The Firm and its Goals

The Firm and its Goals

The Firm

Ø  A firm is a collection of resources that is transformed into products demanded by consumers

Ø  Profit is the difference between revenue received and costs incurred

Ø   Transaction costs are incurred when entering into a contract

Types of transaction costs: investigation, negotiation, enforcing contracts.

Ø  Transaction costs are incurred when entering into a contract

Influences : Uncertainty , frequency of recurrence , asset specificity

Ø  Limits to firm size

-          tradeoff between external transactions and the cost of internal operations

-          company chooses to allocate resources so total cost is minimum

-          outsourcing of peripheral, non-core activities

Economic goal of the firm

Ø  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

Ø  Optimal decision is the one that brings the firm closest to its goal

Ø  Short-run versus Long-run

·         nothing to do directly with calendar time

·         short-run: firm can vary amount of some resources but not others

·         long-run: firm can vary amount of all resources

·         at times short-run profitability will be sacrificed for long-run purposes

Goals other than profit

Ø  Economic goals

·         market share, growth rate

·         profit margin

·         return on investment, Return on assets

·         technological advancement

·         customer satisfaction

·         shareholder value

Ø  Non-economic objectives

·         good work environment

·         quality products and services

·         corporate citizenship, social responsibility

Do companies maximize profit?

Ø  Criticism: companies do not maximize profits but instead merely aim to satisfice, which means to achieve a satisfactory goal, one that may not require the firm to ‘do its best’

Ø   Position and power of stockholders

Ø  Position and power of management

Ø   Counter-arguments which support the profit maximization hypothesis

Two major types of risk:

Ø  Business risk involves variation in returns due to the ups and downs of the economy, the industry, and the firm

   All firms face business risk to varying degrees

Ø  Financial risk concerns the variation in returns that is induced by ‘leverage’

   Leverage is the proportion of a company financed by debt

o   the higher the leverage, the greater the potential fluctuations in stockholder earnings

o   financial risk is directly related to the degree of leverage