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CHAPTER 9: Organizing Production (Pg. 196-200 and 205)
Answers to the Review Quizzes
Review Quizzes Page 198
1. A firm’s goal is to maximize profit, which is the return on the firm owner’s investment in labour, entrepreneurial effort, and capital. If the firm fails to maximize profits it is either eliminated or bought out by other firms maximizing profit.
2. Accounting profits differ from economic profits because accounting profits include only explicit costs. Economic costs, however, include both explicit and implicit costs that reflect the full opportunity cost of production incurred by the firm. Economic profit will be equal to or less than accounting profits.
3. Opportunity cost includes all explicit costs incurred by the firm, such as wages paid to workers, expenses for raw materials, and rent paid to capital owners. Explicit costs such as these comprise an accountant’s measures. Opportunity cost also includes all implicit costs incurred by the firm, which makes an economist’s measure differ from an accountant’s. These implicit costs include the implicit rental rate of owner’s capital, labour, and entrepreneurial ability. The total opportunity cost incurred by a firm is the sum of all explicit and all implicit costs.
4. Normal profit is the return to a firm’s owner for the owner’s supply of entrepreneurial ability and labour to the firm’s production process. Using the owner’s ability to run the business implies that the owner could have received a return for using it in another capacity, like running another firm. This is an implicit cost for the firm and must be included in calculating the firm’s full opportunity cost of production.
5. The three types of constraints a firm faces are technology constraints, information constraints, and market constraints. Technology is any specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. Information is never complete, for the future or the present. A firm is constrained by limited information about the quality and effort of its work force, current and future buying plans of its customers, and the plans of its competitors. The cost of coping with limited information itself limits profit. What 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. 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. The expenditures a firm incurs to overcome these market constraints will limit the profit the firm can make.
Review Quizzes Page 200
1. Technological efficiency occurs when a firm produces a given level of output by using the least amount inputs. Adopting the latest available technology does not necessarily imply that a firm’s production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.
2. Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency.
3. The difference between technological and economic efficiency is that technological efficiency concerns the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.
4. The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labour-intensive methods.
Review Quizzes Page 204
1. A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm’s profit.
2. The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. There are three ways of coping with this problem: Ownership, often offered to managers, gives the agents an incentive to maximize the firm’s profits, which is the goal of the owners, the principals; incentive pay links managers’ or workers’ pay to the firm’s performance and helps align the managers’ and workers’ interests with those of the owners, the principal; long-term contracts tie managers’ or workers’ long-term rewards to the long-term performance of the firm, encouraging the agents to work in the best long-term interests of the firm owners, the principals.
3. The three main ways of organizing a firm have both advantages and disadvantages:
a. Proprietorship. Advantages - easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. Disadvantages - bad decisions on the part of the owner are not subject to review; the owner’s entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labour is expensive.
b. Partnership. Advantages - easy to set up; has diversified decision-making so that more than one person’s expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. Disadvantages - all the owners’ wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; and capital costs can be high.
c. Corporation. Advantages - perpetual life; limited liability for its owners; readily available, large-scale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labour contracts. Disadvantages - potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.
4. All three types of firms survive since each may have a superior advantage for the unique characteristics of the industry in which the firm operates. For example, there are more proprietorships in industries where flexibility in decision-making is important. This is why we see most agriculture firms are single-family owned farms. For industries where a large amount of capital is used, we see mostly corporations. This is true of the capital-intensive manufacturing industries. Partnerships are seen most prominently in mining. This suggests mining firms benefit from the diversified decision-making of a partnership as well as profits being taxed only once.
Review Quizzes Page 209
1. Economists identify four market types:
1. Perfect competition is a market with many firms, each selling an identical product. There are many buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices and products of all firms in the industry.
2. Monopolistic competition is a market with many firms that produce similar but slightly different goods.
3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost identical or differentiated goods.
4. Monopoly is a market in which only one firm produces the entire output of the industry. There are no close substitutes for the monopolist’s product and there are barriers to entry that protect the firm from competition of entering firms.
2. Two measures of concentration have been developed and are in common use: the four-firm concentration ratio and the Herfindahl-Hirschman index (HHI).
