Chapter 10

The Firm, Production and Cost

Forms of Business Organization

Sole ProprieitorshipPartnershipCorporation (Joint-Stock Company)Public CorporationGovernment

Sole Proprieitorship

Advantages

Easy to OrganizeNo Legal Red TapeProfit Depends on one’s own effortIncentive to Manage Business Efficiently

Sole Proprieitorship

Disadvantages

Financial resources are limited.Commercial banks are unwilling to lend.Carry out many tasks and functions (buying,

selling, training personnel etc) UNLIMITED LIABILITY

Partnership

Advantages

Easy to Organize but still requires a written agreement.

Greater specialization in management.Financial resources are greater than

proprietorship

Partnership

Disadvantages

Division of authorityFinances are still limited to partners’ capital.Continuity is precarious, after withdrawal or

death of a partner.Unlimited Liability

Corporation

Separate Legal EntityDistinct from Its Owners.Can acquire or sell assets, incur debts,

extend credit, sue and be sued.TWO TYPES

Private Limited Company (shares cannot be traded on stock exchange)

Public Limited Company (shares are traded on some public exchange

ADVANTAGES OF CORPORATION

Can sell stocks and bonds. Easier access to bank credit

Most effective for raising capital.

Limited LiabilityOwners risk only what they paid for stockPersonal assets are not at stake in case of

bankruptcy.

ADVANTAGES OF CORPORATION

Easier to expand size and scope of operations.

Greater Specialization in use of human and capital resources.

Relative permanence to other forms of business organization.

PUBLIC CORPORATION

Setup to run a nationalized industry

Owned by state

Organization and legal status similar to a joint-stock company.

Government

Government agencies providing for various services.Health (Mayo Hospital, Jinnah Hospital,

National Health Service in England, Medicare in U.S.)

Education (public schools)Defence

Financing of Firms

Financial CapitalSharesBondsLong-Term Loans

Physical CapitalFactoriesMachineryOfficesOffice Equipment

Financial Capital

EquityAcquire fund by selling stocks and shares.Retain Current profits and finance investment

from undistributed profits.

Debt InstrumentsBonds (Long-Term, Specified Time of

Maturity and interest rate)Loans Between financial institutionsBills and Notes (for short-term loans,

specified principal and time of maturity)

Theory of the Firm

Firm as the Unit of Analysis

Firm Makes Decisions regarding production

OBJECTIVE OF FIRMProfit Maximization

Production, Costs and Profits

Total Revenue=Price× Quantity

Total Profit=Total Revenue –Total Cost

Increase in cost, decreases profit.

What determines the costs of production of a firm?

PRODUCTION FUNCTION

Inputs – the factors of production classified as:1. Land – all natural resources of the

earthPrice paid to acquire land = Rent

2. Labour – all physical and mental human effort involved in productionPrice paid to labour = Wages

INPUTS AND PRODUCTION

3. Capital – buildings, machinery and equipment not used for its own sake but for the contribution it makes to productionPrice paid for capital = Interest

Intermediate Products

Output of one firm, could be an input for another. These inputs are called “intermediate products”.

INPUTS AND COST

Increase in inputs will lead to higher cost in the form of wages, rent, interest.

Which costs to consider, as a firm hires or purchases an input?

Opportunity Cost

The cost of using something in a particular use is the benefit foregone by not using it in its best alternative use.

For hired inputs, opportunity cost is easy to measure.

If firm pays $10,000 for electricity, it has sacrificed its claims to whatever else $10,000 could buy.

Purchase price as reasonable measure of opportunity cost.

IMPUTED COSTS

How to assign a cost to factors that the firm “already owns”.

Costs of using such factors are called “imputed costs”.

These costs will reflect what the firm could have earned if it shifted these factors, to their next best use.

IMPUTED COSTS

Firm’s Own Capital EquipmentLoss in Value of Asset, called

depreciation.Buys machine for $12,000 and intends to

use for 6 years. Depreciation of $2000 per year.But after 1 year, car is worth $9,000 only.Charge $3000, as she can buy 1 year old

car and operate it for 5 years.

SUNK COSTS

EXAMPLEFirm buys a set of machines for $100,000.Machines can be used to make only one

product and cannot be leased to anyone else.

Life of 10 years. Depreciation =$10000/year.Cost of all other factors utilized in produciton

of output is $25,000After purchasing machines, firm realizes that

output can be sold for only $29,000 per year, instead of $35,000.

SUNK COSTS

Total Cost=$25,000+ 10000=$35,000

Revenue=$29,0000

Profit=29000-35000=-$6000 (i.e. LOSS)

Should product be made???

SUNK COSTS

The depreciation charge is a sunk cost.Firms cannot use machines anywhere

else, as they have no alternative use.Net Profit =29,000-25,000=$4,000i.e. if firm did not produce goods, it would

earn $4000 per year less, than if it carried on with production.

(-$10000 vs$ -6,000)

Resource Allocation and Profits

If firms are earning profits in one industry, owners of factors of production (f.o.p) will move their resources into that industry.

If losses are being earned, owners of f.o.p. will take resources out of that industry.

Crucial role of profits, in the working of a free-market system.

Profits encourage efficiency.