations:

Large companies have a large, diverse group of shareholders all over the world.  Ownership is diluted.  Separation of Ownership-Control.  May be hard for the shareholders to monitor managers.  What to do?  See page 185.

1. Competition with other firms will limit shirking.
2. Compensation can be structured to limit shirking.  Bonuses, profit sharing, stock options, etc.
3. Threat of a hostile takeover - discipline of last resort.

Conclusion: Despite its defects, the corporation is generally a cost-efficient, consumer-sensitive organization.
 

ECONOMIC ROLE OF COSTS

Consumer Demand is the voice of consumers telling producers what we want.  The production cost of a good reflects the value of the resources used to produce, in term of the opportunity cost - the value of the other opportunities to make other goods that have been foregone.  Example: if gold is used to for dental fillings, it has to be "bid away" from the other uses - jewelry, gold coins, gold plating, etc.  If gold is used for jewelry, it has to bid away from other uses, etc.  Point: Production costs reflect opportunity costs.
 

ECONOMIC COSTS AND PROFITS

TOTAL ECONOMIC COSTS = EXPLICIT COSTS (ACCOUNTING)  + IMPLICIT COSTS (OPPORTUNITY)

Explicit costs: wages, interest, taxes, supplies, materials, insurance, licenses, fees.
Implicit costs: foregone opportunities.  Example, page 189.

Terry quits his $28,000 job at Safeway to start his own business with $30,000 of personal savings in a commercial building that he inherited (it is fully paid for).  Opportunity costs for Terry include: a) $3000 of foregone interest that he would have gotten if his $30,000 was in the bank getting 10% interest, b) $6000 of foregone rental income that he could have gotten if he had rented out his building and c) $28,000 of foregone income if he had kept his job and not quit to start a business.

Accounting vs Economic Profit is illustrated in the example on p. 189.

Accounting (explicit) Profit = TOTAL REVENUE - EXPLICIT COSTS =
$85,000 - $50,000 = $35,000.

Economic Profit = TOTAL REVENUE - TOTAL COSTS =
$85,000 - $87,000 ($50,000 + $37,000 Implicit Costs) = -$2000 LOSS

IMPORTANT POINT: ZERO ECONOMIC PROFITS IS NORMAL.  When accounting profits are zero, the firm is just breaking even, may be in danger of going out of business.  Zero economic profits generally means positive accounting profits, but when taking into account opportunity costs, economic profits can be zero.  Means that all resource owners are getting a normal, risk-adjusted rate of return.  Positive economic profits means abnormally high profits, which will attract entry and competition, bidding profits back down to normal level.

SHORT RUN AND LONG RUN for PRODUCTION

Short run - time period where major changes in production (expansion or contraction) are not possible, because at least one factor of production (input) cannot be changed.  Inputs: machinery, plant size, labor force, raw materials.
Long run - time period long enough to make major changes in output, major expansion, major contraction. All factors of productions (inputs) are variable in the long run.
 

OUTPUT AND COSTS IN THE SHORT RUN

We look at various short run costs (SR) of production, in relation to the level of output (Q), assuming that certain factors (like the size of the plant) are fixed in the SR.
See page 191 for a summary of SR production costs.  Even without detailed knowledge of the specific industry/production process, we know something about a firm's costs, assuming profit maximization.

Costs can be either: FIXED (not dependent on Q) or VARIABLE (dependent on Q).

We also look at three types of costs: TOTAL, MARGINAL and AVERAGE.

TFC (total fixed cost) = Total of all costs that DO NOT vary with Q (level of output).  Even if Q=0, there are certain costs to the firm, e.g. property taxes, insurance premiums, interest expense, licenses, opportunity costs of capital tied up in the firm (very significant).  The only way to avoid the fixed costs is to go out of business.  See graph.

AFC (average fixed cost) per unit = TFC / Q.  As output expands (Q goes up), the fixed costs are spread over increasing units of output, so AFC declines, see graph.

TVC (total variable costs) TVC = f (Q).  Variable costs vary with the level of output, if Q goes up, VC go up.  Examples of variable costs are labor, raw materials, parts, supplies, etc.  Example: real estate construction.  Depending on how many houses (Q) need to be built, the owner/manager hires workers and orders materials.

