MANAGERIAL ECONOMICS

214ECN

Department of Economics, Finance

and Accounting

1
The Firm and its Objectives

Learning objectives
understand the rationale for existence of firms

explain economic goals and optimal decision making

2
Overview
The firm
Economic goal of the firm
Goals other than profit
Do companies maximize profits?
Maximizing the wealth of
stockholders
Economic profit
3
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

4
The Firm

 Transaction costs are incurred when

entering into a contract

– types of transaction costs

• investigation
• negotiation
• enforcing contracts

5
The Firm

 Transaction costs are incurred when

entering into a contract

– influences
• uncertainty
• frequency of recurrence
• asset specificity
6
The Firm

 Examples

• Kodak – uses offshoring to source

cameras
• IBM – manufacturing computers
overseas
• Exult – third party services used in
human resources

7
 The Firm
 Limits to firm size

– tradeoff between external

transactions and the cost of
internal operations

– company chooses to
allocate resources so total
cost is minimum

– outsourcing of peripheral,
non-core activities

8
Economic goal of the firm

 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
9
Economic goal of the firm

 Short-run versus Long-run

– nothing to do directly with calendar time

– short-run: firm can vary amount of some
resources but not others
– long-run: firm can vary amount of all
resources
– at times short-run profitability will be
sacrificed for long-run purposes
10
 Goals other than profit
 Economic goals  Non-economic
– market share, growth objectives
rate – good work
– profit margin environment
– return on investment, – quality products and
Return on assets services
– technological – corporate citizenship,
advancement
social responsibility
– customer satisfaction
– shareholder value 11
Do companies maximize profit?
 Criticism: companies do not maximize
profits but instead merely aim to
satisfize, which means to achieve a
satisfactory goal, one that may not
require the firm to „do its best‟

– two forces affect satisfizing:

• position and power of stockholders
• position and power of management
12
 Do companies maximize profit?
 Position and power of stockholders
– larger firms are owned by thousands of shareholders
– shareholders own only minute interests in the firm ... and hold
diversified holdings in many other firms
– shareholders are concerned with performance of entire portfolio
and not individual stocks
– less informed about the firm than management
– stockholders not likely to take any action if earning a „satisfactory‟
return
 Position and power of management
– high-level managers may own very little of the firm‟s stock
– managers tend to be more conservative because jobs will likely be
safe if performance is steady, not spectacular
– managers may be more interested in maximizing own income and
perks
– management incentives may be misaligned (eg. revenue not
profits)  divergence of objectives is known as „principal-agent‟
13
problem
Do companies maximize profit?
 Counter-arguments which support the
profit maximization hypothesis

– large stockholdings held by institutions (mutual

funds, banks, etc.)  scrutiny by professional
analysts
– stockmarket discipline  if managers do not seek
to maximize profits, firms face threat of takeover
– incentive effect  the compensation of many
executives is tied to stock price

14
Maximizing the wealth
of stockholders
 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: says a dollar earned in the future is
worth less than a dollar earned today

15
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

16
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

17
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 by debt
 the higher the leverage, the greater the
potential fluctuations in stockholder earnings
 financial risk is directly related to the
degree of leverage
18
 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)

D1 D2 D3 Dn
P (1 k ) (1 k ) 2
(1 k ) 3  (1 k ) n

P = present price of the stock

D = dividends received per year
k = discount rate
n = life of firm in years
19
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
 Given an infinitely lived firm whose dividends grow at a constant
rate (g) each year, the equation for the stock price becomes:
P = D1/(k-g)
where D1 is the dividend to be paid during the coming year

Multiplying P by the number of shares outstanding gives total

value of firm‟s common equity („market capitalization‟)

20
Maximizing the wealth
of stockholders
 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 the stream of dividends always
create the highest price for the company‟s
stock

When stock options are substantial part of

executive compensation, management
objectives tend to be more aligned with
stockholder objective
21
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
 Market value includes value of both equity and debt
„Capital‟ includes book value of equity and debt as
well as certain adjustments
e.g. accumulated R&D and goodwill
While the market value of the company will always be
positive, MVA may be positive or negative

22
Maximizing the wealth
of stockholders
 Another measure of the wealth of stockholders is
called Economic Value Added (EVA)®

EVA=(Return on total capital – Cost of capital) x Total

capital

if EVA > 0 shareholder wealth rising

if EVA < 0 shareholder wealth falling

23
 Production Theory

Objectives:
To examine the relationship between inputs and outputs

To identify the most important determinants of cost per unit

economies of capacity utilization
economies of scale
economies of scope
Minimum efficient scale
Break even analysis

To identify the difficulties involved in the empirical estimation of these

effects.

