Economics Study Notes

Chapter 7

Firms

- There are 6 different ways a firm can be organized:

o Single Proprietorship – has one owner-manager who is personally
responsible for all aspects of the business, including its debts
o Ordinary Partnership – has two or more joint owners, each of whom is
personally responsible for all of the partnership’s debts
o Limited Partnership – provides for two different partners. General
Partners take part in the running of the business and are liable for all the
firm’s debts. Limited Partners take no part in the running of the business,
and their liability is limited to the amount they actually invest in the
enterprise.
o Corporation – is a firm regarded in law as having an identity of its own;
its owners are not personally responsible for anything that is done in the
name of the firm, though its directors may be. The shares of a private
corporation are not traded on any stock exchange (such as the TSX or
NYSE) whereas the shares of a public corporation are.
o State-owned enterprise – is owned by the government but is usually
under the direction of a more or less independent, state-appointed board.
Although its ownership differs, the organization and legal status of a state-
owned enterprise are similar to those of a corporation. In Canada, such
state-owned enterprises are called Crown corporations.
o Non-profit Organizations – established with the explicit objective of
providing good or services to customers, but any profits that are generated
remain with the organization and are not claimed by individuals. In many
cases, some goods or services are sold to customers while others are
provided free of charge. Non-profit firms therefore earn their revenues
from a combination of sales and donations.
- Not all production in the economy takes place within firms, government agencies
also provide goods and services
- In most government cases, the goods and services are provided to the citizens
without directly charging, they are financed through taxes
- Multinational Enterprises (MNE) – are firms that have operations in more than
one country
- A large amount of international trade represents business transactions of MNE’s
- The money that a firm raises for carrying its business is sometimes called its
financial capital, the two basic types of financial capital is equity and debt
- Equity: the funds provided by the owners of the firm
o in individual proprietorships and partnerships, one or more owners proved
much of the required fund
 o A corporation acquires funds from its owners in return for stocks, shares,
or equities (as they are variously called). These are basically ownership
certificates.
o The money goes to the company and the shareholders become owners of
the firm, risking the loss of their own money and gaining the right to share
in the firm’s profit
o The profits paid out by the firm to the shareholders are called dividends
(also called distributed profits)
o An easy way for firms to raise money is to retain current profits rather
than paying them to shareholders
o Financing investment from such undisclosed profits has become an
important source of funding in modern times
o Reinvested profits add to the value of the firm, and hence raise the market
value of existing shares; they are funds provided by owners
- Debt: the funds borrowed from creditors outside the firm
o The firm’s creditors are not owners; they have lent money in return for
some form of loan agreement
o There is a bewildering array of such agreements, which are collectively
called debt instruments in the business world, and called bonds in
economic theory
o Bond – a debt instrument carrying a specified amount and schedule of
interest payments and (usually) a date for redemption of its face value
o Each debt instrument has its own set of characteristics and its own name
o Two characteristics are, however, common to all
 First, they carry an obligation to repay the amount borrowed,
called the principal of the loan
 Second, they carry an obligation to make some form of payment to
the lender called interest
o The time at which the principal is to be repaid is called the redemption
date of the debt
o The amount of time between the issue of the debt and its redemption date
is called its term
- The theory of the firm is based on two key assumptions, first, all firms are
assumed to be profit-maximizers, seeking to make as much profit for their owners
are possible, and second, assumed to be a single, consistent, decision-making unit
- The desire to maximize profits is assumed to motivate all decisions made within a
firm, and such decisions are assumed to be unaffected by the peculiarities of the
persons making the decision and by the organizational structure in which they
work

Production, Costs, and Profits

- in order to produce the goods or services that it sells, each firm needs inputs
- for example, among the many inputs entering into car production, there are steel,
rubber, spark plugs, electricity, the site of the factory, machinists, accountants,
spray-painting machines, forklift trucks, painters, and managers
- these can be split into four broad categories:
o inputs to the car firm that are outputs from some other firm, such as spark
plugs, electricity, and steel
o inputs that are provided directly by nature
o inputs that are provided directly by people, such as the services of workers
and managers
o inputs that provided by the factories and machines used for manufacturing
cars
- the inputs above are called intermediate products
- intermediate products – all outputs that are used as inputs by other producers in
a further stage of production
- these only appear as inputs because the stages of production are divided among
different firms
- if these intermediate products are traced back to their sources, all production can
be accounted for by the services of the other three kinds of input, which are called
factors of production
- Factors of production – a functional relation showing the maximum output that
can be produced by each and every combination of inputs
- These are: land (soil, raw materials), labour (physical and mental efforts by
people), capital (manmade aids to production)
- The production function describes the technological relationship between the
inputs that a firm uses and the output that it produces
- In terms of functional notation, it is written as: Q = f(L,K) where Q is the flow of
output, K is the flow of capital services, and L is the flow of labour services
- Firms get their profits by taking the revenues that they obtain from selling their
output and deducting all the costs associated with their inputs