Chapter 3

Decisions and objectives of the firm

Thus far…
We have described the activity of the
company from two different perspectives:
no time dimension (Chapter 1) or over
time (Chapter 2)

We have not said anything about how to

manage the company: What decisions
should be taken (Management)
Chapter 3 Objectives
Enumeration and identification of key business
decisions

Decisions within the firm

Decision Theory
Business Strategy
Selection and implementation
Firm Goals
What decisions do you make daily?

What was the biggest decision you have made in

the past year? Was it a good one?

If individual decision-making can be so

complex... (Example: Netflix series! Narcos,
Stranger Things, Black Mirror) Now let´s
consider firm-level decisions?

What decisions need be taken within a firm?

1. Decisions within the firm
Who makes the decisions in a company?
Self-employed
Administrators
Board of directors

What decisions?
Production activities
How to organize them
Transactions
 1. Decisions within the firm
1. Production activities: product portfolio (eg. Apple)
Transformation process (technology) determines product
characteristics and demand for inputs
Brands, commercial names to identify products

2. Organization of production process

i. Who performs the processes?
ii. Where?
iii. Which production factors?
iv. Contracting production factors
 1. Decisions within the firm

2. Organization of production process

i. Who performs the processes?
(from decisions to actions)
Internal organization of the firm (organization chart)
Delegation of decisions
Vertical integration (buy a firm or a production plant, produced in-
house)
Outsourcing (*subcontratar)
text
1. Decisions within the firm
ii. Where?
Location and size of production plants
Suppliers’ provision of raw materials
Distribution channels to clients (logistics)
Markets of output
Degree of internationalization
Local firms: production and distribution within country
Exporting firms: part of distribution outside home country
Multinational firms: part of production and distribution
outside home country
Example Apple: design and commercialization of products
1. Decisions within the firm
iii. Which production factors?
Suppliers
Labor
Sources of financing

iv. Contracting production factors

Suppliers with exclusivity, preferential treatment, or
occasional suppliers.
Workers: temporary, permanent, in training
Financing: capital, external funds (bonds, loans, trade
credit, etc.)
2. Decision theory

Elements of a decision:
1. Strategies (S)
2. Predictions of outcome (P)
3. States of Nature (EN)
4. Theories (f)
5. Decision Criteria
2. Decision theory
Elements of a decision:
1. Strategies (S)
The production activities involve undertaking actions
These actions represent the choice among different
alternatives or strategies
S = (S1... Sj, .., SJ)
2. Decision theory

Elements of a decision:
2. Predictions of outcome (P)

Choice is based on the prediction of the consequences

or outcomes of the different strategies.
The prediction of outcomes also depends on the
strategies, and our knowledge of other factors that
go beyond our decision framework.
2. Decision theory

Elements of a decision:
3. States of Nature (EN)
The quality of the predictions depend on the
information we have on other factors (states of
nature) that are beyond our decision framework.
States of nature: EN = (EN1,... ENn,... ENN)
2. Decision theory
Elements of a decision:
4. Theories (f)
The quality of our predictions depends on our
knowledge and our ability to find the relevant
information.
Different theories will tell us how to relate different
variables and allow us to make predictions of
outcomes for each strategy and state of nature

Pj, n= f (Sj, ENn)

2. Decision theory

Where do these theories come from?

Academic studies of real business situations that
analyze consequences of decisions on stakeholders
Analyzing behaviour, practices or decisions
Statistics
Predictive capacity of the theories
Value of information on environment variables
2. Decision theory

Table with a summary of these 4 items:

State of Nature
EN1...... ENn........ ENN
Strategy

S1 P1.1 P1, n P1, N

.
.
.
.

Sj Pj, 1 Pj, n Pj, N

.
.
.
.

SJ PJ, 1 PJ n PJ, N
2. Decision theory
Elements of a decision:
5. Criteria Decision
Given a certain knowledge and a certain state of nature, we
associate a particular outcome for each strategy j:
Pj, 1 ,..., P j, n ,..., P j, N
We also need a criterion for assessing the results and therefore
value the different strategies.
(Mathematics: Optimization)
Sj = argmax O j= O (P j,1 ,..., P j,n ,..., P j,N)

For example: expected value

ATC example: Government sets the decision criteria
2. Decision theory
Once we chose an strategy and execute the action, we
obtain a result R j,n
If the result differs from the expected outcome (R j,n Pj,n )
we will have to revise our knowledge / theories

Learning:
Contrast hypothesis, statistics, econometrics.
2. Decision theory
Decision Theory (t) Learning (t+1)
Knowledge (t): Knowledge (t+1)
Theories concerning Choose/revise the possible new or revised
the consequences of explanations. theories
specific actions
(strategies).

