Flashcards in Second Midterm - Class Notes 2 Deck (23)
The Legal Organization of Firms
1. Sole Proprietorship (Owned by one person)
2. Partnerships (Owned by 2 ppl or more)
3. Corporation (Legal entity that may conduct business in its own name just as an individual does)
Elaborate on Sole Proprietorship
Owned by one person
1) Easy to form and dissolve
2) Decisions reside with one person
3) Taxed once, as profits are individuals net income
1) Unlimited Liability for the debt of the firm. The owners personal assets can be seized by firms creditors.
Elaborate on Partnerships
Business owned by 2 people or more
1) Easy to form and dissolve
2) Permits Specialization
1) Joint Unlimited liability
2) Decision making becomes more costly
An agreement that limits a partners liabliity
Elaborate on Corporations
A legal entity that may conduct business in its own names just as an individual does
The owners are called SHAREHOLDERS
1) Corps are well positioned to raise large sums of money
2) Shareholders enjoy LIMITED LIABILITY
1) Subject do Double Taxation. The profits of a corporation are subject to corporate taxation. The after tax profits that are distributed to shareholders are income and are subject to income tax too
2) Corporations re subject to Principle Agent Problem
Shareholders are the principles and managers are the agents.
Shareholders want the firm to maximize profits
Managers may want to maximize their personal returns
This leads to conflict
Managers may not always do what is in the best interest of the shareholders.
Methods of Corporate Financing
Corporations have two principle means of raising funds, bonds and stocks
1) BONDS (Debt financing)
ii) Bills and Notes
iii) Bonds and Debentures
Elaborate on Bonds (Debt Financing)
A bond is a legal claim against the company.
It represents debt.
The return to a bond is the interest rate which must be paid whether the corporation makes profits or not. Bondholders are not owners of the corporation rather they are creditor. Thus, in general, they will have no say in the corporations operations
Bonds usually have a maturity date at which time they bondholders are repaid the face value of the bond plus any remaining interest
Private agreements between the firm and a bank, usually calling for a periodic payment of interest and repayment of the principal, either at a stipulated future date or on demand.
ii) BILLS AND NOTES
Used for short term loans of up to one year. They carry no fixed interest payments, only a principal value and a redemption date. Interest arises because the borrower sells the bills at a price below redemption value. For example, a firm may sell a $1000 bill or noes for $950, implying an interest rate of 5.25%
Bills are negotiable, which means that they can be bought and sold on the open market.
iii) BONDS AND DEBENTURES
Fixed redemption date and the obligation to make periodic interest payments.
Typically used for long term loans and are negotiable.
Elaborate on Stocks (Equity FInancing)
A stock is called a share. It represents ownership in the corporation
All corporations must issue stocks
Stockholders have a right to a portion of companies profits, called DIVIDENDS
They are not however, assured of a fixed rte of return on their stocks
Holders of COMMON STOCK elect the company board of directors and thus have some say in the company operations.
Holders of PREFERRED STOCK do not have a vote but get preferential treatment in the payment of dividends.
The Markets for Stocks and Bonds
1) THE PRIMARY MARKET
When a company issues new stocks or new bonds ,these stocks and bonds are bought and sold in the primary market
Companies make money from selling the initial first stocks
2) THE SECONDARY MARKET
A secondary market is a market in which existing stocks an bonds are bought and sold
Companies don't make more money off of these stocks being sold and bought
What influences the demand for a stock int he secondary market?
