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Chapter 2
The Firm and its Goals
• Firm= According to the traditional neoclassical approach, the firm is defined as a
collection of resources that is transformed
into products demanded by consumers.
• Profit=Revenue-Costs
• The aim of the firm is to maximize its
profit.
• Car manufacturing →Exhaust production requires
different technology====>transaction cost
• Draw Figure 2.1 here and explain in the class
• Tradeoff between Transaction cost & Internal operating
cost
• The firm has to find the way to allocate its resources
between external transactions and internal operations so
the total cost is at a minimum, which in this case will
occur about midway between the two extremes.
• If Transaction cost > Internal operating cost ==> company is
benefiting from performing this work-task in house.
• i.e. Ford (tires, steel and glass)
• Many companies acquire
• Cleaning services
• Security services
• Cafeterias
• A to Z catering company in London does all of the
above (2010)
• Transaction costs=are incurred when a company enters
into a contract with other entities. Transaction costs are
influenced by uncertainty, frequency of recurrence, and
asset specificity.
• Opportunistic Behaviour=if a buyer contracts for a
specialized product with just one seller, and furthermore,
if the product necessitates the use of some specialized
machinery, the two parties become tied to one another.
In this case, future changes in market conditions may
lead to opportunistic behavior, where one of the parties
seeks to take advantage of the other. In such cases,
transaction costs will be very high.
• The company has to choose to allocate its
resources between external transactions and
internal operations so the total cost is at a
minimum, which in this case will occur about
midway between the two extremes.
• ie, Kodak, HP, Ford, IBM, etc
• Some companies use third-party services for
recruitment, health-care, benefits, pensions and
many other services.
• Quite recently, US legal companies, Indian legal
services, and UK’s Earnst & Young are the major
companies who provide third party services,
even off-shore.
The economic goal of the firm and
optimal decision-making
• Every business has a goal. Economic
theory of the firm says that principle
objective of a firm is to maximize its profits
or minimize its losses. The foundation on
which much of managerial economics
rests assumes that the same objective is
among many economists as the profitmaximization hypothesis.
• Different goals can lead to very different
managerial decisions, given the same limited
amount of resources. Ie, if the main goal of the
firm is to maximize market share, rather than
profit, the firm might decide to reduce its prices.
Among many goals providing the most
technologically advanced products by promoting
more research and development, may result in
achieving a company’s goal.
• Given the goal(s) that the firm is pursuing, we
can say that the optimal decision in managerial
economics is one that brings the firm closest to
this goal.
Optimal decision
MR = MC
• To maximize profit or minimize the loss, a firm
should price its product at a level where the
revenue earned on the last unit of a product sold
(called marginal revenue) is equal to the
additional cost of making this last unit (called
marginal cost).
• In other words, the optimal price equates the
firm’s marginal revenue with its marginal cost.
• Stress the difference between LR and SR time
period.
Goals other than profit
• Economic goals (p.30 CEO’s memo 1-2) class
exercise
• Company’s objectives, profit maximization,
growth rate, profit margin, return on its asset?
• Consider the ultimate goal of a firm is to
maximize firm’s overall profits. Company’s
economic environment, competition,
technological improvements and market
potential are needed to reach maximum profit by
the combination of growth and profit
measurement.
Non-economic objectives
•
•
•
•
Provide a good place for our employees to work.
Provide good products/services to our customers.
Act as a good citizen in our society.
The new concept in today’s business environment, is to
have an aim to “satisfice” instead of maximizing profit.
• Shareholders may not be capable of knowing whether
corporate management is doing its best for them, and
they actually may not be very concerned as long as they
receive what they consider a satisfactory return on their
investment-hence “satisficing.”
Maximizing the wealth of the stock
holders
• P.36
• The discount rate is affected by reisk, so
risk becomes another component of the
valuation of the business. Financial
theorists differentiate various types of
risks.
– Business risks
– Financial risks
Business risk
• Involves variation in returns due to the ups
and downs of the economy, the industry,
and the firm. This is the kind of risk that
attends all business organizations,
although to varying degrees.
Financial risk
• Concerns the variation in returns that is induced
by leverage. Leverage signifies the proportion
of a company financed by debt. Given a certain
degree of leverage, the earnings accruing to
stockholders will fluctuate with total profits
(before the deduction of interest and taxes). The
higher the leverage, the greater the potential
fluctuations in stockholders earning. Thus,
financial risk moves directly with the company’s
leverage.
Present price of stock
• Dividends represent the returns on the
stock, generated by the corporation. We
can derive an equation of
P=(D1/(1+k)+(D2/(1+k)^2)+….. (Dn/(1+k)^n
Where
p=present price of stock
d=dividends received per year (in year 1, year 2, year n)
k=discount rate applied by financial community, often
referred to as cost of equity capital of a company
• The price of each share of stock can be
calculated as a perpetuity with the following
formula:
P = D/k
• Investors in general expect dividends to rise. In
the case where dividends grow at a constant
rate each year, the formula for share price
becomes:
P = D1/(k-g)
• Where D1 = dividend to be paid during coming
year and g = annual constant growth rate of
dividend expressed as a percentage. Multiplying
P by the number of shares outstanding gives the
total value of the company’s common equity.
• Assume that a company expects to pay a
dividend of 4 dollars in the coming year,
and expects dividends to grow at a 5%
each year. The rate at which stockholders’
discount their cash flows (which is really
the rate of return stockholders require to
earn from this stock) is 12 percent. There
are 1 million shares outstanding. What
would the price of each share be
expected? Calculate.
• P = 4/(0.12-0.05) = 4/0.07 = $57.14
• The value of the company’s stock would be $57.14
million. This is the expected market value given the
variables that we have assumed. However, this may not
be the maximum value the company could achieve. The
variables in the equation may have to change. Because
k is a function of the company’s level of risk, the
company may be able to decrease k by lowering the
riskiness of its operations or by changing its leverage. It
can affect g and D by retaining more or less of its
earnings. By retaining a larger portion of its earnings and
devoting a smaller portion of its earnings to dividends,
the company may by able increase its growth rate, g.
• Thus, under this construction maximizing the wealth of
the shareholders means that a company tries to manage
its business in such a way that the dividends over time
paid from its earnings and the risk incurred to bring
about this stream of dividends always create the highest
price and thereby the maximum value for the company’s
stock.
ECONOMIC PROFITS
• The term “profits” is not well defined.
Accountants report it in conformity with financial
records. The use of depreciation change the
level of profits in a corporation.
• Economists do not agree with accountants on
the concept of costs. Accountant report costs on
a historical basis. The economist considers cost
that a business makes in making decisions. That
is future costs. In other words, they call this
“opportunity costs” or “alternative costs”. Thus,
the differences can be cited as:
• -Historical cost versus replacement cost
• -Implicit costs and normal profits
– Owners’ time and interest on the capital are
counted as profit in a partnership. But these
are really costs, not profit.
– Economic Profit=TR - All economic costs
=TR – TC - Implicit costs
Read page 42, The Solution: GLOBAL FOODS
• The Solution:
• In Stockholder meeting, Bob Burns,
CEO…..”Over the past decade, American based
global companies have faced increased
competition necessitating a restructuring of their
operations. Over this period, we are aware that
the price of our stock has not been increasing at
the rate it did earlier. We have remained
committed to a long-run increase in the price of
our stock. To do this, we must have a doubledigit annual increase in revenue and profits. As a
part of this growth strategy, we are entering the
growing market for bottled water.