Chapter 2: Firms

Which route does a product follow until it reaches the customer?
How are firms divided?
What is the structure of a company?
What does is mean: to produce?
What does a firm need to produce?
How does a firm finance its production?
What role does a firm play in society?

1. It is a long way

To produce a book and bring it to the customer, it takes a long way.  

All firms who are co-participating in the production of a good or service are part of the production cycle.

Everybody who is helping to produce or handle a good or service is a producer.

A production cycle is the chain of firms that the product follows from the early beginning to the consumer.  Only the firms who are the owners of the product are part of the production chain.

Traders are also producers: they produce a service because they bring the product closer to the consumer.

The service giving firms are also producers.  However, they co-operate to bring the product closer to the consumer without being owner of the product.  That is why they are not in the production chain.

2. All firms are not equal

2.1 Every firm has it's specialty 

Example: the production chain of coffee:

Production chain Service giving firms
plantation
exporter
importer
coffee roaster
wholesaler
retailer
shipment company
insurance company
transportation company

Some companies transform raw materials into products.  All firms that are transforming raw materials are industrial companies.

Producers who are cultivating raw materials are agricultural companies.

All producers who give services are service giving firms.

2.2 Every firm has its place

Firms are not only divided according to their function.  They are also divided according to their sector.

Primary sector

Firms who are cultivating products come on the first place in the production chain.  They belong to the primary sector.

Examples:

Secondary sector

Firms which are producing basic goods. They are the industrial firms.

Tertiary sector

Firms who are handling products.  These are the commercial firms.

Exercises

1) The following firms are necessary to bring tomato ketchup to the consumer: can making company, shopkeeper, tomato cultivator, wholesaler in food, auction. 

Production chain Function Sector
tomato cultivator cultivating primary sector (agricultural)
(auction) service tertiary sector
can making company producing secondary sector (industrial)
wholesaler in food handling products tertiary sector
shopkeeper handling products tertiary sector

2) Chocolate is made of cacao beans.  The most important producer is Ghana in Africa.  The beans are cultivated on a plantation and brought to the hacienda.  There the beans receive their taste and color.  After drying, they are sold to an exporter, who is selling them to a Bulgarian importer.  They are then shipped to Bourgas.  the chocolate firm buys the beans and makes a fluid from them.  From this liquid they make three products: chocolate, cacao butter and cacao powder.  The firms sells the chocolate to the wholesaler, who is selling it to the shops.  Most of the cacao butter goes to the bakeries to produce cakes.  The cacao powder goes partly to the dairy factory to produce chocolate milk.

Production chain Function Sector
plantation cultivating primary sector (agricultural)
hacienda producing secondary sector (industrial)
exporter handling products tertiary sector
importer handling products tertiary sector
chocolate firm producing secondary sector (industrial)
wholesaler - bakery - diary factory handling - producing - producing tertiary - secondary - secondary

Service giving firms:

2.3 The structure of a company

In a big company it is very difficult to have only a few people for all functions. 

For every important task there is a group of people responsible.  Those groups are called divisions or departments.  

At the head of a division we find a manager or chief.  

All divisions together form the organization of a company.

The schematic drawing of an organization is called an organigram

Exercises

1) The transport firm "The Lion" has 13 managers/employees.  Each of them is responsible for a particular task.  Hereunder follows the list with the names and the functions. Make the organigram.

2) In the transport firm "The Lion", who is responsible for:

2.4 Produce and realize gains

2.4.1 The production possibility frontier

The limited resources and the technologies available for transforming those resources into goods and services limit what can be produced.  That limit is described by the production possibility frontier (PPF).

The PPF marks the boundary between those combinations of goods and services that can be produced and those combinations that cannot.

To explain the PPF we replace the real economy by a model economy.  The model economy is a simplification of the real economy in three ways:

Jana uses all the resources of her island economy to produce corn and cloth.  She works 10 hours each day.  The amount of corn and cloth that Jana produces depends on how many hours she devotes to producing them.

