Before we look into the operational aspects of firms we need to establish the goals of the firm. This may seem straightforward that firms exist for

Transcription

1 Before we look into the operational aspects of firms we need to establish the goals of the firm. This may seem straightforward that firms exist for making profits. However, changes in recent times have required firms to balance a wider range of objectives, which will partly depend on the type of good produced. 1

2 Two broad characteristics of goods include excludable and rivals. Excludables are goods where a person can be prevented from using it when they do not pay for it. Rival goods are ones where one person s use diminishes other people s use. Using these broad definitions we can further divide goods into four categories: Private goods- such as chocolate bar, shoes- are both excludable and rival. A chocolate bar cannot be simultaneously consumed by two people and therefore it is a rival good. Also chocolate bar is excludable as people who do not pay for it can be prevented from consuming it. Our discussion of the demand and supply earlier was based on private goods. Public goods are neither excludable nor rival. Examples of public goods include fireworks display and national defence. One person s use of either of these commodities does not prevent anyone else from using it nor does one person s use reduce another person s ability to use it. Common resources are rival but not excludable. Fish in the ocean are a rival good as two people cannot simultaneously catch the same fish. But the fish in the ocean not excludable. No one can practically be prevented from taking out any particular fish. Natural monopoly: A good can be excludable but non-rival at the same time. For example, fire services in a town. Once a town has paid for the fire service, all the houses can be simultaneously protected by the same fire services as they are unlikely to be burning down at the same time. However, despite this people can be excluded 2

3 from using the fire services for whatever reasons. Thus, fire services are excludable and non-rival. Moreover, the cost of including an additional house in the town for the fire services is almost negligible. 2

4 To unpack the firm s behaviour further we also need to understand firm s aim and objectives. Firm s aims are classified as long-term goals, generally captured in mission and vision statement. Objectives on the other hand are ways through which the business will meet it aims. Objectives are concrete targets that allow the businesses to stay on track. Most companies publish their mission and vision statements. The textbook provides the following example of mission statements of some international companies: BASF (chemical company): We combine economic success, social responsibility and environmental protection. Through science and innovation we enable our customers to meet the current and future needs of society (Mankiw, Taylor and Ashwin 2013, p. 181). Cairo poultry company: Our vision is to be recognized as the brand of choice in market segments in which we choose to compete, while maximizing our stakeholder's values. Our mission is to produce market safe and healthy wide-range of food products and attract, reward and retain the best people in the food industry (Mankiw, Taylor and Ashwin 2013, p. 182). Union Carriage and Wagon- Through our unique capabilities and business model, we offer our customers a full spectrum of boundless solutions in the rolling stock sector. Customized rolling stock to meet our customers unique operational needs, as well as standard product designs in the industry form part of this spectrum. The UCW 3

5 Advantage provides customers with quality products on time. Constant emphasis on customer relations, co-operation as well as clear communication with its customers, ensures that the UCW customer enjoys unmatched after sales support to keep the wheels turning! (Mankiw, Taylor and Ashwin 2013, p. 183). These mission statements provide limited reference to profit and are typical of a number of mission statement provided by profit making enterprises that focus on customers, environmental and social responsibility, quality, shareholder value, stakeholder well-being and employees. This is reflective of the complex set of expectations on companies in relation to the broader community. Even though profit is not explicitly emphasised, a number of these goals are linked to profit. For example, shareholder value can only be maximised by a profiteering company. 3

6 Strategy is defined as actions, decisions and obligations which lead to the firm gaining a competitive advantage and exploiting the firm s core competencies. Strategies define the position that the company wants to take in the long term whereas a tactic provide a more short term framework for the firm. Confusion does arise on the use of word because there is no definition regarding how long is the future time period. For example, in a sports game the long term may be till the end of the game. Strategy may be to win the game against a particular rival and tactics may be the steps taken during the course of the game. Some may argue that long term may, however, be the end of the season. Since there is no agreement on the terminology, we will stick with the definition of strategies and tactics as defined in the book. The term goals will be used in more generic terms. As discussed earlier the firm published statements express a variety of views in terms of the goals that they want to achieve. However, for any private firm, long term survival is dependent on making a profit and hence we will focus on the profit aspect of the business. 4