24
 The Relationship Between Inputs and
Outputs
 The fundamental relationship is that between inputs
and outputs - expressed as the production function
 This can be examined at a number of levels
– the economy as a whole
– the industry
– the firm
 A number of different mathematical forms can be
used to model the relationship
– Cobb-Douglas: Q = aKaLb
– translog production function

25
The Cobb-Douglas Example
 Q = aKaLb : Where K= capital; L = Labour

 As each individual input (K,L) is increased, output

increases, but at a decreasing rate - the principle of
diminishing returns - one of the most fundamental
economic ideas

 A production function identifies many different

techniques within the same technology

26
The Cobb-Douglas Example

 Q = aKaLb : Where K= capital; L = Labour

 If (a+b) > 1; economies of scale

 If (a+b) < 1; diseconomies of scale

 If (a+b) = 1; constant returns to scale

27
 How to Find the Cost Minimizing Way to
Produce Each Level of Output?

 As a mathematical problem, for level of output Q*

• minimiseTC=(w)(L)+(r)(K)
• subject to Q*=aKaLb

 As a verbal explanation
– the ratio of the wage rate to the cost of capital should be equal to
the ratio of the marginal productivity of labour to the marginal
productivity of capital: WHY?
– because otherwise $1 could be moved from spending on one input
to another and increase output without increasing cost

28
 From Production Functions to Cost Curves

 Short run - some inputs are fixed. (K). The firm is

restricted to a fixed set of plant and equipment
– capacity utilisation decisions

 Long run - both inputs are variable. (K,L). The firm

can choose the set of plant and equipment it wants
– investment decisions

29
From Production Functions to Cost Curves

 Short run cost curves

• each short run curve shows costs for a specific set of plant and
equipment
• AFC declines
• Average variable cost rises after some point
• AC is U-shaped
 Long run cost curves
• the firm can choose from all of the known sets of plant and
equipment
• the shape of the curve depends upon economies or
diseconomies of scale

30
 Long-run average cost function
Shows the minimum cost per unit of producing each
output level when any scale of operation is available

SR average cost
Average functions
cost
LR average cost

Quantity of output
Economies and diseconomies of scale
 The source of scale economies
– in manufacturing, engineering relationships
– indivisibilities
– specialization and division of labour
– stochastic economies
 The source of diseconomies
– managerial diseconomies
– control loss
– transactional problems

32
Statistical Evidence
 Collect data on size and cost, or on inputs and
outputs and fit a production or cost function
– but are the observed firms on their cost curve? They may be
above it
– how can firms at high cost/inefficient sizes survive? If they
cannot where do we get the data from?
– Is the curve fitted a good fit?
 Observed firms may be X-inefficient, so a „data
envelope‟ approach may be required

33
The fundamental problem

 What we need to know is:

 WHAT COST WOULD BE IF FIRMS WERE
PRODUCING OUTPUT USING THE BEST SET OF
PLANT AND EQUIPMENT FOR THE PURPOSE,
USING THE CURRENT TECHNOLOGY AND AT
CURRENT FACTOR PRICES, AND IF THEY ARE
100% EFFICIENT
 But we cannot observe that by looking
at real firms
34
Engineering approach

 Ask consulting engineers to design

facilities of different sizes and calculate
cost
– advantage is that it does involve estimating
cost for current technology and best
practice
– disadvantage is that this approach takes
no account of the MANAGERIAL factors
which might cause scale economies
35
The survivor technique
 Classify the firms in an industry by size and
compute the percentage of industry output coming
from each size class at various times -e.g. small,
medium, large.
 Observe the market share of the different groups
over time;
1.If the share of one class diminishes over time, it is assumed to be
inefficient ; These firms are then operating below minimum efficient
scale.
2. if large firms gain share - scale economies. small firms –
diseconomies. medium - U-shaped curve.
 Can market forces be relied upon to
select out the lowest cost firms over
time?
 Firms might have different objectives,
different products, different
environments, different strategies
 But used in a recent study of the US
beer industry (Elzinga 1990)

37
 Economies of Scope and Learning
Effects

 Economies of scope
– the production of two or more products
together is more efficient than producing
them separately
 Learning Effects
– costs fall as cumulative output to date
increases

38
 Economies of scope

Exist when the cost of producing two (or more)

products jointly is less than the cost of
producing each one alone.

S = C(Q1) + C(Q2) - C(Q1+ Q2)

C(Q1+ Q2)

39
Multi-product Firms

 Multi-product firms complicate the idea

of scale economies
– ray economies - if costs fall as more is
produced of the same output mix
– product-specific economies - if costs fall as
output of a single product increases

40
 Learning effects
 Important in World War 2 - the same plants,
same rate of output but lower costs over time
 Most important for complex products and
processes where humans can learn
 A possible source of „first-mover‟ advantages
- important in business strategy
 Boston Consulting Group made the
experience curve and learning effects the
centre of their approach in the 1970s

41
 Minimum efficient scale
The smallest output at which long-run
average cost is a minimum.
Average
cost

Quantity of output
Qmes
 Break-even analysis
Total Revenue
Dollars Total Cost

Profit

Loss

Quantity of output
Models of Market Structure

Objectives:
To explain the formal models of market structure
used in economic analysis.
Perfect competition; Monopoly; Oligopoly;
Monopolistic Competition

To explain how price is determined in these models.

