CHAPTER TWOCHAPTER TWO

THE FIRM AND ITS GOALS

Dr. Mohammed Alwosabi1

The Firm• The firm is an organization which brings• The firm is an organization, which brings

resources together to produce a good or service that is demanded in the marketservice that is demanded in the market.

• The firm bears costs of production. These costs are influenced by the availablecosts are influenced by the available technologyTh t t d d th i t• The amount to produce and the price to charge are affected by the market t t i hi h th fi tstructure in which the firm operates.

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• Dealing with others in the market, the firm incurs transaction costs

• Transaction costs are the costs incurred when making an exchange (buying andwhen making an exchange (buying and selling). This includes the costs of

(1)search and investigation(1)search and investigation, (2)negotiation, and (3)enforcement of contracts and coordinating

transactions.

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• Transaction costs are influenced by 1 Uncertainty which refers to the inability to1.Uncertainty, which refers to the inability to know the future perfectly, particularly in the long termthe long term.

2.Frequency of recurrence, which refers to how many times these transaction arehow many times these transaction are repeated.

3 Asset specificity which refers to the3.Asset specificity, which refers to the extent to which the parties are "tied in" in a two way or multiple way businessa two-way or multiple-way business relationship. This might lead to an opportunistic behavior when one partyopportunistic 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’more profitable to produce all its products components (goods and services) internally or to order some of parts from y pother firms, through what is known as outsourcing.Fi ll t th i h l• Firms usually outsource the peripheral, non-core activities.

• Company chooses to allocate resources• Company chooses to allocate resources so total cost is minimum

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• 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 anWhen the (external) transaction cost of an item is higher than its internal operation, the firm will provide that item internally.firm will provide that item internally.

• The opposite is true.I t t h d th t ti t t• Internet has caused the transaction costs to decrease drastically, making it easier for the fi t t f th i j b tfirm to outsource some of their job to specialized and more efficient companies

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The Economic Goal of the Firm and Optimal Decision Making:g• Profit Maximization (or loss minimization,

when there is a loss) is traditionally knownwhen there is a loss) is traditionally known to be the ultimate goal of the firm.

• Profit is the difference between revenue• Profit is the difference between revenue received and costs incurred.

TR TCπ = TR – TC • To maximize profit, the firm should produce

th tit f t t hi h t ththe quantity of output which equates the revenue generated with the cost incurred of th l t it d dthe last unit produced.

MR = MC 7

• For public sector or not-for-profit organization the usual assumption will beorganization, the usual assumption will be that the organization wants to use its resources efficiently to maximize theresources efficiently to maximize the benefits that this organization was established to achieveestablished to achieve.

• Whether the firm wants to maximize profit hi th l th ti lor achieve other goals, the optimal

decision is the one that brings the firm l t t it lclosest to its goals.

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• Along with the discussion of the firm’s goal it is important to distinguish between short-p grun and long-run.

• This distinction in economics has nothing toThis distinction in economics has nothing to do directly with months or years

• Short run (SR): when the firm can vary the• Short-run (SR): when the firm can vary the amount of some resources but not othersL (LR) h th fi th• 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 be sacrificed for long-run purposes 9

Goals Other than Profit Maximization:• Firms’ managers may adopt a variety ofFirms managers may adopt a variety of

other targets as well, according to the different stages of the firm life cycle.different stages of the firm life cycle.

• Different goals may lead to different managerial decisions given the samemanagerial decisions given the same amount of resources.

E i G lEconomic 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?

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• Manager of the firm has to break down the overall goal of profit maximization into some g pintermediate targets to be adopted by various divisions or department of the firm.p

• The manager has to define production targets, input procurement targets, salestargets, input procurement targets, sales growth rate, required growth in R&D, maximum allowed increase in wage bill,maximum allowed increase in wage bill, needed increase in advertising budget.

• Against these targets department heads will• Against these targets, department heads will be accountable, and incentives will be payable only to those who accomplishedpayable only to those who accomplished their targets. 11

• Some of economic goals that, at the end, results in maximizing profit might include:g p g

Firm’s Goal Managerial DecisionMa im m market share Red ce the selling priceMaximum market share Reduce the selling price,

advertising, promotionsMaximum revenue growth Produce the maximumMaximum revenue growth Produce the maximum

level of outputMaximum shareholder Maximizing presentMaximum shareholder value

Maximizing present value of profits

Advanced technology Investment in R & DAdvanced technology Investment in R & DCustomer satisfaction Quality product at low

prices12

pricesMaximum earning per share

Higher leverage (debt finance)

• Nevertheless, all of the above goals result, directly or indirectly, in maximizing the profit y y, g pof the firm.

• The economists, generally, lean toward theThe economists, generally, lean toward the profit-maximization hypothesis, which means that a firm is unlikely to survive in themeans that a firm is unlikely to survive in the long run if it is not profitable.

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Non-Economic Objectives• In today’s world, firms are concern with today s o d, s a e co ce t

workers and customers’ satisfaction, and how to be socially responsible more than in y pthe past.