7 The business goals will also be impacted by whether the firm is in the private or public sector. Public sector is where business activity is owned, financed and controlled by the government. Examples include street lighting, justice and police. Most public sector organizations are dependent on funds from the government as well charges from the sale of goods or services being provided. For example, Sydney Railways which provides services at lower than market rates where part expenditure is met by the sale of tickets and part by the government. The aim of the public organization is less focused on profit maximizing and may include goals such as equity, consumer satisfaction, safety etc. In many countries a large share of economic activity is composed of government expenditure. In the year 2010, Government expenditure as a percentage of GDP in Germany was 46.7%; Netherlands was 51.2%; Iceland was 50.0%; United Kingdom was 51.0%; Greece was 49.7%; Turkey was 37.1%; Italy was 50.6% and Denmark was 58.2%. The private sector is where business is owned, financed and run by private individuals. Since private sector is not financially supported by government or the wider community, profit making is fundamental to its long term survival. Certain goods are mixed and are provided by both public and private. Merit goods are provided by the public sector because market provision would not lead to an optimal production. Examples of such goods include health care and education. Even though we have private health insurance, government still provides health cover as some individuals may not be able to afford private cover or may choose not do so. 5

8 So for the purposes of this course we will focus on private firms and assume that their main goal is profit maximisation. We need to introduce a few terms that will become useful in finding the profit maximising point. Profit=Total Revenue Total Cost; where total revenue is simply price times quantity. For the moment we will focus on the perfect competition. Think of a commodity like milk which is homogenous and produced by many different producers. Essentially the market Demand and Supply diagram (introduced previously) determines the market price and quantity of milk. The market supply is made up of many individual suppliers and the market demand is made up of many individual consumers. Lets say the equilibrium price is Pe. Under perfect competition an individual firm can sell as much as they want at price Pe. Since the individual is a small supplier in the market, the amount sold by an individual does not have any influence on the market price and the individual can sell as much as they want at price Pe. But if an individual firm charges a price higher that Pe, the individual firm will sell nothing. Therefore, we say that under perfect competition the individual supplier is a price taker. Once we have the price and quantity we can calculate marginal revenue and average revenue. Average revenue is the total revenue divided by the amount sold. Marginal revenue is the change in total revenue from the sale of each additional unit of output. 6

9 Lets practise the definitions introduced on the previous slide. In the table above price faced by the dairy farm is If quantity sold is 1, total revenue is At quantity 2 total revenue is 0.7. Average revenue is simply calculated by dividing total revenue by quantity. Since price is constant in perfect competition, average revenue is simply the price of the good. Marginal revenue is the change in total revenue from the sale of each additional unit of output. To calculate this, find the change in revenue at each point. For example, when we sold 0 units then the revenue was zero. But the sale of one unit meant that the additional revenue increased to.35. Thus marginal revenue is.35. If we now produce 2 units instead of one, total revenue is 0.7 but the change in revenue is 0.35 ( ). We can keep extending the analysis to find that every point Marginal revenue is.35. We have a constant marginal revenue in the example above because the firm faces a constant price. 7

10 To analyze profits further, we need to re-visit opportunity cost, which is the value of the next best alternative forgone. It includes both implicit and explicit costs in its valuation. Accounting profit, on the other hand, only includes explicit costs. Hence, economic costs are most likely to be greater than accounting costs. Lets take a simple examples. I get paid to $200 per hour for this lecture (I wish!). My next best alternative to this lecture was taking tutorials paying me $100 per hour. Therefore, the value of next best alternative is $100. Here $100 is the opportunity cost of my time and an implicit cost. Lets say the explicit costs are zero. Will I take this lecture? Yes of course! Lets modify this a bit. My costs of getting to the lecture are $50. Making the opportunity cost $150 but still not changing the outcome. Lets take the example of me running a restaurant. Opportunity cost of my restaurant will include both explicit cost (like costs of supplies) + the value of my time if I am running the restaurant. Which is again different from accounting costs. 8

11 The marginal cost is the change in total costs from the production of each additional unit. Here by total cost we mean opportunity cost. Typically marginal cost increase as production increases. Why? The answer is embedded in the concept of diminishing marginal product which emphasizes that the marginal product of an input declines as the quantity of the input increases. If you take labor as the main input in production, then the property of diminishing marginal product implies that as we hire more labor units, the extra output or marginal product received from each labor unit decreases. Again be very careful as we are talking about marginal product, not total product. To simplify things lets take an example. Lets say that a coffee shop opens on campus. The coffee shop provides coffee+cake+sandwiches. At first there is only one person working in the coffee shop who runs around and does everything. This person struggles most of the time making customers a bit weary of the shop. Now the shop hires one more person and suddenly things improve as the two workers are able to specialize. The extra output we get from the additional worker increases by a lot. Thus marginal product increases. Now we continue hiring more people. As more people come into the coffee shop there is less room for people to specialize. The total output increases but not as much. Thus, marginal product is going down. So what we have here is that marginal product is going down, which essentially implies that marginal cost is going up. Why are the two related? Each additional worker is able to contribute less to the total cups of coffee in this instance, but takes essentially takes the same wage. What this means is that value of the product contributed by each additional worker is reducing but the wage is not. Therefore marginal costs are 9

