Description
Ppt also covers topics like Cobb-Douglas PF, Leontief PF, cost analysis, Baumol’s Model, John Bates Clark Model, Williamson's Model of Managerial Discretion.
Theory of Production & Cost
Production Function
• A production function specifies the maximum output that can be produced for a given amount of inputs. • A discrete production function involves distinct, or “lumpy,” patterns for input combinations. • In a continuous production function, inputs can be varied in an unbroken marginal fashion. • The returns to scale characteristic of a production system describes the output effect of a proportional increase in all inputs. The relation between output and variation in only one of the inputs used is described as the returns to a factor. • Constant returns to scale exist when a given percentage increase in all inputs leads to that same percentage increase in output. • Increasing returns to scale are prevalent if the proportional increase in output is larger than the underlying proportional increase in inputs. • If output increases at a rate less than the proportionate increase in inputs, decreasing returns to scale are present.
Production Function
• The total product indicate the total output from a production system. • The marginal product of a factor, MPx? is the change in output associated with a 1-unit change in the factor input, holding all other inputs constant. • A Factor?s average product is the total product divided by the number of units of that input employed. • The law of diminishing returns states that as the quantity of a variable input increases, with the quantities of all other factors being held constant, the resulting rate of increase in output eventually diminishes.
Cobb-Douglas PF
• In economics, the Cobb–Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. It was proposed by Knut Wicksell (1851–1926), and tested against statistical evidence by Charles Cobb andPaul Douglas in 1900–1928.
– For production, the function is
Y = AL?K?, where:
– – – – – Y = total production (the monetary value of all goods produced in a year) L = labor input K = capital input A = total factor productivity ? and ? are the output elasticity of labor and capital, respectively. These values are constants determined by available technology.
• Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. For example if ? = 0.15, a 1% increase in labor would lead to approximately a 0.15% increase in output.
Cobb-Douglas PF
• Output Elasticity, if: • ? + ? = 1,
– the production function has constant returns to scale. That is, if L and K are each increased by 20%, Y increases by 20%. If
• ? + ? < 1,
– returns to scale are decreasing, and if
• ?+?>1
– returns to scale are increasing. Assuming perfect competition and ? + ? = 1, ? and ? can be shown to be labor and capital's share of output.
Difficulties and criticisms
• Neither Cobb nor Douglas provided any theoretical reason why the coefficients ? and ? should be constant over time or be the same between sectors of the economy. Remember that the nature of the machinery and other capital goods (the K) differs between timeperiods and according to what is being produced. So do the skills of labor (the L). • Dimensional analysis: The Cobb–Douglas model is criticized on the basis of dimensional analysis of not having meaningful or economically reasonable units of measurement. • The model is accordingly criticized because the ? and K? have economically meaningless units quantities L unless ?=?=1 (which is economically unreasonable, as there are then no diminishing returns to scale). • For instance, if ?=1/2, L? has units of "square root of man-hours over square root of years", neither of which is meaningful. • Total factor productivity A is yet harder to interpret economically.
Leontief PF
• In economics, the Leontief production function is a production function that implies the factors of production will be used in fixed proportions, as there is no substitutability between factors. • It was named after Wassily Leontief and represents a special case of the constant elasticity of substitution production function. • For production, the function is of the form q = Min((z1/a),(z2/b)) • Where q = quantity produced, z1 and z2 are quantities of input 1 and input 2 respectively and a and b are constants.
Least Cost Combination of Inputs
• In order to determine the best combination of capital and labor to produce that output, one has to know the amount of finance available to the producer to spend on the inputs and also the prices of the input. Suppose that the producer has at its disposal Rs. 10,000 for the two inputs, and that the prices of the two inputs as Rs. 1000 per unit of capital and Rs. 200 per unit of labor. The firm will have three alternative possibilities before it . • a) To spend the money only on capital and secure 10 units of it . b) To spend the amount only on labor and secure 50 unit of labor c) To spend the amount partly on capital and partly on labor . • The factor price line is also known as isocost line because it represents various combinations of inputs that may be purchased for the given amount of money allocated . The slope of the factor price line shows the price ratio of capital and labor i.e.1:5. • By combining the isoquant and the factor price line , one can find out the optimum combination of factors which will maximize output.
• • • • • •
•
Equal product curves IQ1 , IQ2 , and IQ3 represents output of 1000 units , 2000 units and 3000 units respectively . AB is the factor price line . At point E the factor-price line is tangent to isoquant IQ2 representing 2000 units of output . Point E indicates the maximum amount of capital and labor which the firm can combine to produce 2000 units of output . The isoquant IQ3 falls outside the factor price line AB and therefore cannot be chosen by the firm . On the other hand , Isoquant IQ1 will not be preferred by the firm even though between R and S it falls within the factor price line. Points R and S are not suitable because output can be increased without increasing additional cost by the selection of a more appropriate input combination . Point E , therefore ,is the ideal combination which maximizes output or minimizes cost per unit , it is the point at which the firm is in equilibrium.
Production Function
• An isoquant represents the different combinations of inputs that can be used efficiently to produce a specified quantity of output. • Efficiency in this case refers to technical efficiency, meaning the least-cost production of a target level of output. • Input substitution, or the systematic replacement of productive factors, is an important consideration when judging the efficiency of any production system. • The marginal rate of technical substitution measures the amount of one input that must be substituted for another to maintain a constant level of output. It is irrational for a firm to use any input combination outside the ridge lines that indicate the bounds of positive marginal products.
Production Function
• The marginal revenue product is the amount of revenue generated by employing the last input unit. Profit maximization requires that marginal revenue product and marginal cost be set equal for each input. • Economic efficiency is achieved in the overall economy when all firms employ resources to equate each input?s marginal revenue product and marginal cost. • In all instances, it is important to consider the net marginal revenue of each input, or marginal revenue after all variable costs. • Similarly important is the firm?s iso-cost curve (or budget line), or line of constant costs, An expansion path depicts optimal input combinations as the scale of production expands.
Production Function
• Output elasticity is the percentage change in output associated with a 1 percent change in all inputs, and it is a practical means for returns-to-scale estimation. • Power production functions indicate a multiplicative relation between input and output and are often used in production function estimation. • One of the most prominent uses of economic survey information is to track the pace of economic betterment, or productivity growth, in the overall economy. Productivity growth is the rate of increase in output per unit of input. • Labor productivity refers to the relationship between output and the worker time used to generate that output. It is the ratio of output per worker hour In multifactor productivity measures, output is related to combined inputs of labor, capital, and intermediate purchases. • The successful analysis and estimation of production relations is fundamental to the ongoing success of any organization.
• Cost analysis plays a key role in most managerial decisions. • For tax purposes, historical cost, or historical cash outlay, is the relevant cost. This is also generally true for annual 10-K reports to the Securities and Exchange Commission and for reports to stock-holders. • Current cost, the amount that must be paid under prevailing market conditions, is typically more relevant for decision-making purposes. • Current costs are often determined by replacement costs, or the cost of duplicating productive capability using present technology. Another prime determinant of current cost is opportunity cost, or the foregone value associated with the current rather than the next-best use of a given asset. Both of these cost categories typically involve out-ofpocket costs, or explicit costs, and noncash costs, called implicit costs.
