Lecture 8: Capitalist Production
Reading: Chapter 10
Capitalist Production
Q: What social institution is responsible for
organizing the production of most commodities
supplied to the market?
Firms
Q: What is it that firms do?
Firms accomplish two social tasks:
1. Organize Production
2. Organize Distribution
continued
Capitalist Production
Q: What is involved in organizing production:
There are a number of related decisions:
technology decision:
factor input decisions: 1. Hiring workers and managers (L) 2. Financing and purchasing capital
goods (K) 3. Purchasing intermediate inputs.
Capitalist Production
Q: What is involved in organizing distribution?
This is often referred to as marketing:
1. Pricing decision.
2. Output decision.
3. Distribution decision.
4. Advertising decision.
Capitalist Production
Q: How are firms themselves organized?
Two types of business organization
Unlimited Liability sole proprietorship Partnership
Limited Liability Private Corporation Public Corporation Crown Corporation
Q: Why has limited liability been so important?
Limited liability was a legal innovation which
enabled firms to attract a group of investors to
cooperate on large projects.
Q: What is the social significance of this legal
innovation?
The ability to raise much larger investment funds
made modern capitalism possible.
Capitalist Production
Capitalist Production
Q: Large corporations have an advantage in
financing projects that require large investments.
How do corporations finance investments?
Firms finance investments by
selling stock (equity)
selling bonds
bank loans
retained earnings from cash-flow
(borrowing from shareholders)continued
Capitalist Production
Q: Firms play a social role of organizing and distributing
production. This requires making decisions on output,
input, and technology, etc. What guides firm decision-
making?
Decisions are aimed at Maximizing Economic Profits
If the firm fails to maximize its profit, the firm is either
eliminated or bought out by other firms seeking to
maximize profit.
A manager who fails to pursue this objective loses his
job.
Capitalist Production
Q: What is profit?
The most common measure of profit is accounting profit:
Accounting Profit = Revenue – Accounting Costs
Q: What are Accounting Costs?
Accounting Costs = Explicit Costs
+ Conventional Depreciation
Explicit Costs = money costs of inputs
Conventional Depreciation = rate at which accountants
cost wear and tear on Capital (i.e. buildings and
equipment)
Capitalist Production
Q: Is accounting profit the true economic profit?
Economic Profit = Revenue – Opportunity Cost
Q: What is the Difference?
Opportunity Costs ≠ Accounting Costs
Q: What are a firm’s Opportunity Cost of Production?
A firm’s opportunity cost of production is the value
of the best alternative use of the resources that a
firm uses in production.
A firm’s opportunity cost of production is the sum
of the cost of using resources
Bought in the market (Explicit costs)
Owned by the firm (Implicit costs)
Supplied by the firm's owner (Implicit costs)
Resources Owned by the Firm
If the firm owns capital and uses it to produce its
output, then the firm incurs an opportunity cost. Instead of using the capital, the firm could
have sold the capital and rented capital from another firm.
The firm implicitly rent the capital from itself.
The firm’s opportunity cost of using the capital it
owns is called the implicit rental rate of capital.
The implicit rental rate of capital is made up of
1. Economic depreciation: is the change in the
market value of capital over a given period.
2. Interest forgone: is the return on the funds
used to acquire the capital.
Resources Supplied by the Firm’s Owner
The owner might supply both
entrepreneurship and labour.
The return to entrepreneurship is profit.
The profit that an entrepreneur can expect
to receive on average is called normal
profit.
Normal profit is the cost of
entrepreneurship and is a cost of
production.
In addition to supplying entrepreneurship, the
owner might supply labour but not take a wage.
The opportunity cost of the owner’s labour is the
wage income forgone by not taking the best
alternative job.
Economic Accounting: A Summary
Economic profit equals a firm’s total revenue
minus its total opportunity cost of production.
The example in Table 10.1 on the next slide
summarizes the economic accounting.
The Firm and Its Economic Problem
Capitalist Production
Q: What is the relationship between accounting and
economic costs and profits
Opportunity Costs > Accounting Costs
Economic Profits < Accounting Profits
Normal profit is considered a cost in the
economic framework, while it is considered profit
under the accounting framework.
Capitalist Production
Q: If firms make decisions to maximize profits, what
characterizes a good decision?
To maximize profits, decision-makers should
focus on marginal revenue (MR) and marginal
costs (MC) and follow this simple rule:
Increase an activity if MR>MC
Decrease an activity if MR<MC
Leave activity unchanged if MR = MC
Capitalist Production
For instance consider the decision on how much to produce and sell.
The MR will be the additional revenue from an additional unit produced and sold. The MC will be the additional opportunity cost of that unit.
The rule:
Increase Q if MR>MC
Decrease Q if MR<MC
Profit maximizing Q where MR=MC
Capitalist Production
For many firms the decision can be illustrated as
Capitalist Production
Q: What determines the shape of the total revenue
and total cost curves for a firm?
The shape of the total revenue curve depends on:
Market structure of the firm’s industry
The shape of the total cost curve depends on:
Input prices
Technology
Capitalist Production
Economists identify four types of market structure:
1. Perfect competition
2. Monopolistic competition
3. Oligopoly
4. Monopoly
The shape of the total revenue curve depends on
the market structure for the firm’s sales.
Perfect competition is a market structure with
Many firms
Each sells an identical product
Many buyers
No restrictions on entry of new firms to the
industry
Both firms and buyers are all well informed
about the prices and products of all firms in the
industry.
Capitalist Production
Monopolistic competition is a market structure
with
Many firms
Each firm produces similar but slightly different
products—called product differentiation
Each firm possesses an element of market
power
No restrictions on entry of new firms to the
industry
Capitalist Production
Oligopoly is a market structure in which
A small number of firms compete.
The firms might produce almost identical
products or differentiated products.
Barriers to entry limit entry into the market.
Capitalist Production
Monopoly is a market structure in which
One firm produces the entire output of the
industry.
There are no close substitutes for the product.
There are barriers to entry that protect the firm
from competition by entering firms.
Capitalist Production
Economists use two measures of market
concentration:
The four-firm concentration ratio
The Herfindahl–Hirschman index (HHI)
Capitalist Production
Two measures of market concentration The Four-Firm Concentration Ratio is the
percentage of the total industry sales accounted for by
the four largest firms in the industry.
The Herfindahl–Hirschman Index (HHI) is the square
of percentage market share of each firm summed over
the largest 50 firms in the industry.
The larger the measure of market concentration, the
less competition that exists in the industry.
Capitalist Production
The main limitations of only using concentration
measure as determinants of market structure
are
The geographical scope of the market
Barriers to entry and firm turnover
The correspondence between a market and an
industry
Capitalist Production
Capitalist Production
Why do we have firms at all?
We have already learned that markets coordinate a great deal of the economy. Why not production as well?
The market mechanism has many advantages:
Participation is voluntary
Market allocations are efficient
Markets are decentralized and automatically adjust to changing scarcity
Because of these advantages, Firms will coordinate
production only when they can do so more
efficiently than a market.
When are firms more efficient? Firms can achieve
Lower transactions costs
Economies of scale
Economies of scope
Economies of team production
Capitalist Production
Transactions costs 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.
Economies of scale occur when the cost of producing a unit of a good falls as its output rate increases.
Economies of scope arise 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 specialize in mutually supporting tasks.
Capitalist Production
Capitalist Production
End of Lecture