MANAGERIAL ECONOMICS

Instructor: Dr. Bui Thi Lan Huong

CFVG-HCM-HN [email protected]

CHAPTER V THEORY OF THE FIRM

SECTION I THE FIRM AS AN ORGANIZATION

WHY ARE THERE FIRMS

Firms exists as an alternative to a pure market structure of transactions. Managers of firms have always to be asking should activity X be done inside the firm or bought in via the market from another supplier? Definition of the firm: unit that takes decisions with respect in the production and sale of goods and services.

A PERFECTLY COMETITIVE MARKET

Large number of sellers and buyers, Large number of sellers and buyers, each acting independently each acting independently and exerting no individual monopolistic power. and exerting no individual monopolistic power. Full information everyone about prices and can evaluate the quality of the good or services being produce Consumers aims to maximize utility (personal satisfaction) and firms aims to maximize profits.

Prices are flexible in all markets. 5

IMPLICATIONS AND CONDITIONS

The law of one price at which transactions occur.

Price takers: Buyers and sellers take the price of the product as given. Free entry: all firms have identical long run cost functions.
6

DEMAND FACING A TYPICAL FIRM IN A PERFECTLY COMPETITIVE MARKET

The industry
Price per unit (USD)

A representative firm Each firm faces a perfectly elastic demand curve.

S P* D
Units of output Q Units of output q

Recall that price is assumed to be fixed in the perfectly competitive market. each firm is very small relative in the industry that changes in its inputs do not affect the market price. 7

THE PRINCIPAL AGENT PROBLEM

The idea of profit maximisation applied to a world of owners-managers. Owners (the shareholders) might be presumed to want maximum profit. But managers might want maxomise something different: their salaries, their executive power, =>Possibility of conflicting objectives between owners and managers

The principal-agent problem PRINCIPALS: shareholders or owners AGENTS: Managers The problem: How do the owners get managers to act in their interests? (TO MAXIMIZE THE FIRM PROFIT)

10/10/11

HOW TO SOLVE THE PRINCIPAL-AGENT PROBLEM

Base salary Base salary Share options Share options

Profit-related Profit-related incentives incentives

10/10/11 9

Fixed-term Fixed-term contract contract

AN EXAMPLE OF PROFIT MAXIMIZATION IN ACTION

A history of Coca Cola reports that R. Goizueta, newly appointed CEO in 1981, was frustrated by Coke executives varied reactions to competition in setting their goals some going after increased sales, some market share, and only a few concerned over return of capital. The new CEO believed something had to be done. At the heart of his strategy lay the PROFIT TARGET. This emphasis on profitability was instrumental in raising per share by 10% per year. THE MORAL OF THIS STORY IS THAT THE FAILURE TO MAXIMIZE PROFITS WILL EVENTUALLY BE DETECTED AND CORRECTED BY MARKET FORCES.
Source: Cited by MacAleese

10

THE FIRM IN ECONOMIC THEORY

???? ???? ???? ???? ????

THE FIRM THE FIRM

PRODUCTION PRODUCTION

PROFIT PROFIT

11

FIRMS AND PROFIT MAXIMIZATION

Economists assume that firms choose output to maximize profits. Profit maximization as the objective of the firm. In the short term, the acquisition or defense of market share may often need taking price and quality decisions which conflict with profitability and may even involve short-term losses. With the possibility of conflicting objectives between owners and managers, the firm might not always behave in the way one would expect on the basis of the profitmaximization assumption. The divergence in objectives between owners and managers leads to the PRINCIPAL AGENT PROBLEM.
12

IMPLICATIONS OF THE PROFIT MAXIMIZATION HYPOTHESIS

Output decisions

Pricing decisions

13

SECTION II THE BEHAVIOR OF PROFITMAXIMIZING FIRMS AND THE PRODUCTION PROCESS

14

15

THREE DECISIONS THAT ANY FIRM MUST MAKE

How much output to supply? Which production technology to use? How much of each input to demand?

Profit maximizing objective

16

THE BASES OF OPERATION DECISIONS

TO OPERATE A GAS STATION You need to know: 1. The wage rates for mechanics and unskilled workers, the cost of gas pumps, interest rates, rents per square of land on high traffic corners, and the wholesale price of gasoline. 2. What equipment you need, how many workers, what kind of a building, 3. How much you can sell gasoline and repair services for. THE BASES OF DECISION MAKING: 1. The market price of output;

2. The techniques of production that are available;

3. The prices of inputs.

17

AN EXEMPLE OF A MULTINATIONAL PRODUCTION FIRM

Corporate Headquarters Collections

Industrial Complex

Megastore Automatic Distribution Center 18

THEORY OF SUPPLY

Technology Production costs

Total costs

Marginal costs

Level of output

Marginal revenue

Average costs

TO PRODUCE OR TO CLOSE

Demand curve facing the firm

19

THE PRODUCTION PROCESS

Price of outputs Production techniques Input prices

Determines total revenue

Profitable?

Determines total cost and optimal method of production

Total revenue Total cost = Total profit DETERMINING THE OPTIMAL METHOD OF PRODUCTION TO MAXIMISE PROFITS.
20

COST STRUCTURE OF THE FIRM

Total Cost Total Fixed Cost Total Variable Cost

Average Fixed Cost Average Cost

Average Variable Cost

21

THE BREAK-EVEN POINT

Higher

Total Revenue and Cost

Profit Area Break-Even Point Loss Area

Total Revenue Curve Total Cost Curve

Total Variable Costs

Total Fixed Costs

More

Units of Production
22

COST MINIMIZATION
To maximize profits, the firm chooses the best level of output. changing output affects both the costs of production and the revenues from sales. => COSTS and DEMAND CONDITIONS jointly determine the output choices of a profitmaximizing firm. => COST MINIMIZATION: the firm certainly wants to make its chosen output level at the least possible cost.

