Study Session 4

Economics: Microeconomic Analysis

1. Elasticity ____________________________________________ 3 2. Efficiency and Equity _________________________________ 21 3. Markets in Action ____________________________________ 29 4. Organizing Production ________________________________ 37 5. Outputs and Costs ____________________________________ 49

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Organizing Production

4. Organizing Production
Learning Objectives
This summary includes a review and an analysis of the principles set forth by CFA Institute. Upon review of this summary, you should be able to: Know what kinds of opportunity costs exist and how opportunity cost relates to economic profit ........................................................................................................... pg. 38 Calculate economic profit ........................................................................................... pg. 39 Understand what constrains a firm and how this impacts maximizing profits ........... pg. 40 Explain technological and economic efficiency and know when a firm is technologically or economically efficient ................................................................... pg. 41 Calculate economic efficiency of various firms under different scenarios ................. pg. 41 Know how a firm can organize production using command and incentive systems ... pg. 42 Know how the principal-agent problem occurs and how a firm can reduce agency costs ............................................................................................................................ pg. 43 Explain different types of business organizations, including the advantages and disadvantages of each system individually and relative to each other ........................ pg. 43 Discuss and calculate the four-firm concentration ratio and the Herfindahl-Hirschman Index and know the limitations of concentration measures ..................................................................................................................... pg. 47 Explain how economic activity can be coordinated and how firms can be more efficient than markets ................................................................................................. pg. 48

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Overview
This reading focuses on economic profits, including how to define, obtain, and calculate economic profit. It also looks at obstacles to maximizing economic profits, looking at technological and economic efficiency. It also discusses the organization of the firm, and the agency (principal-agent) problems that can arise. Finally, the reading looks at business concentration and its impact on efficiency.

Opportunity Costs
Learning Objective: Know what kinds of opportunity costs exist and how opportunity cost relates to economic profit. Costs serve to allocate resources in an economy such that the goods most highly valued by consumers are produced. Since the production of one good necessitates a reduction in the production of other goods, producers signal through the price, which goods they value most. The cost of production is essentially the most highly valued opportunity that was forgone in order to produce the good. The production cost of a good reveals the value of the resources used to produce it, with this value stated in terms of other opportunities relinquished. Explicit costs are what a firm pays to purchase productive resources. Examples include wages, interest payments, and rental payments. These are also called accounting costs. Implicit costs are the opportunity costs arising from using its existing resources. These costs do not involve a direct money payment. For example, if a firm uses a plot of land it owns to build a factory, it forgoes the revenue it might have earned if the land was used as a parking lot. The potential revenues from the parking lot project are an implicit cost charged to the factory project cash flows. Implicit rental rates are rental incomes foregone because the firm used its capital to fund its own projects. The implicit rental rate includes: economic depreciation - This is the change in market value of capital during a specified period. For example, suppose a piece of property could have been sold for $1,000 and a year later it could be sold for $800. The $200 difference represents economic depreciation, and is an implicit cost of using capital during the period. foregone interest - If the $1,000 had been used for some other purpose, it would have earned a return. That foregone return is a cost of capital.

Owners resources refer to the firm owner, who supplies entrepreneurial ability to his or her firm. Normal profit is the return an entrepreneur expects to receive, on average. It is an opportunity cost, because it represents the cost of a foregone opportunity - the opportunity to run a different firm. A firms owner can also supply labor to the firm and receive wages.

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The opportunity cost of working for the firm is the wages foregone by not working at the best alternative job. Total costs are the implicit plus the explicit costs to the firm. This figure also includes an imputed normal rate of return for the firms equity capital. Opportunity cost of equity capital is the rate of return required by investors to supply funds for a project. This rate of return is determined by what other opportunities of equivalent risk the investor has for those funds. If the rate of return they are earning on their investment in the firm is less than the normal market rate they could earn elsewhere, they will remove their investment. Economic profit is the amount of profit investors receive over and above their opportunity cost of investing. For example, if the required return on a project was 10%, and the investor received a 12% return, the additional 2% represents economic profit to the investor. Zero economic profits means the investor is receiving exactly the market rate of return on the investment in the firm. The goal of the firm is to maximize shareholders wealth, which it accomplishes by maximizing stock price, which in turn is maximized by maximizing economic profits - accepting all possible positive net present value projects. Accounting profits are the sales revenues minus the expenses during a specified time period. No allowances are made for the opportunity cost of the equity capital of the firms owners or other implicit costs. Accounting costs may be different from economic costs. Accounting rules may leave out implicit costs, for example, the owners labor services or capital. While this applies primarily to small businesses, accounting rules may also leave out the opportunity costs of alternate uses of a resource used in production. Using accounting costs may understate the actual economic costs and therefore overstate accounting profits.

