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E-201.Study Guide Chapter10. Key Terms and Questions

E-201.Study Guide Chapter10. Key Terms and Questions -...

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167 10 ORGANIZING PRODUCTION K e y C o n c e p t s The Firm and Its Economic Problem A firm is an institution that hires factors of production and organizes these factors to produce and sell goods and services. The firm’s goal is to maximize its (eco- nomic) profit, which equals its revenue minus its (op- portunity) costs. The opportunity cost of any action is the best alternative foregone. Opportunity cost is ex- pressed in terms of money so that the alternatives can be added up. A firm’s opportunity costs can be sepa- rated into costs of resources bought in the market, costs of resources owned by the firm, and costs of resources supplied by the owner. Cost of capital — The implicit rental rate of capital is the opportunity cost the business incurs by using its own capital rather than renting the capital to an- other firm. It is equal to the sum of economic de- preciation plus foregone interest costs. Economic depreciation is the change in the market value of the capital over a given period. The foregone inter- est is the interest income lost on the funds used to buy the capital. Cost of owners’ resources — owners often supply labor and entrepreneurship to the business. The re- turn to entrepreneurship is profit and the profit an entrepreneur earns on the average is called normal profit. Economic profit = Total revenue – Opportunity cost. A business earning an economic profit is earning a profit that exceeds the normal profit. Three features limit a firm’s profit: Technology constraints — a technology is any me- thod of producing a good or service. Technology limits how a firm can turn resources into output. Information constraints — the future is always un- certain and elements of the present are unknown. Marketing constraints — how much the firm can sell and at what price are limited by its customers’ will- ingness to buy its goods or services and by the prices and marketing efforts of other firms. Technology and Economic Efficiency Technological efficiency — when the firm produces a given output using the least amount of inputs. Economic efficiency — when the firm produces a given output at the least cost. If a business is economically efficient, it must be tech- nologically efficient, but technological efficiency does not necessarily imply economic efficiency. A firm must be economically efficient to maximize its profit. Information and Organization Command system — organizes production using a managerial hierarchy, so that commands go from managers to workers. Incentive system — organizes production using market-like mechanisms, so that incentives are set up to induce workers to maximize the firm’s profit. The principal–agent problem is to set rules for com- pensation so that agents (people employed by others) act in the best interests of a principal (the individual who employs the agents). Giving managers partial ownership of the company, using incentive pay, and using long-term contracts help overcome the principal- agent problem.
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