EC2204- Economics of Enterprise1: Goals of the Firm

EC2204- Economics of Enterprise1: Goals of the Firm

Learning OutcomesLearning OutcomesUpon completing this section, you should be able to:

• Describe the four dimensions to the business environment (PEST).

• Illustrate and describe the decision-making process.• Describe the objectives of the firm.• Explain the shareholder wealth maximization model of

the firm.• Differentiate between the various theories of profit.• Describe the goals in the not-for-profit sectors of the

economy.• Identify the criteria used in estimating expenditures in

the public sector.• Calculate profit maximization and cost minimization

levels of output for the firm.• Distinguish between economic and accounting cost.

What Is Business Economics?

• It deals with the application of microeconomic reasoning to real-world decision-making problems faced by private, public, and not-for-profit institutions.

• It extracts from microeconomic theory the concepts and techniques that enable a decision maker to select strategic direction, to allocate efficiently the resources of the organization, and to respond effectively to tactical issues.

Economics of Enterprise aims to:• To identify the alternative means of achieving given

objective(s), and

• To select the alternative that accomplishes the objective(s) in the most resource efficient manner, talking into account the constraints and the likely actions and reactions of interdependent rival decision makers.

• There are generally 4 dimensions to the business environment:

1. Political/legal, (P)

2. Economic, (E)

3. Social/cultural and (S)

4. Technological (T)

The Business Environment (PEST Analysis)The Business Environment (PEST Analysis)

• Firms will be directly affected by the actions of government and other political events - These might be major events affecting the whole of the business community, such as the collapse of communism, global banking/financial crisis, the Gulf War or a change of government.

• Alternatively, they may be actions affecting just one part of the economy - for example, an anti-smoking campaign by the government will affect the tobacco industry.

• Similarly, businesses will be affected by the legal framework in which they operate - Examples include industrial relations legislation, product safety standards, regulations governing pricing in the privatised industries and laws preventing collusion (Anti-thrust) between firms to keep prices up.

1. Political/legal factors (P)

A firm typically operates a two levels:• The microeconomic environment – which includes the

economic factors that are specific to a particular firm operating in its own particular market. Thus one firm may be operating in a highly competitive market, whereas another may not; one firm may be faced by rapidly changing consumer tastes (e.g. a designer clothing manufacturer), while another may be faced with a virtually constant consumer demand (e.g. a potato merchant); one firm may face rapidly rising costs, whereas another may find that costs are constant or falling.

• The macroeconomic environment. This is the national and international economic situation in which business as a whole operates. Business in general will fare much better if the economy is growing than if it is in recession. Taxation- corporate tax rate influence FDI, interest rates influence investment and exchange rates have a major impact on firms competiveness especially exporters [€1 = $1.38 Sept 2011]

2. Economic factors (E)

• Social attitudes and values include attitudes towards working conditions and the length of the working day, equal opportunities for different groups of people (whether by ethnicity, gender, physical attributes, etc.), the nature and purity of products, the use and abuse of animals, and images portrayed in advertising.

• The social/cultural environment also includes social trends, such as an increase in the average age of the population, or changes in attitudes towards seeking paid employment while bringing up small children.

• In recent times, various ethical issues, especially concerning the protection of the environment, have had a big impact on the actions of business and the image that many firms seek to present.

3. Social/cultural factors (S)

• Over the last decade the pace of technological change has quickened leading to a huge impact not only on how firms produce products, but also on how their business is organised.

• The use of robots (FIAT factory in Turin) and other forms of computer-controlled production has changed the nature of work for many workers.

• It has also created a wide range of new opportunities for businesses, many of which are yet to be realised.

• The information-technology revolution is also enabling much more rapid communication (e-mail) and making it possible for many workers to do their job from home or while travelling.

4. Technological factors (T)

• The traditional (neoclassical) theory of economics defined the firm as a collection of resources that is transformed into products demanded by consumers.

• The costs at which the firm produces are governed by the available technology, and the amount it produces and the prices at which it sells are influenced by the structure of the markets in which it operates.

• The difference between the revenue it receives and the costs it incurs is profit - it is the aim of the firm to maximize its profit.

The Firm

The Decision-Making Model•The ability to make good decisions is the key to successful managerial performance.

•In the private sector decisions have to be made on pricing, product choice, cost control, advertising, capital investments, dividend policy etc.

