The Firm
Household members once built their own homes, made their own clothes and furniture, grew their own food, and amused themselves with books, games, and hobbies. Over time, however, the efficiency arising from comparative advantage resulted in a greater specialization among resource suppliers. This section takes a look at firms, beginning with their evolution.
Household members once built their own homes, made their own clothes and furniture, grew their own food, and amused themselves with books, games, and hobbies. Over time, however, the efficiency arising from comparative advantage resulted in a greater specialization among resource suppliers. This section takes a look at firms, beginning with their evolution.
The Evolution of the Firm
Specialization and comparative advantage explain why households are no longer selfsufficient. But why is a firm the natural result? For example, rather than make a woolen sweater from scratch, couldn’t a consumer take advantage of specialization by negotiating with someone who produced the wool, another who spun the wool into yarn, and a third who knit the yarn into a sweater? Here’s the problem with that model: If the consumer had to visit each of these specialists and reach an agreement, the resulting transaction costs could easily erase the gains from specialization. Instead of visiting and bargaining with each specialist, the consumer can pay someone to do the bargaining—an entrepreneur, who hires all the resources necessary to make the sweater. An entrepreneur, by contracting for many sweaters rather than just one, is able to reduce the transaction costs per sweater.
For about 200 years, profit-seeking entrepreneurs relied on “putting out” raw material, like wool and cotton, to rural households that turned it into finished products, like woolen goods made from yarn. The system developed in the British Isles, where workers’ cottages served as tiny factories, especially during winter months, when farming chores were few (so the opportunity cost was low). This approach, which came to be known as the cottage industry system, still exists in some parts of the world. You might think of this system as partway between household self-sufficiency and the modern firm.
As the British economy expanded in the 18th century, entrepreneurs began organizing the stages of production under one factory roof. Technological developments, such as waterpower and later steam power, increased the productivity of each worker and helped shift employment from rural areas to urban factories. Work, therefore, became organized in large, centrally powered factories that (1) promoted a more efficient division of labor, (2) allowed for the direct supervision of production, (3) reduced transportation costs, and (4) facilitated the use of machines far bigger than anything used in the home. The development of large-scale factory production, known as the Industrial Revolution, began in Great Britain around 1750 and spread to the rest of Europe, North America, and Australia.
Specialization and comparative advantage explain why households are no longer selfsufficient. But why is a firm the natural result? For example, rather than make a woolen sweater from scratch, couldn’t a consumer take advantage of specialization by negotiating with someone who produced the wool, another who spun the wool into yarn, and a third who knit the yarn into a sweater? Here’s the problem with that model: If the consumer had to visit each of these specialists and reach an agreement, the resulting transaction costs could easily erase the gains from specialization. Instead of visiting and bargaining with each specialist, the consumer can pay someone to do the bargaining—an entrepreneur, who hires all the resources necessary to make the sweater. An entrepreneur, by contracting for many sweaters rather than just one, is able to reduce the transaction costs per sweater.
For about 200 years, profit-seeking entrepreneurs relied on “putting out” raw material, like wool and cotton, to rural households that turned it into finished products, like woolen goods made from yarn. The system developed in the British Isles, where workers’ cottages served as tiny factories, especially during winter months, when farming chores were few (so the opportunity cost was low). This approach, which came to be known as the cottage industry system, still exists in some parts of the world. You might think of this system as partway between household self-sufficiency and the modern firm.
As the British economy expanded in the 18th century, entrepreneurs began organizing the stages of production under one factory roof. Technological developments, such as waterpower and later steam power, increased the productivity of each worker and helped shift employment from rural areas to urban factories. Work, therefore, became organized in large, centrally powered factories that (1) promoted a more efficient division of labor, (2) allowed for the direct supervision of production, (3) reduced transportation costs, and (4) facilitated the use of machines far bigger than anything used in the home. The development of large-scale factory production, known as the Industrial Revolution, began in Great Britain around 1750 and spread to the rest of Europe, North America, and Australia.
Types of Firms
There are more than 30 million for-profit businesses in the United States. Two-thirds are small retail businesses, small service operations, part-time home-based businesses, and small farms. Each year more than a million new businesses start up and many fail. A firm is organized in one of three ways: as a sole proprietorship, as a partnership, or as a corporation.