Jana's production possibilities are (corn and cloth considered separately):

Hours 
worked / day
either Corn grown
(kg / month)
or Cloth produced
(m / month)
0 0 0
2 6 1
4 11 2
6 15 3
8 18 4
10 20 5

Jana's production possibility frontier (corn and cloth considered together):

  Corn Cloth
  hours / day kg / month hours / month m / month
a 10 20 0 0
b 8 18 2 1
c 6 15 4 2
d 4 11 6 3
e 2 6 8 4
f 0 0 10 5

Possibility a shows Jana devoting no time to cloth and spending her entire 10-hour working day to corn.  In this case the can produce 20 kilos of corn per month and no cloth.

For possibility b, she spends 2 hours a day making cloth and 8 hours growing corn, to produce a total of 18 kilos corn and 1 meter cloth a month.

The line passing through the points a, b, c, d, e and f is Jana's PPF which separates the attainable from the unattainable.  Jana can produce anywhere inside this area or on the PPF.  

Jana prefers points on the frontier to any point inside.  She prefers points between b and d on the frontier, to point z inside the PPF because they give her more of both goods.

Jana doesn't produce corn and cloth for the fun of it, but to be able to eat and keep warm.  She wants much more corn and cloth than she can produce.  And the more she has of each, the more she likes it.

Because Jana wants as much as possible of both corn and cloth, the best she can do is produce - and consume - at the PPF.

Exercises

1) How come Jana doesn't prefer point z?

2.4.2 Opportunity costs

Jana wants to produce at some point on her PPF, but she is still faced with the problem of choosing her preferred point.  In choosing between one point and another, Jana is confronted with opportunity costs.

The opportunity cost is the value of the best alternative forgone.  Or differently, the opportunity cost of acquiring one good is equivalent to the amount of another good that must be given up.

Since there are only two gods there is no difficulty in working out what is the best alternative forgone.  More corn can only be grown by having less cloth.  And more cloth can only made by growing less corn.

The opportunity cost of an additional meter of cloth is the amount of corn forgone.  The opportunity cost of an additional kilo of corn is the amount of cloth forgone.

We will calculate how much cloth she has to give up to get more corn and how much corn she has to give up to get more cloth.

If all Jana's time is used to produce corn, she produces 20 kilos of corn and no cloth.  If she decides to produce 1 meter of cloth, how much corn does she have to give up?  She will have to give up 2 kilos of corn (a > b).  So the opportunity cost of the first meter of cloth is 2 kilos of corn.

If she decides to produce an additional meter of cloth, how much corn does she have to give up?  This time she has to give up 3 kilos of corn (b > c).

Example

For a late sleeper the opportunity cost of attending an early morning class is equivalent to 1 hour in bed.

For a jogger the opportunity cost of attending an early morning class is an hour of exercise.

Exercise

1) Calculate Jana's opportunity cost of moving from e to f.

2.4.3 Production and utility

In our society, a brewery also produces something: beer.  The barkeeper is selling beer.  does the consumer have an advantage by the activities of the trader?  Why?

To produce is to create utility by:

We can describe production as the conversion of land, labor and capital into goods and services.

Examples of land

Examples of labor

Examples of capital

Human capital is a special kind of capital.  It is the accumulated skill and knowledge of human beings which arises from their training, education and experience.

Goods and services are all the valuable things that people produce.  Gods are tangible and services are intangible.

The totality of what the brewery sells is income.

The total of what the brewery spends to produce are called costs.

The difference between income and costs is profit.

Each producer increases the importance of a good or service, he creates an added value.

Exercises

1) Arthur is selling Toyota cars.  Each month he sells for about 15.000 EURO.  He has two mechanics.  They each cost 135 EURO per month.  Per month he buys for 12.000 EURO cars, parts, oil, ...  Electricity, heating , phone, water, etc cost 120 EURO per month.  Last but not least there is Tone, his lovely secretary who earns 140 EURO per month.

