Organising Production

Chapter 10

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Main ideas
After studying this chapter, you will be able to:

• Explain what a firm is and describe the economic problem that all firms face
• Distinguish between technological efficiency and economic efficiency
• Define and explain the principal–agent problem and describe how different
types of business organisations cope with this problem
• Describe and distinguish between different types of markets in which firms
operate
• Explain why markets coordinate some economic activities and why firms
coordinate others

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The Firm and its Economic Problem
The Firm’s Goal
• A firm’s goal is to maximise profit
Accounting Profit
• To measure the profit subtract the depreciation from the cash surplus
• Depreciation is the fall in the value of a firm’s capital
Economic Accounting
• Economists measure a firm’s profit to enable them to predict the firm’s decisions,
where the goal of these decisions is to maximise economic profit
• Economic profit is equal to total revenue minus total cost, with total cost measured as
the opportunity cost of production
A Firm’s Opportunity Cost of Production
• A firm’s opportunity cost of production is the value of real alternatives forgone
• A firm’s opportunity cost of production is the sum of the cost of using resources
bought in the market, owned by the firm or supplied by the firm’s owner

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The Firm and its Economic Problem
Decisions
• To achieve the objective of maximum economic profit, a firm must make five
decisions:
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
The Firm’s Constraints
• Technology constraints
• Information constraints
• Market constraints

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Technological and Economic Efficiency
• Technological efficiency occurs when the firm produces a given output by using the
least amount of inputs
• Economic efficiency occurs when the firm produces a given output at the least cost

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Information and Organisation
Command Systems
• A command system is a method of organising production that uses a managerial
hierarchy
• Commands pass downward through the hierarchy, and information passes upward
Incentive Systems
• Managers create compensation schemes to induce workers to perform in ways that
maximise the firm’s profit
Mixing the Systems
• Firms use a mixture of commands and incentives, and they choose the mixture that
maximises profit
• Firms use commands when it is easy to monitor performance or when a small
deviation from an ideal performance is very costly
• They use incentives when it is either not possible to monitor performance or too
costly to be worth doing

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Information and Organisation
The Principal–Agent Problem
• The principal–agent problem is the problem of devising compensation rules that
induce an agent to act in the best interest of a principal
Coping with the Principal–Agent Problem
Ownership
• By assigning ownership of a business to managers or workers, it is sometimes
possible to induce a job performance that increases a firm’s profits
Incentive Pay
• Incentives are based on a variety of performance criteria such as profits, production,
or sales targets
Long-Term Contracts
• Long-term contracts tie the long-term fortunes of managers and workers (agents) to
the success of the principal(s) – the owner(s) of the firm

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Information and Organisation
Types of Business Organisation
Sole Proprietorship
• A sole proprietorship is a firm with a single owner – a sole trader – who has unlimited
liability
Close Corporation (CC)
• A close corporation is a separate legal entity where the owners have limited liability
Private Company
• A private company (Pty Ltd) is a firm owned by one or more limited liability
shareholders

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Markets and the Competitive Environment
• Perfect competition arises when there are many firms, each selling an identical
product, many buyers, and no restrictions on the entry of new firms into the industry
• Monopolistic competition is a market structure in which a large number of firms
compete by making similar but slightly different products
• Oligopoly is a market structure in which a small number of firms compete
• Monopoly arises when there is one firm, which produces a good or service that has
no close substitutes and in which the firm is protected by a barrier preventing the
entry of new firms
Measures of Concentration
The Four-Firm Concentration Ratio
• The percentage of the value of sales accounted for by the four largest firms in an
industry
The Herfindahl-Hirschman Index
• The square of the percentage market share of each firm summed over the largest 50
firms (or summed over all the firms if there are fewer than 50) in a market

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Markets and the Competitive Environment
Limitations of a Concentration Measure
• The three main limitations of using only concentration measures as determinants of
market structure are their failure to take proper account of:
o The geographical scope of the market
o Barriers to entry and firm turnover
o The correspondence between a market and an industry

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Produce or outsource?
Firms and Markets
• To produce a good or service, even a simple one such as a shirt, factors of
production must be hired and their activities coordinated
Firm Coordination
• Firms hire labour, capital, and land, and by using a mixture of command systems and
incentive systems organise and coordinate their activities to produce goods and
services
Market Coordination
• Markets coordinate production by adjusting prices and making the decisions of
buyers and sellers of factors of production and components consistent
Why Firms?
• Firms are often more efficient than markets as coordinators of economic activity
because they can achieve lower transactions costs, economies of scale, economies
of scope and economies of team production

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Produce or outsource?
Transactions Costs
• Firms eliminate transactions costs
Economies of Scale
• When the cost of producing a unit of a good falls as its output rate increases,
economies of scale exist
Economies of Scope
• A firm experiences economies of scope when it uses specialised (and often
expensive) resources to produce a range of goods and services
Economies of Team Production
• A production process in which the individuals in a group specialise in mutually
supportive tasks is team production

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