The Four Types of Competition: Number of Sellers and Type of Product

Type of competition	Number of Sellers	Type of product
Perfect competition	Many	Identical
Monopoly	One	-
Monopolistic competition	Many	Differentiated
Oligopoly	Few	Either identical or differentiated

The Four Types of Competition: Price and Output

Type of competition	Price	Output
Perfect competition	At minimum ATC	At minimum point of ATC
Monopoly	Higher than minimum ATC	Restricted (to left of minimum ATC)
Monopolistic competition	Higher than minimum ATC	Restricted (to left of minimum ATC)
Oligopoly	Higher than minimum ATC	Restricted (to left of minimum ATC)

The Four Types of Competition: Profit and Efficiency

Type of competition	Profit	Efficiency
Perfect competition	Zero economic profit	Peak efficiency
Monopoly	Make an economic profit	Less than peak efficiency
Monopolistic competition	Zero economic profit	Less than peak efficiency
Oligopoly	Make an economic profit	Less than peak efficiency

LECTURE 7: THE FIRM

1. Market and Firm Coordination

2. Size and Types of Business Organizations

3. The Balance Sheet of a Firm

 

Market and Firm Coordination

 

Firm: An economic institution that purchases and organizes resources to produce desired goods and services.

Production in a market economy is based on the principle of the division of labor.

Principle of the division of labor: An economic principle whereby individuals specialize in the production of a single good or service, increasing overall productivity and economic efficiency.

The division of labor in a market economy is a vast network of activities based on such factors as the different levels of skill possessed by members of the labor force.

Basically, there are two methods of economic coordination in a market economy:

1) market coordination;

2) firm coordination.

Market coordination: The process that directs the flow of resources into the production of desired goods and services through the forces of the price mechanism.

Firm coordination: The process that directs the flow of resources into the production of a particular good or service through the forces of management organization within a firm.

In some respects a business firm is like a command economy within a market economy. Decision making in the firm is centralized and performed by managers.

Manager: An individual or group of individuals that organize and monitor resources within a firm to produce a good or service.

Size and Types of Business Organizations

Firms exist when they are the least costly form of economic coordination; their size is determined by what is most efficient (least costly) for production.

We do not use the market to organize all production because it is not costless to use markets. Using the market necessitates finding out what prices are, negotiating and enforcing contractual agreements with suppliers, going to court when promises are not kept, paying transactions costs, and engaging in various other costly and resource-using activities. For these reasons, not all production in a market economy is coordinated through market exchange. It costs less in many cases to organize production in a firm where resource allocation is directed and coordinated by managers.

Team production: An economic activity in which workers must cooperate, as team members, to accomplish a task.

A fundamental principle involved in the operations of many firms is team production, by which several people work together to accomplish a task. None of the individual team members produces a separate product. The classic example is the assembly line invented by Henry Ford.

Monitor: An individual who coordinates team production and discourages shirking.

Shirking: Sometimes rational behavior of members of a team production process in which the individual exerts less than the normal productive effort.

Residual claimant: The individual or group of individuals that share in the excess of revenues over costs, that is, profits.

Scale of Production

As we have seen, firms evolve when team effort can produce goods and services at a lower cost than individual effort. This occurs because of the increased efficiency that may be gained when labor and capital are coordinated through managerial talents. In the following sections, we consider the varying sizes of firms and the advantages and disadvantages of various ways that firms can be organized.

The most efficient size for firms (the size that performs at the lowest cost of production) varies greatly. The most efficient scale of production can be as small as a hot dog stand on a street comer or as large as a General Motors assembly plant.

Scale of production: The relative size and rate of output of a physical plant that may be measured by the volume or value of firm capital.

Categories of Ownership

Generally, a firm is organized to fit one of three legal categories:

1) proprietorship;

2) partnership;

3) corporation.

The nature of ownership is different in each category.

 

Proprietorship

Proprietorship: Is a firm that has a single owner who is liable — or legally responsible — for all the debts of the firm, a condition termed unlimited liability. The sole proprietor has unlimited liability in the legal sense that if the firm goes bankrupt, the proprietor's personal as well as business property can be used to settle the firm's outstanding debts.

Unlimited liability: A legal term that indicates that the owner or owners of a firm are personally responsible for the debts of a firm up to the total value of their wealth.

More often than not, the sole proprietor also works in the firm as a manager and a laborer. Obviously, most single-owner firms are small. Many small retail establishments are organized as proprietorships.

The primary advantage of the proprietorship is that it allows the small businessperson direct control of the firm and its activities. The owner, who is the residual claimant of profits over and above all wage payments and other expenses, monitors his or her own performance. The sole proprietor faces a market price directly. It is up to the sole proprietor to decide how much effort to expend in producing output. In other words, the sole proprietor can be his or her own boss.

