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Understanding Supply Decisions in Economics: Forms of Business, Costs, and Profit Maximization

This chapter introduces supply decisions in economics, covering forms of business organization, key accounting terms, and the production decision process. Topics include revenues, costs, profits, balance sheets, and the role of costs in economic decisions. The chapter also explores the relationship between marginal cost and marginal revenue in maximizing profits, while discussing the influence of ownership, management objectives, and profit maximization strategies within firms.

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Understanding Supply Decisions in Economics: Forms of Business, Costs, and Profit Maximization

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  1. Chapter 6Introducing supply decisions David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

  2. Forms of business organisation • Sole trader • owned by an individual entitled to income and responsible for losses • Partnership • jointly owned by two or more people • unlimited liability • Company • ownership divided among shareholders • legal entitlement to produce and trade • limited liability • shares of public companies resold on the stock exchange

  3. Some key terms • Revenues • the amount a firm earns by selling goods and services in a given period • Costs • the expenses incurred in producing goods and services during the period • Profits • the excess of revenues over costs

  4. Some accounting terms • Cash flow • the net amount of money received (by the firm) during the accounting period • Physical capital • machinery, equipment and buildings used in production • Depreciation • the loss in value of a capital good during the accounting period • Inventories • goods held in stock by the firm for future sales

  5. A firm’s balance sheet • Assets • what the firm owns • Liabilities • what the firm owes • Balance sheet • lists a firm’s assets and liabilities at a point in time

  6. Snark International balance sheet31 December 2004

  7. Costs and the economist • Accounting cost • actual payments made by a firm in a period • Opportunity cost • amount lost by not using a resource in its best alternative use • Supernormal profit • profit over and above the return earned at the market rate of interest • Economists include opportunity cost in a firm’s total costs

  8. The production decision • For any output level, the firm attempts to mimimise costs • Assume the firm aims to maximise profits • Profits depend on both COSTS and REVENUE • each of which varies with the level of output • Marginal cost (MC) is the rise in total cost if output increases by 1 unit • Marginal revenue (MR) is the rise in total revenue if output increases by 1 unit

  9. MC, MR MC E MR 0 Q1 Output Maximising profits If MR > MC, an increase in output will increase profits. If MR < MC, a decrease in output will increase profits. So profits are maximised when MR = MC at Q1 (as long as the firm covers variable costs)

  10. Will firms try to maximise profits? • Large firms are not run by their owners • there is separation of ownership and control • Managers may pursue different objectives • e.g. size, growth • But firms not maximising profits may be vulnerable to takeover • or managers may be given share options to influence their incentive to maximise profits

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