Economic Profit
Learning Objective: Calculate economic profit. To maximize economic profit, a firm must consider what and how much to produce, what production techniques to use, how to organize the firm, how to compensate employees, how to market and price its goods, and whether to produce or buy from other firms. Economic profit can be calculated by looking at revenues and subtracting the costs, including the opportunity costs of producing those revenues.

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Here is an example of accounting for economic profit: Total Cost/Revenue Sales Opportunity Costs Supplies used in production Labor to produce goods Total explicit costs Entrepreneurial wages foregone Interest foregone Economic depreciation Normal profit Total implicit costs Total costs Economic profit $100 $150 $100 $50 -$400 -$900 $100 $300 $200 -$500 $1,000

Constraints
Learning Objective: Understand what constrains a firm and how this impacts maximizing profits. Firm profits are limited by: technology (methods used to produce goods and services) - Whenever a firm wants to produce more, it must spend money on resources. While there are always advances in technology at any point in time, the firms profits are constrained by the technology available. information - A firm always must deal with missing information, for example, what the economy will be like in the future, the future inflation rates, future prices for raw materials needed, future customer tastes, etc. A firm must always deal with some uncertainty. Having limited information also limits profits. the market - The firms profits are limited by the prices consumers are willing to pay for its goods, by the willingness of employees to work for the firm, and the willingness of investors to place their capital in the firm.

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Firm Efficiency
Learning Objective: Explain technological and economic efficiency and know when a firm is technologically or economically efficient. Learning Objective: Calculate economic efficiency of various firms under different scenarios. Production efficiency can be divided into technological and economic efficiency. Technological efficiency refers to achieving production using the least amount of inputs. A firm is operating with economic efficiency when it is producing with the least cost achievable. Technological efficiency looks at what different methods can be used for production and chooses the method that uses a method that requires the least amount of inputs. There may be several methods of production that are technologically efficient. For example, suppose you could produce 100 units of a good with 10 units of labor and 20 units of equipment. You could produce the same 100 units using 20 units of labor and 20 units of equipment. The second method is not technologically efficient because it requires more labor and the same amount of equipment for production. Economic efficiency requires the firm to look at the specific costs of each method that is technologically efficient and determine which method produces a given amount for the least cost. Technological efficiency looks at all available production methods, while economic efficiency looks at the relative costs of each feasible method. Suppose you have alternate ways of producing widgets, one more labor intensive and less capital intensive and another more capital intensive and less labor intensive. The third method is equal in its use of labor and capital. Method 1 2 3 Labor 50 100 50 Capital 100 50 50

None of these methods is technologically inefficient. More labor means less capital and visa versa. Suppose you had a fourth method: Method 4, Labor 50, Capital 60. This method is technologically inefficient because it uses the same amount of labor as Method 3, but more capital.

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Suppose you can assign a cost to labor and capital, with labor costing $1 a day and capital $5. The costs for each method are as follows: Method 1 2 3 4 Labor Cost $1 50 = $50 $1 100 = $100 $1 50 = $50 $1 $50 = $50 Capital Cost $5 100 = $500 $5 50 = $250 $5 50 = $250 $5 60 = $300 Total Cost $50 + $500 = $550 $100 + $250 = $350 $50 + $250 = $300 $50 + $300 = $350

Method 3 is the most economically efficient because it uses the least capital, given the amount of labor needed.

Organization Systems
Learning Objective: Know how a firm can organize production using command and incentive systems. A firm can organize production through: command systems - organizing using a managerial hierarchy Upper level managers make decisions and pass down those decision to the workers who report to them. Information moves up, from lower level employees to management. A prime example of this is the military. Firms may also operate this way, although generally with less structure than the military. Although managers may do their best to make informed decisions, they will not know as much as the employees who are running the firm day to day. When it is easy to monitor performance, for example, on an assembly line, command systems are often used. incentive systems - creating ways, generally through compensation, to induce employees to work to maximize firm profits An example is a sales person who works on commission. They have the incentive to sell as much as possible to maximize their personal earnings. This, in turn, maximizes firm revenues. When it is costly to monitor performance (for example, the performance of the CEO) incentive systems are often used.