Information about the

possible states of Information about the
nature that are relevant observed states of nature
for those decisions.

Predictions about the

results of a given Results
action (strategy) and a
state of nature

Goals or criteria to
prioritize those results
and actions.
Actions or activities by
ourselves or by others.
2. Decision theory
Decision Tree

Decision

Strategy S1 Strategy S2

State of Nature State of Nature State of Nature State of Nature

EN1 EN2 EN1 EN2

P11 P12 P21 P22

Now it’s your turn

Individual work: Task 1 & Task 2

Task 1
It is a rather overcast Saturday morning, and you have 75 people coming for cocktails
in the afternoon. You have a pleasant garden and your house is not too large; so if the
weather permits, you would like to set up the refreshments in the garden and have the
party there. It would be more pleasant, and your guests would be more comfortable.
On the other hand, if you set up the party for the garden and after all the guests are
assembled it begins to rain, the refreshments will be ruined, your guests will get damp,
and you will heartily wish you had decided to have the party in the house.
This particular decision can be represented in the form of a “payoff” table:

Source: https://hbr.org/1964/07/decision-trees-for-decision-making
Task 1: Hint

The tree is made up of a series of nodes and branches.

A decision tree of any size will always combine

(a) action choices with (b) different
possible events or results of action which are partially
affected by chance or other uncontrollable
circumstances.
Task 1: Solution
Thursday, November 16, 2017
So far, we have briefly introduced decision making
within a firm

These are quite complex and very important to a

firm´s success
We will dive into these concepts in the first part of
Problem Set 3

We also started to discuss decision trees and solved

Task 1. Now it´s time to work out Task 2.
But first…
Continue discussion on Decision-Making
How do economists traditionally assume that
people make decisions?

Economists believe people rationally decide what

decision to make by weighing the marginal—or
additional—benefits against the marginal costs

Do you think that people always make correct

economic decisions? Why or why not?
Task 2
The management of a company Stygian Chemical Industries, Ltd., must decide
whether to build a small plant or a large one to manufacture a new product with an
expected market life of ten years. The decision hinges on what size the market for the
product will be.

If the company builds a big plant, it must live with it whatever the size of market
demand. If it builds a small plant, management has the option of expanding the plant
in two years in the event that demand is high during the introductory period; while in
the event that demand is low during the introductory period, the company will
maintain operations in the small plant and make a tidy profit on the low volume.

Management is uncertain what to do. The company grew rapidly during the 1950’s; it
kept pace with the chemical industry generally. The new product, if the market turns
out to be large, offers the present management a chance to push the company into a
new period of profitable growth. The development department, particularly the
development project engineer, is pushing to build the large-scale plant to exploit the
first major product development the department has produced in some years.

Source: https://hbr.org/1964/07/decision-trees-for-decision-making
Task 2a: Solution
Task 2b
The chairman, a principal stockholder, is wary of the possibility of large unneeded
plant capacity. He favors a smaller plant commitment, but recognizes that later
expansion to meet high-volume demand would require more investment and be less
efficient to operate. The chairman also recognizes that unless the company moves
promptly to fill the demand which develops, competitors will be tempted to move in
with equivalent products.

You are trying to decide whether to approve a development budget for an improved
product. You are urged to do so on the grounds that the development, if successful,
will give you a competitive edge, but if you do not develop the product, your
competitor may—and may seriously damage your market share.
Task 2b: Solution
3. Decision theory: Sequential decisions
Decisions within the firm can be seen as sequential
1. Product portfolio and product design
2. Organization of production process:
1. What activities to be performed?
2. Where are they performed? location
3. Which production factors? Selection of suppliers
4. How to contract them?

After taking all decisions, obtain outcome (e.g., sales)

States of nature are revealed over time
3. Decision theory: Sequential decisions
Decision tree. Number of decisions = d=1,2,3,…D.
Example: d=2
Decision 1: location of production plant
2 alternatives or strategies: S1=(S11,…, S1j,…S1J1)
S11 : location in Alcala de Henares
S12 : location in Hospitalet de Llobregat
(Note: some states of nature may be revealed before decision)
Decision 2: distribution of products
2 alternatives or strategies: S2=(S21,…, S2j,…S2J2)
S21 : One market, the closest one (Barcelona or Madrid)
S22 : Two markets (Barcelona and Madrid)
States of nature revealed between those 2 decisions
EN=(EN1 ,…, ENn,…ENN) EN1= no crisis, EN2=crisis
3. Decision theory: sequential decisions

The theories provide outcomes to each combination

of strategies and states of nature.

