The Firm and Its Goals

Chapter 2
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
Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-2

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®

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

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

The Firm
Transaction costs are influenced by
1.Uncertainty, which refers to the inability to know the future perfectly,

particularly in the long term.
2.Frequency of recurrence, which refers to how many times these transaction

are repeated.
3.Asset specificity, which refers to the extent to which the parties are "tied in"
in a two-way or multiple-way business relationship. This might lead to an
opportunistic behavior, when one party seeks to take advantage of the other.

Managers of profit maximizing firms always face the question of
whether it is more profitable to produce all its products’
components (goods and services) internally or to order some
of parts from other firms, through what is known as
outsourcing.
• Firms usually outsource the peripheral, non-core activities.
• Company chooses to allocate resources so total cost is

minimum

There is a tradeoff between the cost of external transactions
and the cost of internal operations of the firm.
• When the (external) transaction cost of an item is higher than

its internal operation, the firm will provide that item internally.
• Internet has caused the transaction costs to decrease

drastically, making it easier for the firm to outsource some of
their job to specialized and more efficient companies

The Economic Goal of the Firm and Optimal
Decision Making:
• Profit Maximization (or loss minimization, when there is a loss)
is traditionally known to be the ultimate goal of the firm.
• Profit is the difference between revenue received and costs

incurred.
Profit = Total Revenue – Total Cost

• To maximize profit, the firm should produce the quantity of
output which equates the revenue generated with the cost
incurred of the last unit produced.
Marginal Revenue = Marginal Cost

• 1. Mike bought a DVD for $ 750 and sold it
for $ 875. Find Mike's gain per cent.

• Solution:
CP = $ 750 and SP = $ 875.
Since (SP) > (CP), Mike makes a gain.
Gain = $ (875 - 750)
= $ 125.
Gain% = {(gain/CP) × 100} %
= {(125/750) × 100} %
= (50/3) %
= 16 (2/3) %

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.

2. Maddy purchased an old scooter for $
12000 and spent $ 2850 on its overhauling.
Then, he sold it to his friend Sam for $
13860. How much per cent did he gain or
lose?

• Solution:
Cost price of the scooter = $ 12000, overheads = $ 2850.
Total cost price = $ (12000 + 2850) = $ 14850.
Selling price = $ 13860.
Since (SP) < (CP), Maddy makes a loss.
Loss = $ (14850 - 13860) = $ 990.
Loss = [(loss / total CP) × 100] %
= [(990 / 14850) × 100] %
=6 %

Economic Goal of the Firm and
Optimal Decision Making
• Profit maximization hypothesis: the primary
objective of the firm (to economists) is to maximize
profits
– Other goals include market share, revenue growth, and
shareholder value
• Optimal decision is the one that brings the firm

closest to its goal
– It is crucial to be precisely aware of a firm’s goals.
Different goals can lead to very different managerial
decisions given the same, limited amount of resources.

Goals other than Profit
• Economic/financial objectives
– market share, growth rate

– profit margin
– return on investment, return on assets
– technological advancement
– customer satisfaction
– shareholder value

Goals other than Profit
• Non-economic objectives
– Good work environment for employees
– Quality products and services for customers
– Good corporate citizenship and social

responsibility

Do Companies Maximize Profit?
• Argument against companies not

maximizing profits but instead merely aim
to satisfice, which means firms seek to
achieve a satisfactory goal--one that may
not require the firm to ‘do its best’.

– Two forces leading to satisficing

• position and power of stockholders
• position and power of management

• Position and power of stockholders
Reasons for satisficing by companies

• larger firms are owned by thousands of shareholders
• stockholders generally own only minute interests in the
firm and hold diversified holdings in many other firms

• Position and power of stockholders
– Stockholders are concerned with performance of

their entire portfolio and not individual stocks
– Stockholders are much less informed about the
firm than management
Thus, stockholders are not likely to take any action if
earning a ‘satisfactory’ return.

