Business organization and behaviour

Chapter 7 Business organization and behaviour David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 7.1 The theory of supply Costs of production Revenues Firms‟ decisions about how much output to supply depend upon the costs of production and the revenue they receive from selling the output. Firm chooses level of output 7.2 Forms of business organization  Sole trader – owned by an individual entitled to income and responsible for losses  Partnership – jointly owned by two or more people – unlimited liability  Company – ownership divided among shareholders – legal entitlement to produce and trade – limited liability – shares of public companies resold on the stock exchange 7.3 Some key terms  Revenues – the amount a firm earns by selling goods and services in a given period  Costs – the expenses incurred in producing goods and services during the period  Profits – the excess of revenues over costs 7.4 A firm‟s balance sheet  Assets – what the firm owns  Liabilities – what the firm owes  Balance sheet – lists a firm‟s assets and liabilities at a point in time 7.5 Snark International balance sheet 31 December 2000 ASSETS LIABILITIES Cash Accounts receivable Inventories Factory building (original value £250,000) Other equipment (original value £300,000) £ 40,000 70,000 100,000 200,000 180,000 £ 590,000 ======== Accounts payable Salaries payable Mortgage from insurance company Bank loan Net worth £ 90,000 50,000 150,000 60,000 _______ 350,000 240,000 £ 590,000 ======= 7.6 Costs and the economist  Accounting cost – actual payments made by a firm in a period  Opportunity cost – amount lost by not using a resource in its best alternative use  Supernormal profit – profit over and above the return earned at the market rate of interest  Economists include opportunity cost in a firm‟s total costs 7.7 The production decision  For any output level, the firm attempts to mimimize costs  Assume the firm aims to maximize profits  Profits depend on both COSTS and REVENUE – each of which varies with the level of output  Marginal cost (MC) is the rise in total cost if output increases by 1 unit.  Marginal revenue (MR) is the rise in total revenue if output increases by 1 unit 7.8 Maximizing profits OutputQ1 E M C , M R MC MR 0 If MR > MC, an increase in output will increase profits. If MR < MC, a decrease in output will increase profits. So profits are maximized when MR = MC at Q1 (so long as the firm covers variable costs) 7.9 Will firms try to maximize profits?  Large firms are not run by their owners – there is separation of ownership and control  Managers may pursue different objectives – e.g. size, growth  But firms not maximizing profits may be vulnerable to takeover – or managers may be given share options to influence their incentive to maximize profits 7.10 Chapter 8 Developing the theory of supply: Costs and production David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 8.12 Choosing output COSTS REVENUES Technology & costs of hiring factors of production TC curves (short & long run) AC (short & long run) MC Demand curve AR MR CHECK: produce in SR? close down in LR? Choose output level 8.13 The production function  The amount of output produced depends upon the inputs used in the production process  A factor of production (“input”) is any good or service used to produce output  The production function specifies the maximum output which can be produced given inputs 8.14 Short run vs. long run  The short run is the period in which a firm can make only partial adjustment of inputs  e.g. the firm may be able to vary the amount of labour, but cannot change capital.  The long run is the period in which a firm can adjust all inputs to changed conditions.  The long-run total cost curve describes the minimum cost of producing each output level when the firm is free to vary all input levels. 8.15 Average cost The average cost of production is total cost divided by the level of output. Long-run average cost (LAC) is often assumed to be U-shaped: LAC Output 8.16 Economies of scale Economies of scale – or increasing returns to scale – occur when long-run average costs decline as output rises: LAC Output 8.17 Decreasing returns to scale – occur when long-run average costs rise as output rises: LAC Output 8.18 Constant returns to scale – occur when long-run average costs are constant as output rises: LAC Output 8.19 The firm‟s long-run output decision  The decision: – If the price is at or above LAC1, the firm produces Q1. – If the price is below LAC1 – the firm goes out of business  NB: LMC always passes through the minimum point of LAC. AC1 £ Output (goods per week) MR LAC LMC Q1 LMC = MR 8.20 The short run  Fixed factor of production – a factor whose input level cannot be varied  Fixed costs – costs that do not vary with output levels  Variable costs – costs that do vary with output levels  STC = SFC + SVC 8.21 The marginal product of labour  The marginal product of labour is the increase in output obtained by adding 1 unit of the variable factor but holding constant the inputs of all other factors.  Labour is often assumed to be the variable factor – with capital fixed. 8.22 The law of diminishing returns  Holding all factors constant except one, the law of diminishing returns says that:  beyond some value of the variable input,  further increases in the variable input lead to steadily decreasing marginal product of that input.  e.g. trying to increase labour input without also increasing capital will bring diminishing returns. 8.23 The firm‟s short-run output decision  Firm sets output at Q1, where SMC=MR  subject to checking the average condition: – if price is above SATC1 firm produces Q1 at a profit – if price is between SATC1 and SAVC1 firm produces Q1 at a loss – if price is below SAVC1, firm produces zero output. SAVC1 £ Output MR SAVC SMC Q1 SATC SATC1 SMC = MR 8.24 The long-run average cost curve LAC Output A v e ra g e c o s t SATC1 Each plant size is designed for a given output level SATC2 SATC3 SATC4 So there is a sequence of SATC curves, each corresponding to a different optimal output level. LAC In the long-run, plant size itself is variable, and the long-run average cost curve LAC is found to be the „envelope‟ of the SATCs 8.25 The firm‟s output decisions – a summary Marginal condition Check whether to produce Short-run decision Long-run decision Choose the output level at which MR = SMC Choose the output level at which MR = LMC Produce this output unless price lower than SAVC. If it is, produce zero Produce this output unless price is lower than LAC. If it is, produce zero.