Households and government generate some goods, but production—from prescription medicines to hot tubs to hot pizza delivered to your door—is concentrated in firms. Painting contractors, the New York Yankees, and Honda are all business firms.

 

Firms are specialized organizations that buy resources from households and other firms to produce goods or services for sale to customers.

Firms range in size from an itinerant fruit vendor, who ekes out a meager living by selling apples out of the back of a pickup, to such multinational corporations as Exxon, with billions of dollars in annual sales being generated by tens of thousands of employees operating out of hundreds of manufacturing facilities and offices spread around the globe.

 

Activities once operated by government are increasingly being privatized throughout the world. In the early 1990s, for example, 6,000 retail shops formerly controlled by what was then the Czechoslovakian government were sold to private owners. Western Europe, Mexico, and many South American countries are also experimenting with privatization. A recent study by the World Bank examined a dozen major privatizations in Britain, Chile, Malaysia, and Mexico.1 The study concluded that nearly all of these privatizations produced net gains through higher investment, improved pricing to consumers, managerial innovation, and efficiencies created by industrial downsizing and reducing the size of their work force. In the United States, privatization includes a trend toward local government contracts with private firms to operate municipal hospitals, garbage collection, prisons, and bus systems.

As Figure 1 shows, today more than 80% of U.S. employment flows through private firms. But in the last four decades the proportion of employment in the goods-producing sector has fallen from 40% to nearly 20% today. This decline in goods producing has seen a parallel rise in the service sector, both private and public. Government employment now accounts for nearly 17% of all employment, exceeding that of manufacturing. Any private firm, regardless of its size, relies on production of goods and services that can be sold.

Production

Resources that enter a production process are known as inputs; the transformed materials and services are outputs. Inputs include machine or labor hours, physical space (e.g., acres used yearly), raw materials, and partially processed (intermediate) products bought from other firms. A firm’s output may be purchased by consumers, other firms, or government.

 

Natural forces or accidents may make things more valuable for human use. For example, geothermal heat and pressure convert coal into diamonds, and the life processes of generations of flora and fauna make soil more fertile. Relying exclusively on nature or luck would, however, sustain only a minuscule human population, most of whom would live a razor’s edge existence. People’s productive activities are the major contributions to enhanced value of goods and services.

Production transforms inputs into outputs (products or services) that are more valuable in form, place, possession, or time.

“More valuable” means that the goods ultimately generate greater consumer utility.

 

Output occurs when materials and services change their form, are available at different places and times, and are possessed by those who value them the most. Altering form entails reshaping materials: crude oil is less valuable than gasoline. Augmenting place utilities requires movement: a lobster is worth more in a restaurant’s glass tank than in the ocean. Possession utilities arise by shifting ownership from people who value goods less to people who value them more: realtors match home buyers who are moving into an area with sellers who are moving out. Time utilities are created when goods are made available when they are wanted most: speculators buy newly harvested wheat and store it to sell when wheat output is nil. Firms make goods more valuable in form, place, or time, or they transfer ownership to people who value them more highly.

 

why do firms exist?

No single household could produce even a respectable fraction of the array of goods most consumers take for granted, from brass beds to yogurt to films and TV programs to world tours. Businesses have huge comparative advantages over households in coordinating resources to generate vast amounts of output at low costs. Thus, firms exist because they are efficient. But firms can produce existing goods more efficiently or innovate new goods only if entrepreneurs recognize opportunities in the market- place and then act.

 

The unique role defining an entrepreneur is the establishment of a firm that, with luck, generates profit. Entrepreneurs prosper by establishing firms that efficiently coordinate specialized resources. To succeed, a firm’s production and management teams must a) reduce transaction costs and (b) exploit economies of scale and scope.

Reducing Transaction Costs

Transaction costs shrink consumers’ purchas-ing power and resource suppliers’ incomes. Enormous transaction costs would be incurred in trying to coordinate a single formal dinner by hiring resources instead of buying products from specialized firms; information, mobility, and negotiation processes are far from instantaneous, perfect, and costless. Imagine how difficult it would be to build a home, or to make all the parts and then assemble a car, if all workers were independent subcontractors rather than employees.

