Download Profits, Production, and the Firm`s Demand For Factors

MBA 814
Profits, Production, and the Firm's Demand For Factors
What does the firm do, and how does it employ resources (factors) to produce output that
it sells to consumers or other firms?
A. The Rationale Underlying Profit Maximization
The term the ``firm'' is more difficult to define than may first appear. At one level the firm
employs resources to produce output. But what is a firm and why does it produce output? The
``right'' to use resources to produce goods and services has been purchased at some point by the
firm's owners, the shareholders. At the most fundamental level these ``rights'' define the firm.
Shareholders may have alternative objectives, the most common is that they purchase these
``rights'' in order to maximize their wealth. Clearly, other objectives are possible. The actor Paul
Newman markets a food products line under his name. The profits from this enterprise are given
to charity. In one sense, the objective of his company is not to maximize shareholder wealth.
However, if Paul Newman wants to make his designated charities as well off as possible, he
should treat the charities as if they were the shareholders, and instruct the managers of the
company to maximize shareholder wealth.
What obstacles do shareholders face in achieving this objective of maximizing
shareholder wealth? Obstacles arise because the shareholders do not do the work. They hire
management to organize the use of resources within the firm. At the same time, there are other
groups within society at large that make claims on the firm's ``profits.'' These other groups are
sometimes referred to as ``stakeholders'' and include labor, suppliers, the community,
government regulators, and plaintiffs attorneys.
Management successfully attains the
shareholder's objectives when they effectively manage the firm's relationships with its
stakeholders. For example, if the firm is non-union, shareholders expect management to design
its human resources practices so as to stay non-union. No CEO will be congratulated at the
annual shareholders meeting for allowing a union to make inroads into the firm while under his
or her watch. Indeed, empirical studies indicate that a company's stock price declines when
unions announce that they have targeted it for a formal organizing campaign. The same principle
holds for the company's relationships with consumers and the legal community. Management
doing business in the United States must recognize the complexity of the legal environment.
Product liability litigation can be very costly and a company's value is measurably reduced when
large jury verdicts go against the firm. Managers must produce their products in a way that
takes into account such risks and the consequent impact that they may have on shareholders.
Not only do the stakeholders affect shareholders' wealth, but so do conflicts between
management's and shareholder's interests. For example, a CEO may enjoy the glory of his or her
position and to ``bask in the limelight.'' This activity may divert the CEO from greater profit
(value) generating activities. Similarly, management may be willing to sacrifice profits for more
amenities on the job: fancy art work, mahogany paneled offices, executive dining rooms staffed
with world class chefs, a fleet of corporate jets. For shareholders, does the use of these resources
help to maximize its wealth or is it a form of expensive consumption on the job? Under such
circumstances, shareholders may be willing to allow management to indulge itself in return for
lower compensation. Alternatively they may prefer a more spartan management team.
This potential conflict between shareholder's and management's objectives may cause the
firm to deviate from purely profit maximizing activity. This problem is known in the social
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sciences as the ``principal-agent problem'' and is the subject of a large literature. We will discuss
this problem in greater detail in a few weeks. In the meantime, you might want to review pages
408 - 413 in the text to get a flavor of the issues involved.
Fortunately for shareholders, there are both external forces and internal mechanisms
that discipline management and help to assure that the objectives of the two parties are aligned.
For example, access to capital markets and the terms of loans depend in part on the lenders
expectations of the firm's performance. Bankruptcy and loss of a high paying job provides
another check on management. Perhaps an even more potent external force is the threat of a
hostile takeover where some outside group buys shares of the company's stock at a higher price
(good for shareholders!), replaces key managers, layoffs other employees, and sells poorly
performing assets.1
As mentioned above, shareholders also have several internal mechanisms to ensure that
management acts in their interest. Among them are well-designed compensation packages. For
example a CEO's base salary is set so that it is only a small part of his or her potential
compensation. Alternatively, shareholders may require top management to own a certain
number of shares of the company's stock. Another mechanism is an independent Board of
Directors. The Board has a fiduciary responsibility to represent the shareholders' interests.
Recently, the business press has evaluated the independence of ``outside'' directors for several
hundred U.S. corporations. Those companys that had the CEO's personal attorney or his child's
elementary school principle on their Boards were signaled out for special criticism.
B. The Production Decision
The foregoing discussion indicated that the principal objective of firms is to maximize
profits. Although practice deviates from this objective, there are powerful external and internal
forces to ensure that management does not deviate too far from this objective for too long.
