LECTURE 1: Organizations and The Economic Environment: Chapter One Inc. Publishing As Prentice Hall. 1

LECTURE 1 : Organizations and the Economic Environment
Chapter 1
Introduction
Copyright 2011 Pearson Education,

Chapter One 1
Inc. Publishing as Prentice Hall.
Economics and managerial
decision making
Questions that managers must
answer:
What are the economic conditions in our

particular market?
Should our firm be in this business?
How can we maintain a competitive
advantage over other firms?
What are the risks involved?

Chapter One 2
Economics of a business
Change: the four-stage model
Stage I (the good old days)

market dominance
high profit margin
cost plus pricing
changes in technology, competition,

customers force firm into Stage II ..
Chapter One 3
Stage II (crisis)
cost management
downsizing
restructuring
re-engineering to deal with changes

and move firm into Stage III ..
Chapter One 4
Stage III (reform)

revenue management
cost cutting has limited benefit
focus on top-line growth ..

Chapter One 5
Stage IV (recovery)
revenue plus
revenue grows profitably

Chapter One 6
Review of economic terms
Allocation decisions must be made
because of scarcity. Three choices:
What should be produced?
How should it be produced?
For whom should be produced?

Chapter One 7
Review of economic terms
Economic decisions of the Firm
What - begin or stop providing

goods/services (production)
How - hiring, staffing, capital budgeting
(resourcing)
For whom target the customers most
likely to purchase (marketing)
Chapter One 8
Three ways to answer three
questions
Market process
Command process
Traditional process
Mixed process

Chapter One 9
Chapter One 10
Chapter 2
The Firm and its Goals

11
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

Chapter Two 12
The Firm
Transaction costs are incurred

when entering into a contract
types of transaction costs

Investigation/search
negotiation
Enforcing/coordinating contracts

Chapter Two 13
The Firm
Transaction costs are incurred

when entering into a contract
Influenced by
uncertainty
frequency of recurrence
asset specificity

Chapter Two 14
The Firm
When transactions cost is high, a firm
may choose to provide the service or
product itself.
However, that creates its own costs
Hiring workers
Monitoring and supervising
incentives

Chapter Two 15
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

Chapter Two 16
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

Chapter Two 17
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

Chapter Two 18
Goals other than profit
Economic goals
market share, growth rate

profit margin
return on investment, Return on assets
technological advancement
customer satisfaction
shareholder value

Chapter Two 19
Goals other than profit
Non-economic objectives
good work environment
quality products and services
corporate citizenship, social
responsibility
Do not interfere with profit maximization.

Chapter Two 20
Do companies maximize profit?
Criticism: companies do not maximize
profits but instead merely aim to
satisfice, which means to achieve a
satisfactory goal, one that may not
require the firm to do its best
two forces affect satisficing:

position and power of stockholders
position and power of management
Chapter Two 21
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

Chapter Two 22
Position and power of stockholders
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
Chapter Two 23
Position and power of management
high-level managers may own very little

of the firms stock
managers tend to be more conservative
because jobs will likely be safe if
performance is steady, not spectacular

Chapter Two 24
Position and power of management
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 problem
Chapter Two 25
What would you do?
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
Chapter Two 27
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
Chapter Two 28
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
Chapter Two 29
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
Chapter Two 30
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
Chapter Two 31
of stockholders
The present price of a firms stock should
reflect the discounted value of the expected
future cash flows to shareholders (dividends)
D3 Dn
P D1
(1 k ) (1 k ) 2 (1 k )3 (1 k ) n
D2
P = present price of the stock

D = dividends received per year
k = discount rate
n = life of firm in years
Chapter Two 32
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

Chapter Two 33
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 companys stock
When stock options are substantial part

of executive compensation,
management objectives tend to be
more aligned with stockholder objective
Chapter Two 34
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
While the market value of the company will
always be positive, MVA may be positive
or negative

Chapter Two 35
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
Chapter Two 36

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LECTURE 1 : Organizations and the Economic Environment

Copyright 2011 Pearson Education,

What are the economic conditions in our

Copyright 2011 Pearson Education,

Stage I (the good old days)

changes in technology, competition,

re-engineering to deal with changes

Stage III (reform)

focus on top-line growth ..

Copyright 2011 Pearson Education,

revenue grows profitably

Copyright 2011 Pearson Education,

What should be produced?

How should it be produced?

For whom should be produced?

What - begin or stop providing

Copyright 2011 Pearson Education,

The Firm and its Goals

Copyright 2011 Pearson Education,

A firm is a collection of resources

Profit is the difference between

Copyright 2011 Pearson Education,

Transaction costs are incurred

types of transaction costs

Copyright 2011 Pearson Education,

Transaction costs are incurred

Copyright 2011 Pearson Education,

Copyright 2011 Pearson Education,

Copyright 2011 Pearson Education,

Other goals include market share,

Optimal decision is the one that

Copyright 2011 Pearson Education,

nothing to do directly with calendar time

Copyright 2011 Pearson Education,

market share, growth rate

Copyright 2011 Pearson Education,

Do not interfere with profit maximization.

Copyright 2011 Pearson Education,

two forces affect satisficing:

Position and power of stockholders

larger firms are owned by thousands of

Copyright 2011 Pearson Education,

shareholders are concerned with

stockholders not likely to take any

high-level managers may own very little

Copyright 2011 Pearson Education,

managers may be more interested in

divergence of objectives is known as

large stockholdings held by institutions

Requires the concept of the time value

The discount rate (k) is affected by risk

Two major types of risk:

Business risk involves variation in

All firms face business risk to varying

Financial risk concerns the variation in

Leverage is the proportion of a company

P = present price of the stock

If the firm is assumed to have an

Copyright 2011 Pearson Education,

When stock options are substantial part

Copyright 2011 Pearson Education,

EVA=(Return on total capital Cost of

if EVA > 0 shareholder wealth rising