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Dr. Mohammed Alwosabi ECON 140 – Ch.

Notes on Chapter 9
ORGANIZING PRODUCTION

— Firms differ in the size and in the type of business they are doing but all firms
perform the same basic economic functions.
— A firm is an institution that hires factors of production and organizes them to
produce and sell goods and services.
— To predict a firm's behavior, we need to know the firm's goals and the
constraints it faces.

The Firm's Main Goal


— A firm’s goal is to maximize profit.
— If the firm fails to maximize profits it is either eliminated or bought out by other
firms seeking to maximize profit.
— Profit is the difference between total revenue and total cost
π = TR – TC.
— To maximize profit, a firm must make five basic decisions:
ƒ What goods and services to produce and in what quantities
ƒ What to produce itself and what to buy from other firms
ƒ How to produce—the production technology to use
ƒ How to organize and compensate its managers and workers
ƒ How to market and price its products

MEASURING A FIRM'S COSTS (OPPORTUNITY COST)


— Accountants typically count money costs only and ignore any resource use that
does not result in an explicit money payment.
— Thus, Accounting cost = explicit cost
— When calculating costs, economists on the other hand, consider the opportunity
cost of all resources used in production whether they are paid or not.

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

— Opportunity cost of any action – as you remember - is the highest-valued


alternative forgone. For a firm, the opportunity cost of production is the value
of the firm's best alternative use of resources.
— Opportunity cost includes both explicit and implicit cost. This is called
economic cost.
— Economic Cost (also called resource cost) refers to the value of all resources
used to produce a good or service, whether the resources are paid or unpaid.
— Economic Cost = opportunity cost
= explicit cost + implicit cost
— Explicit cost is cost paid directly in money.
— Implicit cost is the value of resources used even when no direct monetary
payments are made to these resources. It incurred when a firm gives up an
alternative action. A firms incurs implicit costs when it uses its own capital,
and/ or it uses its owner's resources

1. The cost of firm's own capital


o If the firm rents capital from another firm, it incurs an explicit cost; the
cost of rental payments.
o If the firm buys the capital it uses, it incurs an implicit cost (or the
implicit rental rate of capital) which is made up of
i. Interest forgone: The funds used to buy the capital could have been
used for some other purpose. They would have yielded a return - an
interest income. This forgone interest is an implicit cost and it is part of
the opportunity cost of using the capital
ii. Rent forgone: The firm could rent its capital to another firm. The
rental income forgone is the firm's opportunity cost of using its own
capital.
iii. Economic depreciation: is the decline in the market value of capital
over a given period. It is calculated as the market price of the capital at
the beginning of a period minus the market price of the capital at the
end of the period.

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

2. The cost of the owner's resources


A firm's owner could offer his resources in two ways:
a. As an entrepreneur: The owner's skills and talent as an entrepreneur
could be used in running another business and expect to receive a return
called normal profit.
o Normal profit
ƒ Normal profit is the cost of forgone entrepreneurial abilities
and talent in running another firm.
ƒ It is the average return that could be obtained from running
another business.
ƒ It is an amount equal to what the owners of a business could
have earned if their resources had been employed elsewhere.
ƒ It is equivalent to the opportunity cost of running the firm.
o It is the minimum return a firm's owner must earn in order to stay in
operation. A lower rate would cause some of the established firms to
leave; a higher one would cause new firms to enter.
o It is part of economic cost (part of implicit cost) but it is part of
accounting profit.
b. As a labor: Wage is the return to labor. The opportunity cost of the
owner's time spent on working for the firm is the wage income forgone
by not working in the best alternative job.

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

Measuring a Firm's Economic Profit


— Profit = Total Revenue – Total Cost.
— Economic Profit = Total Revenue - Total Economic Cost
= Total Revenue – Opportunity Cost
= Total Revenue – (Explicit Cost + Implicit cost)
= Total Revenue – Explicit Cost - Implicit cost
— Economic Profit accounts for all resources.
— A firm earns an economic profit only if it earns more than its opportunity cost.
— Economic profits represent an extra profit over and above all costs including
normal profit.
— Economic profit is regarded as a reward (compensation) to the entrepreneur for
taking the risk of running a business that might reap profit or suffer loss.
o If economic profit is zero ⇒ firm earns only normal profit (average rate
of return)
o If economic profit is positive ⇒ firm earns more than normal profit
o If economic profit is negative ⇒ firm earns less than normal profit
(economic loss)
— A firm that makes zero economic profit covers all its costs including a
provision for normal profit. In other words, a firm making just a normal profit is
making zero economic profit.
— Not every business has an equal chance to earn economic profit. There are
many constraints in the market prevent the firm from maximizing its economic
profit.

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

— Example:
Calculating Economic Profit
Total Revenue 400,000
Opportunity Cost
Explicit costs:
Cost of merchandise sold 80,000
Wages 120,000
Utilities 20,000
Interest paid 10,000
Taxes 10,000
Total explicit costs 240,000
Implicit costs:
Owner's wage forgone 40,000
Interest forgone 20,000
Economic Depreciation* 25,000
Normal Profit 50,000
Total implicit costs 135,000
Total Economic Cost (Opportunity Cost) 375,000
Economic Profit 25,000