10/10/11

23

PRODUCTION FUNCTION
States the relationship between inputs and outputs Inputs the factors of production classified as: Land all natural resources of the earth not just terra firma! Price paid to acquire land = Rent Labor all physical and mental human effort involved in production Price paid to labour = Wages Capital buildings, machinery and equipment not used for its own sake but for the contribution it makes to production Price paid for capital = Interest Mathematical representation of the relationship: Q = f (K, L, La) Output (Q) is dependent upon the amount of capital (K), Land (L) and Labor (La) used
24

PRODUCTION FUNCTION

Inputs Land Labor Capital

Process

Output

Product or service generated value added

25

PRODUCTION TECHNOLOGY
Labor-intensive technology Technology that relies heavily on human Capital-intensive technology Technology that relies heavily on capital rather than human labor.

In choosing the most appropriate technology, firms select the one that minimizes the production cost.
26

AN EXAMPLE OF PRODUCTION FUNCTION FOR SANDWICHES

Labor units (employees) 0 1 2 3 4 5 6 Total product (sandwiches per hour) 0 10 25 35 40 42 42 Marginal product of labor 10 15 10 5 2 0
27

Average product of labor 10.0 12.5 11.7 10.0 8.4 7.0

PRODUCTION FUNCTION FOR SANDWICHES

Production function Marginal product Marginal product of labor
20 15 10 5 0 0 1 2 3 4 5 6

50 40

Total product

30 20 10 0 0 1 2 3 4 5 6

Number of employees

Number of employees

28

PRODUCTION FUNCTIONS WITH TWO VARIABLE FACTORS OF PRODUCTION

ONE ONE
Units of labor 0 1 2 3 4 5 6 7

GRILL GRILL
Marginal product 0 10 15 10 5 2 0 0

TWO GRILLS ONE GRILL TWO GRILLS

Total product 0 10 25 40 55 65 75 80 Marginal product 0 10 15 15 15 10 10 5

Total product 0 10 25 35 40 42 42 42

29

SHIFT OF A MARGINAL PRODUCT OF LABOR CURVE RESULTING FROM AN INCREASE IN CAPITAL

20 Marginal product 15 10 5 0
MARGINAL PRODUCT OF LABOR WITH 1 GRILL MARGINAL PRODUCT OF LABOR WITH 2 GRILLS

Number of employees
30

COST STRUCTURE OF THE FIRM

USD Total costs Variable costs

Fixed costs

Quantity

31

CHOOSING THE LOWEST COST PRODUCTION TECHNIQUE

Technique

Capital input

Labor input

Rental Per Machine (USD)

Wage per worker (USD)

Capital cost (USD)

Labor Cost (USD)

Total Cost (USD)

320

300

1280

1200

2480

320

300

640

1800

2440

32

FACTOR PRICES AND THE CHOICE OF TECHNIQUE

Technique

Capital input

Labor input

Rental Per Machine (USD)

Wage per worker (USD)

Capital cost (USD)

Labor Cost (USD)

Total Cost (USD)

320

340

1280

1360

2640

320

340

640

2040

2680

33

TECHNOLOGY CHOICE
Robotics in manufacturing in the USA Substitution of capital for labor Office towers in Mumbay Substitution of capital for land

K Series Robot Painting System

Skycrapers are simply the substitution of capital for land when land in desirable locations becomes 34 expensive.

EXAMPLE: COST, REVENUE, AND PROFIT (Weekly)

Output (1) 0 1 2 3 4 5 6 7 8 9 10 Total cost (2) 10 25 36 44 51 59 69 81 95 111 129 Price (3) 21 20 19 18 17 16 15 14 13 12 Total revenue (4) 0 21 40 57 72 85 96 105 112 117 120 35 Profit (5) -10 -4 4 13 21 26 27 24 17 6 -9

REMARKS FROM EXAMPLE OF FIRM'S SUPPLY DECISION

MAXIMIZING PROFITS IS NOT THE SAME AS MAXIMIZING REVENUE. By selling 10 units/week the firm could earn 120 USD, but it ould cost 129 USD. Making the last few units is expensive and brings in little extra revenue. => It is more profitable to make less.

36

USING MARGINAL COST AND MARGINAL REVENUE TO CHOOSE OUTPUT (Weekly)

Output (1) 0 1 2 3 4 5 6 7 8 9 10 Total cost (2) 10 25 36 44 51 59 69 81 95 111 129 Price (3) 21 20 19 18 17 16 15 14 13 12 Total revenue (4) 0 21 40 57 72 85 96 105 112 117 120 15 11 8 7 8 10 12 14 16 18 37 21 19 17 15 13 11 9 7 5 3 Marginal cost (5) (Marginal revenue (6)

MARGINAL COST AND MARGINAL REVENUE

The approach examining how one more unit of output affects profit focuses on the marginal costs and marginal revenue of producing one more unit. MARGINAL COST: the rise in total cost when output rises one unit

MARGINAL REVENUE: the rise in total revenue when output rises one unit.

38

MARGINAL COST AND MARGINAL REVENUE DETERMINE THE FFIRM'S OUTPUT

25

20

MC
15

Marginal cost (Marginal revenue 10

MR

0 1 2 3 4 5 6 7 8 9 10 11

Q1 Ouput (Q)

39