•In the not-for-profit sectors decisions must be made on budget allocation - The Head of College has to make decisions on academic programs, timetabling, computer facilities, number of lectures required etc.

•All decision making shares several common elements.

•The decision maker must establish or identify the objectives of the organization.

•The failure to identify organizational objectives correctly can result in the complete rejection of an otherwise well-conceived and well-implemented plan.

The Decision-Making Model

To Increase Profit/ market share

1. Advertising Campaign

2. Reduce price

Does the firm have the skills, resources for an Ad Campaign?

Will society accept an Ad Campaign? maybe we are a tobacco or drinks firm

EstablishObjectives

e.g. profit, sales, etc

Review Possible

Strategies

Evaluate Cost/Benefits

of each strategy

Consider Societal

Constraints

Consider Organisational

Constraints

Implement and Monitor the

Strategy

Select the ‘best strategy’

To maximise key objective

Are objectives achieved?

If YesRevise

objectives upwards

If Noreview

implementation and/or

alternatives

The Decision-Making ModelIn 2008, INO took industrial action against the HSE

EstablishObjectives

e.g. profit, sales, etc

Review Possible

Strategies

Evaluate Cost/Benefits

of each strategy

Consider Societal

Constraints

Consider Organisational

Constraints

Implement and Monitor the

Strategy

Select the ‘best strategy’

To maximise key objective

Are objectives achieved?

If YesRevise

objectives upwards

If Noreview

implementation and/or

alternatives

INO objectives

1. Pay increase

2. Reduce their working week to 35 hours

Enter talks with HSE

All out strike

Work to rule

Picketing

No Action

They decided to work to rule, no answering phones, putting in light bulbs etc

Picketing would also take place

Objectives of the FirmObjectives of the Firm

Assuming that the objective of the firm is to maximize profits, marginal (incremental) decision rules provide guidelines for making resource-allocation decisions - for example, if marginal cost is defined as the change in total cost resulting from a decision, and if marginal revenue is defined as the change in total revenue resulting from a decision, then any business decision is profitable if one of these results occurs:

1. It increases marginal revenue (MR) more than marginal costs (MC), (MR > MC)

2. It decreases some MC’s more than it increases others (assuming revenues remain constant).

3. It increases some MR’s more than it decreases others (assuming costs remain constant).

4. It reduces MC’s more than MR, (MC < MR)

The Shareholder

Wealth-Maximization Model The Shareholder

Wealth-Maximization Model • Shareholder wealth is a measure of the value of a firm.• Shareholder wealth is equal to the value of a firm's

common stock, which, in turn, is equal to the present value of all future cash returns expected to he generated by the firm for the benefit of its owners.

0

V

i. V 0 * Shares Outstanding =

)1(...

)1()1()1( 33

22

11

eeee kkkk

=

1 )1(tt

e

t

k

(1.1)

where V is the current (present) value of a share of stock,

π , represents the profits expected in each of the future periods, and

ke equals the investors' required rate of return.

i.e. Share Price * No. of Shares issues = Sum of Future Profits/ investors required rate of return

The Shareholder

Wealth-Maximization Model The Shareholder

Wealth-Maximization Model Additional insight regarding the achievement of the shareholder wealth-maximization goal can be gained by decomposing the profit concept, Π, into its important elements. Profit (π) is equal to total revenue (TR) minus total costs (TQ),

π = TR – TC (1.2)

Similarly total revenue equals price per unit (P) times the number of units of output sold (Q) or

TR = P * Q (1.3)

Total cost equals variable cost (VC) times the number of units of output sold (Q) plus fixed costs (FC) or

TC = VC * Q + FC (1.4)

By combining equations 1.2, 1.3 and 1.4 with equation 1.1, we get

V 0 * Shares Outstanding =

1t k

FCQVCQP

1

** (1.5)

V 0 * Shares Outstanding =

1t k

TCTR

1 (1.6)

The Role of ProfitsThe Role of Profits

• Economic profit is the difference between total revenue and total economic cost.

• Total revenue is measured as the sales receipts of a firm, that is, price times quantity sold.

• The economic cost of any activity may be thought of as the highest valued alternative opportunity that is forgone. -To attract economic resources to some activity, the firm must pay a price for these factors (labour, capital, and natural resources) that is sufficient to convince the owners of these resources to sacrifice other alternatives and commit the resources to this use.

