10 ORGANIZING

PRODUCTION

The Big Picture

W he re w e h av e b e en:
Chapter 10 introduces students to the firm as a decision making entity with an organizational
structure and a specific goal. Key ideas in this chapter are recognizing the importance of having
access to accurate cost and profitability information for making sound business decisions (learning
the difference between economic versus accounting profit) and using the correct notion of efficiency
as a criteria for making these decisions (understanding the difference between technological versus
economic efficiency).

W he re w e a re go ing:
Understanding the nature of the firm allows you to gain a better appreciation of the following
chapters, which cover business decisions made by the firm under different market structures.
Chapter 11 introduces the firm’s production function and cost functions. Chapter 12 examines firm
performance in a competitive environment and Chapter 13 explores the firm as a monopoly.
Chapters 14 and 15 look at firm behaviour under monopolistic competition and oligopoly. Chapter
18 covers the firm’s decisions in factor markets, concentrating on the markets for labour and natural
resources.

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2 CHAPTER 10

Lecture Notes
Organizing Production
• Firms must organize their production so that it is as efficient as possible.
• Firms operate in markets that differ according to the competition within the market.
• Firms organize some economic activities while markets are used for other economic activity.

I. The Firm and Its Economic Problem

• The number and scope of business firms in the economy is vast and diverse. A firm is an institution that
hires factors of production and organizes those factors to produce and sell goods and services.

The Firm’s Goal

• The firm’s goal is to maximize its profit. If a firm fails to maximize profit it is either eliminated through
competition or bought out by other firms seeking to maximize profit.

Do firms really maximize profit? Sometimes firms state they are willing to bear lower profits to expand market
share. Other firms claim to utilize only the “greenest” technology in their production process. Are these long term
goals or short term objectives for these firms?. They should see that maximizing market share or using the latest
green technology is an effort to gain greater market power and consumer loyalty in the long run, so that the firm can
raise market prices and increase its profits. Remember that the capital necessary to pursue green production methods
can only be retained if the firms are able to match the alternative profitable uses for that capital, because the owners
of that capital seek out the highest rate of return.

Accounting Profit and Economic Profit

• A firm’s accounting profit is the firm’s revenues minus expenses and depreciation.
• A firm’s economic profit is equal to total revenue minus total cost, with total cost measured as the
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 uses capital that it owns
rather than selling it or renting it to another firm, the firm incurs an opportunity cost, 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.

Is economic profit a “better” measure of profit than accounting profit? Economic profit and accounting profit really
have different purposes, so one is not universally better or worse than the other. Economic profit is a better measure of
whether a firm is using its resources efficiently and is a better measure for predicting a firm’s actions, but accounting
profit may be a better measure of whether the firm is earning enough revenue to pay its expenses. Understand the

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 ORGANIZING PRODUCTION 3

difference between accounting profit and economic profit when a firm owner is using cost information to make
business decisions.
Note that only economic profit reflects the full opportunity cost of making a business decision and it is vital for
assessing the true financial health of a firm. Accountants are limited in their ability to interpret and report the costs of
production: All accounting costs must either be documented with a receipt or estimated according to strict, generally
accepted accounting procedures (GAAP). The principal–agent problem that arises when firm managers can exploit the
limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy
financial picture for the firm—to the detriment of the firm owners.

Decisions
• In order to maximize economics profit, a firm must decide:
• What to produce and in what quantities.
• How to produce.
• How to organize and compensate its managers and workers.
• How to market and price its products.
• What to produce itself and what to buy from others.

The Firm’s Constraints

• A firm faces three basic constraints that limit its maximum profit:
• Technology Constraints: A technology is any method of producing a good or service. At the existing
level of technology, a firm can produce more output only if it hires more resources, which increases
its costs and limits its profits.
• Information Constraints: A firm has only limited information about the quality and effort of its work
force, about the current and future buying plans of its customers, and about the plans of its competitors.
• Market Constraints: What a firm can sell and the price it at are constrained by its customers’
willingness to pay and by the prices and marketing efforts of other firms.