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How Firms are Organized

Learning Objective: Know how the principal-agent problem occurs and how a firm can reduce agency costs. Learning Objective: Explain different types of business organizations, including the advantages and disadvantages of each system individually and relative to each other. The business firm is designed to organize raw materials, labor, and machines with the goal of producing goods and/or services. To accomplish this, firms buy productive resources, transform resources into other commodities, and sell the new product or service to consumers. Team production and contracting are two ways to organize productive activity. Most firms use a combination of these two types of organization. Because the owners of a firm gain (or lose) what remains after the revenue of the firm is used to pay the costs, they are called residual claimants. In a market economy, the claim of owners to the residual income of the firm plays a very important role. It provides owners with a strong incentive to organize and structure their business in a manner that will keep their production costs low (relative to the value of the output). Shirking occurs when productivity is at lower than normal levels, resulting in reduced output. Unmonitored workers are most likely to shirk since the lower level of output only affects other people. Principal-agent problem is an incentive problem that occurs when the service purchaser (the principal) lacks complete information regarding the sellers (the agents) circumstances and cannot measure the agents performance. In a firm, the agents are the managers of the firm and the principals are the owners. There are three primary agency costs: 1. bonding - the cost the agents incur to assure the principals that they are acting in the principals best interests 2. monitoring - the costs incurred by principals to ensure that their agents are indeed acting in their best interests 3. residual loss - the loss to principals whenever agents make decisions that are not in the principals best interests

Incentives to Operate Efficiently

A small business owner has a strong incentive to operate efficiently and provide good customer service. Since the small business owner receives all of the residual profits of the firm, the lower the costs and the happier the customers, the greater the profitability of the firm and the greater the value to the small business owner. In a large firm, however, shareholders have a residual claim on the firms assets, but managers actually run the firm.

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Managers may not always act in the best interest of shareholders, for example, requiring high salaries, a company jet and other costly perks. For a large firm, the factors that promote cost efficiency and customer service include: a competitive environment - A firm is continually being monitored by outside investors. These investors will buy if they think the company is well managed and profitable and will sell their stock if they believe the opposite is true. Customers also monitor the firm. If they are getting good quality products and services they will continue to patronize the firm. They will go to competing firms if they receive poor service. correctly structured managerial compensation - More companies are providing incentive pay, not only to top managers, but to mid and lower level employees as well. Managers who perform well, as reflected by higher stock prices or higher earnings, may receive bonuses or grants of company stock or options. When managers personal wealth is more closely aligned with the fortunes of the company, they may be more likely to act in the best interests of shareholders. the market for corporate control - A poorly run company, with a depressed stock price, is more likely to be a takeover candidate than a well run company. Similarly, managers of poorly run companies are more likely to lose their jobs if the company is taken over. Managers will work to avoid this unfavorable outcome by managing the company well, satisfying stockholders and customers.

Types of Business Organization

Proprietorship - an individually-owned business. An individual owns the rights to the firms profits and has personal liability for the firms debts. Corporation - shareholders own rights to the firms profits. Their only liability is their investment in the firm. Partnership - two or more individuals own rights to the firms profits. They are personally liable for the firms debts.

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The advantages and disadvantages of these forms of business organization include: Advantages Proprietorship Easy to form Few regulations No corporate income taxes Being your own boss Partnership Same advantages as the proprietorship Often more capital than a proprietorship, but less than a corporation Limited life Difficult to transfer Unlimited liability for general partners Corporation Unlimited life Easy to transfer ownership Limited liability for owners Easier to raise capital Can have professional managers with more abilities than owners and lower labor costs with long-term contracts Double taxation - earnings are taxed at both the corporate and personal levels More costly to set up Can have a complex management structure with a slower and more costly decision process Disadvantages Hard to get capital Unlimited liability Limited life