Given that firms' approximate objective is to produce goods and services so as to
maximize profits, how does the management choose among alternative methods to produce its
output? A layman's way of explaining this problem is to say that the firm's production decision is
like the one a household makes when deciding how to serve spaghetti for dinner. When making
this decision the household decides from among several options:
1) order out
2) Make at home
- buy sauce in a jar, pasta in a box, shredded cheese in a bag.
3) Make at home
- Make sauce at home - buy tomatoes, peppers, and mushrooms
- Make pasta at home - buy flour
- Shred cheese at home - buy cheese in a chunk
4) Make at home
- Grow tomatoes, peppers, wheat, and mushrooms in garden
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Interest in the role that takeovers play in generating shareholder wealth has generated body
of research on the ``market for corporate control.''
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- Grind wheat into flour
- Raise dairy cows to make cheese
How the household chooses from among these options is related to and in turn determines its
size, composition, and the ``factors'' it demands from the market. In the last case the household is
completely self-sufficient (ie. vertically integrated). At the opposite extreme, in the first case the
household has ``subcontracted'' out its production. It has chosen to rely entirely on the market for
its production. The cost of a spaghetti dinner depends on the option that the household chooses.
In western economies, option (4) has become prohibitively costly because of the rising value of
people's time. Indeed, because of the rising cost of this resource, households in the second half of
the 20th century have increasing shifted toward option (1).
This analogy holds almost exactly when characterizing the firms' production decisions
and its employment of resources. By definition, firm (1) is a small firm because it chooses to
subcontract out or purchase business services; firm (4) is a large firm because it is so highly
vertically integrated. In addition, the demand for factors and the composition of the firms'
employment differ dramatically.
In this analogy what defines the size and composition of the firm is how management
chooses to balance the economies associated with co-ordination against the costs of using the
market. The firm has two faces: First, the face of the central planner. Here management allocates
resources under its control by command without directly using the market. Second, the firm also
is a ``consumer'' in the factor market. The firm demands other firm's products. Firms, exist
because using the market is costly. Management needs to establish reliable relationships with
suppliers, worry about purchasing, negotiate favorable terms for its factors, monitor markets. In
many cases it may be more economical to produce these factors ``in house.'' In these cases the
economies associated with using management to allocate resources (as in a command economy)
exceed the benefits associated with using the market. These choices define the firm.
The existence of a successful firm suggests that what it does is done at lower costs than
some other alternative way. For example, compare a grocery story like Meijers (known in the
trade as a ``hypermarket'') to an alternative form of organization: the central market, or the
Turkish bazaar. In the former case, Meijers owns the physical plant and ``runs'' most of the
operations inside the store. (Note that the bank on the first floor and the McDonalds on the
second floor are exceptions). By contrast an alternative form of organization would be for
Meijers to set up a ``market'' place and then to sublet space to other businesses. Meijers could
subcontract with other organizations to run a meat department, a produce department, or a
bakery, much the same way that the owners of shopping malls (eg. the Meridian Mall across the
street) operate their businesses. A shopping mall is a private central market.
How the firm decides among these options is an important question and a subject known
as the economics of organizations. We will not have time to address these issues in this course.
For those of you who are interested in pursuing this topic further, see the reference in note 2 on
page 169 of the text. (The text referenced there is an excellent book that is used in the Stanford
M.B.A. program.) However, we will consider briefly how this issue likely affects the firm's
willingness to supply goods or services to the market place.
Discussion Questions
1. True or false: Because it can buy directly from the manufacturer, eliminating ``middlemen's''
profits, a large discount store can sell exactly the same air conditioner at a lower price than small
neighborhood store. (McCloskey, p. 227)
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2. Jones and Smith run ``sweatshops'' in Los Angeles that employ illegal immigrants to make
shirts. Shirts are made by a worker using a sewing machine and some cloth. True or False: Jones
has a competitive advantage over Smith because he owns his sewing machines, whereas Smith
rents his sewing machines for his workers to use.
3. Critic the slogan: ``Tax Corporations, Not People.'' Also consider the following practice. In the
U.S. the social insurance system is financed by a tax on workers equal to approximately 7.5
percent of their earnings, and by an additional tax on employers equal to approximately 7.5
percent of each workers' earnings. The rationale for this two part tax is that by taxing firms, the
burden on workers of financing the social insurance system is reduced. Return to this question
after you have read through part C of these lecture notes.