Cost Analysis
Cost Analysis
• Incremental cost is the change in cost caused by a given managerial decision, and often involves multiple units of output. Incremental costs are a prime determinant of profit contribution, or profit before fixed charges. Neither are affected by sunk costs, which do not vary across decision alternatives. • Proper use of relevant cost concepts requires and understanding of the cost/output relation, or cost function. Short-run cost functions are used for daytoday operating decision; long-run cost functions are employed in the long-range planning process. The short run is the operating period during which the availability of a at least one input is fixed. In the long run, the firm has complete flexibility.
Cost Analysis
• Long-run cost curves are called planning curves; short-run cost curves are called operating curves.
– Fixed costs do not vary with output and are incurred only in the short run. – Variable costs fluctuate with output in both the short and the long run. A short-run cost curve shows the minimum cost impact of output changes for a specific plant size and in a given operating environment. – A long-run cost curve shows the minimum cost impact of output changes for the optimal plant size using current technology in the present operating environment.
• Economies of scale originate from production and market-related sources, and cause long-run average costs to decline. • Cost elasticity, etc? measures the percentage change in total cost associated with a 1 percent change in output. • Capacity refers to the output level at which short-run average costs are minimized. • Minimum efficient scale (MES) is the output level at which long-run average costs are minimized.
Cost Analysis
• Multi-plant economies of scale are cost advantages that arise from operating multiple facilities in the same line of business or industry. Conversely, multi-plant diseconomies of scale are cost disadvantages that arise from managing multiple facilities in the same line of business or industry. • When knowledge gained from manufacturing experience is used to improve production methods, the resulting decline in average cost reflects the effects of the firm?s learning curve. Economies of scope exist when the cost of joint production is less then the cost of producing multiple outputs separately. • Cost-volume-profit analysis, sometimes called breakeven analysis, is used to study relations among costs, revenues, and profits. A breakeven quantity is a zero profit activity level. The degree of operating leverage is the percentage change in profit that results from a 1 percentage change in units sold; it can be understood as the elasticity of profits with respect of output.
Business Objectives & Basic Models of the Firm Prior to go through Firm?s Objectives one need to understand following: 1. the assumptions of the neo-classical (or profitmaximising) model of the firm and the limitations of the model 2. the differences between the profit-maximising model and the managerial models of the firm 3. the differences between the profit-maximising model and the behavioural model of the firm
The Assumption of the Neo-Classical Model of the Firm
1. The firm is a profit-maximiser - it optimises 2. The firm can be treated in a holistic way
3. There is perfect certainty
Assumption 1: The firm is a profit-maximiser: it is assumed to make as much profit as possible.
This means that the model is an „optimising? model: the firm attempts to achieve the best possible performance, rather than simply seeking “feasible” performance which meets some set of minimum criteria. Assumption 2:
It is a holistic model: the firm is a single entity which has objectives of its own and which can be said to take decisions.
Assumption 3:
It assumes perfect certainty. Cost and demand conditions are perfectly known.
The profit-maxing assumption can be interpreted in two ways:
1. Maximisation of profit in the short-run i.e. the firm has a given set of plant and equipment and makes as much profit as it can with that 2. Long-run profit maximisation i.e. maximise the wealth of the shareholders In most situations these are consistent with each other. Shareholder wealth is maximised by selecting the most profitable set of plant and equipment and then operating it in the most profitable way. BUT THERE MAY BE EXCEPTIONS - making maximum short term profit might trigger entry or government intervention
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • STEP BY STEP TO THE MODEL
$
P1
Demand: Average Revenue
P2
Q1
Q2
Quantity Produced
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • STEP BY STEP TO THE MODEL
$
Demand: Average Revenue
Marginal Revenue
Quantity Produced
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • WHAT IS THE EQUILIBRIUM?
$
Marginal Cost
Profit maximising price
Demand: Average Revenue
Profit maximising output
Marginal Revenue
Quantity Produced
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • MORE DETAIL ON THE EQUILIBRIUM
$
Marginal Cost
Average Cost
Profit maximising price
Demand: Average Revenue
Quantity Produced
Profit maximising output
Marginal Revenue
What Can We Do With This Model?
• Comparative Statics
– begin with an initial equilibrium position - the starting point – change something – identify the new equilibrium, e.g:
• When demand increases? • When costs rise? • When a fixed cost increases?
– This is the main purpose of the model -what it was designed to do
• Normative prescriptions
– it will cost me $30 per unit to supply something which will give me $20 per unit in revenue- should I do it? – I must pay $20 billion to set up in my industry. Should I charge higher prices to get that money back?
• Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit what will it do/what should it do?
The assumptions of profit-maximisation has been criticised in a number of ways; so we have: 1. The “Managerial School” 2. The “Behavioural School”
ABC TELECOM
Chief Executive
Finance Director Executive Director Customer Service Deputy Chief Executive Deputy Chief Executive Director of Human Resources
Director of Corporate Affairs Director of Regional Business Chief Representative China Team
Director of Group Accounting Services & Property Director of Customer Service
Director of Director of Corporate InterMarket national
Director of Director of Information Regulatory Technology Affairs
Director of Corporate Finance & Treasury
Questions for Discussion:
1. What are the objectives of different divisions or departments? 2. Are these objectives compatible? 3. If not, how to resolve conflicts?
“Managerial” Criticisms of the Profit-Maximising Model
• Berle and Means (1932)
– firms are owned by shareholders but controlled by managers – owners? and managers? interests are different – managers have discretion to use the firm?s resources in their own interests
The Managerial School argues that:
1. Ownership and control are in the hands of different groups of people. 2. The interests of owners (shareholders) and Controllers (managers) are different. 3. Managers have the power to let their interests over-ride those of the shareholders. 4. Therefore firms are run in the interests of the managers. In place of the profit-maximising model, the managerial school substitute a variety of alternatives - sometimes referred to as managerial discretion models Sales-revenue maximising (Baumol) Managerial utility maximising (Williamson)
Managerial Discretion Models of the Firm
• Baumol?s Sales Revenue Maximising Model
– managers? rewards seem to be more closely linked to size than to profit – therefore, firms aim to maximise sales revenue – but subject to a profit constraint
Baumol?s Model
$
TR
TC
Profit
Level of Output
Comparison of Baumol?s Model with the Profit-Maximising:
• A. The unconstrained version
– Price? – Output? – Profit?
• B. The constrained version
– depends where the constraint is – note what happens if the constraint is so tight that maximum profit is required
Comparative Statics of Baumol’s Model
• What if demand rises? • What if fixed costs change? • What if variable costs change?
Williamson’s Managerial Utility maximising Model
• What do managers want?
– UTILITY = happiness, satisfaction
• What gives them utility? Utility = f(S, M, D)
Williamson?s Managerial utility Maximization Model
Managers have “expense preferences”, maximisation of utility derived from a) amount spent on staff (S) b) additions to managers? salaries and benefits in the form of “perks” (M) c) discretionary profit (D) which exceed the minimum required to satisfy the shareholders; available as a source of finance for “pet project”
Williamson’s Managerial Utility maximising Model
• How to solve the model? What gives them utility?
– Maths must be used, more complex
• What results does comparative statics?
it
give?
