Introduction & Goals of The Firm

Chapter 1
Introduction &
Goals of the Firm
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whole or in part.
• What is Managerial Economics?
• The Decision-Making Model and the
Responsibilities of Management
• The Role of Profits?
• The Principal-Agent Problem
• Shareholder Wealth Maximization and
the Real Option Value
• Objectives in the Public Sector and
Not-for-Profit Organizations
whole or in part. 2
Economics is the study of how choices are made
regarding the use of scarce resources in the
production, consumption and distribution of goods
and services.
Microecomics is the study of individual consumers
and producers in specific markets.
Macroeconomics is the study of the economy as an
aggregate.
Management is the discipline of organizing and
allocating a firm's scarce resources to achieve its
desired objectives.
whole or in part.
What is Managerial Economics?
The application of microeconomics to
problems faced by decision makers in the
private, public, and not-for-profit sectors.
• Even questions of how best to abate nitrous
oxide by coal-fired power plants involves
economic issues of finding efficient, least cost
solutions.
Managerial economics deals with
microeconomic reasoning on real world
problems such as pricing decisions,
selecting the best strategy in different
competitive environments, and making
efficient choices.
whole or in part. 4
Responsibilities of Management
• Managers solve problems before they become a
crisis.
• Managers select strategies to try to assure the
success of the firm.
• Managers create an organizational culture attune
to the mission of the organization.
• Senior management establish a vision for the firm.
• Managers motivate and promote teamwork.
• Managers promote the profitability of the firm.
• And many managers see it in their long-run
interest to promote sustainability of their
enterprise in their environment.
whole or in part. 5
To Expand Capacity or Not?
An example of a simplified decision problem
• Should Honda or Toyota expand its capacity in North
America? In part, it must consider current and future
demand, and what other firms are likely to do.
• Capacity for making cars is a long-term project, so these
firms should think in terms of the present value (PV) of
future profits.
• Objective Function:
• Max PV of profits (S1NEW, S2USED)
• where S1NEW is expand capacity with new facilities
and S2USED to purchase used facilities from GM.
• Decision Rule:
• Choose S1NEW if PV (Profits S1NEW) > PV (Profits
S2USED)
• Choose S2USED if PV (Profits of S1NEW) < PV (Profits
of S2USED)
whole or in part. 6
What Went Right? ● What Went Wrong?
Saturn Corporation
• Different kind of car company in 1991, but
permanently closed in 2009
• It used no-haggle pricing and designed cars to
compete with Asian imports.
• Sales were above expectations at first because of
tiny margin of only $400 per car to GM, so that
GM earned only 3% on capital.
• Saturn customers wanted bigger Saturn cars
rather than trade up to Buick, as GM hoped.
• Sales later slumped in the late 1990s through
2009.
whole or in part. 7
Moral Hazard in Teams
• Teamwork skills and the ability to motivate teams is the

most critical trait of effective managers.
• Attaining full commitment from a team becomes
difficult when individuals in the team shirk; this
constitutes the moral hazard problem in team-making.
• If penalties and sanctions are few and far between,
team effort reduces due to the free-riding problem.
• Managers are motivated to monitor teamwork because
of economic profits.
• Economic Profit is the difference between total
revenues and total economic cost. Economic cost
includes the “normal” rate of return on capital
contributions by the firm’s partners.
• Economic costs should always be thought of as
opportunity costs.
whole or in part. 8
Figure 1.2 Payoffs from Team Production with
and without a Supervisor
whole or in part. 9
Moral Hazard in Teams
Figure 1.2
• Without supervision, {Shirk, Shirk} appears to be
the dominant strategy
• Hiring a supervisor reduces gross profit to $40;
supervisors imposes a penalty of $15 to the
teammate who shirks.
• With supervision, {Pull Hard, Pull Hard}becomes
the dominant strategy.
whole or in part. 10
The Role of Profits?
• We’d expect high profit areas to attract
investment.
• We’d expect low profit areas to lose
investment.
• Shouldn’t then all industries earn the
same profit eventually?
Theories of Why Profit Varies Across Industries
1. RISK-BEARING Theory of Profit
2. TEMPORARY DISQUILIBRIUM Theory of Profit
3. MONOPOLY Theory of Profit
4. INNOVATION Theory of Profit
5. MANAGERIAL EFFICIENCY Theory of Profit
Shareholder Wealth Maximization [1.1]
π t = REVENUE - COST = TRt -TCt = PtQt - VtQt - Ft
• Value of the Firm = the present value of discounted future cash

flows, both from current operations but also those that might be.
V0·(shares outstanding) = π 1/(1+ke)1 +π 2/(1+ke)2 + … + Real Option

