Have you any questions on the previous lesson, homework, or materials listed on
the previous daily class outline?
2.
Course Objectives
List course the first three objectives from text page 197
:
1.
2.
3.
3.
Outline
I. The Firm
and Its Economic Problem
A. A firm is an organization that
hires factors of production and organizes them to produce and sell goods and services.
B. Firms organize production using command systems — in which managers tell
subordinates what to do — and incentive systems — in which firm owners and
managers must set up methods to give subordinates the proper incentives to work.
C. Incentive systems mean that firms enter into agency relationships, which create the
principal-agent problem. The principal-agent problem is to devise compensation
rules that cause an agent (the person hired to do a specific task) to work in the best
interest of the principal (the entity that hires the agent).
1. Ownership, incentive pay, and long-term contracts attempt to overcome the
principal-agent problem by giving the agent an incentive to work in the best interests of
the principal.
a) Ownership, often offered to managers, gives the managers an incentive to maximize
the firm’s profits, which is the goal of the owners, the principals.
b) Incentive pay, by linking managers’ or workers’ pay to the firm’s
performance, helps align managers’ and workers’ interests with those of the
owners, the principal.
c) Long-term contracts can tie managers’ or workers’ long-run futures to
that of the firm, which helps the owners ensure that the agents work in the best interest
of the company.
D. The main types of business organization are proprietorship, partnership, and
corporation.
1. A proprietorship is a firm with a single owner who makes the management
decisions and is the residual claimant, that is, the person who receives the
profits and must pay all the losses.
a) A proprietor faces unlimited liability, that is has the legal responsibility
for paying the firm’s debts in amounts up to the owner’s entire wealth.
2. A partnership is a firm with two or more owners who jointly make management
decisions and divide the profit or loss amongst themselves.
a) Each partner can be held liable for all the debts, a situation of joint
unlimited liability.
3. Corporations are owned by one or more shareholders. Shareholders are the
residual claimants to any profits, although large corporations are run by professional
managers.
a) Shareholders have limited liability; thus they are not legally responsible
for the debts of the corporation beyond the value of their investment in the business.
E. There are more proprietorships than other forms of business. But corporations
account for the majority of revenue received by businesses.
F. Each type of business organization has advantages and disadvantages:
1. Proprietorships are easy to set up, managerial decision making is simple, and
profits are taxed only once. However, any bad decisions made by the manager are not
subject to review, the owner’s entire wealth is at stake, the firm dies with the
owner, and acquiring capital and labor is expensive.
2. Partnerships are easy to set up, have diversified decision-making, can survive the
death or withdrawal of a partner, and profits are taxed only once. However, partnerships
place the owners’ entire wealth at risk, make difficult the attainment of consensus
about managerial decisions. Further, withdrawal of a partner may create a capital shortage
and result in high capital costs.
3. A corporation has perpetual life, limited liability for its owners, readily
available, large-scale and low-cost capital, professional management not restricted by its
owners’ abilities, and reduced costs from long-term labor contracts. However, a
corporation’s complex management structure may lead to slow and expensive
decision-making, and its profits are taxed twice — once as corporate profit and once
as shareholder income.
II. Business Finance
A. The funds an owner has invested in a
business are the firm’s equity.
B. Corporations can raise money by issuing stock or selling bonds.
1. Stock conveys an ownership (equity) position in the company.
2. A firm borrows money by selling bonds, which are legally enforceable
obligations to pay specified amounts of money at specified future dates.
C. Present value considerations are important factors in a firm’s decision
to borrow funds.
1. The present value of a future amount of money is the (lesser) amount that,
if invested today, with interest grows to equal the future amount.
2. Discounting is the conversion of a future amount of money to its present
value.
3. Expressed in a formula:
D. Marginal benefit minus the marginal cost equals the net benefit, and the present
value of a stream of net benefits is the net present value.
1. If the net present value of borrowing an additional dollar is positive, the firm
increases its profit by borrowing the dollar because the dollar yields more additional
revenue than it incurs in additional costs.
2. The company’s profit is maximized when it borrows the amount that makes net
present value equal zero.
5. Let's begin Questions and Problems (study guide page 163 -
166)
The important true or false, multiple choice, and problems
are those associated with the first three course objectives in which you seek to
understand the economics of:
The Firm and Its Economic Problem;
Technology and Economic Efficiency;
Information and Organization
6. Homework
1. Review Key Concepts pages
161 - 162 in your study guide.
2. Complete the odd-numbered Questions from your study
guide pages 163 - 166 and check your answers on pages 167 - 170.
3. Compare your class notes and your understanding of the homework Questions with
your study partner.
7. Summary
The Firm and Its Economic Problem
1. Firms hire and organize resources to produce and sell
goods and services and maximize profit.
2. Uncertainty and incomplete information place limits on
what firm can attain, and firms must devise incentive schemes that induce managers
and workers to perform in ways that are consistent with the goal of maximum profit.
3. The main forms of business organization are
proprietorships, partnerships, and corporations. Each form has its advantages and
disadvantages. Corporations produce most of the goods and services, but there are
more proprietorships than any other type of firm.
Business Finance
1. Firms get funds from their own owners and form the sale
of stock and bonds. A firm gets its funds from the source that costs least.
2. To make a financing decision, the firms uses the concept
of the net present value of future amounts of money.
3. A firm borrows the amount of funds for which the net
present value of borrowing one additional dollar - the marginal dollar borrowed - is zero.
At this amount of borrowing, the firm is maximizing its profit.
Opportunity Cost and Economic Profit
1. Economic profit is total revenue
minus opportunity cost.
2. Opportunity cost is made up of explicit costs (money
costs) and implicit costs. Implicit costs are opportunities forgone but not for
directly in money. They arise from the use of capital, inventories, and the owner's
own resources.
3. The opportunity cost of the resources supplied by a
firm's owner, including normal profit for supplying entrepreneurial ability, is part of a
firm's costs.