The primary disadvantage of the proprietorship is that the welfare of the firm largely rests on one person. The typical sole proprietor is the chief stockholder, chief executive officer, and chief bottle washer for the firm. Since there are only twenty-four hours in a day, the sole proprietor faces problems in attending to the various aspects of the business.

 

Partnership

Partnership: Is an extended form of the proprietorship. Rather than one owner, a partnership has two or more co-owners. These partners — who are team members — share financing of capital investments and, in return, the firm's residual claims to profits. Jointly they perform the managerial function within the firm, organizing team production and monitoring one another's behavior to control shirking. A partnership is a form well suited to lines of team production that involve creative or intellectual skills, an area in which monitoring is difficult. Imagine trying to direct a commercial artist's work in detail or monitoring a lawyer's preparation for a case.

The partnership also has certain limitations. Individual partners cannot sell their share of the partnership without the approval of the other partners. The partnership is terminated each time a partner dies or sells out, resulting in costly reorganization. And each partner is considered legally liable for all the debts incurred by the partnership up to the full extent of the individual partner's wealth, a condition called joint unlimited liability. Because of these limitations, partnerships are usually small and are found in businesses where monitoring of production by a manager is difficult.

Joint unlimited liability: The unlimited liability condition in a partnership that is shared by all partners.

 

Corporation

While corporations are not the most numerous form of business organization, they conduct most of the business. This means that many large firms are corporations and that this form of business organization must possess certain advantages over the proprietorship and the partnership in conducting large-scale production and marketing.

In a corporation, ownership is divided into equal parts called shares of stock. If any stockholder dies or sells out to a new owner, the existence of the business organization is not terminated or endangered as it is in a proprietorship or partnership. For this reason the corporation is said to possess the feature of continuity.

Share: The equal portions into which the ownership of a corporation is divided.

Share transferability: The power of an individual shareholder to sell his or her portion of ownership without the approval of other shareholders.

Share transferability is the most economically important feature of the corporation. It allows owners and managers to specialize, increasing efficiency and profitability in the firm. Owners of stock in a corporation do not need to be concerned with the day-to-day operations of the firm. All that owners need to do is observe the changing price of the firm's shares on the stock market to decide whether the company is being competently managed. If they are dissatisfied with the performance of the company, they can sell their stock. Managers, on the other hand, specialize in reviewing the day-to-day operations of the corporation.

Limited liability: The legal term indicating that owners of corporations are not responsible for the debts of the firm except for the amount they have invested in shares of ownership.

Other Types of Enterprises

The proprietorship, the partnership, and the corporation are not the only possible types of firms in the economy. Other types of firms are not generally numerous, nor do they account for a large portion of economic activity.

Labor-managed firm: A firm that is, owned and thus managed by the employees of the firm, who have the right to claim residuals.

Nonprofit firm: A firm in which the costs of production and revenues must be equal and which does not have a residual claimant.

Publicly owned firm: A firm owned and operated by government.

 

The Balance Sheet of a Firm

The financial status of a business enterprise is represented by a balance sheet, a statement in which the dollar value of all the firm's assets corresponds to an equal total value of ownership claims. This correspondence is necessary and exact. An asset is a resource owned by the firm, an ownership claim identifies each party who has a property right or a claim to the firm's assets or wealth.

Balance sheet: An accounting representation of the assets and liabilities of a firm.

Asset: Anything of value owned by the firm that adds to the firm's net worth.

A liability is simply a debt of the company—what the company owes to various creditors.

Table 1

Balance Sheet of Joan Robinson, a Sole Proprietor

Assets	Debts
Cash holdings	$ 4,000	Accounts payable	$ 8,000
Equipment	20,000	Mortgage payable	20,000
Warehouse inventory	14,000	Total debts	28,000
Land and building	100,000	Joan Robinson's equity	110,000
Total assets	$ 138,000	Total debts plus equity	$ 138,000

 

The net worth or equity of the firm to Joan Robinson is equal to total assets minus total debts. In a sole proprietorship the single owner has complete claim to all of the equity.

Table 2

Balance Sheet of Smith and Ricardo, a Partnership

Assets	Debts
Cash holdings	$ 60,000	Accounts payable	$ 11,000
Equipment	10,000	Mortgage payable	40,000
Warehouse inventory	52,000	Total debts	51,000
Land and building	120,000	Adam Smith's equity	95,500
Total assets	$ 242,000	David Ricardo's equity	95,500
Total debts plus equity	$ 242,000

The balance sheet of a firm that is a partnership is very much like that of a sole proprietorship In this case; the firm's equity is divided equally between the partners.