• Thus, economic costs may be thought of as opportunity costs, or the costs of attracting a resource from its next best alternative use. -The term economic cost refers to all costs, both explicit and implicit, including a normal return (profit) for owners of the financial resources.

Theories of ProfitsTheories of Profits

• The existence of profits determines the type and quantity of goods and services that are produced and sold, as well as the demand for various factors of production—labour, capital, and natural resources.

• Because of the important role played by profits in our system, we will review the following theories of profit:

1. Risk-Bearing Theory of Profit

2. Dynamic Equilibrium (Friction) Theory of Profit

3. Monopoly Theory of Profit:

4. Innovation Theory of Profit

5. Managerial Efficiency Theory of Profit 6. 710 Part

Risk-Bearing Theory of Profit

• Risk-Bearing Theory of Profit is the economic profits above a normal rate of return are necessary to compensate the owners of the firm for the risk they assume when making their investments.

• Because a firm's share holders are not entitled to a fixed rate of return on their investment—that is, they are residual claimants to the firm's resources—they need to be compensated for this risk in the form of a higher rate of return.

• The risk-bearing theory of profits is explained in the context of normal profits, where normal is defined in terms of the relative risk of alternative investments. Normal profits for a high-risk firm, such as a casino operator, should be higher than normal profits for firms of lesser risk, such as water utilities.

Dynamic Equilibrium (Friction) Theory of Profit

• All firms should tend to earn a long-run equilibrium normal rate of profit (adjusted for risk).

• At any point in time an individual firm or the firms in a specific industry might earn a rate return above or below this long-run normal return level.

• This can occur because temporary shocks in various sectors of the economy - For example, firms that produced oil and natural gas experienced a dramatic increase in profits in response to supply shortages following the invasion of Kuwait by Iraq in 1990 a during the general strike in Venezuela in 2002, and also in 2008 (Price of barrel of crude oil in June 2008 = $138). Rates of return rose substantial However, those high returns declined shortly after the war and strike ended, when market conditions led to excess supplies.

• Similarly, if a new, inexpensive, and readily available energy source were to be discovered, oil prices would decline substantially - Over time, some producers would leave this increasingly unprofitable market until a normal rate of profit was restored for the remaining firms. The inability of our economic system to adjust instantaneously to changes in market conditions may result in short-term profits above below normal levels.

Monopoly Theory of Profit

• In some industries, one firm is effectively able to dominate the market (Guinness in the stout market, Intel in microprocessor industry) and potentially earn above-normal rates of return for a long period time.

• This ability to dominate the market may arise from economies of scale (a situation in which one large firm can produce additional units of output at a lower cost than can smaller firms), control of essential natural resources (Bord na Mona), control of critical patents (Pfizer with Viagra) or governmental restrictions that prohibit competition.

• The conditions under which monopolist can earn above-normal profits are discussed in depth later.

Innovation Theory of Profit

• The innovation theory of profit suggests that above-normal profits are the reward for successful innovations.

• Firms that develop unique high-quality products (such as Microsoft in the computer software industry] firms that successfully identify unique market opportunities (such as Federal Express are rewarded with the potential for above-normal profits.

• Indeed, the patent system is designed to ensure that these above-normal return opportunities furnish strong incentives for continued innovation.

Managerial Efficiency Theory of

Profit • Closely related to the innovation theory the managerial

efficiency theory of profit.

• This theory maintains that above-normal profits can arise because of the exceptional managerial skills of well-managed firm.

• The ability to earn above-normal profits by exercising high-quality managerial skills is a continuing incentive for greater efficiency in any economic system.

Not-For-Profit Sectors

• There are 3 characteristics of NFP organizations that distinguish them from for-profit enterprises and influence decision making in the enterprise:

1. First, no one possesses a right to receive profit or surpluses in an NFP enterprise. The absence of a profit motive can have a serious impact on the incentive to be efficient.

2. NFP enterprises are exempt from taxes on corporate income.

3. Many NFP enterprises benefit from the fact that donations to them are tax deductible. These tax benefits give NFP enterprises an advantage when competing with for-profit enterprises.

Not-for-profit organizations include performing arts groups, museums, libraries, hospitals, churches, volunteer organizations, cooperatives, credit unions, labour unions, professional societies, foundations-Westgate,

Not-For-Profit Objectives

For NFP organizations, such as GOAL, Trocaire, etc. that rely heavily on external contributions, the over-riding objective is to satisfy current and prospective contributors. It is common to find NFP organization that seeks to satisfy its contributors by:

(1) Efficiently managing its resources,

(2) Increasing its capacity to supply high-quality goods or services and

(3) Providing a rewarding work environment for its administrators.

