Topic 3 - Firm's Objective Flashcards
What is a firm’s goal?
To maximise profit.
What is economic profit?
Total Revenue - Total Cost (the opportunity cost of production)
What is a firm’s opportunity cost of production?
It’s the sum of the cost of using resources:
1 = Bought in the market
2 = Owned by the firm
3 = Supplied by the firm’s owner
What are resources bought in the market?
The amount spent on these resources is an opportunity cost because it could have been used to buy different resources to produce another good/service.
Why are resources owned by the firm an opportunity cost?
The firm could sell the capital it owns and rent capital from another firm.
What is the implicit rental rate of capital made of?
Economic Depreciation
= The fall in the market value of a firm’s capital over a given period.
Forgone Interest
= The funds used the buy capital could have been used for some other purpose, or just to earn interest.
Why are resources supplied by the firm’s owner an opportunity cost?
Entrepreneurship = Normal profit is the cost of entrepreneurship and is an opportunity cost of production.
Owners Labour Services = The wage income forgone by not taking the best alternative job.
What decisions must a firm make?
1 = What to produce and in what quantities 2 = How to produce 3 = How to organise and compensate its managers and workers 4 = How to market and price its products 5 = What to produce itself and buy from others
What are the constraints which limit the economic profit a firm can make?
1 = Technology Constraints 2 = Information Constraints 3 = Market Constraints
What are technology constraints?
A technology is any method of producing a good/service. The increase in profit that a firm can achieve is limited by the technology available.
What are information constraints?
A firm is constrained by limited info about the quality and efforts of its workforce, the current and future buying plans of its customers, and the plans of its competitors.
What are market constraints?
The quantity each 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.
What is technological efficiency?
It occurs when the firm produces a given output by using the least amount of inputs.
What is economic efficiency?
Occurs when the firm produces a given output at the least cost.
What do firms use to organise production?
Command and incentive systems
What is a command system?
A method of organising production that uses a managerial hierarchy. Commands pass downwards and information passes back up.
What are incentive systems?
A method of organising production that uses a market-like mechanism inside the firm. Managers don’t issue commands, they create compensation schemes to induce workers to perform in ways that maximise the firm’s profit.
What is the principal-agent problem?
The problem of devising compensation rules that induce an agent to act in the best interest of a principal.
How do firms cope with the principal-agent problem?
Ownership
Incentive Pay
Long-Term Contracts
What is ownership?
By assigning ownership of a business to managers or workers, it’s sometimes possible to induce a job performance that increases a firm’s profits.
What is incentive pay?
Pay related to work performance.
What are long-term contracts?
Long term contracts tie the long-term fortunes of workers to the success of the principals of the firm.
What are the three types of business organisation?
Proprietorship = A firm with a single owner, who has unlimited liability (full legal responsibility for all the debts of a firm). Partnership = A firm with two or more owners who have unlimited liability. Corporation = A firm owned by one of more limited liability stockholders, so the owners have legal liability only for the value of their initial investment.
