Lesson - Firm

DR. RANJANA AGARWAL

10 Economic Principles for
Managers
1. Managers make decisions
2. Decisions are between alternatives
3. Alternatives have costs and benefits
4. Decision goal is to add value to the firm
5. Value is measured by profits or expected profits
6. Revenue depends on demand for the product
7. Maximum profit entails minimum cost
8. Strategy must be consistent with market
9. Growth requires rational investment decisions
10. Legal and ethical behavior leads to success
The Decision-Making Process
The Rationale of firm
What is a firm?

Why does it exist?

What are its functions

Theory of Firm
The firm:
◦ combines and organizes resources for the
purpose of producing goods and/or
services for sale.
◦ internalizes transactions, reducing
transactions costs.
According to economic theory:
◦ the primary goal of managers is to
maximize the value of the firm.
 Value of the Firm
The present value of all expected future profits
 Exercise 1

What is the value of the firm if it expects to earn

a profit of $10,000, $20,000 and $50,000 in the
next three years before it is dissolved if the
discount rate is 5 percent?
 Solving for Present Value
 
 Solution to Exercise 1
 
Constraints on theory of firm
Limited availability of inputs
Lack of skilled labour
Legal constraints

Constraint optimisation is task of manager

Alternative Objectives of firm
Sales revenue maximisation
Managerial Utilty (Corporate power &
managerial discretion)
Growth models
Satisfying behavior
Corporate social responsibility
Alternative Theories of the firm

Sales maximization (William Baumol)

◦ Adequate rate of profit to satisfy share holders; assuming this,
maximise sales, even by sacrificing some profits.
Management utility maximization ( Williamson)
◦ Principle-agent problem: managers try to maximise their benefits
like salaries, fringe benefits, stock options, staff size, lavish offices,
etc. This can be resolved by linking managers’ rewards to firm’s
performance compared to similar firms in the industry.

Satisficing behavior (not maximising) with reference sales, profits,

growth, mkt.. Share etc.
Opportunity Cost
Opportunity cost of a decision is the sacrifice of
alternatives required by that decision.
Returns from second best alternative.

1.All decisions involving choice must have opportunity

cost calculation
2. Opportunity cost may be real or monetary, explicit or
implicit.

What will be opportunity cost of the funds employed in

one’s own business?
Concept of Economic Profits
Profits occur due to risk taking ability, managerial ability,
monopoly, innovation, friction

Economic profit = Total Revenue – Total cost

Cost = Explicit costs + Implicit costs

Explicit cost = direct out of pocket expenditure (accounting

costs)
Implicit cost = costs of factors owned by firm and used in its
own production
Economic vs Accounting
profit
Accounting profits are what show up in a
company’s income statement

Economic profits are the difference between

total revenue and total opportunity cost
 Exercise 2
Emily quits her $80,000 per year job to start a
boutique jewelry store in a building she owns.
She previously rented it for $2,000 per month.
She expects her revenues to be $110,000 while
the accounting costs to be $15,000. What is the
expected business and economic profit? Is it
worthwhile for her to start this business?
 Recognizing Costs
Identify accounting (explicit) and opportunity
(implicit) costs.

Business Revenues Accounting (explicit) costs Opportunity (implicit) costs

$110,000 $15,000 $80,000

$2,000*12=$24,000
 
Solution to Exercise 2
 One more…..
A firm pays Rs 2 lakh in wages, 50000 as interest, 70000 as rent. If the owner
had worked for somebody else he would have earned 40000 a yr. If he lent his
money he would have earned 10000 a yr.
A. find his profit if he received 400000 from selling his output
B.What is his profit to the ordinary man
C. What would happen if his total revenue is 360000 instead
Function 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.
Governments sometimes step in to modify the
operation of the profit system to make it more
consistent with broad societal goals.
 Theories of Profit
Risk-bearing theories of profit:
◦ Above-normal returns are required in fields that are above-average risk.

Frictional theory of profit:

◦ Profits arise from friction or disturbances from long-run equilibrium.

Monopoly theory of profit:

◦ Firms with monopoly power can restrict output and charge higher prices and earn profits even in the long-run.

Innovation theory of profit:

◦ Profit is the reward for the introduction of a successful innovation.

Managerial efficiency theory of profit:

◦ More efficient firms may earn above-normal returns and economic profits in the short-run.
Tools of Economics
Opportunity Cost

Time Perspective

Discounting principle
Discounting principle
A rupee tomorrow is worth less than a rupee today.
One has to discount costs and revenues at future date and make it
comparable to present value
Suppose one has a choice between a gift of Rs.100/- today
or next year. he will chose Rs.100/- today.
i. the future is uncertain , uncertainty
in getting Rs. 100/-
ii. Also, today’s Rs.100/- can be invested so as to earn
interest say as 8% so that one year after Rs.100/- will become Rs
108/-.

PV = Rn /(1+i)n
Business Ethics
Identifies types of behavior that businesses and
their employees should not engage in.
Source of guidance that goes beyond enforceable
laws.
Unethical operations may not sustainable in long-
term
THANK YOU