Value
or ∞
V0·(shares outstanding) = Σ (π t )/(1+ke)t + Real Option Value
t=1
• The real option value of the firm comes from the flexibility that the
firm has to find added cost savings or new revenue possibilities that
have not yet come to pass, but could in the future because of
following their current business plans.
• V0 is the current value of a share of stock.
• Whatever lowers perceived risk of the firm (ke) will raise firm value.
• Whatever raises the profits of the firm, raises firm value.
Separation of Ownership and Control: The
Principal-Agent Problem
• Modern corporations allow firm managers to
have no participation (or only limited
ownership participation) in the profitability of
the firm.
• Shareholders are principals, managers are
agents.
• Two common problems: (1) often hard to
observe managerial effort and (2) random
disturbances in team performance (luck versus
effort?)
• The Principal-Agent Problem
• Shareholders (principals) want profit
• Managers (agents) want leisure & security
• Divergent objectives between these
groups are called agency problems.
• Diversification by Exxon executives was
designed to help smooth their bonuses, but led
to worse stock performance.
• The LBO by O.M. Scott & Sons (a lawn fertilizer
company) from ITT (a conglomerate) improved
Scott’s performance.
Agency Costs
1. Extending grants of stock or deferred stock options
• It helps to make workers act more like owners of
firm to try to raise the price of the stock, but is a
cost
2. Internal audits and accounting oversight boards to
monitor the firm
3. Bonding expenditures and fraud liability insurance
4. Costs of complex internal approval processes to
avoid adverse managerial discretion
Figure 1.3 CEO Pay Trends, 1999-2011
• Across 350 companies, CEO compensation has

mirrored corporate profitability.
What Went Right? ● What Went
Wrong?
Eli Lilly, a Pharmaceutical company
• It takes12.3 years on average to get a new drug approved.
• Patents on Lilly’s Prozac created monopoly power and
profits for a widely used medication for depression.
• As the patent began to expire, Lilly requested a patent
“extension” because of some alterations in Prozac’s
formula.
• But when the patent extension was overturned, generic
drug manufactures took 70% of the share of the market for
anti-depressants.
• Lilly missed the chance of finding a replacement in time for
its blockbuster Prozac.
• This is an example of having and losing monopoly power.
Caveats to
Shareholder Wealth Maximization
1. COMPLETE MARKETS - liquid markets for

firm's inputs and by-products (including polluting
by-products).
2. NO ASYMMETRIC INFORMATION -
buyers and sellers all know the same things.
3. KNOWN RECONTRACTING COSTS -
future input costs are part of the present value of
expected cash flows.
Residual Claimants
» Shareholders have a residual claim on the firm’s
net cash flows.
» All other stakeholders have contractual expected
returns.
» When a CEO is hired by a shareholder owners,
they create fiduciary duty to allocate resources in
a way to maximize the NPV of residual claims.
Goals in the Public Sector and the
Not-For-Profit (NFP) Enterprise
Instead of profit, NFP organizations may have as their
goals:
1. Maximizing the quantity and quality of output, subject
to a breakeven constraint.
2. Maximizing the outcomes preferred by the NFP
contributors.
3. Maximizing the longevity of the NFP administrators.
Knowing their goals, helps to understand their behavior.
• Using cost-benefit analysis, we can evaluate their
efficiency in terms of maximizing benefits for a given
cost; or minimizing costs for a given benefit; or
maximizing net benefits (Benefits - Costs).

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Chapter 1

• Teamwork skills and the ability to motivate teams is the

• Value of the Firm = the present value of discounted future cash

V0·(shares outstanding) = π 1/(1+ke)1 +π 2/(1+ke)2 + … + Real Option

• Across 350 companies, CEO compensation has

1. COMPLETE MARKETS - liquid markets for

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