Chapter5a Managerial Economics Oct 2011

8/3/2019 Chapter5a Managerial Economics Oct 2011

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MANAGERIAL ECONOMICS

Instructor: Dr. Bui Thi Lan Huong

CFVG-HCM-HN

[email protected]


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CHAPTER V

THEORY OF THE FIRM


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SECTION I

THE FIRM AS AN ORGANIZATION


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WHY ARE THERE FIRMS

Firms exists as an alternative to a puremarket structure of transactions.

Managers of firms have always to be

asking should activity X be done inside

the firm or bought in via the market

from another supplier?

Definition of the firm: unit that

takes decisions with respect in

the production and sale of goods

and services.


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Large number of sellers and buyers,each acting independently

and exerting no individual monopolistic power.

Large number of sellers and buyers,each acting independently

and exerting no individual monopolistic power.

Full information everyone about prices

and can evaluate the quality of the good orservices being produce

Consumers aims to maximize utility(personal satisfaction)

and firms aims to maximize profits.

Prices are flexible in all markets.

A PERFECTLY COMETITIVE MARKET


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IMPLICATIONS AND CONDITIONS

The law of one priceat which transactions

occur.

Price takers: Buyers

and sellers take the

price of the product as

given. Free entry: all firmshave identical long run

cost functions.


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DEMAND FACING A TYPICAL FIRM IN APERFECTLY COMPETITIVE MARKET

The industry A representative

firm

S

D

Units of output Q Units of output q

Priceperun

it(USD)

Each firm faces a

perfectly elastic demand

curve.P*

Recall that price is assumed to be fixed in the perfectly competitive

market. each firm is very small relative in the industry that changes in its

inputs do not affect the market price.


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THE PRINCIPAL AGENT PROBLEM

The idea of profitmaximisation applied to aworld of owners-managers.

Owners (the shareholders)might be presumed to wantmaximum profit.

But managers might wantmaxomise somethingdifferent: their salaries, theirexecutive power,

=>Possibility of conflictingobjectives between ownersand managers

The principal-agent problem PRINCIPALS: shareholders

or owners

AGENTS: Managers The problem: How do the

owners get managers to actin their interests? (TOMAXIMIZE THE FIRMPROFIT)


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Base salaryBase salary Share optionsShare options

Fixed-termcontract

Fixed-termcontract

Profit-relatedincentives

Profit-relatedincentives

HOW TO SOLVE THE PRINCIPAL-AGENTPROBLEM


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AN EXAMPLE OF PROFIT MAXIMIZATION INACTION

A history of Coca Cola reports that R. Goizueta, newly appointed

CEO in 1981, was frustrated by Coke executives varied reactions

to competition in setting their goals some going after increased

sales, some market share, and only a few concerned over return

of capital. The new CEO believed something had to be done. Atthe heart of his strategy lay the PROFIT TARGET. This emphasis

on profitability was instrumental in raising per share by 10% peryear.

THE MORAL OF THIS STORY IS THAT THE FAILURE TO

MAXIMIZE PROFITS WILL EVENTUALLY BE DETECTED ANDCORRECTED BY MARKET FORCES.

Source: Cited by MacAleese


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PROFITPROFIT

PRODUCTIONPRODUCTION

THE FIRMTHE FIRM????????

????????

????????

????????

????????

$

THE FIRM IN ECONOMIC THEORY


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FIRMS AND PROFIT MAXIMIZATION

Profit maximization as the

objective of the firm.

In the short term, the

acquisition or defense ofmarket share may often

need taking price and

quality decisions which

conflict with profitability

and may even involveshort-term losses.

With the possibility ofconflicting objectivesbetween owners andmanagers, the firm mightnot always behave in theway one would expect onthe basis of the profit-maximization assumption.

The divergence in

objectives between ownersand managers leads to thePRINCIPAL AGENTPROBLEM.

Economists assume that firms choose output to maximize profits.


