Managerial Economics (MBA ZC416)

Session 02: Theory of the firm: neoclassical and others

Instructor
Monika Gupta
Assistant Professor
Economics and Finance Department
monika.gupta@pilani.bits-pilani.ac.in
A Quick Recap
• A Brief Introduction of the Course
• Introduction
• What is Economics?
• What is Managerial Economics and how is it useful?
• Some Basics Concepts
• Positive vs. Normative Economics
• Inductive vs. Deductive Economics
• Opportunity Costs
• The Ten Economic Principles for Managers

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Session Plan
• Theories of the firm
• Market forces
• Profit theories
• Different Concepts of Revenue: TR, AR, MR
• Profit maximization
• Case discussion: Satyam

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The firm
• What is a firm?
• A firm is an organization producing goods or services.
• Firms operate in a market
• Objective of the firm
• The ultimate goal of the firm is maximize profit or maximize the shareholder’s value
• Profits signal to resource holders where resources are most highly valued
by society
• Form of Business Organizations/firm
• Sole Proprietorship
• Partnership
• Company or Joint Stock Company

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Theory of the firm
• Transaction Cost theory
• Information Theory
• Motivation Theory
• Agency Theory
• Property rights theory
• Game Theory

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How market operates - the market forces
• An institutional arrangement under which buyers and sellers can exchange
some quantity of a good or service through their actual or potential
interactions and determine the price of a product or set of products
• Major Forces –
Consumer – Demand
Producer – Supply
Price Mechanism
• The terms supply and demand refer to the behavior of people . . . as they
interact with one another in markets.
• To understand market mechanism we need to know how supply and
demand interact in markets.
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Types of Profit
• Accounting Profits
• Total revenue minus the explicit or accounting costs of production.
• Reported on the firm’s income statement.
• Economic Profits
• Total revenue minus the explicit and implicit (opportunity) costs of
production.
Economic Profit = total revenue – (explicit + implicit costs)
• Opportunity Cost is nothing but the Implicit value of a resource in its best
alternative use or the opportunity foregone.

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Theories of Profit
• Risk-Bearing Theories of Profit
• Frictional Theory of Profit
• Monopoly Theory of Profit
• Innovation Theory of Profit
• Managerial Efficiency Theory of Profit

Profit is a signal that guides the allocation of society’s resources.

• High profits in an industry are a signal that buyers want more of what the industry
produces.
• Low (or negative) profits in an industry are a signal that buyers want less of what the
industry produces.

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Different Revenue Concepts
• Total Revenue - Total revenue in economics refers to the total receipts
from sales of a given quantity of goods.
TR = Quantity sold * Price of the good
• Average Revenue - Average revenue is the revenue generated
per unit of output sold.
AR = TR/Q
• Marginal Revenue - Revenue earned after selling each additional unit
of good. Change in revenue resulting from a one unit increase in
output
MR = ∆ TR/ ∆ Q = ∂(TR)/∂Q

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The marginal concept
• Rational people think at the margin (The Marginal Principle) i.e., the
relevant benefits and costs to consider are marginal.
• A rational decision-maker takes action if and only if the marginal
benefit of the action exceeds the marginal cost
• Take decisions by considering the effect of small changes from the
existing situation
• For example – Marginal cost, Marginal revenue, Marginal utility, etc.
• “Marginal” is very important in economics as it looks at the addition
unit only and this can help to set the optimal price. Marginal cost and
marginal benefit could provide a guide for firms to set the right price.

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Profit Maximization
• Managers may be more concerned with such goals as profit maximization,
revenue growth, or the payment of dividends to satisfy shareholders
• Profit is the difference between total revenue and total cost P(q) = R(q) -
C(q)
• Profit (p = R – C), is maximized at the point where an additional increment
to output leaves profit unchanged (i.e., p/q = 0): p/q = R/q - C/q = 0
• R/q is marginal revenue MR and C/q is marginal cost MC
• Thus we conclude that profit is maximized when MR - MC = 0, so that
MR(q) = MC(q)
• A necessary condition of profit maximization is where marginal revenue
equals marginal cost

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SATYAM: A Case Study

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SATYAM: A Case Study
• In 1987, B. Ramalinga Raju formed Satyam
• It became a Public Ltd Co. in 1992
• Listed in BSE, NSE, NYSE
• Considered as 4th largest IT company of India
• Ranked 153 in Fortune India 500 in 2011
 What went wrong?
• The company misrepresented its accounts both to its board, stock
exchanges, regulators, investors and all other stakeholders
• India’s Enron

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SATYAM: A Case Study
• It all started on 16.12.2008, when Ramalinga Raju thought, buying an
infrastructure firm
• Satyam intended to buy 100% stakes in Maytas Properties for $1.3
Billion and 51% stakes in Maytas Infra for another $300 Million
• Raju and his immediate family members own up to 35% stakes in
Maytas.
• None of the investors & fund managers were aware of the bid
• The case was initially registered by CB-CID, Andhra Pradesh on
January 9, 2009 on a complaint

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 ACTUAL OPERATING MARGIN 61 Cr (
CREATED AN ARTIFICIAL REVENUE OF
588)

Operating Profit

800
Operatin Profit ( IN 648.61 649.27
CRORES) 600
545.49
468.72
400 401.61

200

0
Sep '07 Dec '07 Mar '08 Jun '08 Sep '08

Series1 401.61 468.72 545.49 648.61 649.27

Quarter

GROWTH IN THE OPERATING PROFIT

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SATYAM: A Case Study
• Actual number of employee 40000 instead of 53000 reported earlier
• Mr. Raju has been allegedly withdrawing RS. 20 crore to pay the non-
existent employee
• Manipulated the accounts by US$1.47-Billion
• Shares fell to 6.00 rupees on 10 January 2009, compared to a high of
544 rupees in 2008.

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 Source: Google Images
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SATYAM: A Case Study
• Impact of the Economy –
• The sensex fell from its closing peak of 20,837 on January 8, 2008 to less than
10,000 by October 17, 2008.
• In New York Stock Exchange Satyam shares peaked in 2008 at US$ 29.10; by
March 2009 they were trading around US $1.80.
• Withdrawal of FII of actual $66.5 billion at the beginning of 2008 to pull out of
$ 11.1billion during the first nine and a half months of 2008 triggered a
collapse in the stock market.
• Withdrawals in FII also led to sharp depreciation in rupees.
• Damage to India's appeal for foreign investors and the IT services industry.
• India’s GDP growth fell by 0.4%.

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Annexure
• Keywords – Theory of the firm, Profit maximization, Satyam, Enron, Principal
Agent Problem
• Readings - Chapter 2 from the prescribed text book.
• Please listen pre-recorded lecture 2.1 and 2.2

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Plan for the Next Session
• Topics
• Total Revenue, Average Revenue & Marginal Revenue;
• Basics of demand Determinants of Demand
• Please reply prerecorded video 3.1 to 3.7
• Readings - Chapter 2 and 3 from the prescribed text book

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Acknowledgements
• All slides in this presentation have been prepared by the instructor
herself. Assistance is taken from the text book and following sources.
• Bhasin, M. L. (2015). Corporate accounting fraud: A case study of Satyam
Computers Limited.
• https://www.slideshare.net/2011barot/satyam-detailed-scam

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Thank you

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