Organising Production

Question 1

What is accounting profit?

Answer 1

Revenue - costs - depreciation

Question 2

What is economic profit?

Answer 2

Economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production.

Question 3

What is the opportunity cost of production?

Answer 3

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.

Question 4

How is opportunity cost of production expressed?

Answer 4

Opportunity cost is expressed in money units so that we can compare and add up the value of the alternatives forgone.

Question 5

What type of alternatives might a firm forego?

Answer 5

Resources…
…Bought in the market
…Owned by a firm
…Supplied by the firm’s owner

Question 6

What are resources in the market?

Answer 6

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

Question 7

How is opportunity cost incurred by resources owned by a firm?

Answer 7

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.

Question 8

What is it called when a firm uses it’s own capital and is implicitly renting from itself?

Answer 8

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

Question 9

What is economic depreciation?

Answer 9

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.

Question 10

How are resources supplied by the owner an opportunity cost?

Answer 10

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.

Question 11

What are technology constraints on the organisation of production?

Answer 11

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

Question 12

What are information constraints on the organisation of production?

Answer 12

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

Question 13

How do firms deal with information constraints on the organisation of production?

Answer 13

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

Question 14

What are market constraints on the organisation of production?

Answer 14

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

Question 15

What is technological efficiency?

Answer 15

Technological efficiency occurs when the firm produces a given output by using the least amount of inputs

Question 16

What is economic efficiency?

Answer 16

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

Question 17

What relationship exists between technological and economic efficiency?

Answer 17

A technologically inefficient method is never economically efficient. A firm that is not economically efficient does not maximise profit

Question 18

How do firms organise the production of goods?

Answer 18

Through command systems and incentive systems

Question 19

What are command systems?

Answer 19

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

Question 20

Why do firms need incentive systems?

Answer 20

To deal with the incomplete information in the command system

Question 21

What are incentive systems?

Answer 21

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

Question 22

What is the principle agent problem?

Answer 22

The PAP is the problem of devising compensation rules that induce an agent to act in the best interest of a principle.

Question 23

Why does the principle agent problem exist?

Answer 23

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.

Question 24

How do managers cope with the principle agent problem?

Answer 24

• Ownership
• Incentive pay
• Long term contracts

Question 25

How does ownership help managers cope with the principle agent problem?

Answer 25

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

Question 26

How does incentive pay help managers cope with the principle agent problem?

Answer 26

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

Question 27

How do long term contracts help managers cope with the principle agent problem?

Answer 27

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

Question 28

What is a proprietorship?

Answer 28

• Single owner
• Unlimited liability
• Responsible for profits and losses
• Profits are taxed at the same rates as other sources of income

Question 29

What is a partnership?

Answer 29

• 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

Question 30

What is a corporation?

Answer 30

• A firm owned by 1+ limited liability stockholders
• Limited liability - only responsible for investment
• Profits taxed independently of personal income

Question 31

How are corporations taxed?

Answer 31

• 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