There are J1 x J2 x N=2 x 2 x 2 =8 possible outcomes

To simplify, we assume zero interest rate

3. Decision theory: Sequential decisions
The prediction of outcomes in the example:
If the location is Alcalá, we need to invest 100 million.
If there is no crisis: (EN1)
In Madrid (One market) we sell 10 million units with a unit margin of
19 euros: R(S11, EN1 , S21) = 19x10-100 = 90 million
If we sell in BCN and Madrid (Two markets), we split in half the
quantity sold in each market with a unit margin of 19 euros in both
markets and pay a unit transportation cost of 10 euros to sell in BCN:
R(S11, EN1 , S22) = 19x5+(19-10)x5 – 100 = 40 million
If there is a crisis: (EN2)
In Madrid (One market) we sell 10 million units at a unit margin of 10
euros: R(S11, EN2 , S21) = 10x10 – 100 = 0
If we sell in BCN and Madrid (two markets), we manage to keep the
price and quantities of the no-crisis situation:
R(S11, EN2 , S22) = 19x5+(19-10)x5 – 100 = 40 million
3. Decision theory: Sequential decisions
Prediction of outcomes in the example:
If the location is Hospitalet, we need to invest 100 million.
If there is no crisis: (EN1)
In Barcelona (One market) we sell 10 million units at a unit margin of 18
euros: R(S12, EN1 , S21) = 18x10 - 100 = 80 million
If we sell in BCN and Madrid (two markets), we split in half the quantity
sold in each market at a unit margin of 20 euros in both markets and pay
a unit transportation cost of 10 euros to sell in Madrid:
R(S12, EN1 , S22) = 20x5+(20-10)x5-100=50 million
If there is a crisis: (EN2)
In Barcelona (One market) we sell 10 million units at a unit margin of 10
euros: R(S12, EN2 , S21) = 10x10-100=0
If we sell in BCN and Madrid (Two markets), we keep price and quantity
of no-crisis situation:
R(S12, EN2 , S22) = 20x5+(20-10)x5 - 100 = 50 million
 3. Decision theory: sequential decisions

Decision 1?

S11 Alcalá S12 Hospitalet

EN1 EN2 EN1 EN2

No Crisis Crisis No Crisis Crisis

S21 S22 S21 S22 S21 S22 S21 S22

One market Two markets One market Two markets One market Two markets One market Two markets

Outcome Outcome Outcome Outcome Outcome Outcome Outcome Outcome

S11 EN1 S21 S11 EN1 S22 S11 EN2 S21 S11 EN2 S22 S12 EN1 S21 S12 EN1 S22 S12 EN2 S21 S12 EN2 S22

90 40 0 40 80 50 0 50
3. Decision theory: Sequential decisions
How to solve sequential decisions?
Backward induction (game theory)
Objective: maximize outcome
Assign a value to each strategy of the final decision
Then, work backwards solving each stage of the game
Decide optimal decision given each potential realization of states of
nature

