Chapter 6 Answers

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chapter Six
businesses and Their Costs

ANSWERS TO END-OF-CHAPTER QUESTIONS

6-1Distinguish clearly between a plant, a firm, and an industry. Contrast a vertically integrated firm, a horizontally integrated firm, and a conglomerate. Cite an example of a horizontally integrated firm from which you have recently made a purchase. A plant is an operating unit where production takes place. This production can be manufacturing, farming, mining, retailing, wholesaling, warehousing—anything, in short, necessary for the production and distribution of goods and services. A firm is the business organization that owns one or more plants. A firm can be very large, such as General Motors, which owns many plants in many countries, or very small, such as an independent corner grocery. An industry is a somewhat arbitrary grouping of firms producing similar products—such as the steel industry. There may be a problem defining which firms belong to an industry; the firms in the automobile industry produce many non-automotive products. A vertically integrated firm contains plants that are involved in various stages of the production process. A horizontally integrated firm contains plants that are involved in the same function of business. A conglomerate firm has plants that are producing products in several industries. Examples might include grocery stores, retail outlets, gas stations, or similar establishments that may have bought out competitors to open new stores. 6-2What major advantages of corporations have given rise to their dominance as a form of business organization? Corporations are dominant in terms of total profits. They can access large amounts of money by issuing stocks and bonds; their limited liability is attractive to potential owners; their size and broader ownership base help ensure continuity that helps to build a large customer base and gain cost advantages (a preview for economies of scale).

6-3What is the principal-agent problem as it relates to managers and stockholders? How did firms try to solve it in the 1990s? In what way did the “solution” backfire on some firms? When the stockholders (owners) and managers of a firm have different interests, the principal-agent problem can occur. Stockholders want profits and share prices maximized, while managers want high pay, extensive fringe benefits, posh working conditions, and other things that inflate costs and lower profits. In the 1990s firms attempted to solve the principal-agent problem by issuing stock to executives (managers) as part of their compensation. The intent was to more closely align the interests of the two groups. It backfired for firms such as Enron and WorldCom because it gave executives the incentive to inflate stock prices artificially (using fraudulent accounting practices to overstate profits and make the stock look more attractive), and then sell before the abuses were discovered. When these deceptions were uncovered, the executives had already reaped huge windfalls and the average corporate employee (with his or her company stock as the basis for the future pension) was left in financial ruin.

6-4Distinguish between explicit and implicit costs, giving examples of each. Why does the economist classify normal profit as a cost? Is economic profit a cost of production? Explain why or why not. Explicit costs are payments the firm must make for inputs to nonowners of the firm to attract them away from other employment, for example, wages and salaries to its employees. Implicit costs are nonexpenditure costs that occur through the use of self-owned, self-employed resources, for example, the salary the owner of a firm forgoes by operating his or her own firm and not working for someone else. Economists classify normal profits as costs, since in the long run the owner of a firm would close it down if a normal profit were not being earned. Since a...
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