44
Formal Textbook Models

 Economic analysis identifies four types of market

structure
 PERFECT COMPETITION
 MONOPOLY
 OLIGOPOLY
 MONOPOLISTIC COMPETITION
 The basis for the STRUCTURE-CONDUCT-
PERFORMANCE approach to industrial organization.
– Structure determines prices and profitability

45
What Is the Structure of These Different Types of
Industry? What is the Result of that Structure?
 Perfect Competition
 Large No of Small Firms, (i.e.No Economies of Scale), Identical
Products, Free Entry to the Industry, Perfect Knowledge of
market Opportunities
 SHORT RUN
– price is determined at industry level by supply and demand
– each firm has a horizontal demand curve at the market price
– demand and marginal revenue curve are the same
– MR = P = MC
 LONG RUN
– entry takes place, shifting supply curve to the right and price down
– super-normal profits are competed away, P= minimum LAC

46
Perfect Competition: Short Run

 Industry Firm
P S P SMC
P2

P P1 D=AR=MR

qq q
Q Q
0 1 2

47
Perfect Competition: Short Run
 The Firm in More Detail
SMC
SAC

P = AR =MR

AC

q
48
Perfect Competition: LongRun
 PL is the only possible long run price
LAC

SAC

P P = AR =MR
L

q
49
 Perfect Competition is
“Socially Optimal”
 P= MC is the important result
 Benefit to Consumers minus Cost to the
Economy is Maximized.
 Price = Marginal Cost (which gives economic
efficiency and a perfect allocation of resources). In
the long run entry forces price down to minimum
average cost. Every firm uses the most efficient plant
available. There is competition but no rivalry

50
 Perfect Competition is
“Socially Optimal”
 Area B is the gross benefit to consumers from having
quantity Q of the good

Q
51
 Perfect Competition is
“Socially Optimal”
 Area C is the avoidable cost to the economy from
producing quantity Q of the good
MC

Q
52
 Perfect Competition is
“Socially Optimal”
 Price P and quantity Q give the maximum difference
between benefit and cost. This is a basic form of
cost/benefit analysis
MC

53
 Monopoly
 One firm, no entry is possible - „pure monopoly‟

 Firm‟s demand-curve is industry‟s demand curve

 Price >Marginal Cost - economic inefficiency. Super-profits can

be made in the long run. The firm does not necessarily use the
plant which gives lowest cost
 Most countries have some kind of anti-monopoly policy
– note that the economic rationale for monopoly policy is P>MC not P>AC
– the problem is inefficiency not inequity

54
 Monopoly
 A monopolist produces less and charges a higher price, relative to the
socially optimal

MC
Pmonopoly
Psocially
optimal

Demand

Qmonopoly Qsocially optimal

55
 Monopolistic Competition
 Many firms, free entry, differentiated products
 Downward-sloping demand-curves
 In the long-run Price = Average Cost. Firms have plants which
are too small to take full advantage of scale economies. (But
there is only an equilibrium in this market structure if heroic and
perhaps contradictory assumptions made)
– when new firms enter, they take customers in equal proportions from all old
firms
– all firms have same cost and demand curves, while producing different
products
– will new firms not imitate successful old ones?

56
 Monopolistic Competition
 The „excess capacity‟ result: but which firm is shown here? ALLOF
THEM? Differentiated products but identical cost and demand
conditions?

MC
AC

Demand = AR

MR
57
 Oligopoly
 Competition amongst the Few
 Key feature is interdependence and rivalry
 Small number of firms (2 = duopoly)
 Condition of Entry may vary
 Product differentiation may vary
 Possible outcomes include:
– co-operation and collusion - the monopoly price
– price war - the perfectly competitive price
 The modern approach to oligopoly is through game
theory

58
 Oligopoly: Pre-Game Theory Ideas

 What determines whether collusion takes place or

not?
– How well-informed are rivals about each other?
• Trade association increases probability of collusion
• Published prices increase it
• Slow technical progress
• Small number of firms
• Limited product differentiation
 The kinked demand-curve model: (see textbook)

59
 How to Describe These Textbook
Models?
 Formal. Assumptions are clearly stated (or should be
- not always true for monopolistic competition)
 Rigourous. The precise logical consequences of the
assumptions are derived.
 Predictive. Purpose is to provide hypotheses which
might be tested. E.g what happens when demand
increases or cost rises?
 Part of a larger picture. How does a market economy
function? (This is the most important role for these
models)

60
What Do These Models Tell Us
About the Impact of Structure?
 Entry Conditions are Important: They affect whether
high profits can be maintained in the long run.

 The Number of Competitors and their Behavior is

Important. A few co-operating “competitors” can lead
to monopoly-type profits

 Product Differentiation is Important. Without it all

firms must charge the same price in a competitive
market
61
 What Are the Limits to the Formal Models?

 A Limited Number of Tightly Defined Cases Are

Examined

 Cannot Be Used to Describe „Real‟ Industries - that is

not their purpose. To Use Them That Way is
Confusing

 Make No Reference to the Structure of the Industries

which Purchase Outputs or Supply Inputs.
(Customers assumed to be households, inputs
bought from perfect markets)
62