In the example:
First stage: analyze second decision D=2 (one or two
markets)
Second stage: analyze first decision D=1 (location)
3. Decision theory: Sequential decisions
Decision 2: one or two markets?
Assume that we choose S11=Alcalá
If there is no crisis: we choose “One market” S21
R(S11, EN1 , S21) > R(S11, EN1 , S22) 90>40
If there is crisis: we choose “Two markets” S22
R(S11, EN2 , S21) < R(S11, EN2 , S22) 0<40
Assume that we choose S12=Hospitalet
If there is no crisis: we choose “One market” S21
R(S12, EN1 , S21) > R(S12, EN1 , S22) 80>50
If there is crisis: we choose “Two markets” S22
R(S12, EN2 , S21) < R(S12, EN2 , S22) 0<50
3. Decision theory: Sequential decisions
Decision 2 (continued):
With these decisions, we can simplify our decision tree from 8
possible outcomes to 4 (J1 x N):
R(S11, EN1)= 90
R(S12, EN1)= 80
R(S11, EN2)= 40
R(S12, EN2)= 50
3. Decision theory: Sequential decisions
Decision 1: the location?
We want to reduce the number of potential outcomes from 4 (J1 x
N) to 2 (J1).
We need an estimation of the probabilities of states of nature. For
example: Pr(no crisis)=0.4 , Pr(crisis)=0.6
Compute expected outcome of each strategy in decision 1
R(S11)= Pr1 x R(S11, EN1)+ Pr2 x R(S11, EN2)
R(S11)= 0.4 x 90 + 0.6 x 40 = 60
R(S12)= Pr1 x R(S12 , EN1)+ Pr2 x R(S12 , EN2)
R(S12)= 0.4 x 80 + 0.6 x 50 = 62
Thus, the strategy that maximizes the expected
outome is to locate the plant in Hospitalet.
3. Decision theory: Sequential decisions
Implementation of sequential decisions
First decision: the location will be Hospitalet
Then, depending on the state of nature (crisis or no-
crisis) we decide where to sell products (in one or two
markets).
There are two potential outcomes:
Pr(no crisis)=0.4 outcome = 80 (One market)
Pr(crisis)=0.6 outcome = 50 (Two markets)
3. Decision theory: sequential decisions
Complexity of the theories and delegation:
Individuals with more complex theories are able to solve
decision trees that involve more decisions
Delegation of actions to individuals with less complex
theories
Necessary conditions for delegation:
Coordination between decision makers: S1
Information flows: EN
 3. Decision theory: sequential decisions
Sometimes, one of the 2 conditions is not necessary
Consider the following cases:

S11 Alcalá S12 Hospitalet

EN1= No Crisis EN2= Crisis EN1= No Crisis EN2= Crisis
S21 S22 S21 S22 S21 S22 S21 S22
One Two One Two One Two One Two
Market markets market markets market markets market markets
Case 1 90 40 0 40 80 50 0 50
Case 2 90 40 40 40 45 50 60 60
Case 3 90 40 0 40 90 60 0 60
3. Decision theory: sequential decisions
Case 2: Superfluous information
If decision 1= Alcalá, then, regardless of state of nature,
“One market” provides bigger or equal outcome than
“Two markets”
“One market” is a dominant strategy
If decision 1= Hospitalet, then, regardless of state of
nature, “Two markets” provides bigger or equal
outcome than “One market”
“Two markets” is a dominant strategy
Decision 2 only depends on the coordination with
decision 1. Information does not change decision
(information on EN is not valuable in this case)
3. Decision theory: Sequential decisions
Case 3: Independent decisions
If “no crisis” we will always choose “One market”. The
Outcome is 90 in both Hospitalet and Alcalá.
If “crisis” always choose “Two markets”. Outcome is 60
in Hospitalet and only 40 in Alcalá.
Without solving the tree, we can see that “Hospitalet” is
dominant strategy
There is no need for coordination between the first
decision maker and the second decision maker.
Only information on state of nature matters
 Thursday, November 23, 2017
So far, we have covered decisions within a firm and decision theory. In
our next section, we will introduce decision theory from a strategic
perspective.
Today´s agenda:
Introduce decision theory from management perspective
Use these slides as a guide to help with the Chapter 3 assignment and
group presentations on the results of your firm
Case study on decision-making process
Provide a different perspective on the difficulties of decisions within a firm
and view decision-making through the lens of a leader
Discussion on corporate social responsibility
This is a very important issue that firm´s face today. You should have an
understanding of what this means. We will discuss the conflicting
viewpoints and conclude with the opportunities for competitive advantage.
You will see how this will lead in to our last section in Chapter 3.
4. Decision theory and strategic management
Learning objectives:
Decision theory from a management perspective:

Strategies (product portfolio and organization of

production activity): Strategic Plan (or business plan for
new firms)
Theories: vision, business model.
Decision criteria / objectives: accounting profit.
Information Systems: Forecasting results, learning

First, let´s start with a case study to get you in the mindset
of a leader who has a very difficult decision to make...
Case Study

Case: How it Went Down

4. Decision theory and strategic management
Strategy: greek word strete-gos
Stratos = army
E-gos = lead
Greeks used the term to refer to the leader or general
of an army
This notion, however, was first described in The Art of
War by Sun Tzu

¨Those who are skilled at executing a strategy, bend the

strategy of others without conflict, uproot the fortifications
of others without attacking, and absorb the organizations of
others without prolonged operations.¨
4. Decision theory and strategic management
Defining Strategy:

1) Primarily about being different: different set

of activities to deliver value to customer

2) What not to do: trade-offs

3) Create a solid fit among the activities so that

they cannot be easily copied by competitors
4. Decision theory and strategic management
Strategy and the Organization: A Framework

What is our purpose?

