Chapter 7 The Firm and Its Goals
7.1 What Do Firms Do?
1. What should the firm produce?
2. How should the firm produce its output?
3. How much should the firm sell, and at what price?
4. How should the firm promote its product?
Why Do Firms Exist?
Transaction Costs are the costs of conducting an economic exchange between two parties. The theory of transaction costs predicts that economic exchange will tend to be organized in ways that minimize the costs of those exchanges. In market-based relationships, people have reputations and information, and trust can be built.
The firm’s goal is to maximize its “economic profit.” Total revenue is the sum of the payments that the firm receives from the sale of its output. The total economic cost is the firm’s total expenditures on the inputs used to produce output, where expenditures are measured in terms of opportunity cost. Economic profit is total revenue minus total economic cost.
Economic profit = Total revenue – Total economic cost
The imputed cost is the opportunity cost incurred when the owner of a factor employs the factor in one use rather than in its best alternative use. E.g. An owner may not pay himself a salary, but his time is worth something (it’s opportunity cost), and this is part of the Total economic cost – since it is implicit, it is an imputed cost.
A sunk expenditure is a factor expenditure that, once made, cannot be recovered. (If a factory already has a paid-for 2-year lease, and cannot be sub-leased, then the opportunity cost during this time would be zero – it can’t be used for any other purpose – it is considered a sunk expenditure.)
User Cost of Capital
The user cost of capital is the opportunity cost that an owner incurs as a consequence of owning and using an asset. This includes both the economic depreciation and the foregone interest. E.g. If the $8000 was not spent on buying an item, it would bring in about $560 in one year – assuming interest is 7%. If an item costs 8,000 and after one year could be sold for $1500, then the user cost of capital includes both the $6500 in depreciation, as well as the $560 in foregone interest. The total user cost of capital would be $7,060.
Depreciation is the fall in value of an asset over a defined period of time. (If an item is bought for $8000 and sold for $1500, then depreciation was $6500.)
Apple Computer Forgets How to Price Memory
Apple ordered millions of 1 megabit memory chips at a price of $38 per chip. Then the price of chips on the market fell to $23 per chip, before their inventory was gone. They had to decide whether to use the price they had paid or the current market price. The economic cost of the chips was $23 – if Apple did not use the chips for its own machines, this is the price at which the chips could be sold to other computer companies (best alternative use). Instead, apple executives chose to use the original purchase price - $38, and their profit plummeted, since they were stuck with millions of unsold chips.
7.2 The Firm as Supplier: The Profit-Maximizing Level of Output
Total Revenue Curve
The total revenue of the firm is equal to the number of units of output sold times the price per unit. The market demand curve tells us how much output can be sold in total by all of the firms in the industry at a given price.
The firm-specific demand curve is a schedule showing the quantity of a single firm’s output demanded for any price charged by that particular firm. Using market research, this information can be determined, and a firm can figure out what price it must choose to sell the number of units it wants to sell. The firm-specific demand curve contains all of the information the firm needs to calculate its total revenue function (price * quantity).
The total revenue curve, R, relates the total revenue earned by the firm (y axis) to the quantity of output produced and sold (x axis). [Image page 207]
Total Economic Cost Curve
The total economic cost curve is the schedule showing the relationship between a firm’s output level and the resulting level of total economic cost. This requires that we hold factor (input) prices constant, hold technological possibilities constant, and also hold product characteristics constant.
The total economic cost curve, C, relates the total cost incurred by the firm (y axis) to the quantity of output produced (x axis).
The profit function is the algebraic or geographical relationship between a firm’s output level and its resulting profit level. To maximize its profit, a firm should produce at the output level where the total revenue curve is the greatest distance above the total economic cost curve. This distance can be graphed separately, as the profit function curve. The highest point on this curve shows where profit is maximized.
The Optimal Output Level for an Active Firm
The optimal level of output can be found by looking at the highest point on the profit curve. It can also be found by looking at how profit changes as output changes.
Marginal revenue (MR) is the change in revenue due to the sale of one more unit of output. The marginal cost is the change in total cost due to the production of one more unit of output.
The marginal output rule states that if the firm does not shut down, then it should produce output at a level where marginal revenue is equal to marginal cost. (Although the precise shapes of the marginal revenue and marginal cost curves depend on the particulars of the market in which the firm operates, the rule that the firm should produce at a point where marginal revenue is equal to marginal cost is valid for any profit-maximizing firm.)
The average revenue is the firm’s total revenue divided by the number of units produced. The average economic cost is the firm’s total economic cost divided by the number of units produced.
The Shut-Down Decision
The shut-down rule states that if for every choice of output level the firm’s average revenue is less than its average economic cost, the firm should shut down. (It is important to use economic cost – sometimes it may be better to operate at an accounting loss, rather than shutdown completely – this happens when there are sunk costs – costs like a lease on a building that cannot be sublet that are accounting costs, but not economic costs.)
