CHAPTER TWO
THE FIRM AND ITS GOALS
Dr. Mohammed Alwosabi
1
The Firm
• The firm is an organization,
organization which brings
resources together to produce a good or
service that is demanded in the market
market.
• The firm bears costs of production. These
costs are influenced by the available
technology
• The
Th amountt tto produce
d
and
d th
the price
i to
t
charge are affected by the market
structure
t
t
i which
in
hi h the
th firm
fi
operates.
t
2
• Dealing with others in the market, the firm
incurs transaction costs
• Transaction costs are the costs incurred
when making an exchange (buying and
selling). This includes the costs of
(1)search and investigation,
investigation
(2)negotiation, and
(3)enforcement of contracts and coordinating
transactions.
3
• Transaction costs are influenced by
1 Uncertainty which refers to the inability to
1.Uncertainty,
know the future perfectly, particularly in
the long term
term.
2.Frequency of recurrence, which refers to
how many times these transaction are
repeated.
3 Asset specificity
3.Asset
specificity, which refers to the
extent to which the parties are "tied in" in
a two
two-way
way or multiple
multiple-way
way business
relationship. This might lead to an
opportunistic behavior,
behavior when one party
seeks to take advantage of the other.
4
• Managers of profit maximizing firms
always face the question of whether it is
more profitable to produce all its products’
products
components (goods and services)
internally
y or to order some of p
parts from
other firms, through what is known as
outsourcing.
• Firms
Fi
usually
ll outsource
t
the
th peripheral,
i h l
non-core activities.
• Company chooses to allocate resources
so total cost is minimum
5
• There is a tradeoff between the cost of
external transactions and the cost of
internal operations of the firm.
• When the (external) transaction cost of an
item is higher than its internal operation, the
firm will provide that item internally.
• The opposite is true.
• Internet
I t
t has
h caused
d the
th transaction
t
ti costs
t to
t
decrease drastically, making it easier for the
fi
firm
to
t outsource
t
some off their
th i job
j b to
t
specialized and more efficient companies
6
The Economic Goal of the Firm and Optimal
g
Decision Making:
• Profit Maximization (or loss minimization,
when there is a loss) is traditionally known
to be the ultimate goal of the firm.
• Profit is the difference between revenue
received and costs incurred.
π = TR – TC
• To maximize profit, the firm should produce
th quantity
the
tit off output
t t which
hi h equates
t the
th
revenue generated with the cost incurred of
th last
the
l t unit
it produced.
d
d
7
MR = MC
• For public sector or not-for-profit
organization the usual assumption will be
organization,
that the organization wants to use its
resources efficiently to maximize the
benefits that this organization was
established to achieve.
achieve
• Whether the firm wants to maximize profit
or achieve
hi
other
th goals,
l the
th optimal
ti l
decision is the one that brings the firm
closest
l
t to
t its
it goals.
l
8
• Along with the discussion of the firm’s goal
p
to distinguish
g
between shortit is important
run and long-run.
• This distinction in economics has nothing to
do directly with months or years
• Short-run
Short run (SR): when the firm can vary the
amount of some resources but not others
• Long-run
L
(LR) when
(LR):
h the
th firm
fi
can vary the
th
amount of all resources
• The firm’s goal is to maximize profit in SR
and LR,
• However, at times short-run profitability will
9
be sacrificed for long-run purposes
Goals Other than Profit Maximization:
• Firms
Firms’ managers may adopt a variety of
other targets as well, according to the
different stages of the firm life cycle.
• Different goals may lead to different
managerial decisions given the same
amount of resources.
E
Economic
i Goals
G l
• If maximizing profit is the firm goal, how
could the manager be sure that the actions
taken in the present will result in the largest
possible profit?
10
• Manager of the firm has to break down the
goal of p
profit maximization into some
overall g
intermediate targets to be adopted by
p
of the firm.
various divisions or department
• The manager has to define production
targets, input procurement targets, sales
growth rate, required growth in R&D,
maximum allowed increase in wage bill,
needed increase in advertising budget.
• Against these targets
targets, department heads will
be accountable, and incentives will be
payable only to those who accomplished
their targets.
11
• Some of economic goals that, at the end,
g profit
p
might
g include:
results in maximizing
Firm’s Goal
Managerial Decision
Ma im m market share
Maximum
Reduce
Red
ce the selling price,
price
advertising, promotions
Maximum revenue growth Produce the maximum
level of output
Maximum shareholder
Maximizing present
value
value of profits
Advanced technology
Investment in R & D
Customer satisfaction
Maximum earning per
share
Quality product at low
prices
Higher leverage (debt12
finance)
• Nevertheless, all of the above goals result,
y or indirectly,
y, in maximizing
g the profit
p
directly
of the firm.
• The economists, generally, lean toward the
profit-maximization hypothesis, which
means that a firm is unlikely to survive in the
long run if it is not profitable.
13
Non-Economic Objectives
• In today
today’s
s world,
o d, firms
sa
are
e co
concern
ce with
t
workers and customers’ satisfaction, and
y responsible
p
more than in
how to be socially
the past.