How will environmental forces impact our
business?
What stakeholders are important?
In what business or areas will we compete?
Who will we serve?
How will we distinguish our firm from competitors?
4. Decision theory and strategic management
What is the firm´s purpose?

First, strategists declared: Make profits

Produce revenues that exceed costs by the widest
margin possible
Next: Maximize shareholder value

But… Shouldn´t we have additional duties to all

stakeholders?

Now, in the strategic management field, it is most widely

accepted: primary purpose of a firm is to make profits
for shareholders in an ethical and responsible manner.
4. Decision theory and strategic management

How do we arrive to our firm strategy?

Vision: how to bring value to customers and satisfy

stakeholders

Mission: activities a firm performs for its customers

Mission Statement: statement that defines the firm´s
reason for existence

Objectives: series of quantifiable milestones or

benchmarks by which a firm can assess its progress
4. Decision theory and strategic management

Business-Level vs Corporate-Level Strategy

Business-Level Strategy: entails how a company will

compete in a given business and position itself
among its competitors

Corporate-Level Strategy: the way a company seeks

to create value through the configuration and
coordination of multi-market activities
4. Decision theory and strategic management
Corporate Social Responsibility
Core responsibilities of business in a society:
Economic responsibilities: duty to make a profit and increase shareholder
value
Legal responsiblities: duty to pursue its economic responsibilities within
the boundaries of the law
Ethical responsibilities: duty to meet expectations of society beyond its
economic and legal responsibilities

Duties of Corporate Social Responsibility:

Economic = Required
Legal = Required
Ethical = Expected

Is this good for business?

4. Decision theory and strategic management

Discussion:

What are your thoughts on CSR? Should

it be required? Regulated? Other
considerations?
4. Decision theory and strategic management
Corporate Social Responsiveness

Zappos founder, Tony Hsieh: reconcile corporate

philanthropy and financial performance
2011: $350mil to abandoned areas of Las Vegas
Invested in new local businesses, apartments, startups to
support these areas

BP: 2010 oil crisis in Gulf of Mexico

Difference between these?

 4. Decision theory and strategic management
CSR as a Competitive Advantage
Healthy society needs succcessful businesses- sucessful businesses need
a healthy society to sustain increasing demand

Panera Bread founder, Ron Schaich

Re-evaluated philanthropic activities:
$100mil to various communities; however, it was disconnected
Panera Cares: based in communities that are economically
troubled, donation-based
Individuals who need a meal can gain access to one

Very risky decision- what factors do you think are considered? How do you
think this decision was viewed by others?
 4. Decision theory and strategic management
Supporting Core Business Activities
CSR is strategic when: it supports core business activities
that contribute to a firm´s mission, vision, and
strategy.
Various routes- human relations as example
Subaru of Indiana Automotive: ¨nation´s first zero-landfill
car factory¨
Achieved through employee incentives
Salesforce.com: CSR as strategic initiative from the start
1% of of stock, products, & employees´work hours to company
foundation
4. Decision theory and strategic management
Creating a Strategic CSR Platform

1) Identify point of intersection between company

and society

2) Select social isssues to address

3) Create a corporate social agenda (incorporate with

strategy)

4) Create a social dimension to value proposition

Tuesday, November 28, 2017
Now, we will move on to the final section of
Chapter 3! This is regarding firm goals.

Objectives:
Owner´s goals of a firm
Maximizing Value Theorem
Value Creation

We will do this by reverting back to what we learned in

Chapter 1 and evolve our capabilities to calculate social
cost and value creation. Let´s see how Dr. Coase´s earlier
work plays a role in this…
5. Firm goals
Refer back to social costs
Opportunity cost in terms of lost production in the economy, or the value of
total production is not maximized
Transaction costs: Costs incurred by parties to carry out an exhange
Finding partners, meeting, negotiating contracts, monitoring performance,
enforcing the agreement
Forecasting uncertain future conditions

¨The Problem of Social Cost¨(Coase 1960)

Essentially: social costs are not a problem because private parties can negotiate
inefficiencies through voluntary transactions
What is important: resource flow that create the most value, amounting to
maximizing the value of production

