LOS l6b Discuss a firms constraints and their impact on achievability of maximum profit

Constrained profit maximization. Firms face three primary constraints as they endeavor to maximize profits: (!) technological, (2) information, and (3) market constraints.

Technology constraints. For our current purposes, technology may be defined simply as the means of producing a good or service. Technological developments are continuous. At any given point in time, a firm has the opportunity to increase output, and ultimately revenue, by employing additional technological resources. But to do so often means that the firm must incur additional costs. The additional profit from any increased output and revenue is limited by the cost of adopting new technology.

Information constraints. Profit maximization is constrained by the lack of information on which to base decisions. Many times, more information is available, but the cost of obtaining it may exceed its value (to increase firm profits). As with any productive resource, the firm will expend resources to acquire additional information only up to the point where the increase in total revenue from additional information is greater than the cost of the information.

Market constraints. Profits are also constrained by how much consumers are willing to pay for a firm's product or service and by the prices and marketing activities of its competitors. Resource markets also place constraints on profit maximization. The prices and availability of the resources that a firm uses and the willingness of people to invest in the firm present constraints on the firm's growth.

LOS I6.c: Differentiate between technological efficiency and economic efficiency, and calculate economic efficiency of various firms under different scenarios.

Technological efficiency refers to using the least amount of specific inputs to produce a given output.

Economic efficiency refers to producing a given output at the lowest possible cost.

The difference between technological and economic efficiency is illustrated in the following example. Consider the four methods of producing a microwave oven illustrated in Figure 2.

Figure 2: Methods for Manufacturing 100 Microwave Ovens Per Da}'




Capital (machine day equivalent)

Labor (worker-days)

Robotic manufacturing (RM)



Assembly line manufacturing (ALM)



Work station manufacturing (WSM)



Hand crafted manufacturing (HCM)



'Method descriptions:

• RM requires one worker to monitor a completely robotic process.

• ALM requires the microwave assembly to be automatically moved from one work station to the next, where the worker at that station performs a specific, repetitive operation.

• WSM requires the workers to move from station to station to perform the same operation.

• HCM requires one worker to build an entire microwave oven using specialized tools.

An examination of the microwave oven manufacturing methods described in Figure 2 reveals that robotic manufacturing (RM) uses the most capital and least labor, whereas hand crafted manufacturing (HCM) uses the most labor and least capital. Assembly line manufacturing (ALM) and work station manufacturing (WSM) fall between these two extremes. WSM uses 50 units of capital and 500 units of labor to produce 100 ovens per day; ALM can also produce 100 ovens using 50 units of capital, but requires only 50 units of labor. ALM is more technologically efficient than the WSM method because it uses absolutely less inputs to produce the same output.

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Both the RM and HCM methods are technologically efficient because compared to ALM, RM uses less labor (but more capital), and HCM uses less capital (but more labor).

Economic efficiency is achieved when a given level of output is achieved at the least possible cost. Let's assume for our example that labor costs $75 per worker-day and capital costs $250 per machine-day. The costs of the four different methods are shown in Figure 3. ALM has the lowest cost per oven. Even though RM requires the least amount of labor, it requires more capital. On the other hand, while the HCM method requires the least amount of capital, it uses much more labor.

Recall that WSM is not technologically efficient. This fact ensures that WSM is not economically efficient either. WSM uses the same capital input ($12,500) as ALM, but requires much more labor ($37,500 versus $3,750).

The total costs in Figure 3 will be different if the costs of labor and capital are different. Firms must routinely re-evaluate economic efficiency as the costs oi inputs change.

Figure 3: Cost of Four Methods of Manufacturing 100 Microwave Ovens Per Day


Capital Cost S250¡unit

Labor Cost $^5/an it

Total Cost

(,ost Per Oven





S 12,503.75
















LOS 16.d: Explain command systems and incentive systems to organize production., the principal-agen» problem, and measures r: firm uses to reduce the 5rv.'îir(pai-agerif problem.

Firms can organize production in two different ways: (1) command systems and (2) incentive systems.

Command systems organize production according to a managerial chain of command. In a command system, managers spend much of their time processing information about the performance of the people who report to them, about what steps to take, and the best way to implement those steps. The U.S. military is an example of a command system; the President is at the top of the hierarchy. For a corporation using a command system of organizing production, the Chief Executive Officer is at the top of the system

An incentive system is a means of organizing production whereby senior management creates a system of rewards intended to motivate workers to perform in such a way as to maximize profits. It is an effective system for organizing the production of a large sales force, where sales people may be paid a base salary that is relatively small, and also rewarded for sales volume. CEOs are often subject to incentive systems, which provide them with compensation based on their firm's profit, sales, or stock price performance.

