Mogadishu University

Faculty of Economics and Management Science

Department: Economics & Statistics 1st Year Subject: Principles of
Economics
UNIT 2: MICROECONOMICS CHAPTER 7: BUSINESS ORGANIZATIONS:

SECTION1: BUSINESS FIRMS

Why Do Business Firms Exist?

Business firms are organizations that use resources to produce goods and services that are sold
to consumers, other businesses, or the government. Businesses typically are formed when
someone has an idea about how he or she can earn profits by producing and selling a good or
service.
While many new businesses begin with just one person, most businesses exist because people
working together can produce more than the sum of what individuals working alone can produce.
A business firm of people working together can be more effective than a group of people all
working individually.
Types of Firms
Business firms commonly fall into one of three legal categories: sole proprietorships,
partnerships, and corporations.
1- Sole Proprietorships
A sole proprietorship is a business that is owned by one individual, who makes all the business
decisions, receives all the profits or takes all the losses of the firm, and islegally responsible for
the debts of the firm. Many family farms are sole proprietorships, as are many other businesses
such as barbershops, restaurants, and carpet-cleaning services.
Advantages of Sole Proprietorships
1. Sole proprietorships are easy to form and to dissolve. To start a sole proprietorship, you
need only meet certain broadly defined governmental regulations. To dissolve a sole
proprietorship, you need only to stop doing business.
2. All decision-making power resides with the sole proprietor. If you are the owner of a sole
proprietorship, you alone can make all the business decisions. Decisions can be made
quickly and easily, since only one person counts—the sole proprietor.
 3. The profit of the firm is taxed only once. If you are the owner of a sole proprietorship, the
profit you earn is counted as your income, and only personal income taxes (taxes paid on
your income) apply.

Disadvantages of Sole Proprietorships

1- The sole proprietor faces unlimited liability. Liability is a legal term that has to do with
the responsibility to pay debts. Saying that sole proprietors have unlimited liability means
that their personal assets may be used to pay off the debts of the firm.
2- Sole proprietors have limited ability to raise funds for business expansion. Sole
proprietors do not find borrowing funds easy, because lenders are not eager to lend funds
to business firms whose success depends on one person. The sole proprietor’s sources of
money are often limited to personal funds and the funds of close friends and family
members.
3- Sole proprietorships usually end with the retirement or death of the proprietor; they have
a limited life. When the owner of a sole proprietorship dies, the business “dies” as well.

2- Partnerships
A partnership is a business that is owned by two or more co-owners, called partners, who share
any profits the business earns and are legally responsible for any debts incurred by the firm.
Partnerships include such businesses as some medical offices, law offices, and advertising
agencies.
Advantages of Partnerships
1- In a partnership, the benefits of specialization can be realized.
1- The profit of the partnership is the income of the partners, and only personal income
taxes apply to it.
Disadvantages of Partnerships
1- They face unlimited liability, just as sole Operations proprietors do. However, unlimited
liability is even more of a disadvantage in a partnership than it is in a sole proprietorship.
2- Decision making in a partnership can be complicated and frustrating.