4. In the capitalist system, firms have insufficient incentive to maximize long-term profits.
C. Employment of Factors.
Once we abstract away from the decision regarding the size and composition of the firm,
the production decision for a competitive firm can be characterized as one in which management
employs different factors to maximize profits. The technology that the firm uses amounts to a
``recipe'' that tells how factors are converted into output. An example of this recipe can be found
in many ``TQM'' work places in which the employees have prepared detailed manuals describing
their ``jobs'' and how the tasks that they perform contribute to the company's output.
Economists in their analysis of firm behavior characterize this recipe as a production
function: For example consider Table 1:
Table 1
Output
Revenue
Workers
Wage Bill
APL
MPL
0
0
1
5
0
0
1
10
2
10
0.5
1.0
2
20
3
15
0.67
1.0
4
40
4
20
1.0
2.0
5
50
5
25
1.0
1.0
5.5
55
6
30
0.92
0.5
5.75
57.5
7
35
0.82
0.25
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Notes: The market price for the output is assumed to be P = $10; workers wages are W=$5. APL
refers to the average product of labor, MPL refers to the marginal product of labor.
The figures in the table describe a production function. They relate how factors (labor) are
transformed into output. The important point to observe is that for a competitive firm the
decision regarding how many workers to employ is the same as the decision regarding how
much output to produce.
To decide how much labor to employ, the firm maximizes profits. In this example it wants
to choose the amount of labor so that
Revenue - Wage Bill
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is at a maximum. Can you see where this is? Note it is at the point where the firm employs five or
six workers. One way to see this is to subtract the Wage Bill from the Revenue for each level of
output in the table. Another way is to find the point where the additional revenue received from
hiring another worker equals the cost of hiring that worker:
P*MPL = W.
The firm should continue to hire workers as long as the additional or ``marginal'' revenue
generated by that worker exceeds the costs of hiring them. This measure of additional revenue is
sometimes referred to as the value marginal product or the marginal revenue product of labor.
The firm's demand curve for factors of production is sometimes referred to as a ``derived''
demand. Its a derived demand because it results directly from conditions in the product. For
example, if consumers are not price sensitive to changes in product price, then firms are not
likely to be sensitive to changes in wages. Indeed, the firm's demand for labor is simply the
firm's value marginal product (VMP): it measures the maximum amount that a firm would be
willing to pay to hire an additional worker. This maximum amount is of course the additional
revenue that the worker generates for the firm.
An interesting policy application of this principle is the analysis of government mandated
benefits. Governments regulate the terms and conditions of employment between firms and
their employees in a variety of ways. For example, in Europe firms usually are required to pay
severance payments to employees that they layoff or receive approval of the layoff from a
government agency. In the United States, employers are required to buy insurance to cover their
workers in the event they are injured on the job or are laid off. In Hawaii, nearly all employers
are required to buy health insurance for their employees. These government mandates raise the
cost of employment. One way to evaluate their impact on wages and employment is to consider
what they do to the demand for labor. As mentioned above, value marginal product is the
maximum amount that a firm is willing to pay for a worker's labor. If governments increase the
cost of this relationship, then the maximum amount firms will be willing to pay their workers is
their value marginal product minus the per worker cost of the benefit. On a graph this notion is
represented by a ``left-ward'' shift in the demand for labor. (See attached Figure.)
Discussion Questions:
5. Consider the mandated benefits application. Draw a labor supply curve on the graph. What
impact does the government mandate have on wages and employment? Who pays for the
mandated benefit? Firms? Consumers? Workers? What impact does the mandate have on output
in the economy?
6. True or False: A given the amount of electricity is produced efficiently, if the output is divided
up among a utility's power generating plants so that the average cost per kilowatt hour produced
is the same.
7. Suppose Consumers Energy has two power plants, one a steam plant with rising marginal costs
of a kilowatt of electricity produced and the other an atomic plant with falling marginal costs.
a. True or false: The company should concentrate all production in the atomic plant if it
wishes to produced a given output at the lowest cost. (McCloskey, p. 246.)
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b. Suppose that the demand for electricity reaches a peak during the summer months and
is at its lowest levels during the spring and early autumn. How would the season of the year affect
your answer to part a?
Footnote
Interest in the role that takeovers play in generating shareholder wealth has generated body of
research on the ``market for corporate control.''