12 increasing. Don t confuse marginal costs with average costs here! 9

13 Profit maximisation point can be found in to ways. First is the traditional method of finding the profit maximisation point- which is by finding total profit for each point and then settling for the point which gives the highest profit. This is incredibly tedious. Economist tend to use a simpler method of comparing marginal revenue and marginal costs. Marginal revenue essentially provides us with the extra revenue that we get from selling each additional unit. In the example of the waterlane farm dairy this was Marginal cost is the extra cost associated with producing each additional unit. So if MR>MC then it pays to produce more. However, if MR<MC then it pays to cut production. Profit is therefore maximised at MR=MC. Please note that the graph is typical of a perfectly competitive firm. In the textbook figure 8.2 reflects most of what is expressed above. However, the textbook also discusses Average total cost and average variable costs. We will omit the discussion of this until next session. Please also ignore break even analysis. 10

14 Companies often come under criticism for revenue maximisation rather than profit maximisation. For a perfectly competitive firm the total revenue curve is a straight line as the price is constant. But firms not operating under perfect competition will face a downward sloping demand curve. This will mean that price and elasticity faced by the firm will change. 11

15 Elasticity of demand is measured as percentage change in quantity demanded divided by percentage change in price. It is very important to remember the ceteris paribus assumption. We can calculate the price elasticity of demand only if other things are held constant. There is an inverse relationship between price and quantity demanded, hence own price elasticity of demand is always negative. For reasons of convention, we drop the minus sign and speak of own price elasticity in absolute terms. From the previous sessions recall that elasticity is not constant along the linear demand curve. As price increase demand becomes more elastic. The elastic area on the demand curve shows the region where Elasticity>1, followed by region of unit elasticity and then the area of where Elasticity<1. According to the formula of price elasticity, elastic area means that a percent fall in price increases the quantity demanded by more than a percent. Connecting this to Total revenue or revenue implies that if we are in the elastic region and we reduce the price then total revenue will increase. On the other hand in the inelastic region a percent reduction in price will lead to less than a percent increase in quantity, causing the total revenue to fall. Total revenue is maximized at the point of unit elasticity. This relationship is represented the diagrams above. If the wrong incentives are established in a firm then the manager may be tempted to revenue maximize rather than profit maximize. Stressing again that these are two different things. 12

16 Businesses may face the concept of product life cycle. Most products go through phases in which the sales revenue varies. Product life cycle may vary from launch through to growth, maturity and decline. For example, in the introduction stage sales rise slowly and then may pick up speed. Sales may then continue to grow until the market matures reaching a period after which they start to decline. Firms facing product life cycle may have no choice but to focus on minimizing costs as they are bound by phases of development in the market and therefore to ensure sustainability of the product in the market. Firms may therefore use techniques such as making its human resource management more efficient, better allocation of resources, reorganizing business to have the most suitable organizational structure, deploying the most suitable technologies etc. One of the important aspects of this exercise is productivity. Productivity = Total Output divided by units of a factor If there are gains in efficiency then this implies that productivity increases. If a cutlery manufacturer employed 200 workers to produce 20,000 cutlery per month then productivity will be 100 sets per month. If the production increases to 40,000 cutlery per month and the workers employed remain at 200, then productivity increases to 200 sets per month. Another possibility of reducing costs is restructuring the supply chain. Supply chain is the various steps in moving business to business or business to consumers. Most 13

17 supply chains can be long and complex providing potential for reducing costs. 13

18 Shareholders partly own the business and have a claim on the future earnings of the business because of their investment in the business. Shareholder value refers to the reward that shareholders receive for investing in the firm. The reward in either in the following two ways: -Increase in the share price of the business -Increase the value of the dividends paid to shareholders The CEO thus has a responsibility of improving the performance of the company to improve shareholder value. Performance however is a contested issue. Should it focus on profit or future growth. Some also argue that performance is fundamentally related to freeing the cash generated from the firm s operations minus that spent on capital assets. 14

19 We have in this session looked at the following financial objectives of the firm: 1. Profit maximization 2. Revenue maximization 3. Cost minimization 4. Shareholder value All four views are interrelated. However, for the purposes of the sessions coming upwe will focus on the profit maximisation goals. 15