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

The Firm's Main Constrains


— There are three main constraints that limit the ability of the firm to achieve its
goal of maximum profit. These three constraints are: Technology Constraint,
Information Constraint, Market Constraint
— Technology Constraints
o Technology is any method of producing a good or service. It includes
the design of the machines, the lay out of the work place, the
organization of the firm, etc.
o At any point in time, the increase in profit that the firm can achieve is
limited by the technology available. If there is an improvement in the
technology or discovery of new technology the cost of production will
decrease and profit will increase, everything else remaining the same
o With a given technology, to produce more output and gain more
revenue, a firm must hire more resources and incur higher costs
— Information Constraints
o A firm is constrained by limited information about the quality and effort
of its work force, the current and future buying of its customers, the
plans of its competitors, and the changes that may occur in the local and
global economies.
o In addition, the cost of coping with the limited information itself limits
profits
— Market Constraints
What each firm can sell and prices it can obtain are constrained by
1. its customers' willingness to pay,
2. prices and marketing efforts of other firms,
3. the resources that a firm can buy and the prices it must pay for them,
and
4. the willingness of people to work for and invest in the firm

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

TECHNOLOGICAL AND ECONOMIC EFFICIENCY


— To maximize profit, the firm must be efficient. To achieve production
efficiency the firm must achieve both technological efficiency and economic
efficiency
— 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 using the
least cost methods; i.e., the cost of producing a given level of output is as low
as possible.
— Input prices should be known first in order to calculate economic efficiency.
— A firm that is technologically efficient is not always economically efficient, but
a firm that is economically efficient must always be technologically efficient.
— Example: Suppose we have 3 methods of producing 11 units of good X per day
using only Labor (L) and capital (K)
Method L K
A 10 20
B 30 5
C 10 25
o To know which method is technologically efficient, compare between the
methods. You can see that methods A and C have the same quantity of labor
but different quantities of capital. Method C uses more capital than method
A. Because method C uses the same amount of labor but more capital than
method A, method C is not technologically efficient. Firms prefer to use less
capital with the same amount of labor.
The other two methods are technologically efficient. Method A has less
labor and more capital than method B; and method B has less capital and
more labor than method A
o The method that is technologically inefficient can never be economically
efficient

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

o To know which method is economically efficient


o Economic efficiency depends on input prices
ƒ If P (L) = $1 per hour and P (K) = $ 5 per hour. Then
TC of method A = (1*10) + (5*20) = 110, and
per unit cost = 110/11 = 10
TC of Method B = (1*30) + (5*5) = 55, and
per unit cost = 55/11 = 5
Hence, method B is economically efficient because it produces the 11
units of X at the least cost but method A is not.
ƒ Now suppose P (L) = $5 per hour and P (K) = $1 per hour. Then
TC of method A = (5*10) + (1*20) = 70, and
the per unit cost = 70/11 = 6.36
TC of Method B = (5*30) + (1*5) = 155, and
the per unit cost = 155/11 = 14.09
Hence, method A is economically efficient because it produces the 11
units of X at the least cost but method B is not.
o The economically efficient method is the one that uses a smaller amount of
the more expensive inputs and a large amount of the less expensive inputs
— A firm that is not economically efficient does not maximize profit
— Profit can be maximized only by firms that achieve technological efficiency an
economic efficiency.

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

MARKET STRUCTURE
— The opportunity of the firm to maximize its profit may be limited by the
structure of the industry.
— Market structure refers to the number and the relative size of the firms in an
industry
— There are four main types of market structure: perfect competition,
monopolistic competition, oligopoly and monopoly.
— It is important to note that: (1) these markets may change over time from one
structure to another, and (2) some real life markets may not fit well in any of
these four structures

— Perfect Competition
o Perfect competition refers to a market in which there are many firms
selling an identical product and many buyers. None of the buyers or
sellers has market power. Each firm is a price taker. No barriers to enter
or exit this type of market. Information is available to all. In the long
run, economic profit of any firm in this type of market is zero.
o Market Power refers to the ability to influence the market price of a
good or service
o Examples: the markets for agricultural product (corn, wheat, coffee),
financial instruments (stocks, bonds, foreign exchange), precious metals
(gold, silver, platinum) and the global petroleum industry
o In each of these markets, the products are standardized commodities, and
supply and demand are the primary determinants of their market price.

— Monopolistic Competition
o Monopolistic competition is a market in which large number of
relatively small firms produce similar but different product
(differentiated products). Each firm maintains some control of its own
price. It is easy to enter or exit this market. In the long run, economic
profit of any firm in this type of markets is zero.

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Dr. Mohammed Alwosabi ECON 140 – Ch. 9

o There are many of monopolistic competitive firms in any given city or


area of the city. The start-up capital is relatively low, so it is fairly easy
to start these types of business. Each one tries its best to stand out among
its many competitors by differentiating its product.
o Examples: Small industries such as retail and service establishments
(restaurants, boutiques, luggage stores, shoe stores, stationary stores,
repair shops, laundries, beauty parlors)

— Oligopoly
o Oligopoly is a market in which a small number of firms producing all or
most of the market supply of a particular good or service. The product
may be identical or differentiated. This market is generally considered to
be for large firms. It is difficult to enter this market. Firms in this market
can make positive economic profit based on whether they compete with
each other severely or they have some kind of mutual agreements
regarding prices, market share and products.
o Examples: manufacturing sector, oil refining, certain types of computer
hardware and software, chemical and plastics, steel, automobile, soft
drinks, airline travel, banking industry, insurance companies,
telecommunications, etc

— Monopoly
o Monopoly refers to the firm that produces the entire market supply of a
particular unique good or service (no close substitutes for this product).
It has market power. It is a price maker. It is very difficult or impossible
for any other firm to enter this market. This firm makes high economic
profit subject to regulations.
o Examples of pure monopoly are not easy to find. Electricity and water
industry in some countries, patent laws sometimes provide companies
with temporary monopolies, a company that is so dominant might be
said to exhibit monopolistic status (such as Microsoft)

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