1. Companies history (Transaction history)
2. Company stock prices (perceived future prices)
Bear Markets: General downward trend in stock prices
Bull Markets: General upward trend in stock prices
3. Earnings (And perceived future earnings)
4. Companys board of directors
5. Events in the economy
6. Policies of governments
7. Ethical issues
8. Levels of income
9. Interest rate on government bonds
Theory of Production
TECHNOLOGY: The state of societies knowledge about the industrial and agricultural arts
OUTPUTS: The products that result from production
INPUTS: The facts that are used to produce outputs
1. Land (Natural resources, natural capital) (Rent)
2. Labour (Human capital, human capital is # of workers and their skills) (Wages)
3. Capital (Physical capital, buildings, equipment, machinery) Rentk
4. Entrepreneurship (Contribution of the owners)
Inputs, Short/Long Run, TP/AP
FIXED INPUTS: Inputs where the quantity can't be changed in the TIME PERIOD
VARIABLE INPUTS: Inputs where the Q can be changed in the time period
SHORT RUN: time period in which at least one input is fixed.
LONG RUN: Time period in which input is variable
TOTAL PRODUCT: TP = Q, total amount produced in the same time period
AVERAGE PRODUCT: AP L = Q / L
MARGINAL PRODUCT: Change in output resulting from an incremental change win the use of an input, holding the quantities of all other inputs constant.
Marginal Product (MP)
Change in TP resulting from a change in the use of one input holding the quantities of all other inputs constant
MPl = change in Q / Change in L
The Law of Diminishing Marginal Returns
As more of a variable input is added to the production process, holding the Q;s of all other inputs constant, the resulting Q will, at someone begin to DIMINISH
Labour: As labour increases, Marginal Product of labour decreases.
The Costs of Production
ACCOUNTING COST: Include actual expenditures and depreciation expenses for capital equipment. Accounting costs are explicit costs.
Econ Costs = Accounting Costs + Opportunity Costs
COSTS IN THE SHORT RUN
Recall we talked about how there are fixed and variable inputs in the short run.
There are also fixed costs and variable costs.
FIXED COSTS: Costs that do not change in the Quantity of output changes.
VARIABLE COSTS: Costs that change as the quantity of output changes. Variable costs increase as the quantity of output increases.
The short run is a time period in which at least one cost is fixed, in the long run. ALL are variable.
Costs of Owning a Car Example
VARIABLE: Gas, repairs, tires
FIXED: Insurance (can change after an accident), registration
IN THE SHORT RUN
Cost = FC + VC
VARIABLE COSTS = 0 when quantity of output equals 0, so when Q = 0, C = FC.
AVERAGE TOTAL COSTS
- ATC = C / Q
AVERAGE VARIABLE COSTS
- AVC = VC / Q
AVERAGE FIXED COSTS
- AFC = FC / Q
Since C = VC + FC
C/Q = VC / Q + FC / Q
ATC = AVC + AFC
Marginal Costs (MC)
Is the change in costs that results from an incremental change win the Q of output
MC= Difference In Cost / Difference in Quantity
The Marginal Average Rule
(Applied to average cost)
1) IF MC > ATC , then average total cost is RISING
2) IF MC
Costs in the Long Run
All costs are variable
REGION 1: ECONOMICS of SCALE
- With economics of scale, as output double, cost less than double
- Economics of scale occur due to gains from specialization. Here, they are average cost advantage to becoming bigger.
- LRAC is Horizontal
- As outputs double, costs double
REGION 3: DISECONOMIES OF SCALE
- With diseconomies of scale, as outputs double, costs more than double
- As the plant site becomes very large, administrative difficulties and coordination difficulties result in average costs rising
Theory of Competitive Markets
Four Different Market Structures
1) Perfect Competition
3) Monopolistic competition (difference in products, so they still have power)
The Equilibrium of a Profit Maximizing Firm
The decision of a firm (or firms) to choose a price an output is ONE DECISION
Once the firm has selected a price, the quantity that they sell is up to the customers.
If a firm chooses OUTPUT, they must leave it to the market to determine the price of what they sell.
To maximize profits int he SHORT RUN, the firm must follow two rules
A firm should produce only if TOTAL REVENUE is greater than or equal to TOTAL VARIABLE COST (TR = TVC)
A firm maximizes profit when it chooses the quantity where MARGINAL COST equals MARGINAL REVENUE
(MR = MC)