THE FIRM AND ITS GOALS. Dr. Mohammed Alwosabi

Transcription

1 CHAPTER TWO THE FIRM AND ITS GOALS Dr. Mohammed Alwosabi 1

2 The Firm The firm is an organization, which brings resources together to produce a good or service that is demanded in the market. The firm bears costs of production. These costs are influenced by the available technology The amount to produce and the price to charge are affected by the market structure t in which h the firm operates. 2

3 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, (2)negotiation, and (3)enforcement of contracts and coordinating transactions. 3

4 Transaction costs are influenced by 1.Uncertainty, which refers to the inability to know the future perfectly, particularly in the long term. 2.Frequency of recurrence, which refers to how many times these transaction are repeated. 3.Asset specificity, which refers to the extent to which the parties are "tied in" in a two-way way or multiple-way business relationship. This might lead to an opportunistic behavior, when one party seeks to take advantage of the other. 4

5 Managers of profit maximizing firms always face the question of whether it is more profitable to produce all its products components (goods and services) internally or to order some of parts from other firms, through what is known as outsourcing. Firms usually outsource the peripheral, non-core activities. Company chooses to allocate resources so total cost is minimum 5

6 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 t has caused the transaction ti costs to decrease drastically, making it easier for the firm to outsource some of their job to specialized and more efficient companies 6

7 The Economic Goal of the Firm and Optimal 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 the quantity of output t which h equates the revenue generated with the cost incurred of the last unit produced. d MR = MC 7

8 For public sector or not-for-profit organization, the usual assumption will be that the organization wants to use its resources efficiently to maximize the benefits that this organization was established to achieve. Whether the firm wants to maximize profit or achieve other goals, the optimal decision is the one that brings the firm closest to its goals. 8

9 Along with the discussion of the firm s goal it is important to distinguish between short- run and long-run. This distinction in economics has nothing to do directly with months or years Short-run run (SR): when the firm can vary the amount of some resources but not others Long-run (LR): when the firm can vary the 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

10 Goals Other than Profit Maximization: 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. Economic Goals 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

11 Manager of the firm has to break down the overall goal of profit maximization into some intermediate targets to be adopted by various divisions or department of the firm. 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, department heads will be accountable, and incentives will be payable only to those who accomplished their targets. 11

12 Some of economic goals that, at the end, results in maximizing gprofit might include: Firm s Goal Maximum m market share Maximum revenue growth Maximum shareholder value Advanced technology Customer satisfaction Maximum earning per share Managerial Decision Reduce the selling price, advertising, promotions Produce the maximum level of output Maximizing present value of profits Investment in R & D Quality product at low prices Higher leverage (debt finance) 12

13 Nevertheless, all of the above goals result, directly or indirectly, in maximizing the profit 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

14 Non-Economic Objectives In today s world, firms are concern ce with workers and customers satisfaction, and how to be socially responsible more than in the past. Therefore, Firms may announce the adoption of objectives that apparently not economical or has no relation with profit maximization such as: 14

15 1. Corporate citizenship and social responsibility 2. Firms programs for pollution abatement. 3. Labor lifetime contracts. 4. Firms guarantee of none-genetic engineered product 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 another support firms efforts toward their goals of profit maximization. 15

16 Do Companies Maximize Profits? First Argument: Against (Principal- Agent Problem) This argument is known as principal-agent agent problem or agency problem High-level l managers who are responsible for major decision making may own very little of the company s stock and may be more interested in maximizing their own income and perks, not to maximize i profit because they know that: 16

17 1.Medium-sized or large corporations are owned by thousands of shareholders who have no time or resources to follow closely 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

18 3.Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness 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 return on their investment. 18

19 For these reasons, managers act in accordance with their own interest, save their jobs, protect their benefits, while, shareholders are quite happy as long as they receive some reasonable return on their capital. 19

20 Second Argument: With the profit maximization hypothesis Manager s objective is to maximize profit because: 1.Financial institutes mostly hold the largest portion of firms stocks. They keep close eye on managerial performance with the help of specialized consulting companies, and external auditors. 2.In the presence of efficient i financial i markets, managers misconducts would be reflected on stock prices in the market. 20

21 This will have a negative effect on stockholders wealth. 3.Competition between firms secures that inefficient managers will soon be discovered and forced out of their jobs. 4.The compensation of many 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; managers would do their best to maximize firms profits. 21

22 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

23 1. Accountants base their assessments of capital depreciation and inventories on historical costs, while economists, on the other hand, neglect historical costs and call it sunk costs that should not affect decisions. Instead, they 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

24 Implicit costs include the value of resources owned by owners of the firm even if there are no monetary payments. Part of the economic cost (part of implicit cost) is the normal profit. Normal profit is the average 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 and talent t had been employed elsewhere. 24

25 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. A lower rate would cause some of the established firms to leave; a higher one would cause new firms to enter. 25

26 Economic profit represents an extra profit over and above all costs including normal 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. Economic Profit = TR - TEC = TR Opp. Cost = TR (Explicit Cost + Implicit cost) 26

27 A firm earns an economic profit only if it earns more than its opportunity cost. 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 less than normal profit (economic loss) 27

28 A firm that makes zero economic profit covers all its costs including a normal profit. In other words, a firm making just a normal profit is making zero economic profit. 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

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