The Economics of Business Firms

Study Questions

n 1. What are the differences in the three forms of business organization?

n 2. What are the three types of merger?

n 3. What is the difference between fixed costs and variable costs?

n 4. How do average variable costs, average fixed costs, average total costs, and marginal cost fit together to form a production model?

n 5. What is the difference between accounting, economic, and normal profit?

n 6. Why does the existence of economic profit lead to industry expansion?

n 7. What are the profit maximization rules?

n 8. How can an industry in monopolistic competition evolve into an oligopoly?

n 9. How can a firm exploit economies of scale?

Organizing a Business

n Sole Proprietorship

n Partnership

n Corporation

Mergers

n horizontal – two firms that serve the same set of customers

n vertical – two firms operating at different stages of the production/distribution process

n conglomerate – two firms operating in unrelated industries

Income Statement

n Revenues – costs = profits

¨ Revenues – money coming into the firm

¨ Costs – money and nonmoney costs, also called expenses

¨ Profits – the positive difference between revenues and costs

¨ Losses – the negative difference between revenues and costs

Total Revenue (TR)

n Sales revenue received by the firm

n TR = P x Q

Marginal Revenue (MR)

n Additional revenue received when the firm sells one more unit of the product.

¨ MR = (change in revenue)/(change in output)

n In most markets, MR slopes downward twice as fast as the demand curve

Figure 4-1. Demand and Marginal Revenue

Costs

n Fixed costs (FC) – payment for the fixed inputs

n Variable costs (VC) – payment for the variable inputs

n Total costs (TC) = FC + VC

Figure 4-2. FC, VC, and TC

Figure 4-3. Graph of FC, VC, and TC

Modeling the Production Process

n Any production process can be modeled using:

¨ Average fixed costs (AFC)

¨ Average variable costs (AVC)

¨ Average total costs (ATC)

¨ Marginal costs (MC)

Average fixed costs (AFC)

n AFC = FC/Q

n At low Q, AFC is high

n As Q increases, AFC continuously decreases

Figure 4-4. Average Fixed Costs (AFC)

Average variable costs (AVC)

n AVC = VC/Q

n At low Q, AVC is high

n As Q increases, AVC falls to a minimum, then rises rapidly as the firm approaches maximum capacity

Figure 4-5. Average Variable Costs (AVC)

Average total costs (ATC)

n ATC = TC/Q = AFC + AVC

n At low Q, ATC is high

n As Q increases, ATC falls to a minimum, then rises rapidly as the firm approaches maximum capacity.

n ATC is always higher than AVC

Figure 4-6. Average Total Costs (ATC)

Marginal cost (MC)

n MC = (change in TR/change in Q)

n At low Q (start-up mode), MC falls at first, then rises rapidly through the range of normal production

Figure 4-7. Marginal Costs (MC)

The production model

n The four cost curves fit together.

n MC rises through the minimum points of both the AVC and the ATC.

n This model applies equally to small businesses and gigantic firms.

Figure 4-8. The Production Model

Explicit and implicit costs

n Explicit costs – actual out-of-pocket payments by the firm, plus depreciation.

n Implicit costs – the opportunity costs of the owner’s assets, time and effort.

¨ Also called normal profit

n Total costs = explicit costs + implicit costs

Profits

n Accounting profit = TR – explicit costs

n Economic profit = TR – both explicit costs and implicit costs

n Normal profit (implicit costs) is the minimum return on investment necessary for the owner to continue to operate the business.

Decision making

n Economic profit > zero:

¨ return on investment is larger than normal profit

¨ customers like the product

¨ owner may consider expanding

¨ rivals may expand into this market

¨ either way, the industry will expand

Decision making

n Economic profit < zero:

¨ return on investment is less than normal profit

¨ customers no longer like the product as much

¨ owner may consider cutting back production

¨ owner may exit this market

¨ either way, the industry will shrink

Decision making

n Economic profit = zero:

¨ return on investment is exactly equal to normal profit

¨ customers like the product enough to cover costs

¨ owner will continue to operate at the current output

¨ the industry will neither expand nor shrink

Summary

n Economic profits > zero:

¨ high consumer demand

¨ firms in the industry expand

¨ new firms enter the industry

¨ supply shifts right

¨ prices fall

¨ economic profits move to zero

¨ industry expansion stops

Summary

n Economic profits = zero:

¨ firms in the industry earn normal profit

¨ industry will neither expand or shrink

¨ supply does not shift

¨ price does not change

Summary

n Economic profits < zero:

¨ customer demand has decreased

¨ firms in the industry cut back or exit

¨ industry will shrink

¨ supply shifts left

¨ prices rise

¨ economic losses move to zero

¨ industry shrinkage stops

Goals of Running a Business

n Provide a product that best satisfies customers’ wants and needs

n Do it using a production process that minimizes the use of scarce resources and keeps costs as low as possible

n Return at least a normal profit to the business owners.

n Strive to maximize profits.

