BUSINESS ECONOMICS

Theory of the Firm

LECTURE #3
Dr Sarath Divisekera
Lecture Outline
2
Theory of the firm
Objective and value of the firm
Discounting and present value
Business decision making
Alternative theories of the firm
Function of profit
27/12/2011
Dr Sarath Divisekera
The Theory of the Firm

3
The theory of the firm is the single most important
element in Business Economics.
Theory of the firm stipulates how firms/businesses
behave and what their goals are.
A firm is an organisation that combines and
organises resources for the purpose of producing
goods and/or service.
27/12/2011 Dr Sarath Divisekera
4
Theory of the Firm
The firm combines inputs to produce outputs
after choosing some available technology
Labor
Materials
Capital (plant,
equipment)
Components
Production
Process
(technology)

O
u
t
p
u
t
27/12/2011 Dr Sarath Divisekera
Business Economics
The Growth of Firms
The Growth of Firms
Internal Growth:
Generated through increasing sales
To increase sales firms need to:
Market effectively
Invest in new equipment and capital
Invest in labour
The Growth of Firms
External Growth:
Through amalgamation, merger
or takeover (acquisitions)
Mergers agreed amalgamation between two
firms
Takeover One firm seeking control over another
Could be friendly or hostile
External Growth
Vertical Integration
Horizontal Integration
Conglomerate Merger
The Growth of Firms
External growth types of acquisition:
Vertical integration amalgamation, merger or
takeover at different stages of the productive
process
Vertical Integration
Primary
Secondary
Tertiary
Retail Stores
Manufacturer
Vertical Integration
Backwards
acquisition takes place
towards the source
Vertical Integration
Primary
Secondary
Tertiary
Dairy Farming Co-
operative
Cheese Processing Plant
Vertical Integration
Forwards acquisition
takes place towards the
market
Horizontal Integration
Amalgamation, merger or takeover at the same
stage of the productive process
Horizontal Integration
Primary
Secondary
Tertiary
Soft Drinks
Manufacturer
Confectionery
Manufacturer
Conglomerate Acquisition
Amalgamation, merger or takeover of firms in
different lines of business.
Motives
Cost Savings
External growth may be
cheaper than internal growth
acquiring an underperforming or
young firm may represent a cost
effective method of growth
Managerial Rewards
External growth may satisfy
managerial objectives power,
influence, status
Shareholder Value
Improve the value of the overall
business for shareholders
Asset Stripping
Selling off valuable parts of the
business
Economies of Scale
The advantages of large scale
production that lead to lower
unit costs

Motives
Efficiency
Improve technical, productive or
allocative efficiency
Synergy
The whole is more efficient than the
sum of the parts (2 + 2 = 5!)

Control of Markets
Gain some form of monopoly
power
Control supply
Secure outlets
Risk Bearing
Diversification to spread risks

Key Issues
Key Issues
Divorce between ownership and control who runs the
business?
Shareholders?
Board of Directors?
Principal-Agent Relationship:
Shareholders act as principals, Board as agents principals expect
agents to act in their interest
Sub-contracting work operates on a similar basis
Contracts and compensation procedures to ensure agents act on
behalf of principals

Efficiency
Productive
Lowest Cost
Productive efficiency can be achieved where the
same output could be produced at lower total cost
Achieved through re-organisation (e.g. to cell
production), investment in new technology, training
for staff and so on
Technical
Minimum inputs
Technical efficiency can be achieved
if the same output can be produced using fewer
inputs
Can be achieved using labour saving devices, more
efficient machinery, more effective re-organisation
of restructuring and so on
Allocative
Needs of Consumers (P = MC)
Allocative efficiency occurs where the goods and services
being produced match the demand by consumers
P = MC the value placed on the product
by the buyer (the price) = the cost of the resources used to
generate the good/service

Social
MSC = MSB
Social efficiency occurs where the private and social cost of
production is equal to the private and social benefits
derived from their consumption
A measure of social welfare

Motives of Firms
Profit Maximisation
Profit maximisation assumed to be the standard motive of
firms in the private sector
Profit maximisation occurs where Marginal Cost = Marginal
Revenue
MC = MR
The firm will continue to increase output up to the point
where the cost of producing one extra unit of output = the
revenue received from selling that last unit of output
This assumes that firms seek to operate at maximum
efficiency
Revenue Maximisation
Total Revenue
Average Revenue
Marginal Revenue
In this model the policies to achieve revenue maximisation
may be different to those adopted to maximise profits
Other Objectives of Firms
Sales maximisation:
Attempts to maximise the volume of sales rather than the
revenue gained from them
Share Price Maximisation:
Pursuing policies aimed at increasing the share price
Profit Satisficing:
Generating sufficient profits to satisfy shareholders but
maximising the rewards to the managers/board and
avoiding attention from rivals or regulatory authorities

Behavioural Objectives
Modern firms have to attempt to match competing
stakeholder needs:
Shareholders
Employees
Consumers
Suppliers
Government
Local communities
Environment
Behavioural Objectives
Firms may have to balance out
their responsibilities:
Fat cat pay
Management rewards bonuses, etc.
Social and environmental audits
Employee welfare
Meeting consumer needs
Paying suppliers on time
Satisfying shareholders and The City about its policies,
plans and actions
The Objective and the Value of the Firm
31
The theory of the firm assumes that the goal or
objective of the firm is to maximise current
profits.
However, firms/businesses, in reality, may not
necessarily maximise profits always, sometimes
they sacrifice short-term profits for the sake of
increasing future profits.
27/12/2011 Dr Sarath Divisekera
The Objective and the Value of the Firm
32
Thus, the version of the theory used here assumes
that the primary goal of the firm is to maximise
the wealth or value of the firm.
Value of the firm is defined as the present value
of its expected future profits (cash flows).
Present Value, PV = The value today of an amount
of money to be received later
27/12/2011 Dr Sarath Divisekera
Profit Maximisation
33
Maximising profit means maximising the value of
the firm, which is the present value of all future
profit/cash flows.
Profit = Revenue - Cost (t = R - C)



Where PV is the present value of expected profits
of the firm, t
t
is the expected profits in year t
t = R
t
- C
t
, and r is the interest (discount) rate.