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IMPLICATIONS OF THE PROFITMAXIMIZATION HYPOTHESIS

Pricing decisionsOutput decisions


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SECTION IITHE BEHAVIOR OF PROFIT-

MAXIMIZING FIRMS AND THEPRODUCTION PROCESS


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THREE DECISIONS THAT ANY FIRMMUST MAKE

How much of eachinput to demand?

How much outputto supply?

Which productiontechnology to use?

Profit maximizing objective


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THE BASES OF OPERATION DECISIONS

TO OPERATE A GAS STATION

You need to know:

1. The wage rates for

mechanics and unskilled

workers, the cost of gas

pumps, interest rates, rents

per square of land on high

traffic corners, and the

wholesale price of gasoline.

2. What equipment you need,

how many workers, whatkind of a building,

3. How much you can sell

gasoline and repair services

for.

THE BASES OF DECISION

MAKING:1. The market price of

output;

2. The techniques of

production that are

available;

3. The prices of inputs.


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Megastore

Collections

Industrial Complex

Corporate Headquarters

Automatic Distribution Center

AN EXEMPLE OF A MULTINATIONALPRODUCTION FIRM


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THEORY OF SUPPLY

Technology

Production costs

Total

costs

Marginal

costsLevel of

output

Marginal

revenue

Demand

curve

facing

the firm

Average

costsTO PRODUCEOR TO CLOSE


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THE PRODUCTION PROCESS

Determines

total revenue

Determines total cost

and optimal method ofproduction

Total revenue Total cost =Total profit

DETERMINING THE OPTIMAL METHOD OF PRODUCTION TO

MAXIMISE PROFITS.

Price ofoutputs

Productiontechniques

Input prices

Profitable?


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COST STRUCTURE OF THE FIRM

Total Cost

AverageFixed Cost

Total VariableCost

AverageVariable Cost

Total FixedCost

Average Cost


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THE BREAK-EVEN POINT

TotalRevenueandCost

Units of Production

Break-Even Point

Profit Area

Total Fixed Costs

Total Variable Costs

Total Cost Curve

Total Revenue Curve

Loss Area

More0

Higher


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COST MINIMIZATION

To maximize profits, the firm chooses the best

level of output. changing output affects both

the costs of production and the revenues from

sales.

=> COSTS and DEMAND CONDITIONS jointlydetermine the output choices of a profit-maximizing firm.

=> COST MINIMIZATION: the firm certainlywants to make its chosen output level at the

least possible cost.


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PRODUCTION FUNCTION

States the relationship between inputs and outputs

Inputs the factors of production classified as: Land all natural resources of the earth not just terra

firma! Price paid to acquire land = Rent

Labor all physical and mental human effort involved inproduction

Price paid to labour = Wages Capital buildings, machinery and equipment

not used for its own sake but for the contributionit makes to production

Price paid for capital = Interest Mathematical representation

of the relationship:

Q = f (K, L, La)Output (Q) is dependent upon the amount of capital (K), Land(L) and Labor (La) used


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PRODUCTION FUNCTION

Inputs Process Output

Land

Labor

Capital

Product orservice

generated

value added


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PRODUCTION TECHNOLOGY

Labor-intensive technology

Technology that relies heavily

on human

Capital-intensive technology

Technology that relies heavily on

capital rather than human labor.

In choosing the most appropriate technology, firms select the

one that minimizes the production cost.


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AN EXAMPLE OF PRODUCTION FUNCTIONFOR SANDWICHES

Labor units(employees)

Total product(sandwiches

per hour)

Marginalproduct of

labor

Averageproduct of

labor

0 0 - -

1 10 10 10.0

2 25 15 12.5

3 35 10 11.7

4 40 5 10.0

5 42 2 8.4

6 42 0 7.0


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PRODUCTION FUNCTION FORSANDWICHES