Command systems and incentive systems are often mixed within the same organization. Command systems are used when it is easy to monitor the performance of employees, as in the case of production workers. Incentive systems are usually most effective for organizing the production of employees whose activities are difficult or costly to monitor, like those of the firm's CEO and senior officers or outside sales people.

The principal-agent problem refers to the problems that arise when the incentives and motivations of managers and workers (agents) are not the same as the incentives and motivations of their firm's owners (principals). In many corporations, agents have their own goals, which may be different than those of the principals. For workers, there is often an incentive to shirk, which is to work below their normal level of productivity. At the managerial level, managers may work to maximize their own income and benefits rather than to maximize the value of the firm to its owners. The essence of the problem is that it is difficult or costlv for the principals to monitor the actions of the agents.

Three methods are commonlv used to reduce the principal-agent problem bv better aligning the motivations of agents with those of principals: (1) ownership, (2) incentive pay, and (3) long-term contracts.

• When managers or workers have an ownership interest in the firm, it may motivate them to perform in a manner that maximizes the firm's profits or value. Ownership arrangements are commonly used with senior management, but less so for workers.

• Incentive pay is pav that is based on performance and is quite common in many industries. Incentive pay may be based on profits, sales, production quotas, or stock prices. Promotions mav also be used as a form of incentive pay to align the interests of a firm's agents and principals.

• Long-term contracts for employment are often assigned to firms' CEOs to encourage them to develop strategies that will maximize profits over a relatively long period.

LOS I6.e: Describe the different types of business organization and the advantages and disadvantages of each.

Types of business organization. The three main forms of business organization are: (1) proprietorships, (2) partnerships, and (3) corporations. Each form has its own advantages and disadvantages.

A proprietorship is a form of business organization with a single owner who has unlimited liability for the firm's debts and other legal obligations. Income flows through to the proprietor (owner) who pays taxes on it as personal income.

• Advantages-. Easy to establish, simple decision making process, and profits are only taxed once.

• Disadvantages'. Decisions are not checked by a group consensus, the owner's entire wealth is exposed to risk, the business may cease to exist when the owner dies, and raising capital can be difficult and relatively expensive.

A partnership form of business organization involves two or more owners who both have unlimited liability for the debts and other legal obligations of the partnership. A

partnerships taxable income is allocated (as personal income) to the partners based on their proportional ownership of the partnership.

• Advantages-. Easy to establish, decision making is diversified among partners, may survive even if a partner leaves or dies, and profits are only taxed once.

• Disadvantages-. It can be difficult to achieve consensus decisions, owners' entire wealth is exposed to risk, and there may be a capital shortfall when a partner dies or leaves for other reasons. Since each partner may bring capital to the firm, capital is generally more readily available than for a proprietorship, but there are still significant limitations on the ability to raise large amounts of capital.

A corporation is owned by its stockholders, and their liability is legally limited to the amount of money they have invested in the firm. The firm is a legal entity that pays (corporate) income taxes. Corporations account for the largest share of revenue by far among the three types of business organization.

• Advantages-. Owners have limited liability, large amounts of relatively inexpensive capital are available, management expertise is not limited to that of the owners, a corporations life is not limited to thai of the owners, and long-term labor contract* can be used to reduce costs.

• Disadvantages-. Relatively complex management structure mav make the decisionmaking process slow and costlv, and double taxation—corporate earnings are taxed when earned and again when distributed to owners as dividends.

Professor 's Note: The most commonly cited advantages of the corporate form of business over proprietorships and partnerships is its unlimited access to relatively cheap capital and its limited Liability to the owners. 7 he biggest disadvantage of the corporate form over the other two forms is the double taxation of distributed profits.

LOS 16.F: Characterize the four market types.

The four tvpes of economic markets are: (1) perfect competition, (2) monopolistic competition, (3) oligopoly, and (4) monopoly.

Perfect competition exists when all the firms in the market produce identical products. There is a large number of independent firms, each seller is small relative to the total market, and there are no barriers to entry or exit. Furthermore, each of the many buyers and sellers knows the prices of the competing products in the market. While some commodity markets, such as corn and wheat, approach this ideal of competitive markets, many markets exhibit some deviations from perfect competition.

Monopolistic competition is the term used to describe markets where a large number of competitors produce (slightly) differentiated products. Product differentiation gives a degree of market power to firms under monopolistic competition because each firm produces a slightly different product. Thus, firms in monopolistic competition face demand curves that slope downward, at least to some degree. Laundry detergent and canned spaghetti sauce are examples of products that are sold under monopolistic competition. Sometimes the product "differentiation" involves only differences in advertising, brand names, and packaging.

Oligopoly is a market structure characterized by a small number of producers selling products that may be similar or differentiated. There is greater interdependence among competitors in that the decisions made by one firm directly affect the demand, price, and profit of others in the industry. Also, significant barriers to entry exist which often include large economies of scale. The U.S. auto, light bulb, battery, and soft drink industries are examples of oligopoly markets.

