Chapter 2

The Firm and its Goals

• Firm= According to the traditional neo-classical 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 profit-maximization 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 decisionMR = 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 stockd=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 double-digit annual increase in revenue and profits. As a part of this growth strategy, we are entering the growing market for bottled water.