The
Note the Common Characteristics Shared by Managerial Models and the Profit Maximising Model • Optimising
– the firm aims for a maximum
• “Holistic”
– the firm has purpose and takes decisions and actions as a single entity
• Deterministic
– full knowledge of market opportunities and costs is assumed
Behavioural Model of the Firm [Simon (1959), Cyert and March (1963)] • the firm hardly exists; it consists of a group of
people with multiple objectives
• decision-makers exhibit “satisficing” behaviour; organisational slack/X-inefficiency
• problem-oriented search using rules of thumb, which are a function of the past experience of the firm and the people within it • organisational learning: meeting all objectives; then raising aspiration levels. If cannot meet; then reducing aspiration levels
The Behavioural Approach
• “organisations do not have objectives, only people have objectives” • the firm does not exist - it is a set of shifting coalitions of individuals • individuals and groups do not maximise - they “satisfice” • information about the environment is very limited
The Behavioural Approach
• If all aspirations are being met everyone is satisfied - do nothing • BUT then aspiration levels will rise until someone is not satisfied • THEN rules of thumb used to find solutions to “the problem”
The Behavioural Approach
• Aspiration levels, which adjust according to experience • Problem-oriented „rules of thumb? based on past experience • A dynamic model • not “holistic” • not “deterministic” • not optimising
• Behavioural approach is a more accurate description of what happens INSIDE the firm. • BUT it tells us almost nothing about how the firm will respond to changes in the environment. • To use it to make predictions about how the firm will react to changes in the environment we need to know everything about the individual firm. • However, if shareholders are a powerful group and their aspiration level requires making maximum profit the firm will again behave in the same way as a profit-maximiser.
Which Approach is Most Useful?
In Conclusion?
• The behavioural approach is a useful complement to the profit-maximising and managerial approaches, not a substitute for them.
Theory of the Firm
Introduction
Introduction
In developing the supply and demand approach to economics, economists first worked out the basis of the demand curve.
Introduction
As a first step, we need to think about the decision-makers in supplying goods and services, and what a "rational decision" to supply goods and services would mean. In economics, this is often called the "Theory of the Firm."
Firms
•Proprietorships •Partnerships •Corporations
Proprietorships
A proprietorship (or proprietary business) is a business owned by an individual, the "proprietor." Many "Mom and Pop stores" and other "Mom and Pop" businesses, as Americans call them - are proprietorships.
Partnerships
A partnership is a business jointly owned by two or more persons. In most partnerships, each partner is legally liable for debts and agreements made by any partner.
Corporations
A corporation has two characteristics that distinguish it from most proprietorships and partnerships: • Limited liability • Anonymous ownership
Traditional Theory of the Firm
This assumes that firms aim simply to maximise profits. The classical theory of the firm relied heavily on the notion that firms are small, owner-managed organisations, such as proprietorships, operating in highly competitive markets whose demand functions are given and where only normal profits can be earned.
If the firm did not therefore maximise profits it would fail to survive under these conditions.
Traditional Theory of the Firm
There are two main objections to this notion:
1. The model of a profit-maximising firm is an owner-managed firm producing only one good, which knows all future cost and revenue streams with certainty. • Such a firm could indeed choose the levels of output and price that would maximise its profits. • But, in fact, firms are faced with • much more complex decisions, • to be taken in a dynamic and • uncertain environment, and in • this case it is far less clear how • a profit-maximising firm will behave. 2. Firms may be aiming to do something completely different; for example to maximise sales or growth. Such an objection may well apply to modern joint-stock companies or to any other company that is not managed by its owners.
What does a supplier maximise?
The operations of the firm will, of course, depend on its objectives. One objective that all three kinds of firms share is profits, and it seems that profits are the primary objective in most cases.
What does a supplier maximise?
There are two reasons for this assumption.
1. First, despite the growing importance of nonprofit organizations and the frequent calls for corporate social responsibility, profits still seem to be the most important single objective of producers in our market economy. 2. Second, a good deal of the controversy in the reasonable dialog of economics has centered on the implications of profit motivation.
Profit
Profit is defined as revenue minus cost, that is, the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output. However, we need to be a little careful in interpreting that. Remember, economists understand cost as
opportunity cost –
the value of the opportunity given up. Thus, when we say that businesses maximize profit, it is important to include all costs -- whether they are expressed in money terms or not. Because accountants traditionally considered only money costs, the net of money revenue minus money cost is called "accounting profit." (Actually, modern accountants are well aware of opportunity cost and use the concept for specific purposes).
The economist's concept is sometimes called "economic profit."
The John Bates Clark Model
• • • • • Like any other unit, a firm is limited by the technology available. Thus, it can increase its outputs only by increasing its inputs. As usual, this will be expressed by a production function. The output the firm can produce will depend on the land, labour and capital the firm puts to work. In formulating the Neoclassical theory of the firm, John Bates Clark took over the classical categories of land, labour and capital and simplified them in two ways. First, he assumed that all labour is homogenous -- one labour hour is a perfect substitute for any other labour hour. Second, he ignored the distinction between land and capital, grouping together both kinds of nonhuman inputs under the general term "capital." And he assumed that this broadened "capital" is homogenous.
The John Bates Clark Model
•
•
Some inputs can be varied flexibly in a relatively short period of time. We conventionally think of labour and raw materials as "variable inputs" in this sense.
•
Other inputs require a commitment over a longer period of time. Capital goods are thought of as "fixed inputs" in this sense.
More Simplifying Assumptions
• • The John Bates Clark model of the firm is already pretty simple. We are thinking of a business that just uses two inputs, homogenous labour and homogenous capital, and produces a single homogenous kind of output. The output could be a product or service, but in any case it is measured in physical (not money) units such as bushels of wheat, tons of steel or minutes of local telephone calls. The price of output is a given constant. The wage (the price of labour per labour hour) is a given constant.
•
• •
• • •
The Firm's Decision
In the short run, then, there are only two things that are not given in the John Bates Clark model of the firm. They are the output produced and the labour (variable) input. And that is not actually two decisions, but just one, since labour input and output are linked by the "production function.“ Either the output is decided, and the labour input will have to be just enough to produce that output or the labour input is decided, and the output is whatever that quantity of labour can produce. Thus, the firm's objective is to choose the labour input and corresponding output that will maximize profit.
•
•
Labour Input and Profits
Problems with Profit Maximisation
• • • Returning to the concept of Profit
Maximisation
we'll now take a closer look at the problems associated with it and, perhaps more importantly, its alternatives. Firstly the problems, the existence of uncertainty and the complexity of large firms.
1. Uncertainty
•
•
•
•
The Profit maximising model is a static one in which the firm knows its revenue and cost curves with certainty and maximises profits by equating marginal cost and marginal revenue. In practice firms make decisions in a dynamic context. Therefore, revenue and cost calculations must take into account the dimension of time. Future cost and revenue streams must be discounted to yield the Net Present Value (NPV) associated with each course of action. Profit maximisation means choosing the course of action which yields the highest NPV.
Net Present Value n NPV = S i=1
Where
pi
(1 + r)i
pi = Ri - Ci
r = discount rate n = time horizon
With uncertainty
(NPV) = S n E(pi)
i=1
(NPV) = S n i=1
(1 + r)i
pi p(Hi) (1 + r)i
Where p(Hi) = probability attached to each value that profits may take in year i
Risk Minimisation v. Profit Maximisation
Policy A
Profit 0 40 100 Prob 0.25 0.50 0.25
Policy B
Profit 0 100
B = 0 x 0.50 + 100 x 0.50 = 50
Prob 0.50 0.50
A = 0 x 0.25 + 40 x 0.5 + 100 x 0.25 = 45
But 50% probability of zero profits with policy B.
