Managerial Economics

Class 5
1. Types of Firms
2. Maximizing Profit
3. Social Responsibility
4. Profits Over Time

Reading: Ch. 7, sections 7.1 – 7.3

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 Review Clicker 1
15.0

Consider this plot, showing sales

revenue, R, versus advertising
10.0

expenditure, A. 5.0

0.0
0 2 4 6 8 10 12 14 16 18

a) We cannot estimate the coefficients describing this relationship using

OLS
b) A multivariate regression with A and A2 on the right-hand side would likely
have a higher R2 than a regression with only A on the right-hand side.
c) The t-statistic for the coefficient on A2 is likely to be less than 2 in
absolute value.
d) The confidence interval for the coefficient on A2 likely contains zero.
e) All of the above.
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 1. Types of Firms
a. Private Sector
Owned by individuals or other non-government entities. Owners try to earn a
profit. Most firms we consider are examples (Apple, IBM, Toyota, etc.)

b. Public Sector
Owned by government or government agency
Includes state-owned enterprises such as Translink, ICBC, BC Hydro

c. Not-For-Profit
Organizations pursuing social or public interest objectives such as charities,
environmental groups, etc. Examples include Greenpeace, Salvation Army, etc.

d. Mixed enterprises are enterprises with significant ownership by government and

by private sector. They are sometimes called public-private partnerships.
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 Private Sector Firms – Types of
Ownership
In Canada there are three main types of ownership.

Sole proprietorship – owned by a single person

Partnership – owned jointly by two or more people operating

under a partnership agreement

Corporation – owned by shareholders who are not personally

liable for debts. Shareholders own stock in the corporation.
Stock can either be closely held or “publicly traded”.

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 Limited and Unlimited Liability

In Canada, sole proprietorships have unlimited liability. (In some

countries, such as the U.S., it is possible for sole proprietorships to
become LLCs – limited liability companies.)

Partnerships may be limited liability or general (unlimited liability)

partnerships.

Corporations have limited liability.

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 Corporations
Corporations may by privately held or publicly traded.

Corporations start out as privately held – which means the stock is not
traded on a public stock exchange (such as the TSX or NYSE). Stock in
privately held corporations is often called “private equity”.

A corporation becomes publicly traded if it has an initial public offering

(IPO), after which its stock is available to be bought and sold by the general
public. Do not confuse this use of the term “public” with the public sector.
Publicly traded corporations are part of the private sector. There are also
public sector corporations. They are not publicly traded.

It is possible for a publicly traded corporation to “go private”.

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 Relative importance of firm types

• Most of GDP in Canada is produced in the private sector (~ 75%).

• The public sector produces about 13%.
• The non-profit sector produces the rest.
(Public sector expenditure is much higher than 13%, but that is not
production. It is mostly transfers of income.)

Most firms are sole proprietorships.

Most corporations are privately held.
However, most employment and output in the economy is generated by
large, publicly traded corporations.

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 2. Maximizing Profit

Profit = Revenue - Costs

=R-C
Revenue = P*q
Revenue and Cost vary with output (q)

Output decision – how much should I produce to maximize

profit?

Shutdown decision – Is it more profitable to shut down than to

operate?

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Profit curve

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 Finding the Profit-Maximizing
Output
Using calculus:
p = R(q) – C(q)
To maximize a function we take the derivative and set it to zero. A point
where the derivative is zero is called a “critical point”. It could be a
maximum or a minimum depending on “second order conditions”.

dπ (q)/dq = dR/dq – dC/dq = 0

or MR – MC = 0
or MR = MC , where MR = marginal revenue and MC = marginal cost.

The second order condition is d2 π /dq2 < 0. This is satisfied if MR slopes

down and MC is constant or slopes up.

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 Equivalent Rules for Setting
output to max 

1. If MR > MC then the firm could make more by increasing q so

keep increasing q until profit no longer goes up

2. Set q such that Marginal Profit = d/dq = 0 so keep increasing

q until d/dq = 0. Maximum profit occurs where slope of profit
curve is zero

3. Set q such that MR(q) = MC(q) as marginal profit = MR - MC.

The extra income raises profit but the extra cost reduces profit.
Maximum profit occurs at: MR(q) = MC(q).