Sole Proprietorships
The simplest form of business organization is the sole proprietorship, a single-owner firm. Examples include self-employed plumbers, farmers, and dentists. Most sole proprietorships consist of just the self-employed proprietor there are no hired employees. To organize a sole proprietorship, the owner simply opens for business by, for example, taking out a classified ad announcing availability for plumbing services or whatever. The owner is in complete control. But he or she faces unlimited liability and could lose everything, including a home and other personal assets, to settle business debts or other claims against the business. Also, because the sole proprietor has no partners or other investors, raising enough money to get the business up and running and keep it going can be a challenge. One final disadvantage is that a sole proprietorship usually goes out of business when the proprietor dies or leaves the business. Still, a sole proprietorship is the most common type of business, accounting most recently for 71 percent of all U.S. businesses. Nonetheless, because this type of firm is typically small, proprietorships generate just a tiny portion of all U.S. business sales—only 4 percent. But keep in mind that many of the largest businesses in the world today began as an idea of a sole proprietor.
Partnerships
A more complicated form of business is the partnership, which involves two or more individuals who agree to combine their funds and efforts in return for a share of any profit or loss. Law, accounting, and medical partnerships typify this business form. Partners have strength in numbers and often find it easier than sole proprietors to raise enough funds to get the business going. But partners may not always agree. Also, each partner usually faces unlimited liability for any debts or claims against the partnership, so one partner could lose everything because of another partner’s mistake. Finally, the death or departure of one partner can disrupt the firm’s continuity and require a complete reorganization. The partnership is the least common form of U.S. business, making up only 10 percent of all firms and 15 percent of all business sales.
Corporations
By far the most influential form of business is the corporation. A corporation is a legal entity established through articles of incorporation. Shares of stock confer corporate ownership, thereby entitling stockholders to a claim on any profit. A major advantage of the corporate form is that many investors hundreds, thousands, even millions canpool their funds, so incorporating represents the easiest way to amass large sums to finance the business. Also, stockholders’ liability for any loss is limited to the value of their stock, meaning stockholders enjoy limited liability. A final advantage of this form of organization is that the corporation has a life apart from its owners. The corporation survives even if ownership changes hands, and it can be taxed, sued, and even charged with a crime as if it were a person.
The corporate form has some disadvantages as well. A stockholder’s ability to influence corporate policy is limited to voting for a board of directors, which oversees theoperation of the firm. Each share of stock usually carries with it one vote. The typical stockholder of a large corporation owns only a tiny fraction of the shares and thus has little say. Whereas the income from sole proprietorships and partnerships is taxed only once, corporate income gets whacked twice first as corporate profits and second as stockholder income, either as corporate dividends or as realized capital gains. A realized capital gain is any increase in the market price of a share that occurs between the time the share is purchased and the time it is sold.
hybrid type of corporation has evolved to take advantage of the limited liability feature of the corporate structure while reducing the impact of double taxation. The S corporation provides owners with limited liability, but profits are taxed only once as income on each shareholder’s personal income tax return. To qualify as an S corporation, a firm must have no more than 100 stockholders and no foreign stockholders.
There are more than 30 million for-profit businesses in the United States. Two-thirds are small retail businesses, small service operations, part-time home-based businesses, and small farms. Each year more than a million new businesses start up and many fail. A firm is organized in one of three ways: as a sole proprietorship, as a partnership, or as a corporation.
Sole Proprietorships
The simplest form of business organization is the sole proprietorship, a single-owner firm. Examples include self-employed plumbers, farmers, and dentists. Most sole proprietorships consist of just the self-employed proprietor there are no hired employees. To organize a sole proprietorship, the owner simply opens for business by, for example, taking out a classified ad announcing availability for plumbing services or whatever. The owner is in complete control. But he or she faces unlimited liability and could lose everything, including a home and other personal assets, to settle business debts or other claims against the business. Also, because the sole proprietor has no partners or other investors, raising enough money to get the business up and running and keep it going can be a challenge. One final disadvantage is that a sole proprietorship usually goes out of business when the proprietor dies or leaves the business. Still, a sole proprietorship is the most common type of business, accounting most recently for 71 percent of all U.S. businesses. Nonetheless, because this type of firm is typically small, proprietorships generate just a tiny portion of all U.S. business sales—only 4 percent. But keep in mind that many of the largest businesses in the world today began as an idea of a sole proprietor.