2. Organisational Complexity
• The owners of the modern firm are a large number of share-holders, who have nothing to do with the running of the firm, while the main decisions are made by the board of directors of the firm and implemented by managers and workers all through the different levels and departments of the firm. This has two main implications for the profit maximisation assumption: even if managers do wish to maximise profits, this objective will often be difficult to achieve in a modern firm; the managers who take the decisions may be interested not in maximising profits but in some other goal.
•
•
Baumol?s Static Sales Revenue Maximising Model without Advertising TR
TC TC (£)
TR
p max
0
p
constraint rev.max
ps
p
Q
Dr J. R Anchor, HUBS
Qp max
Qp constraint
Qs revenue max
Alternatives to Profit Maximisation
Baumol's Theory of Sales Revenue Maximisation
Baumol's Theory of Sales Revenue Maximisation
Two basic models: •static single-period model; •multi-period dynamic growth model.
Each model can include advertising activity or not.
1. Rationalisation of the Sales Maximisation Hypothesis
- There is evidence that salaries and other (Mach) earnings of top managers are correlated more closely with sales than with profits. - Banks and other institutions, which keep a close eye on the sales of firms, are more willing to finance firms with large and growing sales.
1. Rationalisation of the Sales Maximisation Hypothesis
- Personnel problems are handled more satisfactorily when sales are growing. Employees of all levels can be given higher earnings and better terms of work in general. Declining sales make the converse and lay-offs more likely. - Large sales, growing overtime, give prestige to managers; large profits go into the pockets of shareholders.
1. Rationalisation of the Sales Maximisation Hypothesis
- Managers prefer a steady performance with satisfactory profits to spectacular profit maximisation projects. If they realise high profits in one period, they might find themselves in trouble in other periods when profits are less than maximum. - Large, growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-à-vis its rivals.
1. Rationalisation of the Sales Maximisation Hypothesis
The implication of Baumol’s model is that risk avoidance has a statistical effect upon economic activities, eg. R&D in large firms.
2. Baumol’s Static Models The basic assumptions of the static models:
- The time-horizon of a firm is a single period. - During this period the firm attempts to maximise its total sales revenue (not physical volume of output) subject to a profit constraint.
2. Baumol’s Static Models
- The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and other financial institutions. The firm must realise a minimum level of profits to keep shareholders happy and avoid a fall of the prices of shares on the stock exchange.
2.
Baumol’s Static Models
- Conventional cost and revenue functions are assumed - cost curves are ill-shaped and the demand curve of the firm is downward sloping.
2. Baumol’s Static Models
Four models:
- A single-product model, without advertising. - A single-product model, with advertising. - A multi-product model, without advertising. - A multi-product model, with advertising.
3. Baumol’s Dynamic Model
The most serious weakness of the static model is the short-time losses of the firm and the treatment of the profit constraint as an exogenously determined magnitude. In the dynamic model the time horizon is extended and the profit constraint is endogenously determined.
The assumptions of the dynamic model
- The firm attempts to maximise the ratio of growth of sales over its lifetime.
- Profit is the main means of financing growth of sales, and as such is an instrumental variable whose value is endogenously determined.
The assumptions of the dynamic model - Demand and of cost have the traditional shape - demand is downward-sloping and costs are U-shaped. Profit is not a constraint (as in the static model) but an instrumental variable, a means whereby the top management will achieve its goal of a maximum rate of growth of sales. - Growth may be financed by internal and external sources. However, there are limits to the external sources of finance.Thus profits will be the main source for financing the rate of growth of sales revenue.
The assumptions of the dynamic model
• Growth may be financed by internal and external sources. However, there are limits to the external sources of finance. Thus profits will be the main source for financing the rate of growth of sales revenue.
Williamson's Model Managerial Discretion
of
Williamson argues that managers have discretion in pursuing policies which maximise their own utility rather than attempting the maximisation of profits which maximises the utility of ownershareholders.
Williamson's Model of Managerial Discretion
Profit acts as a constraint to this managerial behaviour, in that the financial markets and shareholders require a minimum profit to be paid out in the form of dividends, otherwise the job security of managers is endangered.
Williamson's Model of Managerial Discretion
The managerial utility function includes such variables as salary, security, power, status, prestige, professional excellence. Expense preference is defined as the satisfaction which managers derive from certain types of expenditures.
Williamson's Model of Managerial Discretion
Staff expenditures on emoluments, and funds available for discretionary investment give to managers a positive satisfaction (utility) because these expenditures are a source of security and reflect the power, status, prestige and professional achievement of managers.
Williamson's Model of Managerial Discretion
Staff expenditures, salary and benefits, emoluments and discretionary investment expenses are measurable in money terms and can be used to replace the non-operational concepts of power, status, prestige and professional excellence in a managerial utility function.
Williamson's Model of Managerial Discretion
The latter may be written: U = f1 (S, M, ID) where S = staff expenditure, including managerial salaries M = managerial emoluments ID = discretionary investment
Marris - Growth Maximisation
Model highlights two important factors as far as management is concerned: the attitude to risk and uncertainty and the desire for utility which may not be maximised by the pursuit of maximum profits.
Marris - Growth Maximisation
Marris, like Williamson, suggests that managers have a utility function in which salary, prestige, status, power, security, etc., are important. The owners of the firm are, however, likely to be more concerned with profits, market share, output, etc.
Marris - Growth Maximisation
In contrast to Williamson, Marris argues that the owners and managers have one aspect of the firm in common; namely, its size. He therefore postulates that managers will be primarily concerned with maximisation of the rate of the growth of size rather than absolute firm size.
Marris - Growth Maximisation
The attraction of the growth rate of size is thought to stem from the positive effect growth has upon promotion prospects. Stress is put on an alleged preference of managers for internal promotion and this is made easier if the firm is seen to be expanding rapidly.
Marris - Growth Maximisation
Managerial utility function may be written as follows: Um = f (gD,s) where gD = rate of growth of demand for the products of the firm; s = a measure of job security.
Marris - Growth Maximisation
Owners utility function may be written as
U0 = f *(gc)
where gc = rate of growth of capital.
Marris - Growth Maximisation
s can be measured by a weighted average of three ratios: the liquidity ratio, the leverage debt ratio and the profit-retention ratio.
Marris - Growth Maximisation
S can be measured by weighted average of liquidity ratio, debt ratio and profit retention ratio Liquidity ratio = Liquid assets Total assets Value of debt Total assets Retained profits Total profits
Debt ratio
=
Retention ratio
=
Marris - Growth Maximisation
• Too low liquidity ratio may lead to insolvency and bankruptcy and there is a threat of take-over in case it being too high. • Too low Retention ratio may upset shareholders and too high ratio may inhibit growth.
Cyert and March Behavioural Theory
1. The Firm as a Coalition of Groups with Conflicting Goals
based on a large multiproduct group operating under uncertain conditions in an imperfect market - difference between ownership and control - firm treated as a multi-goal, multi-decision organisational coalition of managers, workers, shareholders, customers, suppliers, bankers.
Cyert and March Behavioural Theory 2. Goal Formation – The Concept of the Aspiration Level
Individuals may have (and usually do have) different goals to those of the organisation-firm.