 

You learned in Chapter 4 that intermediaries reduce transaction costs. Virtually all firms are intermediaries, in the sense that the materials they process to make more valuable products are secured from other firms. For example, a chicken ranch that sells eggs to the supermarket where you buy groceries can be viewed as merely altering the form of the chicken feed it bought from a supplier. Thus, chicken ranches are intermediaries that, like all firms, could not survive without reducing transaction costs for their customers.

 

Shopping malls are in the business of renting space to retail firms. This reduces transaction costs for both retailers and consumers. Malls help slash transaction costs by massing large numbers of similar outlets that allow shoppers to see what is available without traveling extensively between stores and to compare prices and quality. The variety of goods available in modern supermarkets provides another example of how a firm can cluster goods to minimize the transaction costs of customers.

Economies of Scale and Scope

Specialization and the division of labor are at the heart of modern production. People once relied almost exclusively on production within families or clans. Today, a few types of production remain relatively solitary pursuits, such as writing novels or customizing computer software, and relatively few resources are required to successfully operate such small organizations as magazine stands or mortuaries. But only huge organizations can efficiently produce and market steel, gasoline, or oil tankers. Specialized technology often requires teamwork by thousands of workers using billions of dollars’ worth of capital.

Economies of scale in production or distribution occur when average costs decline in the long run as a firm expands its productive and distributive capacity.

When production processes use vast amounts of capital and armies of employees, the managerial coordination of production teams becomes as specialized a function as engineering or piloting a jumbo jet. Production can be coordinated by professional managers (who are employees of corporations or government agencies) or by entrepreneurs.

 

Even when economies of scale are not significant, large or multiplant firms sometimes lower their costs by producing multiple products.

Economies of scope occur when a firm realizes lower costs by producing or distributing multiple products which utilize the same technologies or marketing and distribution networks.

It is cheaper to produce beef and leather simultaneously than to have one group of ranches raising cattle to supply only leather and another group to supply only beef.

Large firms establish marketing, distribution, and service networks. Closely related products can share these networks, reducing the overall cost of providing them to consumers. For example, when 3M developed Post-its, they were able to advertise and distribute them much as they had done with their other office products. Casio found that, as the market for calculators grew, average costs for liquid crystal displays (LCDs) fell dramatically. These production economies (and profit opportunities) led Casio to enter the market for watches that used LCDs. One hurdle to efficient production is that a firm’s goals may not be well served by the resource suppliers whose productive activities require coordination. Such conflicts are important determinants of the best legal form for a business.

Business Goals

Adam Smith’s 1776 assertion that people pursue their own interests translates, for the purposes of consumer theory, into the idea that people try to maximize their utility, or satisfaction. People in business want to generate income for themselves, and most also want to produce goods and services of which they can be proud. But maximizing utility may be inconsistent with maximizing tangible income (the power to purchase goods). For example, most people could increase tangible income by working two jobs or by enduring harsher job conditions. Instead, most ultimately prefer more leisure and more enjoyable work to higher tangible income. In this section, after exploring the meaning of economic profit, we will examine whether maximizing a firm’s profit is consistent with maximizing the personal satisfactions of professional managers and other key employees.

Profit Maximization

Such slogans as “buy low, sell high” or “never give a sucker an even break” echo people’s expectations that firms try to maximize their profits. Profit maximization is the standard economic assumption used to analyze the behavior of firms.

Profit is a firm’s total revenue minus its total cost; loss is incurred when revenue fails to cover costs. Profits are positive, while losses are negative.

Although, economists and bookkeepers define profits and losses similarly, economic profits and accounting profits often differ. Different definitions of costs explain this inconsistency.

• Economic vs. Accounting Costs  You know that the value of the best alternative forgone is the economic cost of anything from lard to romance. All costs, whether monetary or nonmonetary are opportunity costs. One way to break down economic (opportunity) costs of production is to view them as either explicit or implicit costs.

Explicit costs require outlays of money.

For example, wages paid to employees, rent payments, and utility bills are all explicit costs.

Implicit costs are the opportunity costs of resources the firm’s owner makes available for production with no direct cash outlays.

Examples include the value of an entrepreneur’s labor and the interest that could be earned were the owners’ assets (including the values of stock in corporations) not tied up in the business. Both implicit and explicit costs bear heavily on rational business decisions.

Economic costs of production include both explicit and implicit costs.

