32. A Firm’s Opportunity Cost of Production
A Firm’s Opportunity Cost of Production
A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.
Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner.
For example, renting capital means the firm is paying a rental cost reflecting the opportunity cost to the owner of the capital when someone else using the capital. However, if the firm buys capital it incurs an opportunity cost of using its own capital, which is called the implicit rental rate of capital. The implicit rental rate includes economic depreciation, which is the change in the market value of capital over a given period, and the interest forgone, which is the lost potential return on the funds that were used to acquire the capital.
The return to the owner for the owner’s entrepreneurial ability is profit. The return for this input that an entrepreneur can expect to receive on the average is called normal profit. The normal profit is part of the firm’s opportunity cost. Economic profit is a firm’s total revenue minus its opportunity cost. Because normal profit is part of the firm’s opportunity costs, economic profit is profit over and above normal profit.
33. Technological and Economic Efficiency
Technological and Economic Efficiency
There typically are many different combinations of inputs that can produce a specific level of output. Technological efficiency occurs when a firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output at the least possible cost. An economically efficient production process is always technologically efficient. But, a technologically efficient process might not be economically efficient.
The table has 4 different methods of producing a unit of output. The columns show the number of units of labor and capital needed to produce 1 unit of output.
Method 2 is technologically inefficient because it uses the same amount of capital but more labor than does Method 1.
Which method is economically efficient depends on the prices of labor and capital. If labor is $10 per unit and capital is $1, then Method 1 is economically efficient (with a cost of $60 per unit of output). If labor is $1 per unit and capital is $10 per unit, then Method 4 is economically efficient (with a cost of $30 per unit of output).
34. Information and Organization
A firm organizes production by combining and coordinating productive resources using a mixture of command systems and incentive systems.
A command system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward.
An incentive system uses a market-like mechanism inside the firm.
The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. For example, the stockholders of a firm are the principals and the managers of the firm are their agents. Stockholders wish to provide incentives to the managers to bring the manager’s decisions in line with profit maximization. Firms cope with the principal-agent problem in many ways:
Ownership: Firms’ owners often offer managers partial ownership of the firm to give the managers an incentive to maximize the firm’s profits, which is the goal of the owners.
Incentive pay: Firms’ owners can links managers’ or workers’ pay to the firm’s performance, such as its sales, to help align the managers’ and workers’ interests with those of the owners.
Long-term contracts: Firms’ owners can tie managers’ or workers’ long-term rewards to the long-term performance of the firm.
35. Types of Business Organization
A proprietorship is a firm with a single owner. This owner has unlimited legal liability, which means the owner has legal responsibility for all debts incurred by the firm up to an amount equal to the entire wealth of the owner. The proprietor is the only one who makes management decisions and is the sole claimant of the firm’s profit. Profits are taxed the same as the owner’s other income.
A partnership is a firm with two or more owners. Each partner has unlimited legal liability. The partners must agree upon a management structure and agree how to divide up the profits from the firm. Profits from partnerships are taxed as the personal income of the owners.
A corporation is a firm that is owned by one or more stockholders with limited liability, which means the owners have legal liability only for the initial value of their investment so the personal wealth of the stockholders is not at risk if the firm goes bankrupt. The profit of corporations is taxed twice—once as a corporate tax on the firm’s profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.
Proprietorships are the most common form of business organization but corporations account for the majority of revenue received by all types of business organization