CFA Level 1
Microeconomics - Achieving Economic & Technological Efficiency
Constraints on a firm include:
- Information - firms will not have complete information regarding strategies of competitors, ethics of their workers, customer buying plans, forthcoming technologies and many other factors that affect firm profitability. Acquiring relevant information can be costly, so benefits and costs of acquiring information must be weighed.
- Market - prices firms charge will be impacted by the offerings of other firms. Firms are in competition with other firms for resources such as employees and raw materials. Market constraints limit what firms can charge and enforce pricing on the input side.
- Technology - economists view technology as the methods and processes that firms use to produce goods and/or services. There is a "technology" associated with any business, and the set of available technologies will limit what a firm can do and impact its profit.
Technological efficiency relates quantities of inputs to the quantity of output, while economic efficiency relates the dollar value of inputs to the dollar value of output. A firm would be operating with technological efficiency when it produces a certain level of output with the least amount of input. Economic efficiency would be achieved when a certain level of output is produced with the lowest cost of inputs.
Suppose there are two available methods to produce widgets, one that is highly automated with industrial robots, and a mostly manual one that requires significantly more workers. The automated method costs $50,000 per month to produce 1,000 widgets over a monthly period, using three robots and one worker. The manual method costs $40,000 per month to produce 1,000 widgets over the same time period, with 10 workers that have a minimal amount of tools. We can't say that either method is technologically inefficient - the automated method requires fewer workers, while the manual method requires less capital for the same quantity of output. However, we can say that the manual method is economically efficient, since it produces 1,000 widgets at the lower cost.
Ways to Organize Production
There are two broadly defined methods of organizing production. A command system utilizes a hierarchical organization whereby commands flow down from the top of the organization. Armies typically are organized by this method. An incentive system tries to provide market-like incentives to each layer of the organization. Sales organizations predominantly use incentive systems. Incentives also can be provided to personnel, such as assembly line workers, by relating pay to certain production targets.
The Principal-Agent Problem
The principal-agent problem is an example of incomplete and asymmetric information. Principal-agent problems occur when the principal (buyer) has less information than the agent (supplier). For example, a patient at a hospital has much less information about the medical treatments being conducted than the doctors. The patient would prefer to have the illness resolved at the lowest possible cost to him. The doctors may be facing pressures or may be influenced by incentives that are not in the best interests of the patient. It is difficult for the patient to judge the quality of his or her own treatment.
Owners (shareholders) of firms face similar problems. The owner (principal) compensates an agent (an employee) to perform acts that are useful to the principal, costly (or otherwise undesirable) to the agent, and where performance is costly or difficult to observe. Because of the difficulty/cost of observing the work, the principal finds it difficult to assess the agent's competence and achievements and adjusting compensation accordingly. Likewise, there is an inherent conflict of interest at work – the principal seeks to gain maximum output for minimum compensation, while the agent seeks to maximize compensation and minimize output.
A firm can reduce principal-agent problems by giving the agent an ownership stake in the enterprise, incentive compensation and/or a long-term employment contract. These serve to give the agent a vested interest in the overall health of the enterprise and align the interests of the principal and the agent.
Types of Business Firms:
Proprietorships are businesses owned by a single individual (or sometimes a family). Risks and rewards for the business are the responsibility of that one individual. Note that the sole proprietor is legally responsible for the debts of the business.
Partnerships are businesses that have two or more people acting as co-owners of the business. Agreements are made beforehand as to how to share the risks and rewards. As with proprietorships, owners are personally responsible for all debts associated with the business. Law firms and accounting firms are organized often as partnerships.
Corporations are businesses that have been granted a charter so that they are recognized as separate legal entities. Individuals in a corporation are not subject to the liabilities of the firm; the most that they can lose is the amount they invested. Taxes are paid, assets are acquired and contracts are entered into n the name of the corporation. Corporations generally have easier access to capital than proprietorships or partnerships.
Major factors promoting cost efficiency and customer service within the corporate world include:
1. The threat of takeover - Inefficient corporate management can attract the interest of outsiders, who will try to take over of the corporation with the intent of running the corporation more efficiently, so as to increase shareholder value. The takeover company most likely would remove the current management. The threat of such a takeover gives management an incentive to serve the interests of corporate shareholders.
2.Competition for capital and customers - Poor management will tend to drive the price of a company's stock down, which will tend to make raising more capital difficult. An efficient and/or innovative management will tend to cause the price of a company's stock to go up, which will make raising additional capital easier. The corporation's products must be competitive, in terms of both price and quality, in order to attract customers. The production of inferior goods will tend to drive customers away, which will decrease corporate revenues. Therefore, competitive forces tend to limit the ability of management to serve their own needs in lieu of stockholder and customer needs.
3.Management compensation - Compensation can be set up so that management incentives are in line with those of the corporation. For example, a significant amount of executive compensation can be in the form of stock options, which are of value only when a certain stock price is met.