Underlying the balance sheet is a fundamental identity:

Value of assets - Value of total claims to ownership = Value of liabilities (the amount owed) + Value of owned property in the firm

Another familiar way of expressing this identity is:

Assets = Liabilities + Net worth

Net worth is:

Net worth = Assets — Liabilities

Net worth, also called equity, is the amount of a firm's wealth left over for the owner(s) after all liabilities are met from the firm's assets. If liabilities exceed assets, the firm's net worth is negative.

Ownership claims: The legal titles that identify who own the assets of a firm.

Liability: Anything that is owed as a debt by a firm and therefore takes away from the net worth of the firm.

Net worth: The value of a firm to the owners, determined by subtracting liabilities from assets; also called equity. For corporations, net worth is termed capital stock.

Table 3

Balance Sheet of Robert Malthus, Inc., a Corporation

Assets	Debts
Cash holdings	$ 60,000	Accounts payable	$ 13,000
Equipment	10,000	Mortgage payable	40,000
Warehouse inventory	52,000	Total debts	53,000
Land and building	120,000	Capital stock	189,00
Total assets	$ 242,000	Total debts and capital stocks	$ 242,000

The capital stock of a corporation is the firm's net worth. This equity is divided among the shareholders, the owners of the firm.

 

Summary:

1. The basic function of a business firm is to combine inputs to produce outputs.

2. Economic coordination in a market economy can take place through prices and markets or within firms. Market coordination relies on price incentives; firm coordination relies on managerial directives.

3. Firm coordination of economic activities exists because there are costs to market exchange and sometimes efficiencies in large-scale production.

4. Team production takes place in firms. In team production, group output can be observed but individual output cannot.

5. Team production makes it natural for individual team members to shirk, that is, to reduce individual effort in achieving the team goal. It is the function of managers in the firm to control shirking.

6. A proprietorship is a single-owner firm whose owner faces unlimited liability for the contractual obligations of the firm. With unlimited liability, the personal wealth of the owner, above and beyond what he or she has invested in the firm, can be drawn on to settle the firm's obligations in the event of bankruptcy.

7. A partnership is owned by two or more individuals who face shared unlimited liability for the contractual obligations of the firm.

8. A corporation is owned by shareholders who have limited liability. Shareholders are liable only for the amount they have invested in the corporation.

9. Balance sheet is an accounting representation of the assets and liabilities of a firm.

LECTURE 8: COSTS OF A FIRM

1. Types of costs

2. Short-run costs

3. Long-run costs

 

Types of Costs

As we have seen, consumers have virtually unlimited wants, but resources to satisfy their wants are limited. Costs of production arise from the fact that resources have alternative uses. The same resources that are used to produce a good to satisfy consumers' demands can also be used to produce other goods. For resources to be drawn into the production of a particular good, they must be bid away from their present uses.

Explicit and Implicit Costs

The opportunity costs of production include both:

-explicit costs;

-implicit costs.

The firm does not make explicit payments for all the resources it uses to produce goods (services). The owner of the firm may not enter a wage for his own services on the balance sheet. Omitting his salary from the balance sheet, however, does not mean that the owner's services are free. They carry an implicit cost, valued by what the owner could have done with his time instead of working in his firm. Implicit costs are the opportunity costs of resources owned by the firm. They are called implicit costs because they do not involve contractual payments that are entered on the firm's balance sheet.

The main implicit cost that is not entered on the firm's balance sheet is the opportunity cost of capital. Individuals who invest in firms expect to earn a normal rate of return on their investment. For instance, they could have placed their capital in money market certificates and earned at least a 10 percent rate of return. In this case, the10 percent rate of return represents the opportunity cost of capital invested in business ventures. Unless investors earn at least the opportunity cost of capital, they will not continue to invest in a business.

The total cost of production is the sum of explicit and implicit costs. Total cost is the value of all the alternative opportunities forgone as a result of production of a particular good or service.

Costs of production: Payments made to the owners of resources to ensure a continued supply of resources for production.

Accounting costs: Payments that a firm actually makes, in the form of bills or invoices, explicit costs.

Implicit costs: The value of resources used in production for which no explicit payments are made, opportunity costs of resources owned by the firm.

Opportunity cost of capital: The value of the payment that could be received from the next-best alternative investment, the normal rate of return.

Total cost of production: The value of all resources used in production, explicit plus implicit costs.

Economic profit: The amount by which total revenues exceed total costs.

Accounting profit: The amount by which total revenues exceed accounting costs.