Cyert and March Behavioural Theory
3. The Goals of the Firm: Satisficing Behaviour
Goals set management. by top
Cyert and March Behavioural Theory The main goals:
• Production goal - smooth running. • Inventory goal - adequate stock of suitable raw material. • Sales goal - from sales department. • Share of the market goal – also from sales department. • Profit goal – shareholders, finances.
Cyert and March Behavioural Theory 4 Means for the Resolution of Conflict Conflict is inevitable. Nevertheless the groups and the firm as a whole may remain in a stable position - limited time to bargain, etc. Behaviour, goals and decisions are largely based on past history.
Cyert and March Behavioural Theory
5. The Theory of Decision Making
- At Top Management Level Resource allocation - implemented by the budget - share of budget taken by each department. Largely determined by bargaining power which is itself determined by past performance.
Cyert and March Behavioural Theory
6. Uncertainty and the Environment of the Firm Two types of uncertainty: - market (cannot be avoided) - competitor's reactions (overcome by tacid collution, eg. trade associations)
Problem
• What is the relation between production functions and cost functions? Be sure to include in your discussion the effect of competitive conditions in input factor markets. • With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck and must meet an annual deductible of a few hundred dollars. After that, insurance picks up most of their health care costs. Companies complain that this gives workers little incentive to help control medical insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers better ince3ntives to control employer medical insurance costs?
Problem
• Is use of least-cost input combinations a necessary condition for profit maximization? Is it sufficient condition? Explain. • “Output per worker is expected to increase by 10 percent during the next year. Therefore, wages can also increase by 10 percent with no harmful effects on employment, output prices, or employer profit.” Discuss this statement. • Explain why the MP/P relation is deficient as the sole mechanism for determining the optimal level of resource employment.
SESSION-VII OVER
doc_617922014.pptx
Ppt also covers topics like Cobb-Douglas PF, Leontief PF, cost analysis, Baumol’s Model, John Bates Clark Model, Williamson's Model of Managerial Discretion.
Theory of Production & Cost
Production Function
• A production function specifies the maximum output that can be produced for a given amount of inputs. • A discrete production function involves distinct, or “lumpy,” patterns for input combinations. • In a continuous production function, inputs can be varied in an unbroken marginal fashion. • The returns to scale characteristic of a production system describes the output effect of a proportional increase in all inputs. The relation between output and variation in only one of the inputs used is described as the returns to a factor. • Constant returns to scale exist when a given percentage increase in all inputs leads to that same percentage increase in output. • Increasing returns to scale are prevalent if the proportional increase in output is larger than the underlying proportional increase in inputs. • If output increases at a rate less than the proportionate increase in inputs, decreasing returns to scale are present.
Production Function
• The total product indicate the total output from a production system. • The marginal product of a factor, MPx? is the change in output associated with a 1-unit change in the factor input, holding all other inputs constant. • A Factor?s average product is the total product divided by the number of units of that input employed. • The law of diminishing returns states that as the quantity of a variable input increases, with the quantities of all other factors being held constant, the resulting rate of increase in output eventually diminishes.
Cobb-Douglas PF
• In economics, the Cobb–Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. It was proposed by Knut Wicksell (1851–1926), and tested against statistical evidence by Charles Cobb andPaul Douglas in 1900–1928.
– For production, the function is
Y = AL?K?, where:
– – – – – Y = total production (the monetary value of all goods produced in a year) L = labor input K = capital input A = total factor productivity ? and ? are the output elasticity of labor and capital, respectively. These values are constants determined by available technology.
• Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. For example if ? = 0.15, a 1% increase in labor would lead to approximately a 0.15% increase in output.
Cobb-Douglas PF
• Output Elasticity, if: • ? + ? = 1,
– the production function has constant returns to scale. That is, if L and K are each increased by 20%, Y increases by 20%. If
• ? + ? < 1,
– returns to scale are decreasing, and if
• ?+?>1
– returns to scale are increasing. Assuming perfect competition and ? + ? = 1, ? and ? can be shown to be labor and capital's share of output.
Difficulties and criticisms
• Neither Cobb nor Douglas provided any theoretical reason why the coefficients ? and ? should be constant over time or be the same between sectors of the economy. Remember that the nature of the machinery and other capital goods (the K) differs between timeperiods and according to what is being produced. So do the skills of labor (the L). • Dimensional analysis: The Cobb–Douglas model is criticized on the basis of dimensional analysis of not having meaningful or economically reasonable units of measurement. • The model is accordingly criticized because the ? and K? have economically meaningless units quantities L unless ?=?=1 (which is economically unreasonable, as there are then no diminishing returns to scale). • For instance, if ?=1/2, L? has units of "square root of man-hours over square root of years", neither of which is meaningful. • Total factor productivity A is yet harder to interpret economically.
Leontief PF
• In economics, the Leontief production function is a production function that implies the factors of production will be used in fixed proportions, as there is no substitutability between factors. • It was named after Wassily Leontief and represents a special case of the constant elasticity of substitution production function. • For production, the function is of the form q = Min((z1/a),(z2/b)) • Where q = quantity produced, z1 and z2 are quantities of input 1 and input 2 respectively and a and b are constants.
Least Cost Combination of Inputs
• In order to determine the best combination of capital and labor to produce that output, one has to know the amount of finance available to the producer to spend on the inputs and also the prices of the input. Suppose that the producer has at its disposal Rs. 10,000 for the two inputs, and that the prices of the two inputs as Rs. 1000 per unit of capital and Rs. 200 per unit of labor. The firm will have three alternative possibilities before it . • a) To spend the money only on capital and secure 10 units of it . b) To spend the amount only on labor and secure 50 unit of labor c) To spend the amount partly on capital and partly on labor . • The factor price line is also known as isocost line because it represents various combinations of inputs that may be purchased for the given amount of money allocated . The slope of the factor price line shows the price ratio of capital and labor i.e.1:5. • By combining the isoquant and the factor price line , one can find out the optimum combination of factors which will maximize output.
• • • • • •
•
Equal product curves IQ1 , IQ2 , and IQ3 represents output of 1000 units , 2000 units and 3000 units respectively . AB is the factor price line . At point E the factor-price line is tangent to isoquant IQ2 representing 2000 units of output . Point E indicates the maximum amount of capital and labor which the firm can combine to produce 2000 units of output . The isoquant IQ3 falls outside the factor price line AB and therefore cannot be chosen by the firm . On the other hand , Isoquant IQ1 will not be preferred by the firm even though between R and S it falls within the factor price line. Points R and S are not suitable because output can be increased without increasing additional cost by the selection of a more appropriate input combination . Point E , therefore ,is the ideal combination which maximizes output or minimizes cost per unit , it is the point at which the firm is in equilibrium.
Production Function
• An isoquant represents the different combinations of inputs that can be used efficiently to produce a specified quantity of output. • Efficiency in this case refers to technical efficiency, meaning the least-cost production of a target level of output. • Input substitution, or the systematic replacement of productive factors, is an important consideration when judging the efficiency of any production system. • The marginal rate of technical substitution measures the amount of one input that must be substituted for another to maintain a constant level of output. It is irrational for a firm to use any input combination outside the ridge lines that indicate the bounds of positive marginal products.
