Managerial Economics Lecture Notes

Topic 2- The Firm: Definition and Objectives of the firm, Theory of Firm,
Limitations of the Theory of the Firm, Five Forces Framework, Business
profit versus Economic profit, Profit Theories and Roles of Profit
What is a firm?
 Firm is useful for producing and distributing goods and services.

 The firm can be viewed as a series of contractual relationships that connect

suppliers, investors, workers, and management in a joint effort to serve the
customers.

 The firm also relates to various functional departments such as marketing

 department, production department, finance department, human resource
department and etc.

What are the objectives of the firm?

Profit maximization

Profits are the primary measure of the success of any business. The firms may not always
try to maximize profits. This may be due to a number of reasons:

a. Achieving leadership: Firms often like to become leaders in the respective line of
business. They would rather try to attain industrial leadership at the cost of profits.
Leadership may connote either maximum sales or manufacture of maximum
product lines.
b. For avoiding potential competition: ‘Firms may restrict the profit in order to
discourage other firms from entering the field and competing with them. If the firm
is maximizing profit, it would attract new firms to enter the field of production. In
order to avoid such potential competition, the firms may adopt a policy of profit
restriction.
c. For preventing Governments’ intervention: Higher profits in business are
considered as a sign of monopoly power. Maximum profit may create an
impression that the firm is exploiting the consumers and this may result in the
public demand for nationalizing the firm or firms. The government may also probe
into the financial structure of the firm; make regulation of prices, profits and
dividends. Just to solve this problem firms may adopt a policy of restricted profits.
d. For maintaining customer’s good will: In modern business, customer’s goodwill is
valued more than anything else. To maintain this, the firms may adopt the policy of
restricted profit and low price for the commodity. Even in times of increased taxes
and excise duties, firms may not increase the price, but reduce the profit margin and
win goodwill of customers.
e. For restraining wage demands: Higher profit is an indication of ability to pay higher
wages by the firms. Organized Trade Unions advance their arguments on the basis
of higher profits earned by the firm for increasing the wages of labourers, bonus
benefit, etc.
f. For achieving financial soundness and liquidity: Some firms may give greater
importance to financial soundness and liquidity, rather than profit-maximization.
Considerations of maximum profit may result in huge investment in fixed assets
and consequently the liquidity of the firm will be reduced.
g. For avoiding risks: Profit maximization may involve risks. Business Managers will
avoid taking those risks which may result even in losing their jobs or losing the
image of the firm. Though firms may not aim at profit maximization, they may try
their best to achieve sufficient profit to cover the risk of economic activity. The
businesses try to survive by avoiding losses.
 What is the Theory of the Firm?
The Theory of the Firm is the basic business model.
The Theory of the Firm is the microeconomic concept founded in neoclassical
economics that states that a firm exists and make decisions to maximize profits. The
theory holds that the overall nature of companies is to maximize profits meaning to
create as much of a gap between revenue and costs. The firm's goal is to determine
pricing and demand within the market and allocate resources to maximize net profits.
What is expected value maximization?
The firm primary goal is to have profit maximization on the short-run however,
this has broadened to consider the time value of money.
Expected value maximization is the optimization of profits in the light of
uncertainty and the time value of money.
What are the limitations of the Theory of the Firm?
 Managers may choose to optimize or satisfice.
 Optimize means seek the best solutions.
 Satisfice means seek satisfactory rather than optimal results.
 Managers are encourage through generous compensation package and stock options
to discourage own personal utility or welfare maximization.
 The need for corporate social responsibility aside from profit and value
maximization.
Explain constraints (self-imposed and social constraints) and the Theory of the Firm
Theory of the Firm
Profit maximization
Expected value maximization

Constraints
Self-imposed
Limited availability of inputs-skilled labor, raw materials, machinery, funds/capital
Social constraints
Legal restrictions

What is the Five Forces Framework?

Entry. Entry can come from a number of directions, including the formation of new companies,
globalization strategies by foreign companies and introduction of new product lines by xisting
firms.

