Topic 3 - Firm's Objective

Question 1

What is a firm’s goal?

Answer 1

To maximise profit.

Question 2

What is economic profit?

Answer 2

Total Revenue - Total Cost (the opportunity cost of production)

Question 3

What is a firm’s opportunity cost of production?

Answer 3

It’s the sum of the cost of using resources:
1 = Bought in the market
2 = Owned by the firm
3 = Supplied by the firm’s owner

Question 4

What are resources bought in the market?

Answer 4

The amount spent on these resources is an opportunity cost because it could have been used to buy different resources to produce another good/service.

Question 5

Why are resources owned by the firm an opportunity cost?

Answer 5

The firm could sell the capital it owns and rent capital from another firm.

Question 6

What is the implicit rental rate of capital made of?

Answer 6

Economic Depreciation
= The fall in the market value of a firm’s capital over a given period.
Forgone Interest
= The funds used the buy capital could have been used for some other purpose, or just to earn interest.

Question 7

Why are resources supplied by the firm’s owner an opportunity cost?

Answer 7

Entrepreneurship = Normal profit is the cost of entrepreneurship and is an opportunity cost of production.
Owners Labour Services = The wage income forgone by not taking the best alternative job.

Question 8

What decisions must a firm make?

Answer 8

1 = What to produce and in what quantities
2 = How to produce
3 = How to organise and compensate its managers and workers
4 = How to market and price its products
5 = What to produce itself and buy from others

Question 9

What are the constraints which limit the economic profit a firm can make?

Answer 9

1 = Technology Constraints
2 = Information Constraints
3 = Market Constraints

Question 10

What are technology constraints?

Answer 10

A technology is any method of producing a good/service. The increase in profit that a firm can achieve is limited by the technology available.

Question 11

What are information constraints?

Answer 11

A firm is constrained by limited info about the quality and efforts of its workforce, the current and future buying plans of its customers, and the plans of its competitors.

Question 12

What are market constraints?

Answer 12

The quantity 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.

Question 13

What is technological efficiency?

Answer 13

It occurs when the firm produces a given output by using the least amount of inputs.

Question 14

What is economic efficiency?

Answer 14

Occurs when the firm produces a given output at the least cost.

Question 15

What do firms use to organise production?

Answer 15

Command and incentive systems

Question 16

What is a command system?

Answer 16

A method of organising production that uses a managerial hierarchy. Commands pass downwards and information passes back up.

Question 17

What are incentive systems?

Answer 17

A method of organising production that uses a market-like mechanism inside the firm. Managers don’t issue commands, they create compensation schemes to induce workers to perform in ways that maximise the firm’s profit.

Question 18

What is the principal-agent problem?

Answer 18

The problem of devising compensation rules that induce an agent to act in the best interest of a principal.

Question 19

How do firms cope with the principal-agent problem?

Answer 19

Ownership
Incentive Pay
Long-Term Contracts

Question 20

What is ownership?

Answer 20

By assigning ownership of a business to managers or workers, it’s sometimes possible to induce a job performance that increases a firm’s profits.

Question 21

What is incentive pay?

Answer 21

Pay related to work performance.

Question 22

What are long-term contracts?

Answer 22

Long term contracts tie the long-term fortunes of workers to the success of the principals of the firm.

Question 23

What are the three types of business organisation?

Answer 23

Proprietorship = A firm with a single owner, who has unlimited liability (full legal responsibility for all the debts of a firm).
Partnership = A firm with two or more owners who have unlimited liability.
Corporation = A firm owned by one of more limited liability stockholders, so the owners have legal liability only for the value of their initial investment.