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CHAPTER TWO

THE FIRM AND ITS GOALS

Dr. Mohammed Alwosabi

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

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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 and selling). This includes the costs of (1)search and investigation, investigation (2)negotiation, and (3)enforcement of contracts and coordinating transactions.

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

• Company chooses to allocate resources so total cost is minimum 5 . i h l non-core activities.• Managers of profit maximizing firms always face the question of whether it is more profitable to produce all its products’ products components (goods and services) internally y or to order some of p parts from other firms. through what is known as outsourcing. • Firms Fi usually ll outsource t the th peripheral.

• Internet I t t has h caused d the th transaction t ti costs t to t decrease drastically. the firm will provide that item internally.• There is a tradeoff between the cost of external transactions and the cost of internal operations of the firm. making it easier for the fi firm to t outsource t some of f their th i job j b to t specialized and more efficient companies 6 . • The opposite is true. • When the (external) transaction cost of an item is higher than its internal operation.

when there is a loss) is traditionally known to be the ultimate goal of the firm. π = TR – TC • To maximize profit. the firm should produce th quantity the tit of f output t t which hi h equates t the th revenue generated with the cost incurred of th last the l t unit it produced. • Profit is the difference between revenue received and costs incurred.The Economic Goal of the Firm and Optimal g Decision Making: • Profit Maximization (or loss minimization. d d 7 MR = MC .

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

at times short-run profitability will 9 be sacrificed for long-run purposes . • This distinction in economics has nothing to do directly with months or years • Short-run Short run (SR): when the firm can vary the amount of some resources but not others • Long-run L (LR) when (LR): h the th firm fi can vary the th amount of all resources • The firm’s goal is to maximize profit in SR and LR. • However.• Along with the discussion of the firm’s goal p to distinguish g between shortit is important run and long-run.

according to the different stages of the firm life cycle.Goals Other than Profit Maximization: • Firms Firms’ managers may adopt a variety of other targets as well. how could the manager be sure that the actions taken in the present will result in the largest possible profit? 10 . E Economic i Goals G l • If maximizing profit is the firm goal. • Different goals may lead to different managerial decisions given the same amount of resources.

department heads will be accountable. various divisions or department • The manager has to define production targets. • Against these targets targets. maximum allowed increase in wage bill. input procurement targets. 11 .• Manager of the firm has to break down the goal of p profit maximization into some overall g intermediate targets to be adopted by p of the firm. required growth in R&D. and incentives will be payable only to those who accomplished their targets. sales growth rate. needed increase in advertising budget.

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

13 . y or indirectly. which means that a firm is unlikely to survive in the long run if it is not profitable. • The economists. lean toward the profit-maximization hypothesis. y. generally. all of the above goals result. in maximizing g the profit p directly of the firm.• Nevertheless.

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

Firms’ guarantee of none-genetic g product p engineered 5. 4. Labor lifetime contracts. Quality products and services • These objectives are costly. 3. Good work environment and higher safety standards 6. 15 .1. Firms’ programs for pollution abatement. However. Corporate citizenship and social responsibility 2. all these objectives would in some way or pp firms’ efforts toward their another support goals of profit maximization.

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

Medium-sized or large corporations are y thousands of shareholders who owned by have no time or resources to follow closely p the firm’s performance.1. usually. So. 17 . 2.Shareholders. hold portfolios of diversified stocks in many firms and normally own a small number of any firm’s stocks. they are concerned with performance of their entire portfolio and not individual stocks.

18 .Most stockholders are not well informed on p can do and thus are how well a corporation not capable of determining the effectiveness g of management.3.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” satisfactory return on their investment. 4.

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

In th presence of f efficient ffi i t financial fi i l markets. managers’ misconducts would be reflected fl t d on stock t k prices i in i the th market. k t 20 .Second Argument: With the profit yp maximization hypothesis • Manager’s objective is to maximize profit because: 1. companies and external auditors.Financial institutes mostly hold the largest portion of firms firms’ stocks. 2 I the 2. stocks They keep close eye on managerial performance with the help of specialized consulting companies.

This will have a negative effect on stockholders wealth.Competition between firms secures that g will soon be discovered inefficient managers and forced out of their jobs. • For the abovementioned reasons.The compensation p of many y executives is tied in a way or another to stock price performance in terms of attained profits. manager’s objectives coincide shareholders’ objectives. bj ti managers would ld do d their th i best b t to t maximize firms’ profits. 21 . 3. 4.

and amortization of such items as goodwill and patents can be recorded differently • When it comes to calculating costs.Economic Profit: • Although firms prepare their financial statements according to GAAP recording items. two basic differences do exist between accounting and economics: 22 . profit numbers are not definitive because there are different ways of recording depreciation and inventories.

1. neglect g historical costs and call other hand. Accountants base their assessments of p depreciation p and inventories on capital historical costs. 2. it sunk costs that should not affect decisions. Instead. Accountants are generally concerned with explicit costs. while economists are concerned with the opportunity costs which include both explicit and implicit costs. . 23 . on the . while economists. they y consider replacement cost.

It is an amount equal to what the owners of a business could have earned if their resources including entrepreneurial abilities biliti and d talent t l t had h d been b employed l d elsewhere. 24 . • Part of the economic cost (p (part of implicit p cost) is the normal profit.• Implicit costs include the value of resources y owners of the firm even if there owned by are no monetary payments. • Normal p profit is the average g return that could be obtained from running another business.

a higher one would cause new firms to enter enter. • Normal profit is the minimum return a firm's owner must earn in order to stay in operation. i Al lower rate would ld cause some of f the established firms to leave. 25 .• Normal profit covers the opportunity cost of running the firm.

• It accounts for all resources resources. Cost = TR – ( (Explicit p Cost + Implicit p cost) ) 26 .TEC = TR – Opp. • Economic Profit = TR .• Economic profit represents an extra profit g normal over and above all costs including 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.

earns more than its opportunity • 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 l less than th normal l profit fit (economic ( i loss) l ) 27 .• A firm earns an economic profit only if it pp y cost.

p • Not every business has an equal chance to earn economic profit.• A firm that makes zero economic profit g a normal profit. 28 . p covers all its costs including In other words. There are many constraints in the market prevent the firm from maximizing its economic profit. a firm making just a normal profit is making p g zero economic profit.

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