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Economic Costs

7 Jul

Economic Costs

   Goods or resources have price because they are scarce and may have alternative uses. When a society uses resources to produce a specific good, it loses (forgoes) the opportunity to use this good for any other purpose. Economic cost or opportunity costs measure the value or worth of a good that would have in its best alternative use.

Explicit and Implicit Costs
   Now let’s consider costs from a business viewpoint. Keeping opportunity costs in mind, we may say that economic costs are payments that a business must make or income it must provide, to attract resources it needs from alternative uses. These payments to resource providers may be explicit (expressed) or implicit (present but not obvious). So firms have both implicit and explicit costs while they are producing goods:

  • A firm’s explicit costs are payments that it makes for labor force, resources, transportation of goods and so on.
  • A firm’s implicit costs are the opportunity cost for the goods it owns and it produces. They are the monetary payments that those resources could have earned if they were used in their best alternative uses.

       Normal Profit
            Normal profit (an implicit cost for firms) is the monetary payment that a firm must make to obtain and retain entrepreneurial ability also we may call it as minimum payment entrepreneurial ability must receive to perform the entrepreneurial activity for a firm. For example if you are entrepreneur and you didn’t receive this minimum payment for your effort you could easily withdraw from a business and move to a more attractive one.
   Economists include as costs of production all payments- implicit (including normal profit) and explicit, which are required to attract resources in a specific economic unit.

Economic Profit
     To economists, economic profit is the difference between total revenue (TR) and total costs (TC) (implicit and explicit). So when it is said that a firm receives normal profit, it means that it receives the money needed to cover it costs (implicit and explicit) and the entrepreneur is receiving payments large enough to retain his abilities in this production line.


Economic profit is not a cost, better said it is excess revenue offered to entrepreneur in his line of production.

Economic Costs

Short Run and Long Run
   When firm’s demand changes its profit may depend how quickly it can adjusts to various amount of resources it employs. It can quickly adjust the quantity of resources employed of labor, fuel, resources. However, to adjust plant capacity (size of factory, amount of equipment and machinery and other capital resources) more time it’s needed. For example in heavy industries time needed to increase plant capacity can be very long. That’s why economists distinguish two conceptual periods: long run and short run.
Short Run
       In short run plant capacity is assumed to be fixed because period of time is too short; however it is enough to perform several changes in the method how the fixed plant is used. For example, firm may vary the quantity output by applying different amount of labor force, materials and other resources needed to that plant.

Long Run
      Long run is a period long enough to adjust all quantities of resources that a firm needs even a change in plant’s capacity can occur. For industry, long-run is the period of time in which firms can also leave or enter the industry. While short run determines “fixed-plant” period, long run determines “variable-plant” period.


The Business Sector

7 Jul

Business sector

   A firm can be organized in several ways. We should distinguish three types: a plant, a firm and an industry.

  • A plant is a physical establishment (a factory, a mine, a store or a farm) that may perform one or more functions in producing, fabricating and distributing of goods and services.
  • A firm is an organization that employs resources to produce goods and services. Firms may own and operate one or more plants.
  • An industry is a group of firms that produce the same or similar products.

   The organizational structure of firms is diverse and very complex. Multi-plant firms may be organized horizontally, most of them performing the same function or they may be vertically integrated, meaning that each plant is performing different actions in the various stage of production process. Other firms may be conglomerates, which mean that their plants produce products in different industries.

Forms of Business
   There are three major legal forms of business:

  • Sole Proprietorship- is a business that is owned and operated by a single person. The owner (proprietor) is the person who supervises the whole operation of production.
  • Partnership- this form of business represent an organization that is owned and operated by two or more individuals (partners).All of them usually invest their money in this business and all of them share the risk of having losses.
  • A corporation- is a legal business unit chartered by federal or provincial governments that operates as a distinct unit from the stockholders who own it. This type of business is run by managers.

   Each form of business has its advantages and disadvantages.
Sole Proprietorships are numerous because they are easy to create and organize. The proprietor is the person who makes decisions of further development of this type of business. Proprietor’s revenue depends on success and logic of his actions, so owner has a strong incentive to manage this economic unit efficiently.
   One of the main disadvantages is that financial resources are limited to what owner has in bank or can borrow. Because this type of business often fails banks aren’t eager to offer them credit. The proprietor carries all management functions: takes decision what to produce, how much to produce, whom to hire and where to sell the goods. This type of firm doesn’t get the benefits of specialization since it’s very small and quantity produced is very low. One of the most important characteristic is unlimited liability. Individuals can lose not only firm’s assets, but also personal assets, if firm’s assets aren’t sufficient to pay the bills.
  Partnership, like sole proprietorship, is easy to organize. Greater specialization of management is possible because more people run this economic unit and also financial resources of proprietorship are greater than that of sole proprietorship. Banks are more likely to offer financial resources to this type of business than to sole proprietorships.
    When more people participate in managing of a firm, there may be some disagreements on some basic policies, which will act like a hinder in firm’s economic activity. Even if financial funds of partnerships are generally superior to that of sole proprietorship, they still may not be enough to ensure the rapid growth of a successful business.
   The continuity of partnership may be limited. If one of the partners die this economic unit should be reorganized or dissolved. Like in sole proprietorships partners risk to lose their wealth if one of the partners has a bad performance. So, wealthy partners risk their money on the prudence of less affluent partners.
   Corporations, although are small in number, they are large in size and produce great number of economic operation. This is the most effective form of business for raising financial capital. They have unique methods of getting financial resources- the selling of stocks and bonds- that enable to collect a great amount of people from a large number of people.
    Stocks are shares of ownership, but bonds are promises to repay a loan at a specific rate. Financing via bonds and stocks is very effective. Such kind of financing help households do own a part of business and share the revenues without participating at organizing or managing a firm. Corporations are better risks, so banks are more likely to become profitable clients of banks.
      Corporations have limited liability, which means than stockholders risk only what they paid for the stocks if the corporation becomes bankrupt. Creditors can sue the only the corporation as a legal economic entity, but not the stockholders. Because of their ability to attract enormous financial resources, corporations may develop very quickly. The may take advantage of division of labor and mass-production technologies.
   As a legal entity corporations have an independent life from their stockholders. The transfer of stocks through inheritance or sale of stock doesn’t disrupt life of this economic unit, which permits to have a long-ranged life and grow.
   Even if there are a lot of advantages, corporations have some drawbacks. One of them is that some business owners can avoid personal responsibility from some questionable business activity. Another drawback is double taxation of income. Corporate profit is divided among stockholders as dividends and taxed twice- once as corporate profit another time as stockholders’ income.
Principal-Agent Problem
      Corporations are extremely large so that their managing may create a potential problem. Here stockholders can’t manage entire economic operations of corporations, so that they hire other to do it.
   This action can produce a principal-agent problem. Principals here are stockholders, ones who own the corporation and hire executive as their agents to run business on their behalf. Interests of these managers (agents) don’t always coincide with the interests of corporation’s stockholders. Owners want more profit and maximum stock price, while agents want prestige, power to control the whole enterprise, independent of revenue and stock price. So a problem of interests may occur.
   Many corporations solved this problem by providing a big part of managers’ pay as shares of the companies’ stock. The idea is to combine interests of executive to ones of the owners.
   By getting high profits and share price, owners get high dividends, but executive enhance their revenues.

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