AVC (average variable cost) per unit, = TVC / Q, total variable cost divided by the number of units produced.

TC (total cost) = TFC (total fixed cost) + TVC (total variable cost)

ATC (average total cost) per unit = TC (total cost) / Q, unit cost.

MC (marginal cost) = dTC (total cost) / dQ, the change (d) in TC with a one unit change (d) in output, the cost of producing one additional (marginal) unit of output.  Firms want to maximize profits, and they compare MR (marginal revenue) and MC (marginal costs).  If MR > MC, then profits increase.  Example: NWA cyberfares.

See page 191, panel B, q = plant capacity.  For awhile, MC decline, due to economies of scale, cost efficiencies, etc. but then MC start to rise.  Why?  At some point the firm's costs rise at they approach plant capacity - pay overtime, add a second or third shift, hire inexperienced workers, pay higher costs for overnight delivery to get supplies, machinery breaks down due to overuse, etc.

How does average cost per unit (ATC) vary as output expand?  See panel C on page 191.  ATC is usually U-shaped.  Why?  Think of why ATC is high.  At low levels of output, the plant is underutilized.  AFC is very high since TFC are being spread over very few units of output, resulting in high ATC.  At very high levels of output, AFC is declining, but MC is rising, raising ATC, plant is over utilized.

Does the firm want to produce output to minimize ATC?  Not necessarily.
 

DIMINISHING RETURNS AND PRODUCTION IN SR

Law of Diminishing Marginal Returns - Economic law of production.  What happens to Q (total output) as one variable input increases?  Law says: as a variable input (e.g. labor) is increased (holding other inputs constant), output will first increase at an increasing rate (increasing returns to scale), then output will increase a decreasing rate (decreasing returns to scale) and then output will eventually start to decrease (negative returns to scale).

Increasing economies of scale, then decreasing economies of scale, and eventually negative economies of scale.

Example: Picking strawberries, where Q = total output, # of ripe strawberries picked per day and labor is the variable input.  You start off with one worker (x = 1).  You then double the workforce to 2 and you more than double output.  You double again labor force to 4 and more than double output, i.e. increasing returns to scale.  Why?  They keep each other company, they teach each other picking tips, they compete with each other to pick the most, team production is more efficient, they could specialize in picking/washing/packaging, etc.

Then you double the workforce from 4 to 8, and output goes up by LESS than 2X.  Decreasing returns to scale.  Output is still increasing, but at a decreasing rate.  Reason: There may be only a certain number of ripe strawberries per day.  Inefficiencies start to set in.

Then at some point, you double the workforce and output actually falls, i.e. negative returns to scale.  Reason: too many workers for the job, they start getting in each other's way, etc.  See page 194 and 195.

TP (total product) = total output, # units produced.

MP (marginal product) = (d TP / d x), the change in TP with a one unit change in the variable input (x = labor).

AP (average product) = TP / x, Total Product divided by the units of the inputs required to produce a level of output.

We add one additional unit of labor at a time, and observe what happens to Total Product (Output).  Up to 9 units, TP increases.  At 10 units of labor, TP declines, negative returns to scale.  Up to 3 units of labor, MP is increasing, indicating increasing returns to scale.  Output is increasing at an increasing rate.

From 3-9 units of labor, TP (Q) is increasing but at a decreasing rate.  As we keep adding one additional unit of labor, the MP falls, from 14 to 12 to 10 to 8 to 6 to 4 to 1, because of Diminishing Marginal Returns,  sets in after 3 units of labor.  Output is increasing but at a decreasing rate.

Average Product reaches a maximum at 4 units of labor.
 

DIMINISHING RETURNS AND COST OF PRODUCTION

While a firm is experiencing increasing returns to scale, output is increasing at a faster rate than inputs, resulting in declining marginal costs (MC) of production.  Inputs (labor) double and labor costs double, but output more than doubles, indicating falling costs of production in that range of output.  When diminishing returns set in, marginal costs start to rise, because of decreasing returns to scale.  Inputs double, costs of labor double, but output goes up by less than 2X, so that MC (cost of producing additional units) rises.