Refractories: Staying in Business to Lose Money
New technology was developed, and producers of refractories (special bricks) found that the revenues from producing bricks failed to cover the costs of the special clay formed into bricks, the gas and oil used to fire the kilns, and the large capital costs of the plants used to produce the bricks. However, the large expenditures on specialized plants were sunk because the plants had no alternative uses. The managers correctly recognized that the costs of the plants were sunk and did not let that influence their shut-down decision. The average economic costs – the clay and fuel – were below the price of bricks.
East Germany: Shutting Down on Economy
When East Germany reunified, there were many state firms that had to be brought into the free-market economy. For many people, the best alternative use of their labor was unemployment. The East German wages were set at artificially high wages, making the firms unprofitable. However, from the perspective of maximizing Germany’s profit from these firms, they should be kept in business.
7.3 Do Firms Really Maximize Profits?
1) You might argue people don’t think about producing one “marginal” gallon of paint. However, the size of the margin may be larger than one unit, and at some level, it seems likely that this is taken into account.
2) Some argue that firms don’t think in terms of a marginal choice rule or a shut-down rule. However, the validity of the theory of the firm does not require that firms think of themselves as acting in the terms described by the theory. What is essential is that their actual behavior fits the pattern predicted by the theory.
3) Some argue that perfect profit maximization is not possible. However, models still gives us a good idea of tendancies in firms’ behavior.
4) Some argue that a firm is a collection of people, not one decision maker, so it can’t make rational decisions. This is dealt with next.
The Divorce of Ownership and Control
Most large companies are owned by a large number of stockholders, who have a claim on the firm’s profit (and therefore want the firm to maximize profit). However, they are run by managers. The managers may want to maximize things other than profit, such as leisure, amenity, or sales (maximizing total revenue rather than marginal revenue). Stockholders and managers are an example of a principle-agent relationship – an economic relationship in which one party, the principle, hires a second party, the agent, to perform some task on the first party’s behalf.
Internal Control Mechanisms
Internal control mechanisms are a means of controlling a firm’s managers involving solely the owners and managers of the firm itself. These include the corporate governance scheme, which includes the rules and institutions that specify the responsibilities of the managers and set up means for the shareholders to monitor the managers and to replace them if necessary. It could also include the proxy fight, which is an election in which shareholders vote on key corporate decisions or, in some cases, choose to fire the incumbent managers. However, stockholder apathy often takes place – this is an example of free riding. Free riding is said to take place when a person refrains from taking a costly action because he or she knows that someone else will undertake it (which allows the free rider to reap the benefits without bearing the costs.) A third internal control mechanism is performance-based compensation, which is a system for compensating a firm’s manager under which the amount paid to the manager depends on how well the firm does.
External Control Mechanisms
External control mechanisms are control mechanisms that involve people outside of the firm. An example of an external control mechanism is the hostile takeover. If a firm is not maximizing profit, someone may be able to buy the firm for a relatively low price, put it under good management (which will maximize profit) and then sell it for a high stock price. Even the threat of hostile take-over may incentivize a company to maximize profit. Firms may also be pressured to maximize profit if they face strong product market competition. Another form of external control is discipline from capital suppliers – they may not be able to get loans unless they can show they are making good decisions.
7.4 Profit Maximization over Time and under Uncertainty
How should management take into account the fact that the expenditures and receipts (costs and revenues) occur at different dates? (e.g. A 777 is designed and developed, with no revenue expected from it until many years later.)
Some argue that stockholders tend to hold stock in a given firm for only a short period of time, so that they don’t care about the firm’s long-term prospects. However, this is not logical. Stockholders receive dividend payments from the firm. These are distributions of a firm’s profit that are paid to the owners of the firm’s stock. The stockholder also gets money based on the difference between the price of the stock when they buy it, and the price of the stock when they sell it. (This is the capital gain or capital loss – the difference between the buying and selling prices, depending on whether the selling price is higher or lower than the buying price.) So a stockholder that sells his stock after one year receives the present value of the dividend of the stock, plus the present value of the price he sells it for, minus the price that he bought it for.
Income from one year of stock = d1997/(1+i)+p1998(1+i)-p1997
A stockholder wants the firm to maximize the present value of all future profits even if he or she plans to sell the stock soon. It is not in stockholder’s interest for management to by myopic.
Decisions under Uncertainty
A manager with an undiversified human capital portfolio will take the riskiness of his choices into account while well-diversified stockholders are concerned only with the expected returns. From the owner’s point of view, managers will be biased against risky projects.
Policy Implications of Expected Profit Maximization
Congressman Henry Waxman of California proposed a “consumer protection law” that would force firms that make “excessive profits” from anti-AIDS drugs to lower their prices. However, AIDS activists argued that the bill would harm AIDS victims. Since drugs developed for relatively small populations usually produce low profits, and the firms are penalized if they develop a profitable drug, then they will no longer undertake these projects – the expected value will always be low.
Gold Mines, Shutdown, and Option Value
This year, the price of gold is low, but next year, it could be low or high. In the first year, the mining firm must decide whether to keep the mine open or to close it. In the second year, the firm again confronts the decision of whether to have the mine open or closed, but now it knows the second-year price of gold. A decision tree can be drawn to help decide what action should be taken in the first year, given the uncertain conditions.