Maximizing profits

n Use cost-benefit analysis to choose the profit-maximizing quantity.

¨ For each increase in Q, compare MC (the added cost) to MR (the added revenue):

n If MR > MC, increase Q and profit rises

n If MR < MC, decrease Q and profit rises

n If MR = MC, this is the profit-maximizing Q

Figure 4-10. MR, MC and Profit Maximization

Breakeven Analysis

n 1. Estimate P.

n 2. List the variable inputs; determine AVC per unit. Compute P-AVC.

n 3. List the fixed inputs; determine FC.

n 4. Compute breakeven Q = FC/(P-AVC).

n 5. Determine if you really can sell that Q at that P in your market.

n 6. Don’t forget to include normal profit as a fixed cost.

Sunk costs

n These are expenses that have been paid.

n Do not use sunk costs in decision making.

¨ If decision is Yes, sunk costs are paid.

¨ If decision is No, sunk costs are paid.

¨ So sunk costs don’t matter to the decision.

n Use only relevant changes in revenue and in costs that will occur to make the decision.

Market structure

n Perfect competition

n Monopoly

n Monopolistic competition

n Oligopoly

Market power

n This is a firm’s ability to manipulate the market price.

¨ perfect competition – no market power

¨ monopoly – complete market power

¨ monopolistic competition – some market power at times

¨ oligopoly – considerable market power at times

Perfect competition

n Many small firms

n Identical products sold at the same price

n Easy to enter into and exit from the industry.

n Each firm must accept the market price.

n Each firm can only choose the quantity to produce (they choose the profit-maximizing quantity).

n Economic profit quickly goes to zero.

Monopoly

n Only one firm produces the product.

¨ They control the supply curve.

n There is a total barrier to other firms entering the industry.

n Monopolist will choose to produce its profit-maximizing Q.

¨ The demand curve will then identify the market price.

The Monopolist Profit Maximizes

Barriers to Entry

n Patent

n License requirement

n Franchising requirement

n Extraordinarily high start-up costs

n Government regulation

Monopolies Today

n Government-regulated Industries.

¨ high fixed costs (utilities)

¨ only one firm can attain economies of scale in a geographically distinct market

¨ regulating agency sets the rate

¨ insures economic profits are zero

¨ normal profit is the maximum allowed to shareholders

¨ customers get lowest rate possible

Monopolistic competition

n Many intensely competitive firms

n Each sells a slightly different version of the product at slightly different prices

n Easy entry and exit

n One firm’s product innovation captures the customers’ imagination; that firm becomes a short term monopolist

¨ Earns economic profits

Monopolistic competition

n Other firms “clone” the innovative feature of the preferred product

n Originator of the innovation is no longer a monopolist

¨ Economic profits go to zero

n Another firm innovates and this cycle starts again

Monopolistic competition

n Innovation improves the product

n Economic profits cause the industry to expand

n Prices fall

n Firms that lower costs and keep up with the innovations expand

n Firms that do not, get left behind. Ultimately they make losses and exit

Oligopoly

n Ultimately, a few firms dominate the industry

n High cost firms close and their assets are redeployed to the low cost survivors

n The product is no longer “new”; it becomes a commodity.

n The industry evolves from a growth industry to a mature industry.

Oligopoly

n A few large firms dominate the industry

n Significant price-setting power

n Significant barriers to entry

n Name brand producers

n Nation-wide and world-wide distributors

Oligopoly

n Market share becomes significant.

¨ Losing market share means a rival gains market share.

n Maintaining market share sometimes trumps profit maximization as a goal.

Oligopoly

n The “What if” game:

¨ if we raise prices, what will our competitors do in retaliation?

¨ if we modify our product, what will our competitors do in retaliation?

n This leads to a loss of independence in decision making.

Oligopoly

n Advertising becomes highly important.

¨ Instills brand loyalty in current customers.

¨ Draws customers from a rival firm.

Industry decline

n A new product appears that satisfies the customers’ wants better than the product in an existing industry

¨ Sales fall off for the existing product

¨ Economic losses occur.

¨ Industry shrinks.

Time lines in decision making

n Short run:

¨ cannot change the fixed input

¨ can change the variable inputs

¨ operational decision: what Q to make?

n Long run:

¨ can change both fixed and variable inputs

¨ investment decision: how big a facility?

Economies of scale

n Increase the capacity to produce and costs are decreased

¨ …achieve economies of scale

¨ …up to a point.

n How?

¨ switch from batch mode to assembly line

¨ employees specialize to task

¨ buy inputs in bulk at lower prices

Diseconomies of scale

n Continued increase in production capacity leads, after a point, to rising costs

¨ diseconomies of scale

n How?

¨ multiple assistant managers needed

¨ create a costly bureaucracy

¨ move decision making authority away from the production line

Ideal sized plant

n Build a facility that:

¨ is big enough to achieve all economies of scale

¨ operates at lowest cost (minimum efficient scale)

¨ does not get big enough to experience diseconomies of scale