Production Function
• The marginal revenue product is the amount of revenue generated by employing the last input unit. Profit maximization requires that marginal revenue product and marginal cost be set equal for each input. • Economic efficiency is achieved in the overall economy when all firms employ resources to equate each input?s marginal revenue product and marginal cost. • In all instances, it is important to consider the net marginal revenue of each input, or marginal revenue after all variable costs. • Similarly important is the firm?s iso-cost curve (or budget line), or line of constant costs, An expansion path depicts optimal input combinations as the scale of production expands.
Production Function
• Output elasticity is the percentage change in output associated with a 1 percent change in all inputs, and it is a practical means for returns-to-scale estimation. • Power production functions indicate a multiplicative relation between input and output and are often used in production function estimation. • One of the most prominent uses of economic survey information is to track the pace of economic betterment, or productivity growth, in the overall economy. Productivity growth is the rate of increase in output per unit of input. • Labor productivity refers to the relationship between output and the worker time used to generate that output. It is the ratio of output per worker hour In multifactor productivity measures, output is related to combined inputs of labor, capital, and intermediate purchases. • The successful analysis and estimation of production relations is fundamental to the ongoing success of any organization.
• Cost analysis plays a key role in most managerial decisions. • For tax purposes, historical cost, or historical cash outlay, is the relevant cost. This is also generally true for annual 10-K reports to the Securities and Exchange Commission and for reports to stock-holders. • Current cost, the amount that must be paid under prevailing market conditions, is typically more relevant for decision-making purposes. • Current costs are often determined by replacement costs, or the cost of duplicating productive capability using present technology. Another prime determinant of current cost is opportunity cost, or the foregone value associated with the current rather than the next-best use of a given asset. Both of these cost categories typically involve out-ofpocket costs, or explicit costs, and noncash costs, called implicit costs.
Cost Analysis
Cost Analysis
• Incremental cost is the change in cost caused by a given managerial decision, and often involves multiple units of output. Incremental costs are a prime determinant of profit contribution, or profit before fixed charges. Neither are affected by sunk costs, which do not vary across decision alternatives. • Proper use of relevant cost concepts requires and understanding of the cost/output relation, or cost function. Short-run cost functions are used for daytoday operating decision; long-run cost functions are employed in the long-range planning process. The short run is the operating period during which the availability of a at least one input is fixed. In the long run, the firm has complete flexibility.
Cost Analysis
• Long-run cost curves are called planning curves; short-run cost curves are called operating curves.
– Fixed costs do not vary with output and are incurred only in the short run. – Variable costs fluctuate with output in both the short and the long run. A short-run cost curve shows the minimum cost impact of output changes for a specific plant size and in a given operating environment. – A long-run cost curve shows the minimum cost impact of output changes for the optimal plant size using current technology in the present operating environment.
• Economies of scale originate from production and market-related sources, and cause long-run average costs to decline. • Cost elasticity, etc? measures the percentage change in total cost associated with a 1 percent change in output. • Capacity refers to the output level at which short-run average costs are minimized. • Minimum efficient scale (MES) is the output level at which long-run average costs are minimized.
Cost Analysis
• Multi-plant economies of scale are cost advantages that arise from operating multiple facilities in the same line of business or industry. Conversely, multi-plant diseconomies of scale are cost disadvantages that arise from managing multiple facilities in the same line of business or industry. • When knowledge gained from manufacturing experience is used to improve production methods, the resulting decline in average cost reflects the effects of the firm?s learning curve. Economies of scope exist when the cost of joint production is less then the cost of producing multiple outputs separately. • Cost-volume-profit analysis, sometimes called breakeven analysis, is used to study relations among costs, revenues, and profits. A breakeven quantity is a zero profit activity level. The degree of operating leverage is the percentage change in profit that results from a 1 percentage change in units sold; it can be understood as the elasticity of profits with respect of output.
Business Objectives & Basic Models of the Firm Prior to go through Firm?s Objectives one need to understand following: 1. the assumptions of the neo-classical (or profitmaximising) model of the firm and the limitations of the model 2. the differences between the profit-maximising model and the managerial models of the firm 3. the differences between the profit-maximising model and the behavioural model of the firm
The Assumption of the Neo-Classical Model of the Firm
1. The firm is a profit-maximiser - it optimises 2. The firm can be treated in a holistic way
3. There is perfect certainty
Assumption 1: The firm is a profit-maximiser: it is assumed to make as much profit as possible.
This means that the model is an „optimising? model: the firm attempts to achieve the best possible performance, rather than simply seeking “feasible” performance which meets some set of minimum criteria. Assumption 2:
It is a holistic model: the firm is a single entity which has objectives of its own and which can be said to take decisions.
Assumption 3:
It assumes perfect certainty. Cost and demand conditions are perfectly known.
The profit-maxing assumption can be interpreted in two ways:
1. Maximisation of profit in the short-run i.e. the firm has a given set of plant and equipment and makes as much profit as it can with that 2. Long-run profit maximisation i.e. maximise the wealth of the shareholders In most situations these are consistent with each other. Shareholder wealth is maximised by selecting the most profitable set of plant and equipment and then operating it in the most profitable way. BUT THERE MAY BE EXCEPTIONS - making maximum short term profit might trigger entry or government intervention
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • STEP BY STEP TO THE MODEL
$
P1
Demand: Average Revenue
P2
Q1
Q2
Quantity Produced
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • STEP BY STEP TO THE MODEL
$
Demand: Average Revenue
Marginal Revenue
Quantity Produced
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • WHAT IS THE EQUILIBRIUM?
$
Marginal Cost
Profit maximising price
Demand: Average Revenue
Profit maximising output
Marginal Revenue
Quantity Produced
The Basic Model of the Firm
• The neo-classical model • The firm aims to maximise profit by choosing the level of output which gives the biggest difference between revenue and costs. • MORE DETAIL ON THE EQUILIBRIUM
$
Marginal Cost
Average Cost
Profit maximising price
Demand: Average Revenue
Quantity Produced
Profit maximising output
Marginal Revenue
What Can We Do With This Model?
• Comparative Statics
– begin with an initial equilibrium position - the starting point – change something – identify the new equilibrium, e.g:
• When demand increases? • When costs rise? • When a fixed cost increases?
– This is the main purpose of the model -what it was designed to do
• Normative prescriptions
– it will cost me $30 per unit to supply something which will give me $20 per unit in revenue- should I do it? – I must pay $20 billion to set up in my industry. Should I charge higher prices to get that money back?
• Positive and Normative are linked by “if?” IF the aim of the firm is to maximise profit what will it do/what should it do?
The assumptions of profit-maximisation has been criticised in a number of ways; so we have: 1. The “Managerial School” 2. The “Behavioural School”
ABC TELECOM
Chief Executive
Finance Director Executive Director Customer Service Deputy Chief Executive Deputy Chief Executive Director of Human Resources
Director of Corporate Affairs Director of Regional Business Chief Representative China Team
Director of Group Accounting Services & Property Director of Customer Service
Director of Director of Corporate InterMarket national
Director of Director of Information Regulatory Technology Affairs
Director of Corporate Finance & Treasury
Questions for Discussion:
1. What are the objectives of different divisions or departments? 2. Are these objectives compatible? 3. If not, how to resolve conflicts?
