Lecture 8: Capitalist Production Reading: Chapter 10

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


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.


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.


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.



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


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.


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)


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


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.


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


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


For many firms the decision can be illustrated as


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


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.


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


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.


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.


Economists use two measures of market

concentration:

The four-firm concentration ratio

The Herfindahl–Hirschman index (HHI)


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.


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



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


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.



End of Lecture

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Lecture 8: Capitalist Production Reading: Chapter 10