Partnerships
A more complicated form of business is the partnership, which involves two or more individuals who agree to combine their funds and efforts in return for a share of any profit or loss. Law, accounting, and medical partnerships typify this business form. Partners have strength in numbers and often find it easier than sole proprietors to raise enough funds to get the business going. But partners may not always agree. Also, each partner usually faces unlimited liability for any debts or claims against the partnership, so one partner could lose everything because of another partner’s mistake. Finally, the death or departure of one partner can disrupt the firm’s continuity and require a complete reorganization. The partnership is the least common form of U.S. business, making up only 10 percent of all firms and 15 percent of all business sales.
Corporations
By far the most influential form of business is the corporation. A corporation is a legal entity established through articles of incorporation. Shares of stock confer corporate ownership, thereby entitling stockholders to a claim on any profit. A major advantage of the corporate form is that many investors hundreds, thousands, even millions canpool their funds, so incorporating represents the easiest way to amass large sums to finance the business. Also, stockholders’ liability for any loss is limited to the value of their stock, meaning stockholders enjoy limited liability. A final advantage of this form of organization is that the corporation has a life apart from its owners. The corporation survives even if ownership changes hands, and it can be taxed, sued, and even charged with a crime as if it were a person.
The corporate form has some disadvantages as well. A stockholder’s ability to influence corporate policy is limited to voting for a board of directors, which oversees theoperation of the firm. Each share of stock usually carries with it one vote. The typical stockholder of a large corporation owns only a tiny fraction of the shares and thus has little say. Whereas the income from sole proprietorships and partnerships is taxed only once, corporate income gets whacked twice first as corporate profits and second as stockholder income, either as corporate dividends or as realized capital gains. A realized capital gain is any increase in the market price of a share that occurs between the time the share is purchased and the time it is sold.
hybrid type of corporation has evolved to take advantage of the limited liability feature of the corporate structure while reducing the impact of double taxation. The S corporation provides owners with limited liability, but profits are taxed only once as income on each shareholder’s personal income tax return. To qualify as an S corporation, a firm must have no more than 100 stockholders and no foreign stockholders.
Cooperatives
A cooperative, or “co-op” for short, is a group of people who cooperate by pooling their resources to buy and sell more efficiently than they could independently. Cooperatives try to minimize costs and operate with limited liability of members. The governmentgrants most cooperatives tax-exempt status. There are two types: consumer cooperatives and producer cooperatives.
Consumer Cooperatives
A consumer cooperative is a retail business owned and operated by some or all of its customers in order to reduce costs. Some cooperatives require members to pay an
A cooperative, or “co-op” for short, is a group of people who cooperate by pooling their resources to buy and sell more efficiently than they could independently. Cooperatives try to minimize costs and operate with limited liability of members. The governmentgrants most cooperatives tax-exempt status. There are two types: consumer cooperatives and producer cooperatives.
Consumer Cooperatives
A consumer cooperative is a retail business owned and operated by some or all of its customers in order to reduce costs. Some cooperatives require members to pay an
annual fee and others require them to work a certain number of hours each year in the business. Members sometimes pay lower prices than other customers or may share in any revenues that exceed costs. In the United States, consumer cooperatives operate credit unions, electric-power facilities, health plans, apartment buildings, and grocery stores. Many college bookstores are cooperatives. For example, the UConn Co-op is owned by about 30,000 students, faculty, and staff. These members receive discounts on their purchases.
Producer Cooperatives
In a producer cooperative, producers join forces to buy supplies and equipment and to market their output. Each producer’s objective is to reduce costs and increase profits. Federal legislation allows farmers to cooperate without violating antitrust laws (to be discussed later in the chapter). Firms in other industries could not do this legally. Farmers pool their funds to purchase machinery and supplies, provide storage and processing facilities, and transport products to market. Sunkist, for example, is a farm cooperative owned and operated by about 6,500 citrus growers in California and Arizona.
Producer Cooperatives
In a producer cooperative, producers join forces to buy supplies and equipment and to market their output. Each producer’s objective is to reduce costs and increase profits. Federal legislation allows farmers to cooperate without violating antitrust laws (to be discussed later in the chapter). Firms in other industries could not do this legally. Farmers pool their funds to purchase machinery and supplies, provide storage and processing facilities, and transport products to market. Sunkist, for example, is a farm cooperative owned and operated by about 6,500 citrus growers in California and Arizona.
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