Managerial economics economic tools for todays decision makers 7th edtion by keat young and erfle chapter 02

Chapter 2
The Firm
and Its Goals


Chapter Outline
• The firm and resource allocation
• Profit maximization- the economic goal of the
firm
• Goals other than profit
• Do companies maximize profits?
• Maximizing the wealth of stockholders
• Economic profit

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Learning Objectives
• Understand the reasons for the existence of
firms and the meaning of transaction costs
• Explain the economic goals of the firm and
optimal decision making
• Describe the ‘principal-agent’ problem
• Distinguish between “profit maximization”
and the “maximization of the wealth of
shareholders”
• Demonstrate the usefulness of Market Value
Added® and Economic Value Added®

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The Firm
• A firm is a collection of resources that is
transformed into products demanded by
consumers
• Profit is the difference between revenue
received and costs incurred
Price x Unit sold = Revenue –Costs = Profit

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The Firm
• Why does a firm perform certain functions
internally and others through the market?
• Transaction costs are incurred when entering
into a contract.
– Types of transaction costs:

• investigation
• negotiation
• enforcing contracts

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The Firm
• Transaction costs are incurred when entering
into a contract
– Influences

• uncertainty
• frequency of recurrence
• asset specificity

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The Firm
• Examples of transaction costs

– Offshoring to source consumer products
(e.g. retail stores)
– Manufacturing components overseas (e.g.
the automotive industry)
– Logistics services (e.g. warehousing,
delivery, etc.)

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The Firm
• Limits to firm
size
• tradeoff between
external
transactions and the
cost of internal
operations
• company chooses to
allocate resources so
total cost is
minimized (for a
given level of
output)
• outsourcing of
peripheral, non-core
activities

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The Firm
• Reshoring: Operations returning to the
country where the offshoring occurred
(Example - United States)

• Signs of Reshoring
– Wages in developing countries have been rising.
– The decrease in the value of the dollar has increased the
cost of importing.
– Increases in energy costs have made it more expensive to
ship products
– Manufacturing firms have significantly increased
productivity making firms production more competitive.

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The Firm
• Illustration: Coase and the Internet

– Ronald Coase wrote in 1937, pre-internet,
but his ideas are still relevant today.
– He discussed tradeoff between internal
costs and external transactions.
– Technology has reduced search costs
improving efficiency.

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Economic Goal of the Firm and

Optimal Decision Making
• Profit maximization hypothesis: the primary
objective of the firm (to economists) is to
maximize profits
– Other goals include market share, revenue growth, and
shareholder value

• Optimal decision is the one that brings the
firm closest to its goal
– It is crucial to be precisely aware of a firm’s goals. Different
goals can lead to very different managerial decisions given
the same, limited amount of resources.

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Goals other than Profit
• Economic/financial objectives
– market share, growth rate
– profit margin
– return on investment, return on assets
– technological advancement
– customer satisfaction
– shareholder value

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Goals other than Profit
• Non-economic objectives
– Good work environment for employees
– Quality products and services for customers
– Good corporate citizenship and social responsibility

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Do Companies Maximize Profit?
• Argument against companies not maximizing
profits but instead merely aim to satisfice,
which means firms seek to achieve a
satisfactory goal--one that may not require
the firm to ‘do its best’.

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Do Companies Maximize Profit?
– Two forces leading to satisficing

• position and power of stockholders
• position and power of management

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Do Companies Maximize Profit?
• Position and power of stockholders
Reasons for satisficing by companies

• larger firms are owned by thousands of
shareholders
• stockholders generally own only minute
interests in the firm and hold diversified
holdings in many other firms

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Do Companies Maximize Profit?
• Position and power of stockholders
– Stockholders are concerned with performance of their
entire portfolio and not individual stocks
– Stockholders are much less informed about the firm than
management

Thus, stockholders are not likely to take any
action if earning a ‘satisfactory’ return.

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Do Companies Maximize Profit?
• Position and power of management
– high-level managers may own very little of the firm’s stock
– managers tend to be more conservative—that is, risk
averse—than stockholders would be because their jobs will
most likely be safer if they turn in a competent and steady,
if unspectacular, performance

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Do Companies Maximize Profit?
• Position and power of management
– managers may be more interested in maximizing their own
income and perks
– management incentives may be misaligned (e.g. revenue
goals for compensation and not profits)
– divergence of objectives is known as the ‘principal-agent’
problem

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Do Companies Maximize Profit?
• Arguments supporting the profit
maximization hypothesis
– large stockholdings held by institutions (mutual funds,
banks, etc.)  scrutiny by professional analysts
– Stock market discipline and competition  if managers do
not seek to maximize profits, firms face the threat of
takeover or changes in management
– incentive effect  the compensation of many executives is
tied to stock price

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Do Companies Maximize Profit?
• Other influences
– The Sarbanes-Oxley Act was passed in 2002 in response to
a number of corporate scandals. The Act sets stricter
standards on the behavior of public corporations and more
transparency of corporate information.
– Within the labor market for financial managers, superior
performance is rewarded.

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Maximizing the Wealth
of Stockholders
• Measurements of Wealth
– Views the firm from the perspective of a stream of profits
(cash flows) over time. The value of the stream depends on
when cash flows occur.
– Requires the concept of the time value of money: a
dollar earned in the future is worth less than a dollar
earned today. There is an opportunity cost of getting a
dollar in the future instead of today.

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Maximizing the Wealth
of Stockholders
• Future cash flows (Di) must be ‘discounted’ to
find their present equivalent value
• The discount rate (k) is affected by risk
• Two major types of risk:
– business risk
– financial risk

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Maximizing the Wealth
of Stockholders
• Business risk involves variation in returns due
to the ups and downs of the economy, the
industry, and the firm.
All firms face business risk to varying degrees.

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Maximizing the Wealth
of Stockholders
• Financial risk concerns the variation in
returns that is induced by ‘leverage’
– Leverage is the proportion of a company financed by debt

• the higher the leverage, the greater the
potential fluctuations in stockholder earnings
• financial risk is directly related to the degree
of leverage

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