Power of Input Suppliers. Industry profits tend to be lower when suppliers have the power to
negotiate favorable terms for their inputs. Supplier power tends to be low when inputs are
relatively standardized and relationship-specific investments are minimal,input markets are not
highly concentrated or alternative inputs are available with similar marginal productivities per
Dollar spent.

Power of Buyers. Industry profits tend to be lower when customers or buyers have the power to
negotiate favorable terms for the product or services produced in the industry.

Industry Rivalry. The sustainability of industry profits also depends on the nature and intensity
of rivalry among firms competing in the industry. Rivalry tends to be less intense in concentrated
industries that is those with relatively few firms.

Substitutes ad Complements. The level and sustainability of industry profits also depend on the
price and value of interellated products and services.

Differentiate business profit versus economic profit

 Business profit(accounting profit) is the residual of sales revenue minus the explicit
accounting costs of doing business.
Economic profit is the business profit minus the implicit costs of capital and any other
owner-provided inputs such as owner provided inputs(opportunity cost).
What is variability of business profits?
Business profits can be measured using the company’s financial statements. Limitation
on the use of financial statements includes differences in accounting policies and
procedures, inflation, and window dressing.
Difference in profits measured using financial ratios such as Profit Margin and Return on
equity (ROE).
Profit margin is calculated by dividing accounting net income by sales. The higher the
rate the more favorable.
Return on equity is calculated by dividing accounting net income by the book value of
the total assets minus total liabilities (equity).The higher the rate the more favorable.
Benchmarking should be made to compare business profits within the same industry.
Business profits vary depending on the nature of business.
Define and explain the following profit theory why profit varies among firms:
a. Frictional Profit Theory
A profit theory wherein an abnormal profit is observed following unanticipated
changes in demand or cost conditions. Unanticipated shocked produce positive or
negative economic profits for some firms. For example, at the time of sharp size in
petroleum prices in the 1990 as a result of US-Iraq war many petroleum-refining firms
enjoyed handsome economic profits. Similarly, as a result of slowdown in world trade in
the years 1999-2001 many Indian firms doing export business suffered losses due to the
decrease in the demand for their products in the USA and other countries.
b. Monopoly Profit Theory
A profit theory wherein an above normal profit caused by barriers to entry that
limit competition such as high capital requirements. Monopolies exists, especially in the
production and supply of water, electricity, energy, etc. Monopoly profits are subject to
heavy taxes or otherwise regulated.
c. Innovation Profit Theory
A profit theory wherein an above normal profit results from successful invention
or modernization. Bill Gates introduced Windows operating system and MS-office types
of computer software and has become billionaire by making huge profit on his
innovations. Another example also is Apple Corporation that earned above normal rates
of return as an early innovator with its iPod line of portable digital music and
 video players. Another example also is Facebook.
d. Compensatory Profit Theory
A profit theory wherein an above normal rates of return results from efficiency.
This includes extraordinary success in meeting customer needs and maintaining
efficient operation. On the other hand inefficient firms earn below normal rate of return.
For example, the Ford supply chain management which integrate suppliers into their
system and making delivery more efficient, lower inventory levels, shorter cycle time,
better processes and improve service level on the customer end. Another example is
Toyota’s Total Quality Management (TQM) which is a quality system based on lean
management. It is a proven effective management philosophy which focuses on attaining
the best in every aspect of the business. The company established The Toyota Way, a set
of business principles, in 2001. It is based on kaizen — continuous improvement — and
strives to eliminate waste and overproduction, as well as to create a bureaucratic system
where any employee can suggest a change where they see fit.

What is the role of profits in the economy?

Profits serve as a sign in making managerial decisions:
a. Above normal profit signals that the firm or industry output should be
increased, expansion of current firms or entry by new competitors.
b. Just above normal profits signals the need for expansion and entry.
c. Below normal profit signal the end for contraction and exit.