• Therefore Firms may announce theTherefore, Firms may announce the adoption of objectives that apparently not economical or has no relation with profiteconomical or has no relation with profit maximization such as:

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1. Corporate citizenship and social responsibility

2. Firms’ programs for pollution abatement.3. Labor lifetime contracts.4. Firms’ guarantee of none-genetic

engineered productg p5. Good work environment and higher safety

standards6. Quality products and services• These objectives are costly. However, allThese objectives are costly. However, all

these objectives would in some way or another support firms’ efforts toward their ppgoals of profit maximization.

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Do Companies Maximize Profits?• First Argument: Against (Principal- AgentFirst Argument: Against (Principal Agent

Problem)• This argument is known as “principal agent”• This argument is known as principal-agent

problem or “agency problem”Hi h l l h ibl f• High-level managers who are responsible for major decision making may own very little of th ’ t k d bthe company’s stock and may be more interested in maximizing their own income

d k t t i i fit band perks, not to maximize profit because they know that:

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1.Medium-sized or large corporations are owned by thousands of shareholders who yhave no time or resources to follow closely the firm’s performance.p

2.Shareholders, usually, hold portfolios of diversified stocks in many firms anddiversified stocks in many firms and normally own a small number of any firm’s stocks. So, they are concerned withstocks. So, they are concerned with performance of their entire portfolio and not individual stocks.individual stocks.

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3.Most stockholders are not well informed on how well a corporation can do and thus are pnot capable of determining the effectiveness of management.g

4.Shareholders will be satisfied with an adequate dividend that grows over time andadequate dividend that grows over time and will not likely to take any action as long as they are earning a “satisfactory” return onthey are earning a satisfactory return on their investment.

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• 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 q ppy gthey receive some reasonable return on their capital.p

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Second Argument: With the profit maximization hypothesisyp• Manager’s objective is to maximize profit

because:because: 1.Financial institutes mostly hold the largest

portion of firms’ stocks They keep close eyeportion of firms stocks. They keep close eye on managerial performance with the help of specialized consulting companies andspecialized consulting companies, and external auditors.

2 I th f ffi i t fi i l2.In the presence of efficient financial markets, managers’ misconducts would be

fl t d t k i i th k treflected on stock prices in the market. 20

This will have a negative effect on stockholders wealth.

3.Competition between firms secures that inefficient managers will soon be discovered gand forced out of their jobs.

4.The compensation of many executives is p ytied in a way or another to stock price performance in terms of attained profits.

• For the abovementioned reasons, manager’s objectives coincide shareholders’

bj ti ld d th i b t tobjectives; managers would do their best to maximize firms’ profits.

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Economic Profit: • Although firms prepare their financialAlthough firms prepare their financial

statements according to GAAP recording items, profit numbers are not definitiveitems, profit numbers are not definitive because there are different ways of recording depreciation and inventories; andrecording depreciation and inventories; and amortization of such items as goodwill and patents can be recorded differentlypatents can be recorded differently

• When it comes to calculating costs, two basic differences do exist betweenbasic differences do exist between accounting and economics:

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1. Accountants base their assessments of capital depreciation and inventories on p phistorical costs, while economists, on the other hand, neglect historical costs and call , git sunk costs that should not affect decisions. Instead, they consider , yreplacement cost.

2. Accountants are generally concerned with2. Accountants are generally concerned with explicit costs, while economists are concerned with the opportunity costs whichconcerned with the opportunity costs which include both explicit and implicit costs.

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• Implicit costs include the value of resources owned by owners of the firm even if there yare no monetary payments.

• Part of the economic cost (part of implicit (p pcost) is the normal profit.

• Normal profit is the average return that p gcould 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 biliti d t l t h d b l dabilities and talent had been employed

elsewhere.

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• 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

i A l ld foperation. A lower rate would cause some of the established firms to leave; a higher one would cause new firms to enterwould cause new firms to enter.

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• Economic profit represents an extra profit over and above all costs including normal gprofit.

• It is regarded as a reward (compensation) toIt is regarded as a reward (compensation) to the entrepreneur for taking the risk of running a business that might reap profit orrunning a business that might reap profit or suffer loss.

• It accounts for all resources• It accounts for all resources. • Economic Profit = TR - TEC

= TR – Opp. Cost = TR – (Explicit Cost + Implicit cost)( p p )

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• A firm earns an economic profit only if it earns more than its opportunity cost.pp y

• If economic profit is zero ⇒ firm earns only normal profitonly normal profit

• If economic profit is positive ⇒ firm earns more than normal profitmore than normal profit

• If economic profit is negative ⇒ firm earns l th l fit ( i l )less than normal profit (economic loss)

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• A firm that makes zero economic profit covers all its costs including a normal profit. g pIn other words, a firm making just a normal profit is making zero economic profit.p g p

• Not every business has an equal chance to earn economic profit. There are manyearn economic profit. There are many constraints in the market prevent the firm from maximizing its economic profit.from maximizing its economic profit.

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