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
... [Show More] fails to maximize profit it is either eliminated or bought out by other firms maximizing profit.
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. An accountant calculates 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. An economist calculates a firm's cost and profit in a way that enables him or her to predict the firm's decisions.
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 instance, use of a building the owner has already purchased has an opportunity cost that accountants do not include. Additionally the normal profit, interest foregone, and economic depreciation are other opportunity
costs not recorded by an accountant.
Why is normal profit an opportunity cost?
Normal profit is the return to a firm's owner for the owner's supply of entrepreneurial ability and labor
to the firm's production process. Using the owner's ability to run the business implies that the owner
could have received a return for using it in another capacity, such as running another firm. This cost is
an opportunity cost for the firm because it is the cost of a forgone alternative, which is running another firm, and must be included in calculating the firm's opportunity cost of production
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 specific method of producing a good or service and it advances over time. Using the available technology, the firm can produce more only if it hires more resources, which will increase its costs and limit the profit of additional output. 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.
Is a firm technologically efficient if it uses the latest technology? Why or why not?
Technological efficiency occurs when a firm produces a given level of output using the least amount of
inputs. Adopting the latest available technology does not necessarily imply that a firm's production process is technologically efficient. As long as the firm is getting the maximum possible output for a given combination of inputs, it is technologically efficient.
Is a firm economically inefficient if it can cut its costs by producing less? Why or why not?
Economic efficiency occurs when the firm produces a given level of output at the least cost. If a firm can
decrease production costs by decreasing output, it is not necessarily economically inefficient. If it is producing the new level of output at the least possible cost, it is achieving economic efficiency
Explain the key distinction between technological efficiency and economic efficiency.
The difference between technological and economic efficiency is that technological efficiency concerns
the quantity of inputs used in production for a given level of output, whereas economic efficiency concerns the value of the inputs used. Economic efficiency requires technological efficiency, but technological efficiency does not require economic efficiency.
Why do some firms use large amounts of capital and small amounts of labor while others use small amounts of capital and large amounts of labor?
The mix of resources used, such as large amounts of capital versus small amounts of capital, depends on economic efficiency. Economic efficiency is based on minimizing the value of the resources used, not the quantity. A firm will use the mix that produces output at the lowest possible cost, without regard to specific physical quantities or ratios of inputs. As the cost of capital decreases relative to the cost of other resources, capital-intensive production methods will become economically efficient and firms will avoid labor-intensive methods
Explain the distinction between a command system and an incentive system
A command system uses a managerial hierarchy, where commands pass downward through the hierarchy and information (feedback) passes upward. These systems are relatively rigid and can have many layers of specialized management. Incentive systems use market-like mechanisms to induce workers to perform in ways that maximize the firm's profit.
What is the principal-agent problem? What are three ways in which firms try to cope with it?
The principal-agent problem is the problem of devising compensation rules that induce an agent to act
in the best interests of a principal. There are three ways of coping with this problem: Ownership, often
offered to managers, gives the agents an incentive to maximize the firm's profits, which is the goal of the
owners, the principals; incentive pay links managers' or workers' pay to the firm's performance and helps
align the managers' and workers' interests with those of the owners, the principal; long-term contracts tie
managers' or workers' long-term rewards to the long-term performance of the firm, encouraging the
agents to work in the best long-term interests of the firm owners, the principals
What are the three types of firms? Explain the major advantages and disadvantages of each.
The three main ways of organizing a firm have both advantages and disadvantages:
1. Proprietorship. ADVANTAGES—easy to set up; managerial decision-making is simple and rapid; and profits are taxed only once. DISADVANTAGES—bad decisions on the part of the owner are not subject to review; the owner's entire wealth is at stake because of unlimited liability; the firm dies with the owner; and acquiring capital and labor is expensive.
2. Partnership. ADVANTAGES—easy to set up; has diversified decision-making so that more than one person's expertise can be utilized; can survive the death or withdrawal of a partner; and profits are taxed only once. DISADVANTAGES—all the owners' wealth is at risk because of unlimited liability; if there are many partners, gaining a consensus about managerial decisions may be difficult; the withdrawal of partner may create capital shortage; labor costs are high compared to corporations; and capital costs can be high.
3. Corporation. ADVANTAGES—perpetual life; limited liability for its owners; readily available, largescale, and low-cost capital; can rely on professional managers rather than the talents of the owners; and reduced costs from long-term labor contracts. DISADVANTAGES—potentially complex management structure may lead to slow and expensive decision-making; and profits are taxed twice, once as corporate profit and once as income to the stockholders.
What are the four market types? Explain the distinguishing characteristics of each
1. Perfect competition is a market with many firms, each selling an identical product. There are many
buyers and no restrictions on entry of new firms. Firms and buyers are all well informed of prices
and products of all firms in the industry.
2. Monopolistic competition is a market with many firms that produce similar but slightly different
goods.
3. Oligopoly is a market in which a small number of firms compete and each firm may produce almost
identical or differentiated goods.
