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
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 incurred when

entering into a contract

– Influences
• uncertainty
• frequency of recurrence
• asset specificity
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.)
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
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.
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.
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’.
Do Companies Maximize Profit?

– Two forces leading to satisficing

• position and power of stockholders
• position and power of management
Do Companies Maximize Profit?

• 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
Do Companies Maximize Profit?

• 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.
Do Companies Maximize Profit?

• 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
Do Companies Maximize Profit?

• 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
Do Companies Maximize Profit?

• 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
Do Companies Maximize Profit?

• 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.