CENTRE FOR POLICY STUDIESUNIVERSITY COLLEGE CORK

EC2204 TUTORIAL #2 W/S 22/10/2012

Academic Year: 2012/2013 Instructors: Brenda Lynch/P J Hunt

Contact: brendalynch@ucc.ie or p.hunt@ucc.ie

The Decision-Making ModelDecision making is the responsibility of management. It involves

a; establishing objectives

b; reviewing possible strategies

C; evaluating the costs/benefits of each strategy

•d; selecting the best strategy

•e; implement and monitor the strategy

•f; are the objectives being met

•(See p9 of course book).

Objectives of the FirmFirms can have several objectives, one of which is to maximise profits. Profit is the difference between total revenue and total costs. Profits can be maximised by using the concepts of marginal cost (MC) and marginal revenue (MR).•MC is the change in total cost resulting from a decision•MR is the change in total revenue resulting from a decision

Using the above a decision to allocate resources by management in a specific way will be profitable if;•MR increases more than MC•Some MC’s decrease more than others increase assuming MR remains the same•Some MR’s increases more than others decrease assuming MC remains the same.The profit maximisation model treats all profits the same i.e. €1,000 in one years time is the same as €1,000 now. This is clearly not the case. Also risk is not taken into account.

Both of these shortcomings are overcome by … The Shareholder Wealth-Maximisation Model of the Firm...Which states that the objectives of a firm’s management is to maximise the present value of all expected future cash flows to the firm’s owners (the shareholders). In other word this profits are discounted (reduced) for time and risk. The mathematical formula is;

i. V 0 * Shares Outstanding =

)1(...

)1()1()1( 33

22

11

eeee kkkk

=

1 )1(tt

e

t

k

(1.1)

See p10 of course book And is composed of V0 is the current value of a shareΠ is the profit expected in each future periodk is the investors required rate of return

t takes into account the time issue of payments with each increasing time period attracts an increasing power value.

Also k increases in value if perceived risk increases or decreased if risk has decreases allowing an investor to place a lower value on a high-risk investment and vice versa.

ProfitEconomic profit is the difference between total revenue and economic cost.Economic cost includes a ‘normal’ rate of profitTypes of Profits•Dynamic Equilibrium (Friction) Theory of ProfitA long-run equilibrium normal rate of profit exists. However at any time an individual firm in an individual industry can earn a profit above or below this level. Examples; Airlines after 9/11 or oil producers at the moment.

Profits eventually return to normal.

•Monopoly Theory of ProfitA firm can earn above normal profits for a long time due to dominance in the market. Example; Sky TV, OECD

•Innovation Theory of ProfitA firm with a successful innovation can earn above normal profits. Example; Pfizer and Viagra

•Managerial Efficiency Theory of ProfitExceptional managerial skills can give rise to abnormal profits.

•Risk Bearing Theory of ProfitThe greater the risk the higher the potential profit and vice versa.