Principles of Microeconomics

ECON 101 - SS 18
KFUPM - Fall-22
Dr. Muhammad Imran Chaudhry, CFA
 Producer Choice as Constrained Optimization
• Firms hire factors of production and organize them to produce
and sell goods and services.
– A firm’s goal is to maximize profit, all other goals (e.g., ESG, employee
welfare etc.) are secondary i.e., means to an end.
– If a firm fails to maximize profits, than that firm is either eliminated or
taken over by another firm that seeks to maximize profit.
• There are key differences between accounting and economic profit:
– Accounting Profit equals total revenue minus total cost.
• Accountants use rules in International Financial Accounting Standards to
calculate costs (e.g., depreciation, provisions) of doing business.
• Accountants aim to measure firms’ profits such that the correct amounts
of taxes are paid and investors know how their funds are being used.
– Economic profit is equal to total revenue minus total costs, with total
costs measured as the opportunity cost of production.
• Opportunity costs make a big difference. Think about running a startup?
 Economic Profit
• A firm’s opportunity cost of production is the value of the best
alternative use of resources that a firm uses in production.
– Resources bought in the market easily valued at market prices.
– Resources owned by the firm.
• A firm’s opportunity cost of using the capital it owns is called the implicit
rental rate of capital i.e., what would this capital earn if invested in a firm
with similar risk profile?
• Implicit rental rate includes (1) economic depreciation (change in market
value of capital over a period of time) and (2) interest forgone (return on
funds used to acquire the capital).
– Resources supplied by the firm’s owner/s.
• Owners supply both entrepreneurship and labor. Profit that entrepreneurs
can expect to receive on average is called normal profit.
• Opportunity cost of owners’ labor are the wages forgone by not taking the
best alternative job.
 Decisions of Firms
• To maximize profit, a firm must make five basic decisions:
– What to produce and in what quantities;
– How to produce;
– How to organize and compensate its managers and workers;
– How to market and price its products;
– What to produce itself and what to buy from other firms,
• Firms’ profit maximizing efforts are limited by three features of
the environment:
– Technology constraints:
• Any method of producing goods/services (includes work culture!).
– Information constraints:
• Information about the quality and effort of work force, current and future
buying plans of its customers, and the plans of its competitors.
– Market constraints:
• Their customers’ willingness to pay, marketing efforts and prices of other
firms’ goods/services.
 Technological and Economic Efficiency
• Technological efficiency occurs when a firm uses least amount
of inputs to produce a given quantity of output.
– Different combinations of inputs can be used to produce a given good,
but only some of them are technologically efficient.
– If it is impossible to produce a given good by decreasing any one input,
holding all other inputs constant then the production is technologically
efficient i.e., no wastage of factors of production.
– A technologically efficient process may not be economically efficient.
• Economic efficiency is when firms produce a given quantity of
output at the least cost.
– The economically efficient method depends on relative costs of capital
and labor e.g., production using humans or robots? The economically
efficient production process must be technologically efficient.
– Change in input prices affect costs of production, but not technological
process of production.
 Technological and Economic Efficiency
• Technological efficiency is about quantity of inputs used in production for a
given quantity of output, whereas economic efficiency concerns the cost of
the inputs used. Let's look at an example of TV production:
 Information and Organization
• Firms organize production by both combining and coordinating
productive resources using a mixture of two systems:
– A command system uses a managerial hierarchy.
• Commands pass downward via a hierarchy, and information (i.e., feedback)
passes upward. Often used in military operations.
• This system is relatively rigid with many layers of specialized management.
– Incentive systems organize production by using market-like mechanisms
to induce workers to perform in ways that maximize the firms’ profits.
– Most firms utilize a mix of command and incentive systems to maximize
profits.
• Command systems work well when it’s easy to monitor performance, or if a
small deviation from ideal performance is very costly. An incentives system
works better when monitoring performance is not possible or very costly to
be worth doing.
 Information and Organization
• Principal–agent problem is the task of devising compensation
rules that induce agents to act in best interests of a principal.