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Market Types
The four market types are: 1. Monopoly 2. Oligopoly 3. Perfect competition 4. Monopolistic competition A monopoly is a market where there is an exclusive seller of a product for which there are no good substitutes, and there are high entry barriers for that product. An oligopoly is a market with a small number of sellers in an industry. Some characteristics of an oligopoly are: a small number of competing firms interdependence among the sellers since each is relatively large, compared with the size of the market large economies of scale high entry barriers

Economies of scale are the most significant barrier. Other barriers could include patent rights and control over an essential resource, i.e., petroleum or land. Perfect competition refers to markets where there are multiple firms selling identical products. It is difficult to differentiate goods in perfect markets and prices are well known. Commodities markets are examples of this. Product differentiation is how competing firms make their products different from their competitors, for example, through packaging, design, color, etc. Unlike commodities, which are homogeneous goods, differentiated products have distinguishable characteristics, such as differences in: quality design location method of production

Monopolistic competition occurs when there are multiple firms selling similar products. This term is used because while every firm has a monopoly on the exact product it produces, it faces competition because many close substitutes exist.

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Sellers in competitive price-searcher markets face competition both from firms already producing in the market and from potential new entrants into the market. If profits are present, new rivals will enter the market (since there are low entry barriers) until all profits have been eroded by firm entry.

Concentration
Learning Objective: Discuss and calculate the four-firm concentration ratio and the HerfindahlHirschman Index and know the limitations of concentration measures. Concentration measures include: Four firm concentration ratio - the percentage of sales held by the four largest firms in an industry This would be zero in a market with perfect competition, and 100 in a highly concentrated market. In general, a ratio more than 60% is indicative of a high degree of concentration (oligopoly), and less than 40% indicates a competitive market. Herfindahl-Hirschman Index (HHI) - the square of the market share percentage of each firm, summed over the largest 50 firms in that industry. This number is small in competitive markets. An HHI greater than 1,800 indicates an uncompetitive market, and mergers which result in HHIs greater than 1,800 are more likely to be challenged by the Justice Department antitrust division. The HHI is the square of the percentage of market share of each firm, added up for the top 50 firms in the market (or less than 50 if there are fewer than 50 firms in the market). Suppose there are five firms in a market, with the following market shares: Firm 1: 30%, Firms 2, 3, and 4: 20% each, Firm 5: 10%. The HHI for this industry is 302 + 202 + 202 + 202 + 102 = 2,200. A market with an HHI this high is considered to be uncompetitive. If two of the firms in this market wanted to merge, they would be less likely to obtain permission from the Antitrust Division of the Justice Department for a merger. In addition to the above concentration measures, concentration can be gauged by: barriers to entry - Low barriers to entry, even in concentrated industries can lead to greater competition in the future. number of firms in the industry product type - Is the product a commodity or can it be easily differentiated? price control - Does the firm control price? Is price subject to regulation or market forces beyond the control of the firm?

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Limitations of concentration measures include: scope of the market - Is there a small, domestic market for a product or is there a global market? For example, there is limited worldwide demand for a local newspaper, but there is a wider market for clothing, worldwide. entry barriers - Do firms enter and exit the industry easily or often? market and industry definitions - Markets and industries may not correspond. Companies may compete in multiple product markets, some competitive and others less competitive. Companies may also switch from industry to industry depending on market demands. There may be smaller, sub-markets within an industry that are more or less competitive than the overall market.

Most U.S. markets are competitive. In addition to domestic competition, U.S. companies face competition from international companies as well.

Coordinating Economic Activity

Learning Objective: Explain how economic activity can be coordinated and how firms can be more efficient than markets. A firm can choose to produce everything it needs for its goods and services itself or it can outsource some of its production needs. Firms may be able to coordinate production more efficiently than the overall market. Firms may have: transaction cost advantages - Transactions costs are the costs of doing business such as finding customers, negotiating agreements, and enforcing agreements. economies of scale and scope - Economies of scale result when a larger operation has a lower cost of production per unit. Economies of scope result when the firm uses its resources to produce a wide range of goods or services, for example, have employees who can work on multiple firm outputs. team production economies - One of the advantages of a firm is specialization. Every employee does not need to know every aspect of production. Together, a team with a variety of different skills can work to produce the good or service.

2011 Allen Resources, Inc. All rights reserved. Warning: Copyright violations will be prosecuted. Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws.

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