II. 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 Method Labour Capital
of units of labour and capital needed to produce
1 unit of output. 1 5 10
• Method 2 is technologically inefficient because it uses the 2 10 10
same amount of capital but more labour than does Method 1.
3 15 9
• Which method is economically efficient depends on the
prices of labour and capital. If labour is $10 per unit and 4 20 1
capital is $1, then Method 1 is economically efficient (with a
cost of $60 per unit of output). If labour 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).

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4 CHAPTER 10

Does technological efficiency imply economic efficiency (or vice versa)? Remember that technological
efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency
minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally
productive), there will inevitably be a difference between technological efficiency and economic efficiency.

III. 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 shareholders of a firm are the principals and the managers
of the firm are their agents. Shareholders 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.

Types of Business Organization

• A sole 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 shareholders with limited liability, which means the
owners have legal liability only for the initial value of their investment so the personal wealth of the
shareholders 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 shareholders receiving their
after-tax profits distributed as dividends.
• Sole proprietorships are the most common form of business organization but corporations account for the
majority of revenue received by all types of business organization.

IV. Markets and the Competitive Environment

• Perfect competition is a market structure when there are many firms, each selling an identical product,
many buyers, and with no restrictions on entry of new firms to the industry. Both firms and buyers are well
informed of the prices of the products of all firms in the industry.
• Monopolistic competition is a market structure in which a large number of firms compete by making
similar but slightly different products. Making a product slightly different from the product of a competitor
is called product differentiation and it gives the firm an element of market power.
• Oligopoly is a market structure in which a small number of firms compete. Oligopolies might produce
almost identical or differentiated goods.
• Monopoly arises when there is one firm, which produces a good or service that has no close substitutes
and in which the firm is protected by a barrier preventing the entry of new firms.

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 ORGANIZING PRODUCTION 5

Measures of Concentration
There are two measures of market concentration:
• The four-firm concentration ratio is the percentage of the value of sales accounted for by the four
largest firms in the industry. The four-firm concentration ratio ranges between near 0 (extremely
competitive) to 100 (not very competitive).
• The Herfindahl–Hirschman index (HHI) is the square of the percentage market share of each firm
summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. The
HHI ranges between near 0 (extremely competitive) to 10,000 (a monopoly).
• The HHI can be used to classify markets:
• Markets with an HHI of less than 1,000 are regarded as highly competitive.
• Markets with an HHI of between 1,000 and 1,800 are regarded as moderately competitive.
• Markets with an HHI above 1,800 are regarded as concentrated.
• Concentration measures fail to take account of:
• Geographic Scope of the Market: Concentration ratios define the market as the entire United States,
but the relevant market might be smaller than the entire nation (newspapers, for which the market is a
city) or larger than the entire nation (automobiles, for which the market is the entire world).
• Barriers to Entry and Firm Turnover: For some industries, a few firms might be currently operating
in the market but competition in these industries might be fierce, with firms regularly entering and
exiting the industry.
• Market and Industry Correspondence: Some firms produce a product with very specific
applications for which few competitors exist, but are classified in too broad of a market (specific
pharmaceutical drugs) while other firms have diversified into several distinct product lines and are
subject to more effective competition than what their market share for just one product might suggest.

V. Produce or Outsource? Firms and Markets

• Firms coordinate production when they can do so more efficiently than a market.
• Firms coordinate production when they can do so more efficiently than a market.
• Markets coordinate production by adjusting prices and making the decisions of buyers and sellers of factors
of production consistent.
• Outsourcing, buying parts or products from other firms, is an example of market coordination.

Why might firms be more efficient at coordinating production than markets?

• Firms can reduce transactions costs, which are the costs that arise from finding someone with whom to
do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring
that the terms of the agreement are fulfilled.
• Firms can capture economies of scale, which occurs when the cost of producing a unit of a good falls
as its output rate increases.
• Firms can capture economies of scope, which occurs when a firm can use specialized inputs to produce
a range of different goods at a lower cost than otherwise.
• Firms can engage in team production, in which the individuals can coordinate to specialize in mutually
supporting tasks.
• There are limitations to the efficiency advantage that firms might have over markets in coordinating
resources. If coordination through firms is more costly than coordination through markets, markets will
coordinate production.

Economics in Action: Apple doesn’t produce the iPhone by itself. Global supply chains, high degrees of
specialization and competition, and other innovations have made it possible for a company to design and market a
product, collect most of the profit from it, and yet not produce it.