“Managerial” Criticisms of the Profit-Maximising Model
• Berle and Means (1932)
– firms are owned by shareholders but controlled by managers – owners? and managers? interests are different – managers have discretion to use the firm?s resources in their own interests
The Managerial School argues that:
1. Ownership and control are in the hands of different groups of people. 2. The interests of owners (shareholders) and Controllers (managers) are different. 3. Managers have the power to let their interests over-ride those of the shareholders. 4. Therefore firms are run in the interests of the managers. In place of the profit-maximising model, the managerial school substitute a variety of alternatives - sometimes referred to as managerial discretion models Sales-revenue maximising (Baumol) Managerial utility maximising (Williamson)
Managerial Discretion Models of the Firm
• Baumol?s Sales Revenue Maximising Model
– managers? rewards seem to be more closely linked to size than to profit – therefore, firms aim to maximise sales revenue – but subject to a profit constraint
Baumol?s Model
$
TR
TC
Profit
Level of Output
Comparison of Baumol?s Model with the Profit-Maximising:
• A. The unconstrained version
– Price? – Output? – Profit?
• B. The constrained version
– depends where the constraint is – note what happens if the constraint is so tight that maximum profit is required
Comparative Statics of Baumol’s Model
• What if demand rises? • What if fixed costs change? • What if variable costs change?
Williamson’s Managerial Utility maximising Model
• What do managers want?
– UTILITY = happiness, satisfaction
• What gives them utility? Utility = f(S, M, D)
Williamson?s Managerial utility Maximization Model
Managers have “expense preferences”, maximisation of utility derived from a) amount spent on staff (S) b) additions to managers? salaries and benefits in the form of “perks” (M) c) discretionary profit (D) which exceed the minimum required to satisfy the shareholders; available as a source of finance for “pet project”
Williamson’s Managerial Utility maximising Model
• How to solve the model? What gives them utility?
– Maths must be used, more complex
• What results does comparative statics?
it
give?
The
Note the Common Characteristics Shared by Managerial Models and the Profit Maximising Model • Optimising
– the firm aims for a maximum
• “Holistic”
– the firm has purpose and takes decisions and actions as a single entity
• Deterministic
– full knowledge of market opportunities and costs is assumed
Behavioural Model of the Firm [Simon (1959), Cyert and March (1963)] • the firm hardly exists; it consists of a group of
people with multiple objectives
• decision-makers exhibit “satisficing” behaviour; organisational slack/X-inefficiency
• problem-oriented search using rules of thumb, which are a function of the past experience of the firm and the people within it • organisational learning: meeting all objectives; then raising aspiration levels. If cannot meet; then reducing aspiration levels
The Behavioural Approach
• “organisations do not have objectives, only people have objectives” • the firm does not exist - it is a set of shifting coalitions of individuals • individuals and groups do not maximise - they “satisfice” • information about the environment is very limited
The Behavioural Approach
• If all aspirations are being met everyone is satisfied - do nothing • BUT then aspiration levels will rise until someone is not satisfied • THEN rules of thumb used to find solutions to “the problem”
The Behavioural Approach
• Aspiration levels, which adjust according to experience • Problem-oriented „rules of thumb? based on past experience • A dynamic model • not “holistic” • not “deterministic” • not optimising
• Behavioural approach is a more accurate description of what happens INSIDE the firm. • BUT it tells us almost nothing about how the firm will respond to changes in the environment. • To use it to make predictions about how the firm will react to changes in the environment we need to know everything about the individual firm. • However, if shareholders are a powerful group and their aspiration level requires making maximum profit the firm will again behave in the same way as a profit-maximiser.
Which Approach is Most Useful?
In Conclusion?
• The behavioural approach is a useful complement to the profit-maximising and managerial approaches, not a substitute for them.
Theory of the Firm
Introduction
Introduction
In developing the supply and demand approach to economics, economists first worked out the basis of the demand curve.
Introduction
As a first step, we need to think about the decision-makers in supplying goods and services, and what a "rational decision" to supply goods and services would mean. In economics, this is often called the "Theory of the Firm."
Firms
•Proprietorships •Partnerships •Corporations
Proprietorships
A proprietorship (or proprietary business) is a business owned by an individual, the "proprietor." Many "Mom and Pop stores" and other "Mom and Pop" businesses, as Americans call them - are proprietorships.
Partnerships
A partnership is a business jointly owned by two or more persons. In most partnerships, each partner is legally liable for debts and agreements made by any partner.
Corporations
A corporation has two characteristics that distinguish it from most proprietorships and partnerships: • Limited liability • Anonymous ownership
Traditional Theory of the Firm
This assumes that firms aim simply to maximise profits. The classical theory of the firm relied heavily on the notion that firms are small, owner-managed organisations, such as proprietorships, operating in highly competitive markets whose demand functions are given and where only normal profits can be earned.
If the firm did not therefore maximise profits it would fail to survive under these conditions.
Traditional Theory of the Firm
There are two main objections to this notion:
1. The model of a profit-maximising firm is an owner-managed firm producing only one good, which knows all future cost and revenue streams with certainty. • Such a firm could indeed choose the levels of output and price that would maximise its profits. • But, in fact, firms are faced with • much more complex decisions, • to be taken in a dynamic and • uncertain environment, and in • this case it is far less clear how • a profit-maximising firm will behave. 2. Firms may be aiming to do something completely different; for example to maximise sales or growth. Such an objection may well apply to modern joint-stock companies or to any other company that is not managed by its owners.
What does a supplier maximise?
The operations of the firm will, of course, depend on its objectives. One objective that all three kinds of firms share is profits, and it seems that profits are the primary objective in most cases.
What does a supplier maximise?
There are two reasons for this assumption.
1. First, despite the growing importance of nonprofit organizations and the frequent calls for corporate social responsibility, profits still seem to be the most important single objective of producers in our market economy. 2. Second, a good deal of the controversy in the reasonable dialog of economics has centered on the implications of profit motivation.
Profit
Profit is defined as revenue minus cost, that is, the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output. However, we need to be a little careful in interpreting that. Remember, economists understand cost as
opportunity cost –
the value of the opportunity given up. Thus, when we say that businesses maximize profit, it is important to include all costs -- whether they are expressed in money terms or not. Because accountants traditionally considered only money costs, the net of money revenue minus money cost is called "accounting profit." (Actually, modern accountants are well aware of opportunity cost and use the concept for specific purposes).
The economist's concept is sometimes called "economic profit."
The John Bates Clark Model
• • • • • Like any other unit, a firm is limited by the technology available. Thus, it can increase its outputs only by increasing its inputs. As usual, this will be expressed by a production function. The output the firm can produce will depend on the land, labour and capital the firm puts to work. In formulating the Neoclassical theory of the firm, John Bates Clark took over the classical categories of land, labour and capital and simplified them in two ways. First, he assumed that all labour is homogenous -- one labour hour is a perfect substitute for any other labour hour. Second, he ignored the distinction between land and capital, grouping together both kinds of nonhuman inputs under the general term "capital." And he assumed that this broadened "capital" is homogenous.
The John Bates Clark Model
•
•
Some inputs can be varied flexibly in a relatively short period of time. We conventionally think of labour and raw materials as "variable inputs" in this sense.
•
Other inputs require a commitment over a longer period of time. Capital goods are thought of as "fixed inputs" in this sense.