4. Monopoly is a market in which only one firm produces the entire output of the industry. There are
no close substitutes for the monopolist's p
Is the U.S. economy competitive? Is it becoming more competitive or less competitive?
The U.S. economy would be considered competitive since three-quarters of the value of goods and services bought are in markets characterized as perfect competition or monopolistic competition. The U.S. economy has become increasingly competitive over the decades.
What are the two ways in which economic activity can be coordinated?
Firms and markets both coordinate resources.
What determines whether a firm or markets coordinate production?
Firms coordinate resources when they can do so at lower cost than can a market.
1. Firms may reduce transactions costs, which are the costs arising from finding someone with whom
to do business, reaching agreement on the price and other aspects of the exchange, and ensuring that the terms of the agreement are fulfilled.
2. Firms can capture economies of scale, which occurs when the cost of producing a unit falls as its output
rate increases.
3. Firms can capture economies of scope, where one firm can use specialized inputs to produce a range
of different goods at a lower cost than otherwise.
4. Firms can engage in team production, in which the individuals specialize in mutually supportive tasks.
Firms coordinate economic activity when they can perform a task more efficiently than markets can. In such a situation, it is profitable to set up a firm. If markets can perform a task more efficiently than a firm can, firms will use markets, and any attempt to set up a firm to replace such market coordination will be doomed to failure
What are the main reasons why firms can often coordinate production at a lower cost than markets can?
Firms can often coordinate production at a lower cost than can markets because firms lower transactions costs and achieve economies of scale, scope, and team production. These opportunities are not present when markets coordinate production.
Distinguish between the short run and the long run.
The short run is a period of time during which the quantity of at least one factor of production is fixed and cannot be changed. The long run is a period of time long enough so that the quantities of all factors of production can be varied.
Why is a sunk cost irrelevant to a firm's current decisions?
Sunk cost is irrelevant because it cannot be changed by any decision. It is already incurred and so must
be paid. The only costs that concern the firm are costs that the firm can change with its current decisions
Explain how the marginal product and average product of labor change as the labor employed increases (a) initially and (b) eventually.
Initially, as the quantity of labor is increases, the firm experiences increasing marginal returns, which means that the marginal product increases as more labor is employed. Increasing marginal returns occur because hiring additional workers allows the workers to specialize and become more productive. Eventually, the firm will experience diminishing marginal returns which means that the marginal product decreases as more labor is employed. Decreasing marginal returns occur because eventually the gains from specialization diminish and because more and more workers are working with the same fixed amount of capital. The average product of labor follows the marginal product of labor. Initially, when the marginal product of labor is increasing, the average product also increases. As long as the marginal product of labor exceeds the average product of labor, the average product continues to increase. Eventually when the marginal product is falling it falls enough so that it is less than the average product, at which point the average product of labor decreases.
What is the law of diminishing returns? Why does marginal product eventually diminish?
The law of diminishing returns states that as a firm uses more of a variable factor of production with a
given quantity of fixed factors of production, the marginal product of the variable factor eventually diminishes. Diminishing marginal returns arises from the fact that ever more workers are using the same capital and working in the same space.
Explain the relationship between marginal product and average product
As the quantity of labor initially increases the firm experiences increasing marginal returns and the marginal product of labor increases. The marginal product of labor is greater than the average product over this range of labor, so the average product of labor increases when the quantity of labor increases. Eventually, diminishing marginal returns causes the marginal product of labor to fall. When the marginal product of labor falls below the average product, the average product decreases as the quantity of labor increases
Which of the following news items involves a short-run decision and which involves a long-run
decision? Explain.
1. January 31, 2008: Starbucks will open 75 more stores abroad than originally predicted, for a total of
975.
This decision is a long-run decision. It increases the quantity of all of Starbucks' factors of production,
labor and the size of Starbucks' plant.
2. February 25, 2008: For three hours on Tuesday, Starbucks will shut down every single one of its
7,100 stores so that baristas can receive a refresher course.
This decision is a short-run decision. It involves increasing the quality of Starbucks' labor and so only
one factor of production—labor—changes and all the other factors remain fixed.
3. June 2, 2008: Starbucks replaces baristas with vending machines.
This decision is a short-run decision. It involves changing two of Starbucks' factors of production, labor
and one type of capital. But other factors of production, such as Starbucks' land and other capital inputs
such as the store itself, remain fixed.
4. July 18, 2008: Starbucks is closing 616 stores by the end of March.
This decision is a long-run decision. It decreases the quantity of all of Starbucks' factors of production,
labor and the size of Starbucks' plant
What relationships do a firm's short-run cost curves show?
The marginal cost (MC), average total cost (ATC) and average variable cost (AVC) curves are all related in the short run: When the MC curve lies above (lies below) the AVC curve, the AVC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the AVC curve at its lowest point. When the MC curve lies above (lies below) the ATC curve, the ATC curve rises (falls) with output. This implies that as output increases, the MC curve cuts through the ATC curve at its lowest point. As output increases, the ATC curve becomes vertically closer to the AVC curve.