( ) ( ) ( )
n
r 1
......
r 1 r 1
PV
n
2
2
1
1
+
+
+
+
+
=
t t t
( )
t
t
n
1 t
r 1+
t
=
=
27/12/2011 Dr Sarath Divisekera
Why Discounting?
34
This implies that we discount the future profits
We discount because a dollar tomorrow is less
worth today (i.e., time value of money)

27/12/2011 Dr Sarath Divisekera
Value of the Firm
35
As profit (t) = Total revenue (TR) - Total Costs
(TC), the above may be written as



The above formula provides a unifying theme for
the analysis of managerial decision making.

( )
t
t t
n
t
TC TR
r 1
Firm the of Value
1 +

=

=
27/12/2011 Dr Sarath Divisekera
Which area specialists contribute to
maximising PV?
( )

n
1 = t
t
t t
+ 1
TC TR
= PV
i
Production manager,
MIS engineer,
Human resources manager,
Accountant,
Managerial Economist
Finance officer,
Business administrator,
Managerial economist
Marketing manager,
Managerial Economist
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Managerial Decision Making
37
TR (TR = P*Q) depends on sales of the firms output
(Q) and the firms pricing (P) decisions. These are the
responsibility of marketing managers and sales
representatives who attempt to increase firms revenue.
The TC depends on the technology and the cost of
inputs. These are the responsibilities of production and
personnel departments who attempt to reduce total
costs.
The discount rate (r) depends on the perceived risk of
the firm and the cost of borrowing funds. These are the
major responsibilities of the finance department.
27/12/2011 Dr Sarath Divisekera
38
An alternative formula for
the value of the firm




Where t
0
= is the current level of profits
g = growth rate; r = interest rate
this method is frequently used by long-term planners
within a firm and by securities analysts (to determine
whether a companys stock is under- or overvalued).
|
|
.
|

\
|

+
=
g r
r
PV
Firm
1
0
t
27/12/2011 Dr Sarath Divisekera
39
An alternative formula for the value of the
firm: Example
Suppose the interest rate is 10% (r = 10%)
and the firm is expect to grow at an annual
rate (assume growth rate is constant) of 5%
(g = 5%) for the foreseeable future. If the
current profits of the firm are $100 million,
what is the value of the firm?
200 , 2 $ 100 ) 22 (
05 . 0 1 . 0
1 . 0 1
100 = = |
.
|

\
|

+
=
Firm
PV
27/12/2011 Dr Sarath Divisekera
Function of Profit
40
Profit serves a crucial function in a free-market
economy.
High profits are the signal that consumers want
more of the output of the industry.
So, high profits provide an incentive for firms to
expand output and for more firms to enter the
industry in the long-run.
For a firm of above average efficiency, profits
represent the reward for the greater efficiency.
Thus, profits provide the incentive for firms to
increase efficiency.
27/12/2011 Dr Sarath Divisekera
Function of Profit
41
Lower profits or losses are the signal that
consumers want less of that commodity and/or
that production is not efficient.
So profits provide the incentive for firms to increase
efficiency and/or produce less of the commodity, and for
some firms to leave the industry for more profitable ones.
Profits, therefore, provide the crucial signals for the
reallocating societys scarce resources to reflect
societys needs.
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profits
42
Business vs Economic Profit
Business Profit = Revenue - Explicit or
Accounting Costs (wages, rental on land
and buildings, interest on borrowed capital,
cost of raw materials).
Economic profit = Revenue - Explicit
Costs + Implicit Costs (opportunity cost)
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profits
43
The concept of BF may be useful for accounting
and tax purposes, it is the concept of economic
profit that must be used in order to reach correct
investment decisions.
Implications:
It is the economic, rather than the business, concept
of profit that is important in directing resources to
different sectors of the economy.
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profits
44
If a firm is trying to decide whether it should
continue in business with the goal of making as
much money as possible, the answer depends on the
firms profits measured in terms of economic profits
(and not business profits).
If the firms economic profits are > or = 0, the firm
should continue (otherwise shutdown).
Note: Throughout this course, we will use the term
Profit to mean economic profit and Cost to mean the
sum of explicit and implicit costs.
27/12/2011 Dr Sarath Divisekera
The Nature and Function of Profit:
Example
45
Suppose the firms business profit = $ 30,000. [50,000 (TR) -
20,000(EC)].
Suppose also that the entrepreneur could have earned $35,000 by
managing another firm (instead of managing his own) and $10,000 by
lending out his capital to another firm.
Thus the implicit cost facing this firm = 45,000, and
Economic profits = 50,000 - 20,000 - 45,000= -15,000.
I.e., a business profits of $30,000 corresponds to an economic loss of
$15,000. Even if the entrepreneur owns no capital, he would incur an
economic loss of $5000 by continuing to operate his own firm and
earning BF of 30,000. So, the entrepreneur should close his firm and
work in his best alternative occupation.
27/12/2011 Dr Sarath Divisekera