¨I tend to regard the Coarse theorem as a stepping stone on the way to an

analysis of an economy with positive transaction costs¨(Coase 1992)
5. Firm goals
Contribution to economic theory and crucial link:
Accountants Entrepreneurs
Entrepreneurs: maximize profits, lower costs
Accountants: Accounting Profit
Economists: economic efficiency

Notion of ¨opportunity costs¨

Courses of action with the lowest opportunity costs amounts
to maximizing profits

¨system of relationships which comes into effect when the

direction of resources is dependent on an entrepreneur¨
5. Firm goals
Recall from Chapter 1:

The administrator of the company (individual

entrepreneur or manager) takes decisions and executes
them (or delegates them)
The owners of the firm appropriate accounting profits
We need the participation of all stakeholders to
undertake the production activity
If there is voluntary participation by stakeholders, then,
the productive activity is carried out only if it creates
value
5. Firm goals
Entrepreneur provides all capital

Stakeholder Remuneration Contribution Apropriated

value
Clients VCL p VCL -p
Workers w VL w-VL
Suppliers c VP c-VP
Sources of R VK R-VK
funding
TV=VCL -VL- VP- VK
5. Firm goals
What is the goal of the owners of the firm?
Maximize Economic Profit = R-Vk
Maximizing economic profit will be equivalent to
maximizing residual income (or accounting profit) (R) when
the required minimum return (Vk) is not affected by business
decisions.
What would be a socially desirable goal for
businesses?
Value creation
Maximizing value theorem
Basic result in microeconomics: When decisions that
maximize profit (individual goal) also maximize the total
value creation (social objective)?
5. Firm goals
Maximizing value theorem (Coase 1960):

Given several alternative strategies (S1... Sj, .., SJ) if all the
stakeholders:
i. agree on the value generated by each strategy
(TV1, …,TVj, .., TVJ)
ii. are free to participate or not in the transactions
iii. cash payments can be made between stakeholders

Then, all stakeholders will agree to carry out the strategy

that generates more value at a social level.
5. Firm goals
Notation:
TVj - The value generated by strategy j (j = 1,2)

Ps, j - Part of the value generated by the strategy j that

initially gets the stakeholder s (s = k, t)

TV1=Pk, 1 + Pt, 1
TV2=Pk, 2 + Pt, 2
5. Firm goals
Maximizing Value Theorem Proof:

In this particular case:

Two stakeholders (s = k, t) can choose
between two alternative strategies (j = 1,2)

s = k entrepreneur
s = t worker
5. Firm goals
Starting assumption:

Strategies generate different levels of value

Pk, 1 + Pt, 1 = TV1 > TV2= Pk, 2 + Pt, 2

Strategy 1 generates a higher social value

5. Firm goals
Let´s look at two different situations:

1. Both stakeholders agree on which

strategy to be carried out.

2. There is divergence on the preferences.

5. Firm goals
SITUATION 1:
Strategy 1 Remuneration Contribution Value
Worker W=30 Vt=5 PT =25
Owner B=150- Vk=40 Pk =80
30=120
TV=105
Strategy 2
Worker W=30 Vt=10 PT =20
Owner B=100-30=70 Vk=40 Pk =30
TV=50
5. Firm goals

SITUATION 1: Both stakeholders agree on

which strategy to carry out.

This strategy can only be the one that

maximizes the total value: Strategy 1.
5. Firm goals
Suppose we are in the opposite situation, i.e. the
two people agree to carry out Strategy 2:

Pk, 1 < Pk, 2

Pt, 1 < Pt, 2
Pk, 1 + Pt, 1 =TV 1 < TV2=Pk, 2 + Pt, 2

This is impossible because we initially assumed:

TV1 > TV2
5. Firm goals
SITUATION 2:
Strategy 1 Remuneration Contribution Value

Worker W=30 Vt=25 PT =5

Owner B=150-30=120 Vk=40 Pk =80

TV=85

Strategy 2

Worker W=30 Vt=10 PT =20

Owner B=100-30=70 Vk=40 Pk =30

TV=50
 5. Firm goals
SITUATION 2: There is divergence in the
preferences.
Pk, 1 > Pk, 2 Pt, 1 < Pt, 2
The individual who prefers the strategy that maximizes
the value (strategy 1), can make money transfers (t> 0),
and convince the other.
Pk, 1 - t> Pk, 2
Pt, 1 + t> Pt, 2
Pk, 1 + Pt, 1 =TV 1 > TV2=Pk, 2 + Pt, 2