– Stockholders of a firm are the principals, and the managers of the firm
are their agents. How can stockholders induce mangers to maximize a
firms profits?
• Three strategies to cope with principal–agent problems:
– Ownership gives the managers an incentive to maximize firm’s profits,
which is the goal of the owners i.e., the principals.
– Incentive pay links the managers or workers pay to firm’s performance,
and this helps align managers and workers interests with principals.
– A long-term contract ties managers and workers long-term rewards to
long-term performance of a firm. This arrangement encourages agents
to work in the best long-term interests of the firm owners.
 Information and Organization
• There are three types of business organization:
– Proprietorship is a firm with a single owner who has unlimited liability.
Proprietors make management decisions and receives all firm profit.
• Profits are taxed the same as the owner’s other personal income.
– Partnership is a firm with two or more owners with unlimited liability.
Partners agree on management structure and division of profits.
• Profits from partnerships are taxed as the personal income of owners.
– Corporations owned by one or more stockholders with limited liability:
• Profit of corporations is taxed twice: once as corporate tax on the firm’s
profit, and then again as income taxes paid by stockholders
– Each type of business organization has its pros and cons. All these are
summarized in Table 10.4 of the book.
 Markets and the Competitive Environment
• Economists categorize markets into one of following categories:
– Perfect competition: Many firms selling identical products, with limited
restrictions on entry/exit of firms. Firms/buyers are well informed about
prices and products of all firms in the industry, e.g., maize and wheat in
global commodity markets.
– Monopolistic competition: Many firms selling differentiated goods with
minimal restriction on entry/exit of firms e.g., shampoos and biscuits.
– Oligopoly: Few firms selling differentiated or identical products but with
significant barriers to entry e.g., OPEC, Airbus/Boeing.
– Monopoly: A single firm produces entire output of the industry, with no
close substitutes for the product. Barriers to entry protect this firm from
competition from entry of new firms e.g., STC and Tesla.
• Often, categorization of an industry into one of the four market
structure is not straightforward. We need to exercise judgement
and look closely at several indicative metrics.
Markets and the Competitive Environment
• To determine market structure of an industry, economists
measure the extent to which a small number of firms are
dominating the market.
– Four-firm concentration ratio is percentage of the total industry
sales accounted for by four largest firms in an industry e.g., close
to 100% for monopoly and 80% for oligopoly.
– Herfindahl–Hirschman Index (HHI) is the square of percentage of
market share of each firm summed over the largest 50 firms in an
industry e.g., less than 1,500 considered competitive
• 10,000 in monopoly and more than 3,000 considered concentrated.
– As the market concentration increases, amount of competition in
the industry decreases.
• The main limitations of only using concentration measures
as determinants of market structure are
– (1) Geographical scope of a market (2) Barriers to entry and firm
turnover (3) Correspondence between a market and an industry.
 Produce or Outsource? Firms and Markets
• To produce goods/services, factors of production must be hired
and their activities coordinated.
– Markets coordinate production by adjusting prices, thus making choices
of buyers and sellers of factors of production consistent.
– Outsourcing (buying parts/products from other firms) is one example of
market coordination of production.
• But, firms also hire factors of production and utilize a mixture of
command systems and incentive systems to both organize and
coordinate activities to produce goods and services.
– We are taught that markets coordinate economic activity, yet we often
see firms coordinating economic activity. In fact, firms coordinate more
production than do markets. Why?
– Firms will always coordinate production activities if they can do so more
efficiently than a market due to the following four reasons:
Produce or Outsource? Firms and Markets
– Lower transactions costs: Costs of finding someone with whom to do
business, reaching agreement on the prices and other aspects of the
exchange, and ensuring that the terms of the agreement are fulfilled.
– Economies of scale: The cost of producing a unit of a good falls as its
output scale (overall firm capacity) increases.
– Economies of scope: When firms can leverage specialized inputs and
expertise to produce a range of different but related goods at a lower
cost than the cost incurred to make these different goods separately.
– Economies of team production: Lower costs when labor works as a
team, specializing in mutually supporting tasks.