Sales     15.000 EURO
Costs     12.530 EURO
    Personnel 2 * 135 EURO + 140 EURO 410 EURO  
    Products   12.000 EURO  
    Energy   120 EURO  
Added value     3.000 EURO
Profit     2.470 EURO

2) Harry produces 100 cakes in his bakery.  The raw materials he is using cost 20 EURO.  A person helps him during 1.5 hours and earns 0.70 EURO per hour.  The other costs for producing (electricity, light, heating, ...) are 5 EURO.

Costs     26.05 EURO
    Raw materials   20.00 EURO  
    Personnel 1.5 * 0.70 EURO 1.05 EURO  
    Energy etc   5.00 EURO  
Profit of 40%     10.42 EURO
Total sales necessary     36.47 EURO
Added value     16.47 EURO

2.5 Produce but with?

2.5.1 First start...

Why don't you start your own business?
What is present in your shop?
How are you financed?

Everything what is present in a company are working resources.

The sources from where you got the financial means to pay for the working resources are your financial resources.

All resources which stay in the company for a long time are fixed resources.  Those which are continuously fluctuating and only stay for a short time are the floating resources.

If you could finance yourself, we speak about own capital.

If the resources come from others, we talk about foreign capital.

We could make the following schema:

Materials Resources
Fixed materials Own capital
Floating materials Foreign capital

This presentation is called "the balance".  It is a photograph of a company on a certain moment.

The side of the materials is the "assets" side.  The side of the resources is the "liabilities" side.

Exercise

1) Classify your working materials in fixed and floating materials.

2) Give examples of foreign capital.

3) Make the balance for the carpenter's workshop.  On the 31st of December there is a stock of wood of 10.000 EURO, 8.000 EURO machines, 50.000 EURO buildings, a truck of 5.000 EURO.  On the bank account is 1.000 EURO.  The owner financed 50.000 EURO.  The rest he borrowed from the bank.

2.5.2 Then work

All activities are registered in the bookkeeping.  This bookkeeping gives an overview of all transactions.  At the end of the year it is possible to calculate the result of the year.  

The technical side of bookkeeping is treated in the course of accounting.

2.6 A firm is not an island

Firms are playing an important role in our society.  They have a big influence on our daily life.

Positive influences

Negative influences

Exercises

1) Give 5 advantages and disadvantages of firms.

2) More and more firms prefer to make partnerships in stead of competing.  

2.7 Demand and supply

2.7.1 Demand

The quantity demanded of a good or service is the amount that consumers plan to buy in a given period of time at a particular price.  Demands are different from wants/needs.  

Wants/needs are unlimited desires or wishes that people have for goods or services.

How many times have you thought that you would like to have something "if only you could afford it" or "if it weren't so expensive".?

The quantity demanded is measured as an amount per unit of time.

Example:

Suppose a person consumes one cup of coffee a day.  the quantity of coffee demand by that person can be expressed a 1 cup / day or 7 cups / week or 365 cups / year.

2.7.1.1 What determines buying plans?

The amount that consumers plan to buy of any good or service depends on many factors.  The most important ones are:

2.7.1.2 The law of demand

The law of demand states: "Other things being equal, the higher the price of a good, the lower is the quantity demanded"

Why does a higher price reduce the quantity demanded?  the key to the answer lies in the 'other things being equal'.  Because all other things are being held constant, when the price of a good rises, it rises relative to the prices of all other goods.

Although each good is unique, it has substitutes.  Other goods that serve almost as well.  As the price of a good climbs higher, relative to the prices of its substitutes, people buy less of that good and more of its substitutes.

Example:

Blank audio cassette tapes.  Many different goods pro vide a service similar to that of a tape: records, CD's, pre-recorded tapes, radio, television broadcasts and live concerts.  Tapes sell for about 3 EURO each.  

If the price of a tape doubles to 6 EURO, while the prices of all the other goods remain the same, the quantity demand of tapes will fall.  People will buy more compact discs, pre-recorded tapes and fewer blank tapes.

If the price of a blank tape falls to 1 EURO while the prices of all other goods stay constant, the quantity of tapes demanded will rise and the demand for compact discs and prerecorded tapes will fall.

2.7.1.3 The demand schedule and demand curve

A demand schedule lists the quantities demanded at different prices when all other influences on consumers' planned purchases are being held constant.