1. The four-firm concentration ratio is the percentage of the total industry sales accounted for by the four largest firms in the industry.
2. The Herfindahl-Hirschman index (HHI) equals the sum of the squared market shares of the 50 largest firms in the industry.
3. Concentration measures give a good indication of the degree of competition in a market if the following characteristics of the industry market are correct:
1. The industry market is national in scope, rather than local or international.
2. There are no concerns about over-stating or under-stating the extent of barriers to entry.
3. Firms are not misclassified with respect to their markets.
4. The U.S. economy would be considered competitive since three-quarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.
Review Quizzes Page 211
1. Firms and markets both coordinate resources.
2. Firms coordinate resources when they can do so more efficiently than a market.
1. Firms may reduce transactions costs, which are the costs arising from finding someone with whom to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled.
2. Firms may better capture economies of scale, which occurs when the cost of producing a unit falls as its output rate increases.
3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise.
4. Firms can engage in team production, in which the individuals specialize in mutually supporting tasks.
3. Firms can often coordinate production at a lower cost than markets can because they lower transactions costs and achieve economies of scale, scope, and team production.
Answers to the Problems
1. Explicit costs are $30,000. Explicit costs are all the costs for which there is a payment. Explicit costs are the sum the wages paid ($20,000) and the goods and services bought from other firms ($10,000).
Implicit costs are the sum of the costs that do not involve a payment. Implicit costs are the sum of the interest forgone on the $50,000 put into the firm; the $30,000 income forgone by Jack not working at his previous job; $15,000, which is the value of 500 hours of Jill’s leisure (10 hours a week for 50 weeks); and the economic depreciation of $2,000 ($30,000 minus $28,000).
2. Explicit costs are $23,000. Explicit costs are all the costs for which there is a payment. Explicit costs are the sum the wages paid ($18,000) and the goods and services bought from other firms ($5,000).
Implicit costs are the sum of the costs that do not involve a payment. Implicit costs are the sum of the interest forgone on the $70,000 put into the firm; the $22,000 income forgone by Moffat not working at her previous job; $20,000, which is the value of 1,000 hours of Spieder's leisure (20 hours a week for 50 weeks); and the economic depreciation of $3,000 ($40,000 minus $37,000).
3. a. All methods other than “pocket calculator with paper and pencil” are technologically efficient. To use a pocket calculator with paper and pencil to complete the tax return is not a technologically efficient method because it takes the same number of hours as it would with a pocket calculator but it uses more capital.
b. The economically efficient method is to use (i) a pocket calculator, (ii) a pocket calculator, (iii) a PC.
The economically efficient method is the technologically efficient method that allows the task to be done at least cost.
When the wage rate is $5 an hour: Total cost with a PC is $1,005, total cost with a pocket calculator is $70, and total cost with paper and pencil is $81. Total cost is least with a pocket calculator.
When the wage rate is $50 an hour: Total cost with a PC is $1,050, total cost with a pocket calculator is $610, and the total cost with paper and pencil is $801. Total cost is least with a pocket calculator.
When the wage rate is $500 an hour: Total cost with a PC is $1,500, total cost with a pocket calculator is $6,010, and total cost with pencil and paper is $8,001. Total cost is least with a PC.
4. a. All methods are technologically efficient. To use paper and pencil to complete the accounting assignment takes 30 hours and $5 of capital. To use a pocket calculator, it takes fewer hours (15 hours) and more capital ($20). To use a pocket calculator and paper and pencil, it takes fewer hours (7 hours) and more capital ($25). To use a PC, it takes fewer hours (1 hour) and more capital ($1,000). No method uses more of both resources (time and capital) than any other method. So, all methods are technologically efficient.
b. The economically efficient method is to use (i) a pocket calculator and paper and pencil, (ii) a pocket calculator and paper and pencil, (iii) a pocket calculator.
The economically efficient method is the technologically efficient method that allows the task to be done at least cost.
When the wage rate is $10 an hour: Total cost with a PC is $1,010, total cost with a pocket calculator is $170, total cost with pocket calculator and paper and pencil is $95, and total cost with paper and pencil is $305. Total cost is least with a pocket calculator and paper and pencil.