Accounting Versus Economic Costs

• Accountants have been primarily concerned with measuring costs for financial reporting purposes. As a result, they define and measure cost by the historical outlay of 'funds that takes place in the exchange or transformation of a resource.

• Economists include some additional costs that are typically not reflected in the cost figures appearing in the financial reports of the firm.

• Both the accounting cost and the economic cost of a product will include such explicit costs as labor, raw materials, supplies, rent, interest, and utilities.

Accounting Versus Economic Costs

• Economists also include several implicit costs.

• The implicit costs consist of the opportunity costs of time and capital that the owner-manager has invested in producing the given quantity of output.

• The opportunity cost of the owner's time is measured by the most attractive salary or other form of compensation that the owner could have received by operating or managing a similar kind of firm for another investor.

• The opportunity cost of the capital employed in producing the given quantity of output is measured by the profit or return that could have been received if the owner had chosen to employ capital in the best alternative investment of comparable risk.

Profit Maximisation

Suppose the profit, π, of the ESB can be represented as a function of the output level Q using the expression

π = -40 + 140Q – 10Q2

we wish to determine the profit maximising level of output for the ESB

QQ

20140

= 0, Q = 7

How do we know if a maximum or a minimum?

202

2

Q

, because 02

2

Q

, we know that a maximum-profit has been obtained

Profit is maximised at Q = 7

Note: if 2

2

Q

> 0, if the 2nd derivative is positive, a minimum point is obtained.

Calculate the profit at the profit maximising level of output? π = -40 + 140(7) – 10(7)2

π = 450 at Q = 7

Cost MinimisationSuppose the variable costs, VC, of the ESB can be represented as a function of the output level Q using the expression

VC = 200Q – 9Q2 + 0.25Q3 FC = 150

TC = 200Q – 9Q2 + 0.25Q3 + 150

we wish to determine the cost minimising level of output for the ESB

Q

TC

= 200 – 18Q + 0.75Q2 = Marginal Cost Function

Q

MC

= -18 + 1.5Q

Q = 12

2nd derivative 2

2

Q

MC

= 1.5

because 2

2

Q

MC

> 0, we know its a minimum cost at Q =12.

Calculate the total cost at the cost minimising level of output?

TC = 200(12) – 9(12)2 + 0.25(12)3 + 150

TC =1,686

Calculating Present and Future Calculating Present and Future ValuesValues

• The technique of discounting is used to determine the current value of an asset or business.

PV = FV / (1 + r)n

where PV = Present value, FV = Future value, r = rate of interest, n = number of years

What is the Present Value of an investment that is expected to £500,000 in 5 years if the constant

rate of interest over the period is 6%?

• The technique of compounding is used to determine the Future value of an asset or business.

FV = PV * (1 + r)n

where PV = Present value, FV = Future value, r = rate of interest, n = number of years

What is the Future Value of a business in 5 years if £500,000 is invested and the constant rate of

interest over the period is 6%?

It is important to note that this formula can only be used if there is a constant rate of interest over the life of the investment.

Discounting - bringing an amount backwards in time

•  PV = FV / (1+r)n  What is the present value of one million pounds in benefits from a current project that will occur in 10 years if the discount rate of interest is expected to be 4%?

•  PV = £1,000,000 / (1.04)10

• PV = £675,564.17•  If average interest rates increase to 6%, how will this

affect the outcome?•  PV = £1,000,000 / (1.06)10

• PV = £558,394.78• (So if Interest rates are higher the PV of a Project or investment is lower)

• Implication for Economic Policy – More investment likely if interest rates are lower.

Recall Our Learning OutcomesRecall Our Learning Outcomes

You should now be able to:

• Describe the four dimensions to the business environment (PEST).

• Illustrate and describe the decision-making process.• Describe the objectives of the firm.• Explain the shareholder wealth maximization model of

the firm.• Differentiate between the various theories of profit.• Describe the goals in the not-for-profit sectors of the

economy.• Identify the criteria used in estimating expenditures in

the public sector.• Calculate profit maximization and cost minimization

levels of output for the firm.• Distinguish between economic and accounting cost.