A demand curve graphs the relationship between the quantity demanded of a good and its price, holding constant all other influences on consumers planned purchases.

By convention, the quantity demanded is always measured on the horizontal axis and the price is measured on the vertical axis.

The demand schedule:

  Price 
(EURO per tape)
Quantity 
(millions of tapes per week)
a 1 9
b 2 6
c 3 4
d 4 3
e 5 2

The demand curve:

2.7.1.4 Willingness to pay

There is another way of looking at the demand curve: it shows the highest price that people are willing to pay for the last unit bought.

If a large quantity is available, that price is low; but if only a small quantity is available, that price is high.

2.7.1.5 A change in demand

The term demand refers to the entire relationship between the quantity demanded and the price of a good.  To construct the demand curve we hold constant all other influences on consumers' buying plans.  But what are the effects of each of those other influences:

Prices of related groups

The quantity of tapes that consumers plan to buy does not depend only on the price of tapes.  It also depends in part on the price of related goods.  These related goods fall into two categories: substitutes and complements.

Substitute

A substitute is a good that can be used in place of another good.  For example, if the price of pre-recorded tapes decreases, people play more of these tapes and make fewer of their own tapes.  Therefore the demand for blank tapes falls.  The effects of a change in the price of a substitute will change the demand schedule for tapes and shifts the demand curve.

Complement

A complement is a good that is used in conjunction with another good.  Tapes also have their complements: walkman, tape recorders, stereo tape decks.  If the price of one of these complements increases, people buy fewer tapes.  For example, if the price of a walkman doubles, fewer walkmans are bought and as a consequence, fewer people are interested in buying tapes.

Income

When income increases, consumers buy more of most goods and when income decreases, they buy less of most goods.  

Consumers with higher incomes demand more of most goods.  Consumers with lower incomes demand less of most goods.

Although an increase in income leads to an increase in demand for most goods, it does not lead to an increase in the demand for all goods.  Goods for which demand increases when income increases are called normal goods.

Goods for which demand decreases when income increases are called inferior goods.  

Examples of inferior goods are rice and potatoes.  Those two goods are a major part of the diet of people with very low incomes.  As income increases, the demand for these goods declines as more expensive meat and dairy products are substituted for them.

Expected future prices

If the price of a product is expected to rise, it makes sense to buy more of the good today and less in the future, when its price is higher.

Similarly, if the price is expected to fall, it pays to cut back on today's purchases and buy more later later, when the price is expected to be lower.

Population

Demand also depends on the size of the population.  Other things being equal, the larger the population, the greater the demand for all goods and services and the smaller the population, the smaller the demand for all goods and services.

Preferences

Preferences are an individual's attitudes toward goods and services.  For example, a rock music fan has a much greater preference for tapes than a tone-deaf workaholic. As a consequence, even if they have the same income, their demand for tapes will be very different.

2.7.1.6 Movement along the demand curve versus a shift in the curve

Changes in the influences on buyers plans cause either a movement along the demand curve or a shift in it.

If the price of a good changes but everything remains the same, there is a movement along the demand curve.  For example, if the price of a tape changes from 3 EURO to 5 EURO, the result is a movement along the demand curve.

If the price of a good remains constant but some other influence on buyers' plans changes, we say that there is a shift in the demand curve.  For example, a fall in the price of the walkman - a complement of a tape - increases the demand for tapes.

We illustrate this increase in demand for tapes with a new demand schedule and a new demand curve. Consumers demand a larger quantity of tapes at each and every price.

The table below provides some hypothetical numbers that illustrate such a shift.  The table sets out the original schedule when the price of a walkman is 200 EURO and the new demand schedule when the price of a walkman is 50 EURO.

  Original demand schedule
walkman 200 EURO
  New demand schedule
walkman 50 EURO
  Price
(EURO / tape)
Qty 
(millions of tapes / week)
  Price
(EURO / tape)
Qty 
(millions of tapes / week)
a 1 9 a' 1 13
b 2 6 b' 2 10
c 3 4 c' 3 8
d 4 3 d' 4 7
e 5 2 e' 5 6

2.7.2 Supply

The quantity supplied of a good is the quantity that producers plan to sell in a given period of time at a particular price.