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 Shutdown rules
• Shut down if you can reduce your loss by shutting down.
• Shut down if revenue is less than avoidable cost.

• Variable costs are always avoidable.

• Fixed costs are often unavoidable (sunk) in the short run so
compare revenue to variable costs.

• If fixed costs are not sunk then the fixed cost should be
considered avoidable.

Note: in the long run all ongoing production costs are avoidable.
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 Example: Clicker 2
Suppose a firm faces demand curve q = 45 – p and has cost
function C = 10 + 15q. We can rewrite demand as p = 45 – q and
can determine revenue by writing R = pq = (45 – q)q. We can
determine MR and MC and find that
a) the profit-maximizing quantity is 30.
b) the profit-maximizing quantity is 15.
c) the profit-maximizing quantity cannot be determined.
d) maximum profit occurs where average cost is minimized.
e) none of the above.
Should the firm shut down?

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 3. Social Responsibility

"there is one and only one social responsibility of business

—to use its resources and engage in activities designed to
increase its profits so long as it stays within the rules of
the game, which is to say, engages in open and free
competition without deception or fraud.”
-Milton Friedman

Stakeholder Theory: Corporations have obligations to

several groups in addition to shareholders, including
workers, customers, and the communities in which they
reside.
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 CSR, ESG
• Corporate social responsibility
• The pursuit of social objectives by corporations
• Often referred to by ESG now
• Environmental, Social, Governance

• Strategic ESG
• Social objectives can align with profit maximization
when recognized by consumers: “Doing well by
doing good”

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 Profit maximization is still a reasonable
approximation because

• Market forces make you profit maximize – survivor

principle
• You could be replaced as manager
• You could go bankrupt
• You could be bought (taken over)

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 4. Profits Over Time
• A dollar today is worth more than a dollar tomorrow
• For interest rate, i, you can invest today’s dollar and get 1+ i
dollars next year
• More generally, if you invest an amount PV this year you get FV
= PV*(1 + i) next year
• PV is the present value and FV is the future value
• If you invest for two years
• You get PV*(1 + i) after the 1st year
• You get back (1 + i) times the above amount after the second
year because you earn interest on the original interest
• So after two years you have PV*(1 + i)2
• In general, FV = PV*(1 + i)t after t years of investment
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 Future Payoffs and Present Value

Recall the relationship in the last slide:

FV = PV*(1 + i)t

We can rearrange to find the present value of some future

payoff, to be received in t years:
PV = FV/(1 + i)t

For example, if i = 20%, a $1,000 payment 25 years from

now has a present value of PV = 1,000/(1.2)25 ≈ $10.50.

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 Valuing Future Profit Flows

In many contexts, firms receive a flow of income each

year but must first make an upfront investment.
For example, a real estate investor could purchase a
rental building this year for K and receive a flow of rent, r,
every year for five years. Suppose the investor believes
she can sell the building at that point for the same dollar
value she paid for it. For interest rate, i, profit for this
project is: –K + r/(1 + i) + r/(1 + i)2 + r/(1 + i)3 + r/(1 + i)4 +
(r + K)/(1 + i)5

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 Perpetuities

Suppose the flow of income per year is for an

indefinite number of years. If a firm invests PV at an
interest rate of i, then every year it gets interest
income of Y = PV*i

Dividing both sides by i we obtain PV = Y/i.

So a constant income of Y per year forever has a
present value of Y/i.

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 Clicker Question 3

Toyota is thinking of investing $1billion in R&D this year for a new

electric car. The investment is expected to increase future profits of
the firm by $100 million per year in perpetuity, starting next year.

a) The investment will put downward pressure on current profit.

b) The investment will put upward pressure on Toyota’s stock
price if the interest rate is 5%.
c) The investment has a negative PV if the interest rate is 5%.
d) The investment has a positive PV because a million dollars
every year forever is an infinite payoff.
e) a and b

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 Summary

1. Private sector, public sector, non-profit sector.

2. Sole Proprietorships, partnerships, corporations.
3. Profit Maximization (MR = MC).
4. CSR and ESG are increasingly important managerial
activities.
5. Profit maximization is still not a bad approximation
6. Firms often maximize profits over time using interest
rates to compare current and future costs and revenues.

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