Example: the employer increases the wages of workers

5. Firm goals
These payments are impossible in the case of
individuals who prefer the other strategy, 2.

Pk, 1 < Pk, 2+ t

Pt, 1 < Pt, 2- t
Pk, 1 + Pt, 1 =TV 1< TV2=Pk, 2 + Pt, 2

Impossible because we initially assumed: TV1>TV2

5. Firm goals

If the owner makes a payment to the

employee (increasing the salary) by :
t = 20

Then, we overcome the divergence of

interest and we reach and agreement to
choose strategy 1, which is the one that
maximizes total value.
5. Firm goals
Strategy 1 Remuneration Contribution Value

Worker W=30+20=50 Vt=25 PT =25

Owner B=150-30-20=100 Vk=40 Pk =60

TV=85

Strategy 2

Worker W=30 Vt=10 PT =20

Owner B=100-30=70 Vk=40 Pk =30

TV=50
5. Firm goals
Conclusion:

In a context where all stakeholders agree on

which strategy generates more social value and
can freely decide whether to participate or not,
the strategy that generates more value is the one
that will be finally carried out.

The reason is that we can always redistribute this

value.
5. Firm goals
Separation of the analysis of problems
generation wealth from their distribution

The power of stakeholders affects only

how wealth is distributed between the
different stakeholders that make up an
organization. It makes no sense to speak of
authority or power to impose a contract.
5. Exercise
In this next exercise, we will begin with a
firm scenario from Chapter 1

Value Creation and Social Cost

Productivity and salary changes

Wage Renegotiation
Exercise 5 (covered in chapter1)
A firm is equity-financed for the sum of €160,000. The owner, to be
willing to invest, requires an annual return of 15%. The company
employs 5 workers with the same experience and training, who
receive an annual salary of €12,000 each. These workers would be
willing to devote the same time and similar effort for a minimum
salary of €10,000. Annually, the company produces 2000 physical
units of a product that is sold at a price of €110. Given the excellent
quality of the product, customers would be willing to pay up to €115
per unit. The materials needed to produce one unit of product cost
€65, although the current suppliers would be willing to sell it for a
minimum price of €60.

What is the social unit cost of each product?

What is the value creation associated with each unit of output?
Exercise 5 (covered in Chapter 1)
Stakeholder Receiving Contribution Appropria-
ted value
Clients VCL p

Workers w VL

Suppliers c VP
Funding R VK
Providers
VCL –VL - VP - VK =
 Exercise 5 (covered in Chapter 1)

Stakeholder Receiving Contribution Appropria-

ted value
Clients VCL = 230,000 p= 220,000 10,000
Workers w= 60,000 VL= 50,000 10,000
Suppliers c= 130,000 VP=120,000 10,000
Funding R= 30,000 VK = 24,000 6,000
Providers
VCL –VL - VP - VK = 36,000
Exercise 5 (covered in Chapter 1)

Unit Social Cost : 194,000 / 2,000=97

Unit Value Creation : 36,000 / 2,000= 18

Exercise 5

The firm is considering to move production to

Slovakia. Even though productivity is lower,
production is lower at 1,900 units, they
expect a larger annual profit of 35,500 € due
to lower salaries, 10,000 €.
Exercise 5
Stakeholder Receiving Contribution Appropria-
ted value
Clients VCL p

Workers w VL

Suppliers c VP
Funding R VK
Providers
VCL –VL - VP - VK =
 Exercise 5:

Stakeholder Receiving Contribution Appropria-

ted value
Clients VCL = 218,500 p= 209,000 9,500
Workers w= 50,000 VL= 50,000 0

Suppliers c= 123,500 VP=114,000 9,500

Funding R= 35,500 VK =24,000 11,500

Providers
VCL –VL - VP - VK = 30,500
Exercise 5

Unit Social Cost: 188000/1900= 98.95

Unit Value Creation: 30500/1900= 16.05

 Exercise 5: Wage Renegotiation

Stakeholder Receiving Contribution Appropria-

ted value
Clients VCL = 230,000 p= 220,000 10,000
Workers w= 54,000 VL= 50,000 4,000
Suppliers c= 130,000 VP=120,000 10,000
Funding R= 36,000 VK = 24,000 12,000
Providers
VCL –VL - VP - VK = 36,000