Organising Production Flashcards
What is accounting profit?
Revenue - costs - depreciation
What is economic profit?
Economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production.
What is the opportunity cost of production?
The value of the best alternative use of the resources that a firm uses in production. A firm’s OC of production is the value of real alternatives foregone.
How is opportunity cost of production expressed?
Opportunity cost is expressed in money units so that we can compare and add up the value of the alternatives forgone.
What type of alternatives might a firm forego?
Resources…
…Bought in the market
…Owned by a firm
…Supplied by the firm’s owner
What are resources in the market?
A firm incurs an oc when it buys resources in the market.
The amount spent is the oc because the firm could have bought different resources to produce some other good or service
How is opportunity cost incurred by resources owned by a firm?
Cost of using capital owned by a firm is an OC because the firm could sell the capital that it owns and rent capital from another firm - it is implicitly renting from itself.
What is it called when a firm uses it’s own capital and is implicitly renting from itself?
The firm’s oc of using its own capital is called the implicit rental rate of capital
Implicit rental rate = economic depreciation and foregone interest
What is economic depreciation?
Economic depreciation is the fall in the market value of a firm’s capital at the beginning to the period minus the market price of capital at the end of the period.
How are resources supplied by the owner an opportunity cost?
Owners can supply entrepreneurship and labour. Entrepreneurship brings profit, this on average is normal profit - an oc of production. Owners may not take a wage, the oc is the income foregone.
What are technology constraints on the organisation of production?
Technology advances over time, but at each point in time, to produce more output and gain more revenue, a firm must hire more resources and incur greater costs. The increase in profit that a firm can achieve is limited by the technology available
What are information constraints on the organisation of production?
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
How do firms deal with information constraints on the organisation of production?
Firms create incentives to boost workers’ efforts, conduct market research to lower uncertainty about customers’ buying plans and spy on each other to anticipate competitive challenges
What are market constraints on the organisation of production?
The quantity 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
What is technological efficiency?
Technological efficiency occurs when the firm produces a given output by using the least amount of inputs
What is economic efficiency?
Economic efficiency occurs when the firm produces a given output at the least cost. It depends on the relative costs of resources. The method is the one that uses a smaller amount of the more expensive resource and a larger amount of the less expensive resource
What relationship exists between technological and economic efficiency?
A technologically inefficient method is never economically efficient. A firm that is not economically efficient does not maximise profit
How do firms organise the production of goods?
Through command systems and incentive systems
What are command systems?
Commands pass downward through the hierarchy, and information passes upward. Managers try to be well informed, but they almost always have incomplete information about what is happening in the divisions for which they are responsible
Why do firms need incentive systems?
To deal with the incomplete information in the command system
What are incentive systems?
A method of organising production that uses a market like mechanism inside the firm. Instead of issuing commands, senior managers create compensation schemes to induce workers to perform in ways that maximise the firm’s profit
What is the principle agent problem?
The PAP is the problem of devising compensation rules that induce an agent to act in the best interest of a principle.
Why does the principle agent problem exist?
The firm’s profit depends on the actions of managers (agents) and they have their own goals. Managers want them to work hard but they want to slack off.
How do managers cope with the principle agent problem?
- Ownership
- Incentive pay
- Long term contracts
How does ownership help managers cope with the principle agent problem?
By assigning ownership of a business to workers, it is sometimes possible to induce a job performance that increases a firm’s profits. Part ownership is quite common for senior managers but less so for workers
How does incentive pay help managers cope with the principle agent problem?
Incentives are based on a variety of performance criteria such as profits, production or sales targets. Promoting an employee for good performance is another example of incentive pay or performance related pay
How do long term contracts help managers cope with the principle agent problem?
Tie the long term fortunes of managers and workers (agents) to the success of the principal - the owner of the firm. A multiyear employment contract for a CEO encourages that person to take a long term view and devise strategies that achieve maximum profit over a sustained period
What is a proprietorship?
- Single owner
- Unlimited liability
- Responsible for profits and losses
- Profits are taxed at the same rates as other sources of income
What is a partnership?
- A firm with two or more owners
- Unlimited liability
- Must agree on management decisions and how to divide profits
- Profits are taxed as personal income
- Each partner legally liable for debts
What is a corporation?
- A firm owned by 1+ limited liability stockholders
- Limited liability - only responsible for investment
- Profits taxed independently of personal income
How are corporations taxed?
- Stockholders pay a capital gains tax on the profit they earn when they sell a stock for a higher price than they paid for it
- Capital gains = reinvestment of profit in profitable activities
- Retained earnings are taxed twice because the capital gains they generate are taxed
- Dividend payments are also taxed but at a lower rate than other sources of income