How does marginal cost change as output increases (a) initially and (b) eventually?
At small outputs, marginal cost decreases as output increases because of greater specialization and the division of labor, but as output increases further, marginal cost eventually increases because of the law of diminishing returns.
What does the law of diminishing returns imply for the shape of the marginal cost curve?
The law of diminishing returns states: As a firm uses more of a variable factor of production, with a given quantity of the
fixed factor of production, the marginal product of the variable factor eventually diminishes. The law of diminishing
returns means that each additional worker produces a successively smaller addition to output. So to get an additional unit of output, ever more workers are required. The cost of an additional unit of output—marginal cost—is increasing, so the marginal cost curve eventually slopes upward
What is the shape of the AFC curve and why does it have this shape?
Average fixed cost (AFC) equals total fixed cost divided by total product. As the quantity produced increases, the fixed
costs are spread over a larger and larger quantity of output so average fixed cost decreases. So the AFC curve slopes
downward as the quantity produced increases.
What are the shapes of the AVC curve and the ATC curve and why do they have these shapes?
The average variable cost (AVC), and average total cost (ATC) curves are both U-shaped.
The marginal cost (MC) curve shows how total cost changes when output increases by one unit. If the MC curve lies below the AVC curve, AVC is falling. Diminishing marginal returns means that eventually the MC curve slopes upward. At some point the MC curve lies above the AVC curve, and the AVC curve is upward sloping.
ATC is the sum of average fixed cost (AFC) and AVC. Initially the ATC curve falls as the quantity produced increases because the AFC is initially quite large, but drops rapidly as total fixed costs are spread over greater levels of output. However, eventually diminishing returns cause marginal product to fall below average product, and average product decreases. As a result AVC increases as the quantity produced increases. If AVC rises more quickly than AFC falls, then the ATC curve is upward sloping.
What does a firm's production function show and how is it related to a total product curve?
A firm's production function is the relationship between the maximum output attainable and the quantities of both capital and labor. The total product curve shows the maximum output that a given quantity of labor can produce for a given quantity of capital.
Does the law of diminishing returns apply to capital as well as labor? Explain why or why not.
oes the law of diminishing returns apply to capital as well as labor? Explain why or why not.
The law of diminishing returns applies to capital as well as labor. The marginal product of capital is the change in the total product resulting from a one-unit increase in capital, holding the quantity of labor constant. As the quantity of capital increases for a given level of labor, the first units of capital will increase output substantially. But as capital continues to increase, eventually the increase in production starts to get smaller and diminishing returns to capital are occurring.
What does a firm's LRAC curve show? How is it related to the firm's short-run ATC curves?
The long-run average cost curve (LRAC) shows the relationship between the lowest attainable ATC and output when both plant size and labor are varied. The LRAC curve reflects the minimum possible ATC the firm can attain for any given level of output. For any level of output the firm might choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular plant size. Once the firm has chosen that plant size, it will incur costs corresponding to the ATC curve associated with that plant size
What are economies of scale and diseconomies of scale? How do they arise? What do they imply for the shape of
the LRAC curve?
Economies of scale are features of a firm's technology that lead to falling long-run average cost (LRAC) as output
increases. As plant size increases, the minimum attainable average total cost (ATC) for each plant size falls with output. Diseconomies of scale are features of a firm's technology that lead to rising LRAC as output increases. As plant size increases, the minimum attainable ATC for each plant size rises with output. A firm initially experiences economies of scale up to some output level and over this range of output the LRAC curve is downward sloping as output increases. Beyond that output level, it may move toward diseconomies of scale. When there are diseconomies of scale, the LRAC slopes upward as output increases, resulting in a U-shaped LRAC curve.
What is a firm's minimum efficient scale?
Minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. If the
long-run average cost curve has the typical U shape, the minimum point of the LRAC identifies the level of output that represents the firm's minimum efficient scale.
How do we derive the short-run market supply curve in perfect competition?
The short-run market supply curve is the horizontal sum of each individual firm's supply curve. That is, the amount supplied by the total market equals the sum of what each firm in the industry supplies at a given price.
In perfect competition, when market demand increases, explain how the price of the good and the output and profit of each firm changes in the short run.
When market demand increases, the market price of the good rises, and the market quantity increases.
Because price equals marginal revenue, the rise in the price means marginal revenue rises. As a result,
each firm moves up its marginal cost curve and increases the quantity it produces. The firm's economic profit rises (or its economic loss decreases). If the firm had been making a normal profit before the increase in demand, after the increase the firm makes an economic profit.
In perfect competition, when market demand decreases, explain how the price of the good and the output and profit of each firm changes in the short run.
When market demand decreases, the market price of the good falls and the market quantity decreases.
Because the price equals marginal revenue, the fall in the price means marginal revenue falls. As a result, each firm moves down its marginal cost curve so each firm decreases the quantity it produces. The firm's economic profit falls (or its economic loss increases). If the firm had been making a normal profit before the decrease in demand, after the decrease the firm incurs an economic loss [Show Less]