On the other hand, bookkeeping tends to focus on monetary costs. Bookkeeping is a mechanical exercise focused only on explicit costs; it primarily records flows of funds and provides a base for computing taxes. Accounting requires evaluation of data for decision-making, a purpose not well served by some standard bookkeeping practices for cost accounting or tax accounting. Fortunately, standards for managerial accounting increasingly conform to the economic view of cost. Let us look at some problems that emerge when implicit costs are ignored.

• Profit  Economists include explicit and implicit costs when they think of total (opportunity) cost, while bookkeepers commonly fail to include in total cost many implicit costs incurred by the owners of a firm.

Economic profit occurs only when a firm’s revenue exceeds all costs, including explicit and implicit costs.

Here is an example of how economic profits and accounting profits differ. Imagine that two years after receiving your college degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000 yearly, and your financial assets generate $3,000 per year in interest. On New Year’s Day, after deciding to be your own boss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop.

At the end of the year, your books tell the following story:

 

Total Sales Revenue                    $130,000

Cost of pogo sticks          $85,000

Employees’ wages             20,000

Utilities                                5,000

Taxes                                   5,000

Advertising expenses         10,000

Total (Explicit) Costs                  –125,000

  (subtract from revenue)

 

“Congratulations,” your

bookkeeper pipes up, “you

made a

 

Net (Accounting) Profit of           5,000!”

 

“Hold it just a moment,”

you say, “I have studied 

economics. You forgot to 

subtract my implicit costs.

Being in this business caused

me to lose as income

 

Salary                             –28,000

Rent                                 –10,000

Interest                               –3,000

Total Implicit Costs                     –41,000

 

“Therefore, I’ve had an

economic profit that’s 

negative, a loss of            –36,000

This harebrained business is a loser!”

If, however, you enjoy operating the pogo-stick shop more than your best alternative (assistant store manager), your higher job satisfaction is called psychic income. Psychic income is an implicit revenue that refers to nonmonetary satisfaction gained from an activity. Bookkeeping profit typically overstates economic profit because bookkeepers fail to subtract implicit costs, which tend to be significant, while implicit benefits are usually small.

 

The explicit cost data used to compute accounting profit for tax purposes are more accessible than the additional implicit cost data needed to estimate economic profits or losses. Thus, taxes and national income accounts are based on accounting data. Business decisions tend to be rational, however, and so are most frequently based on expected economic costs and profits.

 

Accountants typically recognize that conventional bookkeeping costs and profits are inadequate; after calculating taxable profits, they subtract estimates of implicit costs from bookkeeping profit. This type of managerial accounting provides a better picture of a firm’s track record.

Normal Profits and Production Costs

One lesson from this discussion is that implicit costs should be considered in production costs. If a firm’s accounting profit is less than that normally received by firms with comparable levels of investment and risks, in the long run its owners will move their resources into ventures where profits at least cover implicit costs. Chronic economic losses ultimately force a firm to shut down.

 

Economic profits and losses will be zero in the long run in competitive markets because profits attract new sellers like picnics attract ants; persistent losses (negative profits) drive firms from the market. Economic profits or losses persist only when entry and exit from an industry are constrained. Profits spur competition and growth of market supply, while losses signal that society wants resources shifted elsewhere. Economists simplify the discussion of cost by including implicit costs, therefore when economic profits are zero, the firm is earning a normal return (positive accounting profits enough to cover implicit costs). We will return to this issue again in the next chapter.

Other Business Goals

Executives’ career ambitions and desires for job security sometimes conflict with maximizing corporate profit (the bottom line). Some analysts contend that firms try to maximize sales revenues (the top line in annual reports), hoping that growth of sales revenues will be interpreted as success by the stock market. Others argue that, after ensuring satisfactory profits that keep stockholders at bay, top managers try to follow socially responsible policies. Their contention, based on psychological theories, is that few people work for money alone; most of us want to feel that our contribution to society’s welfare is positive. Many modern managers consider the interests of the firm’s other stakeholders, including employees, the communities in which they operate, and customers. Today, various court decisions and regulations have significantly reduced managerial discretion in the areas of plant closure, personnel relations, waste disposal, and product marketing.

 

In several books, economist John Kenneth Galbraith takes a different tack, arguing that top managers attempt to secure high incomes and job security for members of their own social class, other administrators and professional employees whom he characterizes as the technostructure. Managers and members of this technostructure may have goals incompatible with those of stockholders, creating problems for modern corporations.