Chapter 3 Performance Copyright © Houghton Mifflin Company.All rights reserved. 3–23–2 Market...

Chapter 3

Performance

Copyright © Houghton Mifflin Company.All rights reserved. 3–2

Market Process

• Recall the survey -- scarce goods and resources can be allocated in many ways.

• The PRICE is one allocation device -- to those willing and able to pay the price.


Miata

Law of one price: Miata

$0

$5,000

$10,000

$15,000

$20,000

$25,000

DETROIT

L. A.

Big Macs

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

Price

LondonNew YorkTokyoPhoenix

professors loaded down with Big Macs


Law of one price: The Market Process

• Identical goods (resources) sell for identical prices in different markets once transportation and other transactions costs are accounted for.

• WHY?


Prices as Allocation Devices

• Let’s consider some examples of the price system functioning . . .


Answer the following:

• (1) You are shopping at a store for a radio. The price is $50.

• You are told that the identical radio is only $45 at a store just a block away.

• What do you do?


Consider the second situation:

• (2) You are shopping at a store for a home theater. The price is $3000.

• You are told that a block away the same system is $2995.

• What do you do?


Most people change in the 1st case but not the 2nd.

• Did everyone act the same in both instances?

• How many chose to go to the other store in one but not the other instance-- which did you choose?


Why Can We Feel Confident that the Law of One Price Occurs?

• What explains the behavior of individuals?

• Self-interest


Self-Interest

• People want to make themselves as happy as possible -- by ensuring that benefits exceed costs, they act in their self-interest.

• Firm executives and managers behave similarly.

Let’s Now Examine the Firm

We are always keeping in mind the behavior of people -- what

we have just discussed.


What is a firm?

• I want you to think about the individual sellers along Silk Road or the individual vendors throughout Beijing.

• Now think about the huge firms like Motorola, Coca-Cola, and Samsung.

How do they differ?


Why do “firms” exist?

• Why aren’t firms just the individual proprietors or vendors rather than institutions with hundreds of employees?

• Because exchange within them is more efficient than the same exchange carried out in the open market

• What does efficient mean?


Why do the “firms” exist?

• Are all firms efficient?

• No, at any one time some are successful and some are not.

• Which is which?


Adding Value

• Successful firms add value to the inputs (resources) they use.

• Microsoft bought $1.6 billion in materials, had a wage and salary bill of $400 million, and used capital worth about $50 million.

• Sales were $2.75 billion -- $650 million more than it cost to produce the output.

• This $650 billion is a measure of the value that Microsoft added.

• Added Value = value of output - full cost of inputs.


Adding Value

• Profit Maximizing is the same as adding value or value maximization for a for-profit firm.

• Adding value for a not-for-profit firm depends on what the objectives of the firm are.

• For instance, what about a charity? What would adding value mean?

• What about the SOE?


Adding Value

• Measuring Added Value:

• It is easier for the for-profit firms than the not-for-profit firms.

• Nevertheless, the approach is the same.


Adding Value

• Added Value -- accounts fully for the inputs a firm uses:

• In other words, the costs of the inputs are subtracted from the value of output.

• Inputs: What are they?

• Land, Labor, Capital

• Added Value = Value of Output - Cost of Land - Cost of Labor - Cost of Capital.


Adding Value

• What is the cost of labor?

• It is the amount that must be paid to an employee to ensure that the employee remains with the firm.

• What is cost of land?

• It is the amount that must be paid to the owner of land to ensure that the land is retained in its use by the firm.


Adding Value

• What is the cost of capital?

• It is the amount that must be paid to the owners of capital in order for the capital to be retained in the firm.


Adding Value

• In every case, the cost is the return the best alternative use of the funds would have yielded.

• This is easy to measure for labor and land.

• Labor is the salary (benefits etc.).

• Land is the rent on the land.

• The cost of capital accounts for the alternatives or opportunities that are missed or forgone in order to invest in the firm.


Adding Value

• Added value < operating profit

• Operating profit = value of output - cost of materials, land, and labor inputs.

• Thus: added value = Operating Profit - cost of capital.


Economic Profit

• Suppose Wal-Mart indicated an operating profit of $120 million. What would that mean to you as an investor?

• As an investor, you are a supplier of capital -- an owner of capital. What return do you want for letting others use your capital?

• You must earn at least what you could get elsewhere or else you will not leave your capital with that firm or that investment.


Economic Profit

• Operating profit does not tell us much unless we know the alternatives.

• Operating profit is referred to as “accounting profit.” It is the profit reported in financial statements and annual reports.

• But, without accounting for all opportunity costs, the profit measure does not provide much information.

• Thus, we want a profit measure that accounts for all opportunity costs.


Economic Profit

• This is what economic profit does.

• Economic profit is revenue less all costs.

• Economic profit can be positive, zero, or negative.

• What does positive economic profit mean?

• What does zero economic profit mean?

• What does negative economic profit mean?


Economic Profit

• Why don’t accountants report economic profits?

1. Too subjective.

2. Too difficult to measure.

• But, there is a strong move to come closer to economic profit.


Measures

• In recent years (last decade) measures of economic profit have become increasingly popular -- examples include economic ralue added or EVA; free cash flow; and residual profit.

• Each is a one-year measure of the difference between the value of output and the full cost of inputs.


Short Termism

• In the chapter we talk about two firms, A and B, with different strategies.

• A is short-term, generating profits today but at a cost tomorrow.

• B is looking long-term, giving up profit today for more in the future.

• So -- should you purchase firm A now and sell it in a year to purchase firm B?

• This won’t work -- market looks ahead and reflect the long term in today’s prices.

• A firm that adds value above opportunity cost is providing a return to shareholders that exceeds any return it could get in an alternative investment of comparable risk.

• This is economic profit or excess shareholder value.


Summary of Economic Profit

• Positive economic profit:

returns exceeding opportunity costs.

• Negative economic profit:

returns less than opportunity costs.

• Zero economic profit

returns equal to opportunity costs.


Implications

• Positive economic profit:others want to do the same thing.

• Negative economic profit:owners/investors want to take their money elsewhere.

• Zero economic profit:owners/investors are indifferent between leaving their money where it is and moving it.


Example

http://www.eva.com/evaluation/overview.shtml#

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