Example page 196.  MC is falling between 1-4 units of output, due to increasing returns to scale.  Above 4 units of output, diminishing returns to scale set in, resulting in rising MC.  ATC is minimized at Q=7.

POINT: Increasing returns result in falling MC, Diminishing returns to scale result in rising MC.
 

OUTPUT AND COSTS IN THE LONG RUN

All resources (inputs) used by firm are VARIABLE in the long run (LR), including plant size.  See page 198.  Firms considers three plant sizes, small-med- large, resulting in three ATC curves (ATC1, ATC2, ATC3).  The curve ABCD would be the LR planning curve for the firm.  If q1 was the expected output, the smallest plant would be the best plant.  If output was expected to be between q1 - q2, then the medium plant would be best, if output was > q2, the large plant would be best.

If more than three plant sizes were being considered, then the LRATC curve would be as shown on page 199.
 

SIZE OF FIRM AND ATC IN LR

Are larger firms always more efficient (lower ATC) than small firms?  It depends.  Large scale production can result in Economies of Scale (falling ATC as output expands), but may eventually result in Diseconomies of Scale (rising ATC as output expands).

Mass production, assembly line production, and specialization results in economies of scale/increased efficiency - e.g automobile production, university education, large farms.  Spreading fixed costs of operation over large number of units/students.

However, large organizations can run into Diseconomies of Scale.  Bureaucratic procedures, inefficiencies of large organizations, harder to coordinate large organizations, harder to monitor employees, lack of innovation/entrepreneurship, etc.  See page 202 for three types of LRATC.

Panel a - ideal plant is one size only, beyond q (ideal output), diseconomies set in.

Panel b - more realistic, there is a wide range of possible ideal plant sizes.  Constant returns to scale are present for a broad range of outputs.  Smaller firms competing successfully with large firms, e.g. small banks and large banks, retailing (Hudson's vs small boutique), discount stores (low prices, high volume) vs speciality stores (high level of service, low volume), Meijers vs Oliver Ts, small micro-breweries vs Miller beer.

Panel c - largest size plant is ideal.  Even the largest plant size doesn't fully exploit economies of scale.  Example: public utilities, telephone, electric, gas service.
 

WHAT CAUSES COST CURVES TO SHIFT?

Same factors that cause supply curves to shift.  Supply curves = entire market, Cost curves = firm.  Three factors: Resource (input) prices, Taxes, Technology.
Anything that makes it more (less) expensive to produce will shift the MC and ATC up (down) and to the left (right).  Page 203, input prices rise.  Page 204, technological advancement improves productivity/efficiency.
 

SUNK (HISTORICAL) COSTS

Cost that have already been incurred and cannot be reversed, the money has been spent.  Sunk costs are irrelevant for decision making.

Example: You buy a license for $500 to rent a stall at the Flint Farmers Market for one month to sell oranges.  You find out after you pay the fee that you can buy oranges for $1 and sell oranges for $2, making a profit of $1/orange, but you can only expect to sell 300 oranges during the month.  Overall, you will lose $200 ($500-$300). What should you do?   The $500 is a sunk cost and is irrelevant to the decision since it can't be avoided.  You should just look at the variable costs.

Current choices must be based on the costs and benefits in relation to current and future market conditions.  Before you spent the $500 the cost was relevant, but after you bought the license the $500 is gone for good, and is now irrelevant.

Example: A restaurant does a good dinner business.  Should the restaurant open for lunch even if business is slow?  Many of the costs of running the business are fixed and sunk - the rent, the equipment, the licenses and fees, property taxes, insurance - so they should NOT be considered in the decision.  What should be considered?
 

COSTS AND SUPPLY

Two Points: 1. In the SR, MC are important.  The profit-maximizing firm should compare MR vs. MC.  If MR > MC, then the firm should take the order or expand output.  NWA and cyberfares.

2. In the long run, LRATC is important, especially P vs ATC.  If P > LRATC, then the firm is profitable.  Before entering an industry, the firm should expect that the market P > expected LRATC, or else not enter.  Existing firms should operate, accept orders only when expected P > LRATC.