0

10

20

30

40

50

0 1 2 3 4 5 60

5

10

15

20

0 1 2 3 4 5 6

Number of employees Number of employees

Production function Marginal product of labor

Totalproduct

Marginalpro

duct

PRODUCTION FUNCTIONS WITH TWO


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PRODUCTION FUNCTIONS WITH TWOVARIABLE FACTORS OF PRODUCTION

ONE GRILL TWO GRILLS

Units of labor Total product Marginalproduct

Total product Marginalproduct

0 0 0 0 0

1 10 10 10 10

2 25 15 25 15

3 35 10 40 15

4 40 5 55 15

5 42 2 65 10

6 42 0 75 10

7 42 0 80 5

ONE GRILL ONE GRILLTWO GRILLS


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SHIFT OF A MARGINAL PRODUCT OF LABORCURVE RESULTING FROM AN INCREASE IN

CAPITAL

0

5

10

15

20

1 2 3 4 5 6 7

Number of employees

MARGINAL PRODUCT OFLABOR WITH 2 GRILLS

MARGINAL PRODUCT OFLABOR WITH 1 GRILL

M

arginalprodu

ct


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COST STRUCTURE OF THE FIRM

Quantity

USD

Fixed costs

Variable costs

Total costs


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CHOOSING THE LOWEST COSTPRODUCTION TECHNIQUE

Technique Capitalinput

Laborinput

RentalPer

Machine(USD)

Wageper

worker(USD)

Capitalcost

(USD)

LaborCost(USD)

TotalCost

(USD)

A 4 4 320 300 1280 1200 2480

B 2 6 320 300 640 1800 2440


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FACTOR PRICES AND THE CHOICE OFTECHNIQUE

Technique Capitalinput

Laborinput

RentalPer

Machine(USD)

Wageper

worker(USD)

Capitalcost

(USD)

LaborCost(USD)

TotalCost

(USD)

A 4 4 320 340 1280 1360 2640

B 2 6 320 340 640 2040 2680


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TECHNOLOGY CHOICE

Robotics in manufacturing

in the USA

Substitution of capital for

labor

Office towers in Mumbay

Substitution of capital for

land

K Series Robot Painting

SystemSkycrapers are simply the substitution

of capital for land when land in

desirable locations becomes

expensive.


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EXAMPLE: COST, REVENUE, AND PROFIT (Weekly)

Output

(1)

Total cost

(2)

Price

(3)

Total

revenue(4)

Profit

(5)

0 10 - 0 -10

1 25 21 21 -4

2 36 20 40 4

3 44 19 57 13

4 51 18 72 21

5 59 17 85 26

6 69 16 96 27

7 81 15 105 24

8 95 14 112 17

9 111 13 117 6

10 129 12 120 -9


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REMARKS FROM EXAMPLE OF FIRM'SSUPPLY DECISION

MAXIMIZING PROFITS IS NOT THE SAME AS

MAXIMIZING REVENUE.

By selling 10 units/week the firm could earn 120

USD, but it ould cost 129 USD.

Making the last few units is expensive and brings

in little extra revenue.

=> It is more profitable to make less.

USING MARGINAL COST AND MARGINAL REVENUE


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USING MARGINAL COST AND MARGINAL REVENUETO CHOOSE OUTPUT (Weekly)

Output

(1)

Total cost

(2)

Price

(3)

Total

revenue(4)

Marginal

cost(5)

(Marginal

revenue(6)

0 10 - 0

1 25 21 21 15 21

2 36 20 40 11 19

3 44 19 57 8 17

4 51 18 72 7 15

5 59 17 85 8 13

6 69 16 96 10 11

7 81 15 105 12 9

8 95 14 112 14 7

9 111 13 117 16 5

10 129 12 120 18 3


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MARGINAL COST AND MARGINALREVENUE

The approach examining how one more unit of output affects

profit focuses on the marginal costs and marginal revenue of

producing one more unit.

MARGINAL COST: the rise in total cost when output risesone unit

MARGINAL REVENUE: the rise in total revenue when outputrises one unit.


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MARGINAL COST AND MARGINAL REVENUEDETERMINE THE FFIRM'S OUTPUT

1 2 3 4 5 6 7 8 9 10 11

0

5

10

15

20

25

Marginal cost

(Marginal revenue

MC

MR

O t (Q)Q1

Chapter5a Managerial Economics Oct 2011

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