• Therefore,
Therefore Firms may announce the
adoption of objectives that apparently not
economical or has no relation with profit
maximization such as:
14
1. Corporate citizenship and social
responsibility
2. Firms’ programs for pollution abatement.
3. Labor lifetime contracts.
4. Firms’ guarantee of none-genetic
g
product
p
engineered
5. Good work environment and higher safety
standards
6. Quality products and services
• These objectives are costly. However, all
these objectives would in some way or
pp
firms’ efforts toward their
another support
goals of profit maximization.
15
Do Companies Maximize Profits?
• First Argument: Against (Principal(Principal Agent
Problem)
• This argument is known as “principal
principal-agent
agent”
problem or “agency problem”
• High-level
Hi h l
l managers who
h are responsible
ibl for
f
major decision making may own very little of
th company’s
the
’ stock
t k and
d may be
b more
interested in maximizing their own income
and
d perks,
k nott to
t maximize
i i profit
fit because
b
they know that:
16
1.Medium-sized or large corporations are
y thousands of shareholders who
owned by
have no time or resources to follow closely
p
the firm’s performance.
2.Shareholders, usually, hold portfolios of
diversified stocks in many firms and
normally own a small number of any firm’s
stocks. So, they are concerned with
performance of their entire portfolio and not
individual stocks.
17
3.Most stockholders are not well informed on
p
can do and thus are
how well a corporation
not capable of determining the effectiveness
g
of management.
4.Shareholders will be satisfied with an
adequate dividend that grows over time and
will not likely to take any action as long as
they are earning a “satisfactory”
satisfactory return on
their investment.
18
• For these reasons, managers act in
accordance with their own interest,, save
their jobs, protect their benefits, while,
quite happy
ppy as long
g as
shareholders are q
they receive some reasonable return on their
p
capital.
19
Second Argument: With the profit
yp
maximization hypothesis
• Manager’s objective is to maximize profit
because:
1.Financial institutes mostly hold the largest
portion of firms
firms’ stocks.
stocks They keep close eye
on managerial performance with the help of
specialized consulting companies,
companies and
external auditors.
2 I the
2.In
th presence off efficient
ffi i t financial
fi
i l
markets, managers’ misconducts would be
reflected
fl t d on stock
t k prices
i
in
i the
th market.
k t
20
This will have a negative effect on
stockholders wealth.
3.Competition between firms secures that
g
will soon be discovered
inefficient managers
and forced out of their jobs.
4.The compensation
p
of many
y executives is
tied in a way or another to stock price
performance in terms of attained profits.
• For the abovementioned reasons, manager’s
objectives coincide shareholders’
objectives;
bj ti
managers would
ld do
d their
th i best
b t to
t
maximize firms’ profits.
21
Economic Profit:
• Although firms prepare their financial
statements according to GAAP recording
items, profit numbers are not definitive
because there are different ways of
recording depreciation and inventories; and
amortization of such items as goodwill and
patents can be recorded differently
• When it comes to calculating costs, two
basic differences do exist between
accounting and economics:
22
1. Accountants base their assessments of
p
depreciation
p
and inventories on
capital
historical costs, while economists, on the
g
historical costs and call
other hand,, neglect
it sunk costs that should not affect
decisions. Instead,, they
y consider
replacement cost.
2. Accountants are generally concerned with
explicit costs, while economists are
concerned with the opportunity costs which
include both explicit and implicit costs.
23
• Implicit costs include the value of resources
y owners of the firm even if there
owned by
are no monetary payments.
• Part of the economic cost (p
(part of implicit
p
cost) is the normal profit.
• Normal p
profit is the average
g return that
could be obtained from running another
business. It is an amount equal to what the
owners of a business could have earned if
their resources including entrepreneurial
abilities
biliti and
d talent
t l t had
h d been
b
employed
l
d
elsewhere.
24
• Normal profit covers the opportunity cost of
running the firm.
• Normal profit is the minimum return a firm's
owner must earn in order to stay in
operation.
i
A llower rate would
ld cause some off
the established firms to leave; a higher one
would cause new firms to enter
enter.
25
• Economic profit represents an extra profit
g normal
over and above all costs including
profit.
• It is regarded as a reward (compensation) to
the entrepreneur for taking the risk of
running a business that might reap profit or
suffer loss.
• It accounts for all resources
resources.
• Economic Profit = TR - TEC
= TR – Opp. Cost
= TR – ((Explicit
p
Cost + Implicit
p
cost))
26
• A firm earns an economic profit only if it
pp
y cost.
earns more than its opportunity
• If economic profit is zero ⇒ firm earns
only normal profit
• If economic profit is positive ⇒ firm earns
more than normal profit
• If economic profit is negative ⇒ firm earns
l
less
than
th normall profit
fit (economic
(
i loss)
l
)
27
• A firm that makes zero economic profit
g a normal profit.
p
covers all its costs including
In other words, a firm making just a normal
profit is making
p
g zero economic profit.
p
• Not every business has an equal chance to
earn economic profit. There are many
constraints in the market prevent the firm
from maximizing its economic profit.
28
29
30