The Firm and its Goals

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Chapter 2

• The Firm and its Goals

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• 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.
• ProfitRevenue-Costs
• The aim of the firm is to maximize its profit.

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• Car manufacturing ?Exhaust production requires
  different technologygttransaction 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 gt Internal operating cost
  gt company is benefiting from performing this
  work-task in house.

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• 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)

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• Transaction costsare incurred when a company
  enters into a contract with other entities.
  Transaction costs are influenced by uncertainty,
  frequency of recurrence, and asset specificity.
• Opportunistic Behaviourif 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.

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• 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 UKs Earnst Young are the major
  companies who provide third party services, even
  off-shore.

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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.

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• 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 companys 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.

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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
  firms marginal revenue with its marginal cost.
• Stress the difference between LR and SR time
  period.

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Goals other than profit

• Economic goals (p.30 CEOs memo 1-2) class
  exercise
• Companys objectives, profit maximization, growth
  rate, profit margin, return on its asset?
• Consider the ultimate goal of a firm is to
  maximize firms overall profits. Companys
  economic environment, competition, technological
  improvements and market potential are needed to
  reach maximum profit by the combination of growth
  and profit measurement.

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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 todays 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.

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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

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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.

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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 companys
  leverage.

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Present price of stock

• Dividends represent the returns on the stock,
  generated by the corporation. We can derive an
  equation of
• P(D1/(1k)(D2/(1k)2).. (Dn/(1k)n
• Where
• ppresent price of stock
• ddividends received per year (in year 1, year
  2, year n)
• kdiscount rate applied by financial
  community, often referred to as cost of equity
  capital of a company

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• 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 companys common equity.

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• 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.

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• P 4/(0.12-0.05) 4/0.07 57.14
• The value of the companys 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
  companys 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 companys stock.

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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

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• -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 ProfitTR - All economic costs
• TR TC - Implicit costs
• Read page 42, The Solution GLOBAL FOODS

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• 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.