Professional Documents
Culture Documents
Theory of The Firm
Theory of The Firm
Theory of The Firm
=
=
27/12/2011 Dr Sarath Divisekera
Which area specialists contribute to
maximising PV?
( )
n
1 = t
t
t t
+ 1
TC TR
= PV
i
Production manager,
MIS engineer,
Human resources manager,
Accountant,
Managerial Economist
Finance officer,
Business administrator,
Managerial economist
Marketing manager,
Managerial Economist
27/12/2011 36 Dr Sarath Divisekera
Managerial Decision Making
37
TR (TR = P*Q) depends on sales of the firms output
(Q) and the firms pricing (P) decisions. These are the
responsibility of marketing managers and sales
representatives who attempt to increase firms revenue.
The TC depends on the technology and the cost of
inputs. These are the responsibilities of production and
personnel departments who attempt to reduce total
costs.
The discount rate (r) depends on the perceived risk of
the firm and the cost of borrowing funds. These are the
major responsibilities of the finance department.
27/12/2011 Dr Sarath Divisekera
38
An alternative formula for
the value of the firm
Where t
0
= is the current level of profits
g = growth rate; r = interest rate
this method is frequently used by long-term planners
within a firm and by securities analysts (to determine
whether a companys stock is under- or overvalued).
|
|
.
|
\
|
+
=
g r
r
PV
Firm
1
0
t
27/12/2011 Dr Sarath Divisekera
39
An alternative formula for the value of the
firm: Example
Suppose the interest rate is 10% (r = 10%)
and the firm is expect to grow at an annual
rate (assume growth rate is constant) of 5%
(g = 5%) for the foreseeable future. If the
current profits of the firm are $100 million,
what is the value of the firm?
200 , 2 $ 100 ) 22 (
05 . 0 1 . 0
1 . 0 1
100 = = |
.
|
\
|
+
=
Firm
PV
27/12/2011 Dr Sarath Divisekera
Function of Profit
40
Profit serves a crucial function in a free-market
economy.
High profits are the signal that consumers want
more of the output of the industry.
So, high profits provide an incentive for firms to
expand output and for more firms to enter the
industry in the long-run.
For a firm of above average efficiency, profits
represent the reward for the greater efficiency.
Thus, profits provide the incentive for firms to
increase efficiency.
27/12/2011 Dr Sarath Divisekera
Function of Profit
41
Lower profits or losses are the signal that
consumers want less of that commodity and/or
that production is not efficient.
So profits provide the incentive for firms to increase
efficiency and/or produce less of the commodity, and for
some firms to leave the industry for more profitable ones.
Profits, therefore, provide the crucial signals for the
reallocating societys scarce resources to reflect
societys needs.
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profits
42
Business vs Economic Profit
Business Profit = Revenue - Explicit or
Accounting Costs (wages, rental on land
and buildings, interest on borrowed capital,
cost of raw materials).
Economic profit = Revenue - Explicit
Costs + Implicit Costs (opportunity cost)
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profits
43
The concept of BF may be useful for accounting
and tax purposes, it is the concept of economic
profit that must be used in order to reach correct
investment decisions.
Implications:
It is the economic, rather than the business, concept
of profit that is important in directing resources to
different sectors of the economy.
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profits
44
If a firm is trying to decide whether it should
continue in business with the goal of making as
much money as possible, the answer depends on the
firms profits measured in terms of economic profits
(and not business profits).
If the firms economic profits are > or = 0, the firm
should continue (otherwise shutdown).
Note: Throughout this course, we will use the term
Profit to mean economic profit and Cost to mean the
sum of explicit and implicit costs.
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profit:
Example
45
Suppose the firms business profit = $ 30,000. [50,000 (TR) -
20,000(EC)].
Suppose also that the entrepreneur could have earned $35,000 by
managing another firm (instead of managing his own) and $10,000 by
lending out his capital to another firm.
Thus the implicit cost facing this firm = 45,000, and
Economic profits = 50,000 - 20,000 - 45,000= -15,000.
I.e., a business profits of $30,000 corresponds to an economic loss of
$15,000. Even if the entrepreneur owns no capital, he would incur an
economic loss of $5000 by continuing to operate his own firm and
earning BF of 30,000. So, the entrepreneur should close his firm and
work in his best alternative occupation.
27/12/2011 Dr Sarath Divisekera