The quantity supplied is not the quantity a firm would like to sell but the quantity it definitely plans to sell.

However, the quantity supplied is not necessarily the same as the quantity actually sold.  If consumers do not want to buy the quantity a firms plans to sell, the firm's sales plans will be frustrated.

Like quantity demanded, the quantity supplied is expressed as an quantity per unit of time.

2.7.2.1 What determines selling plans?

The quantity that firms plan to sell of any particular good or service depends on many factors:

2.7.2.2 The law of supply

The law of supply states: "Other things being equal, the higher the price of a good, the greater is quantity supplied."

Why does the higher price of a good lead to a greater quantity supplied?

2.7.2.3 Supply schedule and supply curve

A supply schedule lists the quantity supplied at each different price when all other influences on the quantity firms plan to sell are held constant.

A supply curve graphs the relationship between the quantity supplied and the price of a good, holding everything else constant.

The table below sets out the supply schedule for tapes.  It shows the quantity of tapes supplied at each possible price.

  Price 
(EURO per tape)
Quantity 
(millions of tapes per week)
a 1 0
b 2 3
c 3 4
d 4 5
e 5 6

The supply curve:

2.7.2.4 Minimum supply price

We can also think about the supply curve as showing the minimum price at which the last unit will be supplied.

What is the minimum price that brings forth a supply of a given quantity?  For firms to supply the 3 millionth tape each week, the price has to be at least 2 EURO a tape.

2.7.2.5 A change in supply

The term supply refers to the entire relationship between the quantity supplied of a good and its price.  The supply of tapes is described by both the supply schedule and the supply curve.

Let's consider the other influences:

Prices of factors of production

The prices of the factors of production used to produce a good exert an important influence on its supply.  For example, an increase in the prices of labor and the capital equipment used to produce tapes increases the cost in producing tapes so the supply of tapes decreases.

Prices of related goods

Substitutes in production

The supply of a good can be influenced by the prices of related goods.  

For example, if an automobile assembly line can produce either sports cars or sedans, the quantity of sedans produced will depend on the price of sports cars and the quantity of sports cars will depend on the price of sedans.

These two products are substitutes in production.  An increase in the price of a substitute in production lowers the supply of a good.

Complements in production

Goods can also be complements in production.  For example, extracting chemicals from coal produces coke, coal tar and nylon.  An increase in the price of any one of these by-products of coal increases the supply of the other by-products.

Tapes have no obvious complements in production, but they do have substitutes in production: pre-recorded tapes.  Suppliers of tapes can produce blank tapes and pre-recorded tapes.  An increase in the price of pre-recorded tapes encourages producers to increase the supply of pre-recorded tapes and decrease the supply of blank tapes.

Expected future prices

If the price of  good is expected to rise, firms may decide to try and sell less today and more later.

If the price is expected to fall, firms try to sell as much as possible right now and less later.

The number of suppliers

The larger the number of firms supplying a good, the larger is the supply of the good.

Technology

New technology that enable the producers to use fewer factors of production will lower the cost of production and increase the supply.

2.7.2.6 Movement along the supply curve versus a shift in the curve

If the price of a good changes, but everything else influencing suppliers' planned sales remains constant, there is a movement along the supply curve.

For example, if the price of tapes increases from 3 to 5 EURO, there will be a movement along the supply curve from point c to point e.

If the price of a good remains constant but another influence on suppliers' planned sales changes, then there is a change in supply and a shift in the supply curve.

For example: technological advances lower the cost of producing tapes and increase their supply.  As a result the supply schedule changes.

  Original technology   New technology
  Price
(EURO / tape)
Qty
(millions of tapes / week)
  Price
(EURO / tape)
Qty
(millions of tapes / week)
a 1 0 a' 1 3
b 2 3 b' 2 6
c 3 4 c' 3 8
d 4 5 d' 4 10
e 5 6 e' 5 12

...