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6 CHAPTER 10

Why do firms exist? Ronald Coase is the classic on this topic. Born in England in 1910, be graduated with a
bachelor of commerce degree in 1932, at the depth of the Great Depression. While still an undergraduate, he was
puzzled by the fact that he was being taught that markets coordinate economic activity, yet all around him he could
see firms that were also coordinating economic activity. “Why?” he wondered. The question was especially
important at that time because Socialists (and the young Coase was one of them) thought that central planning by
government was superior to the market.
Quoting from Coase’s autobiography, http://www.nobel.se/economics/laureates/1991/coase-autobio.html, “I
spent the academic year 1931-32 on my Cassel Travelling Scholarship in the United States studying the structure of
American industries, with the aim of discovering why industries were organized in different ways. I carried out this
project mainly by visiting factories and businesses. What came out of my enquiries was not a complete theory
answering the questions with which I started but the introduction of a new concept into economic analysis,
transaction costs, and an explanation of why there are firms. All this was achieved by the Summer of 1932, as the
contents of a lecture delivered in Dundee in October 1932, make clear. These ideas became the basis for my article
“The Nature of the Firm,” published in 1937, cited by the Royal Swedish Academy of Sciences in awarding me the
1991 Alfred Nobel Memorial Prize in Economic Sciences.”
So, this amazing scholar had done his Nobel-prize-winning work at the age of 22!

Economics in the News: The battle for market share of Internet advertising. Google has introduced real-time ad
words and Facebook attempts to make its site better than other social networking services. Yahoo attempts to make
its search engine better than other search engines, but it has not seen the growth that Google and Facebook have
seen.

Answers to the Review Quizzes(Text book 9th ed)

Page 226
1. What is a firm’s fundamental goal and what happens if the firm doesn’t pursue this
goal?
A firm’s fundamental goal is to maximize its profit. If the firm fails to maximize profit it is either
eliminated or bought out by other firms maximizing profit.
2. Why do accountants and economists calculate a firm’s cost and profit in different
ways?
Accountants and economists have different reasons for computing a firm’s costs and profit.
Accountants measure a firm’s cost and profit to ensure that the firm pays the correct amount of
income tax and to show its investors how their funds are being used. Economists measure a
firm’s cost and profit to enable them to predict the firm’s decisions.
3. What are the items that make opportunity cost differ from the accountant’s measure
of cost?
A firm’s opportunity cost includes the cost of using resources bought in the market, owned by
the firm, and supplied by the firm's owner. Economists and accountants both include the price
of resources bought in the market as costs. But accountants omit costs included by economists.
For example, economists include the cost of a firm using its own capital, called the implicit
rental rate. Additionally economists include normal profit, interest forgone, and economic
depreciation as opportunity costs not recorded by an accountant.

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 ORGANIZING PRODUCTION 7

4. Why is normal profit an opportunity cost?

Normal profit is the profit that an entrepreneur earns on average. Normal profit is an opportunity
cost for the firm because it is the cost of a forgone alternative, which is running another firm.
5. What are the constraints that a firm faces? How does each constraint limit the
firm’s profit?
The three types of constraints a firm faces are technology constraints, information constraints,
and market constraints. Technology is any method of producing a good or service. 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. 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. Market constraints mean that 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.

Page 245

#3. Four ways of laundering 100 shirts are in the table.

Labour Capital
a. Which methods are technologically efficient? Method (hours) (machines)
All the methods are technologically efficient. A 1 10
b. Which method is economically efficient if the B 5 8
C 20 4
hourly wage rate and the implicit rental rate of
D 50 1
capital are:
(i) Wage rate $1, rental rate $100?
Method D is economically efficient because the total cost is the least. Method D’s costs are
50  $1 + 1  $100, which is $150.
(ii) Wage rate $5, rental rate $50?
Method D and Method C are economically efficient because the total cost is the least.
Method C’s costs are 20  $5 + 4  $50, which is $300 and Method D’s costs are 50  $5 +
1  $50, which is also $300.
(iii) Wage rate $50, rental rate $5?
Method A is economically efficient because the total cost is the least. Method A’s costs are 1
 $50 + 10  $5, which is $100.

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