3- Corporations
A corporation is a legal entity that (1) can conduct business in its own name in the same way
that an individual does and (2) is owned by its stockholders. Stockholders are people who buy
shares of stock in a corporation. A share of stock represents a claim on the assets of the
corporation. (Assets are anything of value to which the firm has legal claim.) The owners of the
corporation have limited liability.
Advantages of Corporations
1- The owners of the corporation (the stockholders) are not personally liable for the debts of
the corporation; they have limited liability. To say that the stockholders have limited
liability means that they cannot be sued for the corporation’s failure to pay its debts.
They are not personally responsible for these debts.
2- Corporations continue to exist even if one or more owners sell their shares or die. The
corporation itself is a legal entity. Its existence does not depend on the existence of its
owners.
3- Corporations are usually able to raise large sums of money by selling stock. Because of
limited liability, people are more willing to invest in a corporation than in other business
forms.
Disadvantages of Corporations
1- Corporations are subject to double taxation. both the corporate income tax and the
personal income tax after dividend.
2- Corporations are complicated to set up.
4-The Franchise
The franchise is a form of business organization that has become more common in the last 25
years. A franchise is a contract by which a firm (usually a corporation) lets a person or group
use its name and sell its goods or services. In return, the person or group must make certain
payments and meet certain requirements. For example, McDonald’s Corporation offers
franchises. Individuals can buy the right to use McDonald’s name and to sell its products, as long
as they meet certain requirements. The corporation, or parent company, is called the franchiser;
it is the entity that offers the franchise. The person or group that buys the franchise is called the
franchisee.
SECTION 2: COSTS
Fixed, Variable and Total Costs
All businesses have costs, but not all costs are the same.
1- Fixed cost: A cost, or expense, that is the same no matter how many units of a good are
produced.
2- Variable cost: A cost, or expense, that changes with the number of units of a good produced.
3- Total cost: The sum of fixed costs plus variable costs.
Thus, Total costs = Fixed costs + Variable costs
- Average Total Cost
To compute the average total cost (ATC), or per-unit cost, simply divide total cost (TC) by the
quantity of output (Q):
Average total cost (ATC) =TC/Q
- Marginal cost
The word marginal in economics you should think “additional.”) In other words, marginal cost
is the additional cost of producing an additional unit of a good.
Well, if total cost was $6,000 and then it rose to $6,008, the change in total cost (from $6,000 to
$6,008) must be $8. In other words, total cost has changed by (increased by) $8. This change in
total cost that results from producing an additional unit of output is called marginal cost.
When you think about marginal cost, focus on the word change. Marginal cost describes a
change in one thing (total cost) caused by a change in something else (quantity of output).
In economics, the triangle symbol () means “change in.” Thus, when we write
Marginal cost (MC) = TC/Q
SECTION 3: REVENUE
Total Revenue and Marginal Revenue
Total revenue (TR) was defined as the price of a good times the quantity sold.
The change in total revenue (TR) that results from selling an additional unit of output is
marginal revenue (MR). In other words, marginal revenue is the additional revenue from selling
an additional unit of a good.
Marginal revenue (MR) = TR /Q
Firms Have to Answer Questions
If you start up a business, you’re going to have to answer certain questions. For example, How
many T-shirts are you going to produce each month? What is your answer going to be? Will you
say 100, 1,000, or 10,000?
How Much Will a Firm Produce?
T-shirts MR MC
1st $10 $4
2nd $10 $6
3rd $10 $8
th
4 $10 $9.99
5th $10 $11
The answer will be:
MR > MC Produce
MC > MR Do not produce
Now if you want to produce as long as MR > MC, and you don’t want to produce if MC > MR,
then ask yourself when you should stop producing. For example, you’ve already produced, say,
10,000 hats. Should you go ahead and produce one more? The answer is yes as long as marginal
revenue is greater than marginal cost.
For all practical purposes, then, economists are saying that a business firm should continue to
produce additional units of its good until the marginal revenue (MR) is equal to the marginal cost
(MC).
In the T-shirt example, we didn’t find any unit of T-shirt at which MR _ MC, but we did find one
where there was only a penny difference. We stopped producing after we had produced the
fourth T-shirt because it was as close to MR _ MC as we could get.

How to Compute Profit and Loss

When a firm computes its profit or loss, it determines total cost and total revenue and then finds
the difference:
1. To compute total cost (TC), add fixed cost (FC) to variable cost (VC).
TC = FC + VC
2. To compute total revenue (TR),multiply the price of the good (P) times the quantity of units
(Q) of the good sold.
P = Q - TR
3. To compute profit (or loss), subtract total cost (TC) from total revenue (TR).
Profit (or loss) = TR - TC