Monopoly markets are characterized by a single seller of a specific, well-defined product that has no good substitutes. Barriers to entry are high in monopoly markets. Whether a monopoly exists often depends on how we define the product. Microsoft Corp. certainly has a monopoly of sorts on the Windows® operating system and related software. If we define the market more broadly, there are other operating systems, word processing programs,, spreadsheet programs, and so forth.

LOS 16.g: Calculate and interpret the four-firm concentration ratio and tiv. Herfindahi-Hirschman index, and discuss the iimirations of concentration measures.

The concentration of a market refers to the distribution of firms' market shares. Markets with a few large firms are more concentrated than markets with many smaller firms. There are two primary measures of market concentration: the four-firm concentration ratio and the Herfindahi-Hirschman Index.

The four-firm concentration ratio is the percentage of total industry sales made by the four largest firms in an industry. A highly competitive industry may have a four-firm concentration ratio near zero, while the ratio is 100% for a monopoly. A four-firm concentration ratio below 40% is considered an indication of a competitive market, and a four-firm ratio greater than 60% indicates an oligopoly.

The Herfindahi-Hirschman Index (HHI) is calculated by summing the squared percentage market shares of the 50 largest firms in an industry (or all of the firms in the industry if there are less than 50). The HHI is very low in a highly competitive industry and increases to 10,000 (= 1002) for an industry with only one firm. An HHI between 1,000 and 1,800 is considered moderately competitive, while an HHI greater than 1,800 indicates a market that is not competitive.

The usefulness of concentration measures as indicators of the degree of competition in a market is limited because of: (1) problems with defining the geographical scope of the market, (2) barriers to entry and firm turnover in a market, which are not accounted for by these measures, and (3) weak relationships between a market and an industry.

The geographical scope of the market refers to the fact that products may be marketed in regional, local, or global markets. For example, concentration measures for newspapers

Professor's Note: It is best to view these market structures as a range from perfect (te competition to a pure monopoly. Harriers to entry and interdependence tend to W increase over the range, while price elasticity of demand and the number of firm.

tend to decrease.

in the global market are low, indicating a highly competitive market. But the concentration of newspapers in any given city is usually quite high, indicating relatively low competition at the local market level.

Barriers to entry and firm turnover in a market are not captured in concentration measures. While a small town may have few appliance stores, indicating a lack of competition, there is no barrier to opening a new appliance store, which increases the competitiveness of the market.

The relationship between a market and an industry is not always close, even though concentration measures assume that each firm fits neatly within one specific industry. There are three reasons why firms do not always fit neatly in a given industry. First, markets are often narrower than an industry. Companies may be in the same industry but sell specific products that do not compete with each other. Second, most large firms produce many different products, each facing different levels of competition. Concentration ratios, however, assume one market for the firm as a whole. Finally, firms may switch from one market to another in order to maximize profit. When firms can easily enter and exit a market, this potential competition increases the competitiveness of that market and limits firms' ability to generate economic profit.

LOS I6.h: Explain why' firms arc often more efficient than markets in coordinating economic activity.

Economic activity can be produced through market coordination or through firm coordination.

Market coordination is best described through an example. Consider the production of a heavyweight boxing match. The fight promoter hires an arena, a boxing ring, broadcast specialists, concession services, some boxers, a publicity agency, and a ticket agent. These are all market transactions. The promoter then sells tickets to the event through the ticket agent, along with broadcasting rights to a television network. So, the fight is produced through the coordination of markets.

Another example of market coordination is outsourcing. With outsourcing, a manufacturer of a product buys some or all of the product's components from other firms. The manufacturer then assembles all of the outsourced components to produce the final product. Outsourcing is a common practice in the automobile and personal computer industries.

Firm coordination occurs when firms can coordinate economic activity more efficiently than markets can. This is possible because firms can often achieve lower transaction costs, economies of scale, economies of scope, and economies of team production.

• Transaction costs refer to the costs associated with the negotiations that must take place when attempting to coordinate markets. Firms can often reduce transaction costs by reducing the number of individual transactions that must take place.

• Economies of scale exist when the average unit cost of producing a good decreases as output increases.

• Economies of scope occur when a firm can use its specialized resources to produce a range of goods and services. For example, a publisher hires editors, typists, reporters, marketing experts, and media distribution specialists and uses their skills across all of the firm's published products. This is less expensive to the publisher than it would be for an individual who attempted to hire these services individually in the markets.

• Economies of team production occur when a team of a firm's employees becomes highly efficient at a given task. It is usually less expensive for a firm with a well-honed team to produce a good or service than for an individual who has to hire the individual members of a team in the markets.

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