• Position and power of management
– high-level managers may own very little of the

firm’s stock
– managers tend to be more conservative—that is,
risk averse—than stockholders would be because
their jobs will most likely be safer if they turn in
a competent and steady, if unspectacular,
performance

• Position and power of management
– managers may be more interested in maximizing

their own income and perks
– management incentives may be misaligned (e.g.
revenue goals for compensation and not profits)
– divergence of objectives is known as the
‘principal-agent’ problem

• Arguments supporting the profit

maximization hypothesis
– large stockholdings held by institutions (mutual
funds, banks, etc.)  scrutiny by professional
analysts
– Stock market discipline and competition  if
managers do not seek to maximize profits, firms
face the threat of takeover or changes in
management
– incentive effect  the compensation of many
executives is tied to stock price

• Other influences
– The Sarbanes-Oxley Act was passed in 2002 in
response to a number of corporate scandals. The
Act sets stricter standards on the behavior of
public corporations and more transparency of
corporate information.
– Within the labor market for financial managers,
superior performance is rewarded.

Maximizing the Wealth
of Stockholders
• Business risk involves variation in returns

due to the ups and downs of the economy,
the industry, and the firm.
All firms face business risk to varying degrees.

of Stockholders
• Financial risk concerns the variation in

returns that is induced by ‘leverage’
– Leverage is the proportion of a company

financed by debt
• the higher the leverage, the greater the potential
fluctuations in stockholder earnings
• financial risk is directly related to the degree of leverage

of Stockholders
• A company tries to manage its business in such a
way that the dividends over time paid from its
earnings and the risk incurred to bring about the
stream of dividends always create the highest price
for the company’s stock.
• When stock options are a substantial part of

executive compensation, management objectives
tend to be more aligned with stockholder objective.

of Stockholders
• Another measure of the wealth of stockholders is
called Market Value Added (MVA)®
• MVA = difference between the market value of

the company and the capital that the investors
have paid into the company. Investors means
both stock holders and lenders. Similarly market
value of company means market value of stocks
plus market value of debt.

Summary
• A firm’s 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

The Firm and Its Goals

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Chapter 2

• The firm and resource allocation

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-2

• Understand the reasons for the existence of firms

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-3

• A firm is a collection of resources that is

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-4

• Why does a firm perform certain functions

• Transaction costs are incurred when

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-5

Transaction costs are influenced by

1.Uncertainty, which refers to the inability to know the future perfectly,

2.Frequency of recurrence, which refers to how many times these transaction

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-6

• Firms usually outsource the peripheral, non-core activities.

• Company chooses to allocate resources so total cost is

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-7

• When the (external) transaction cost of an item is higher than

• Internet has caused the transaction costs to decrease

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-8

• Profit is the difference between revenue received and costs

Profit = Total Revenue – Total Cost

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-9

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-10

CP = $ 750 and SP = $ 875.

Since (SP) > (CP), Mike makes a gain.

Gain = $ (875 - 750)

Gain% = {(gain/CP) × 100} %

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-11

• Reshoring: Operations returning to the country

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-12

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-13

Cost price of the scooter = $ 12000, overheads = $ 2850.

Total cost price = $ (12000 + 2850) = $ 14850.

Selling price = $ 13860.

Since (SP) < (CP), Maddy makes a loss.

Loss = $ (14850 - 13860) = $ 990.

Loss = [(loss / total CP) × 100] %

= [(990 / 14850) × 100] %

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-14

• Optimal decision is the one that brings the firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-15

– market share, growth rate

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-16

– Good work environment for employees

– Quality products and services for customers

– Good corporate citizenship and social

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-17

• Argument against companies not

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-18

– Two forces leading to satisficing

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-19

• Position and power of stockholders

Reasons for satisficing by companies

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-20

• Position and power of stockholders

– Stockholders are concerned with performance of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-21

• Position and power of management

– high-level managers may own very little of the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-22

• Position and power of management

– managers may be more interested in maximizing