The Firm
and Its Goals
Chapter Outline
The firm and resource allocation
Profit maximization- the economic goal of
the firm
Goals other than profit
Do companies maximize profits?
Maximizing the wealth of stockholders
Economic profit
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Learning Objectives
Understand the reasons for the existence of firms
and the meaning of transaction costs
Explain the economic goals of the firm and optimal
decision making
Describe the principal-agent problem
Distinguish between profit maximization and the
maximization of the wealth of shareholders
Demonstrate the usefulness of Market Value
Added and Economic Value Added
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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
Price x Unit sold = Revenue Costs = Profit
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The Firm
Why does a firm perform certain functions
internally and others through the market?
Transaction costs are incurred when
entering into a contract.
Types of transaction costs:
investigation
negotiation
enforcing contracts
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The Firm
Transaction costs are incurred when
entering into a contract
Influences
uncertainty
frequency of recurrence
asset specificity
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The Firm
Examples of transaction costs
Offshoring to source consumer products
(e.g. retail stores)
Manufacturing components overseas (e.g.
the automotive industry)
Logistics services (e.g. warehousing,
delivery, etc.)
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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
minimized (for a
given level of
output)
outsourcing of
peripheral, non-core
activities
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The Firm
Reshoring: Operations returning to the
country where the offshoring occurred
(Example - United States)
Signs of Reshoring
Wages in developing countries have been rising.
The decrease in the value of the dollar has
increased the cost of importing.
Increases in energy costs have made it more
expensive to ship products
Manufacturing firms have significantly increased
productivity making firms production more
competitive.
Copyright 2014 Pearson Education, Inc. All rights reserved.
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The Firm
Illustration: Coase and the Internet
Ronald Coase wrote in 1937, pre-internet,
but his ideas are still relevant today.
He discussed tradeoff between internal
costs and external transactions.
Technology has reduced search costs
improving efficiency.
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D1
(1 k )
(1 k )2 (1 k )3 (1 k )n
D2
D3
Dn
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Economic Profits
Economic profits and accounting profits are
typically different
accountants measure explicit incurred costs, as
allowed by GAAP
accountants use historical cost
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Economic Profits
Economists are concerned with implicit
costs.
Accordingly, economic costs include not only
the historical costs and explicit costs recorded by
the accountants, but also the replacement costs
and implicit costs (normal profits) that must be
earned on the owners resources.
Economic profits are total revenue minus all
the economic costs.
Copyright 2014 Pearson Education, Inc. All rights reserved.
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Global Application
When doing business in other countries and other
cultures, business decision-making becomes more
complicated due to:
foreign currencies
legal differences
language
attitudes
role of government
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Summary
A firms objective is the maximization of its profit or
the minimization of its loss.
There are other important non economic goals of
the firm
Understanding risk and the time value of money
are essential for managing a business.
Economic profits for a firm are total revenue minus
all economic costs
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