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

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

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

• 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®

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

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

The Firm

• Transaction costs are incurred when

entering into a contract

– Influences

• uncertainty

• frequency of recurrence

• asset specificity

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.)

The Firm

• Limits to firm size

• tradeoff between

external transactions and the cost of internal

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

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.

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.

Goals other than Profit

Goals other than Profit

• Non-economic objectives

– Good work environment for employees

– Quality products and services for customers

– Good corporate citizenship and social

responsibility

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’.

Do Companies Maximize Profit?

– Two forces leading to satisficing

• position and power of stockholders

• position and power of management

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

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.

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

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

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

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

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

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

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

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

Maximizing the Wealth

of Stockholders

• The present price of a firm’s stock should

reflect the discounted value of the expected future cash flows to shareholders

(dividends)

P = present price of the stock

D = dividends received per year

n

n

k

D k

D k

D k

D

P

) 1 ( )

1 ( )

1 ( )

1

3 2

2 1

Maximizing the Wealth

of Stockholders

• If the firm is assumed to have an infinitely long life, the price of a unit of stock which earns a dividend D per year is given by the equation:

P = D/k

Maximizing the Wealth

Maximizing the Wealth

• When stock options are a substantial part of

executive compensation, management objectives tend to be more aligned with stockholder objective

Maximizing the Wealth

of Stockholders

• Another measure of the wealth of stockholders is

called Market Value Added (MVA) ®

• MVA = difference between the market value of the company and the capital that the investors have paid into the company

Maximizing the Wealth

e.g accumulated R&D and goodwill

• While the market value of the company will always

be positive, MVA may be positive or negative

Maximizing the Wealth

of Stockholders

• Another measure of the wealth of

stockholders is called Economic Value

Economic Profits

• Economists are concerned with implicit

costs.

– Accordingly, economic costs include not only

the historical costs and explicit costs recorded by the accountants, but also the replacement costs and implicit costs (normal profits) that must be earned on the owners’ resources

Global Application

• When doing business in other countries and other cultures, business decision-making becomes more complicated due to: