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CHAPTER TWO

THE FIRM AND ITS GOALS

Dr. Mohammed Alwosabi

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

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.

Transaction costs are influenced by 1 Uncertainty which refers to the inability to 1.Uncertainty, know the future perfectly, particularly in the long term term. 2.Frequency of recurrence, which refers to how many times these transaction are repeated. 3 Asset specificity 3.Asset specificity, 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. This might lead to an opportunistic behavior, 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 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, i h l non-core activities. Company chooses to allocate resources so total cost is minimum

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 an item is higher than its internal operation, the firm will provide that item internally. The opposite is true. Internet I t t has h caused d the th transaction t ti costs t to t decrease drastically, 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
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The Economic Goal of the Firm and Optimal g Decision Making: Profit Maximization (or loss minimization, when there is a loss) is traditionally known to be the ultimate goal of the firm. Profit is the difference between revenue received and costs incurred. = 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. d d 7 MR = MC

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, l the th optimal ti l decision is the one that brings the firm closest l t to t its it goals. l

Along with the discussion of the firms goal p to distinguish g between shortit is important run and long-run. 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 firms goal is to maximize profit in SR and LR, However, at times short-run profitability will 9 be sacrificed for long-run purposes

Goals Other than Profit Maximization: Firms Firms managers may adopt a variety of other targets as well, according to the different stages of the firm life cycle. Different goals may lead to different managerial decisions given the same amount of resources. E Economic i Goals G l 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 goal of p profit maximization into some overall g intermediate targets to be adopted by p of the firm. various divisions or department The manager has to define production targets, input procurement targets, sales growth rate, required growth in R&D, maximum allowed increase in wage bill, needed increase in advertising budget. Against these targets targets, department heads will be accountable, and incentives will be payable only to those who accomplished their targets. 11

Some of economic goals that, at the end, g profit p might g include: results in maximizing Firms Goal
Ma im m market share Maximum

Managerial Decision

Reduce Red ce the selling price, price advertising, 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)

Nevertheless, all of the above goals result, y or indirectly, y, in maximizing g the profit p directly of the firm. The economists, generally, lean toward the profit-maximization hypothesis, which means 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 todays s world, o d, firms sa are e co concern ce with t workers and customers satisfaction, and y responsible p more than in how to be socially the past. Therefore, Therefore Firms may announce the adoption of objectives that apparently not economical 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 g product p engineered 5. Good work environment and higher safety standards 6. Quality products and services These objectives are costly. However, all these objectives would in some way or pp firms efforts toward their another support goals of profit maximization.
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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 companys the stock t k and d may be b more interested in maximizing their own income and d perks, k not t to t maximize i i profit fit because b they know that:
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1.Medium-sized or large corporations are y thousands of shareholders who owned by have no time or resources to follow closely p the firms performance. 2.Shareholders, usually, hold portfolios of diversified stocks in many firms and normally own a small number of any firms stocks. So, they are concerned with performance of their entire portfolio and not individual stocks.

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3.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. 4.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.

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

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Second Argument: With the profit yp maximization hypothesis Managers objective is to maximize profit because: 1.Financial institutes mostly hold the largest portion of firms firms stocks. stocks They keep close eye on managerial performance with the help of specialized consulting companies, companies and external auditors. 2 I the 2.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
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This will have a negative effect on stockholders wealth. 3.Competition between firms secures that g will soon be discovered inefficient managers and forced out of their jobs. 4.The compensation p of many y executives is tied in a way or another to stock price performance in terms of attained profits. For the abovementioned reasons, managers objectives coincide shareholders objectives; bj ti managers would ld do d their th i best b t to t maximize firms profits.
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Economic Profit: Although firms prepare their financial statements according to GAAP recording items, profit numbers are not definitive because there are different ways of recording depreciation and inventories; and amortization of such items as goodwill and patents can be recorded differently When it comes to calculating costs, two basic differences do exist between accounting and economics:
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1. Accountants base their assessments of p depreciation p and inventories on capital historical costs, while economists, on the , neglect g historical costs and call other hand, it sunk costs that should not affect decisions. Instead, , they y consider replacement cost. 2. Accountants are generally concerned with explicit costs, while economists are concerned with the opportunity costs which include both explicit and implicit costs.
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Implicit costs include the value of resources y owners of the firm even if there owned by are no monetary payments. Part of the economic cost (p (part of implicit p cost) is the normal profit. Normal p profit is the average g return that could 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 abilities biliti and d talent t l t had h d been b employed l d 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 operation. i Al lower rate would ld cause some of f the established firms to leave; a higher one would cause new firms to enter enter.

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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. It accounts for all resources resources. Economic Profit = TR - TEC = TR Opp. Cost = TR ( (Explicit p Cost + Implicit p cost) )
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A firm earns an economic profit only if it pp y cost. 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 )

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

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