More Simplifying Assumptions
• • The John Bates Clark model of the firm is already pretty simple. We are thinking of a business that just uses two inputs, homogenous labour and homogenous capital, and produces a single homogenous kind of output. The output could be a product or service, but in any case it is measured in physical (not money) units such as bushels of wheat, tons of steel or minutes of local telephone calls. The price of output is a given constant. The wage (the price of labour per labour hour) is a given constant.
•
• •
• • •
The Firm's Decision
In the short run, then, there are only two things that are not given in the John Bates Clark model of the firm. They are the output produced and the labour (variable) input. And that is not actually two decisions, but just one, since labour input and output are linked by the "production function.“ Either the output is decided, and the labour input will have to be just enough to produce that output or the labour input is decided, and the output is whatever that quantity of labour can produce. Thus, the firm's objective is to choose the labour input and corresponding output that will maximize profit.
•
•
Labour Input and Profits
Problems with Profit Maximisation
• • • Returning to the concept of Profit
Maximisation
we'll now take a closer look at the problems associated with it and, perhaps more importantly, its alternatives. Firstly the problems, the existence of uncertainty and the complexity of large firms.
1. Uncertainty
•
•
•
•
The Profit maximising model is a static one in which the firm knows its revenue and cost curves with certainty and maximises profits by equating marginal cost and marginal revenue. In practice firms make decisions in a dynamic context. Therefore, revenue and cost calculations must take into account the dimension of time. Future cost and revenue streams must be discounted to yield the Net Present Value (NPV) associated with each course of action. Profit maximisation means choosing the course of action which yields the highest NPV.
Net Present Value n NPV = S i=1
Where
pi
(1 + r)i
pi = Ri - Ci
r = discount rate n = time horizon
With uncertainty
(NPV) = S n E(pi)
i=1
(NPV) = S n i=1
(1 + r)i
pi p(Hi) (1 + r)i
Where p(Hi) = probability attached to each value that profits may take in year i
Risk Minimisation v. Profit Maximisation
Policy A
Profit 0 40 100 Prob 0.25 0.50 0.25
Policy B
Profit 0 100
B = 0 x 0.50 + 100 x 0.50 = 50
Prob 0.50 0.50
A = 0 x 0.25 + 40 x 0.5 + 100 x 0.25 = 45
But 50% probability of zero profits with policy B.
2. Organisational Complexity
• The owners of the modern firm are a large number of share-holders, who have nothing to do with the running of the firm, while the main decisions are made by the board of directors of the firm and implemented by managers and workers all through the different levels and departments of the firm. This has two main implications for the profit maximisation assumption: even if managers do wish to maximise profits, this objective will often be difficult to achieve in a modern firm; the managers who take the decisions may be interested not in maximising profits but in some other goal.
•
•
Baumol?s Static Sales Revenue Maximising Model without Advertising TR
TC TC (£)
TR
p max
0
p
constraint rev.max
ps
p
Q
Dr J. R Anchor, HUBS
Qp max
Qp constraint
Qs revenue max
Alternatives to Profit Maximisation
Baumol's Theory of Sales Revenue Maximisation
Baumol's Theory of Sales Revenue Maximisation
Two basic models: •static single-period model; •multi-period dynamic growth model.
Each model can include advertising activity or not.
1. Rationalisation of the Sales Maximisation Hypothesis
- There is evidence that salaries and other (Mach) earnings of top managers are correlated more closely with sales than with profits. - Banks and other institutions, which keep a close eye on the sales of firms, are more willing to finance firms with large and growing sales.
1. Rationalisation of the Sales Maximisation Hypothesis
- Personnel problems are handled more satisfactorily when sales are growing. Employees of all levels can be given higher earnings and better terms of work in general. Declining sales make the converse and lay-offs more likely. - Large sales, growing overtime, give prestige to managers; large profits go into the pockets of shareholders.
1. Rationalisation of the Sales Maximisation Hypothesis
- Managers prefer a steady performance with satisfactory profits to spectacular profit maximisation projects. If they realise high profits in one period, they might find themselves in trouble in other periods when profits are less than maximum. - Large, growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-à-vis its rivals.
1. Rationalisation of the Sales Maximisation Hypothesis
The implication of Baumol’s model is that risk avoidance has a statistical effect upon economic activities, eg. R&D in large firms.
2. Baumol’s Static Models The basic assumptions of the static models:
- The time-horizon of a firm is a single period. - During this period the firm attempts to maximise its total sales revenue (not physical volume of output) subject to a profit constraint.
2. Baumol’s Static Models
- The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and other financial institutions. The firm must realise a minimum level of profits to keep shareholders happy and avoid a fall of the prices of shares on the stock exchange.
2.
Baumol’s Static Models
- Conventional cost and revenue functions are assumed - cost curves are ill-shaped and the demand curve of the firm is downward sloping.
2. Baumol’s Static Models
Four models:
- A single-product model, without advertising. - A single-product model, with advertising. - A multi-product model, without advertising. - A multi-product model, with advertising.
3. Baumol’s Dynamic Model
The most serious weakness of the static model is the short-time losses of the firm and the treatment of the profit constraint as an exogenously determined magnitude. In the dynamic model the time horizon is extended and the profit constraint is endogenously determined.
The assumptions of the dynamic model
- The firm attempts to maximise the ratio of growth of sales over its lifetime.
- Profit is the main means of financing growth of sales, and as such is an instrumental variable whose value is endogenously determined.
The assumptions of the dynamic model - Demand and of cost have the traditional shape - demand is downward-sloping and costs are U-shaped. Profit is not a constraint (as in the static model) but an instrumental variable, a means whereby the top management will achieve its goal of a maximum rate of growth of sales. - Growth may be financed by internal and external sources. However, there are limits to the external sources of finance.Thus profits will be the main source for financing the rate of growth of sales revenue.
The assumptions of the dynamic model
• Growth may be financed by internal and external sources. However, there are limits to the external sources of finance. Thus profits will be the main source for financing the rate of growth of sales revenue.
Williamson's Model Managerial Discretion
of
Williamson argues that managers have discretion in pursuing policies which maximise their own utility rather than attempting the maximisation of profits which maximises the utility of ownershareholders.
Williamson's Model of Managerial Discretion
Profit acts as a constraint to this managerial behaviour, in that the financial markets and shareholders require a minimum profit to be paid out in the form of dividends, otherwise the job security of managers is endangered.
Williamson's Model of Managerial Discretion
The managerial utility function includes such variables as salary, security, power, status, prestige, professional excellence. Expense preference is defined as the satisfaction which managers derive from certain types of expenditures.
Williamson's Model of Managerial Discretion
Staff expenditures on emoluments, and funds available for discretionary investment give to managers a positive satisfaction (utility) because these expenditures are a source of security and reflect the power, status, prestige and professional achievement of managers.
Williamson's Model of Managerial Discretion
Staff expenditures, salary and benefits, emoluments and discretionary investment expenses are measurable in money terms and can be used to replace the non-operational concepts of power, status, prestige and professional excellence in a managerial utility function.
Williamson's Model of Managerial Discretion
The latter may be written: U = f1 (S, M, ID) where S = staff expenditure, including managerial salaries M = managerial emoluments ID = discretionary investment
Marris - Growth Maximisation
Model highlights two important factors as far as management is concerned: the attitude to risk and uncertainty and the desire for utility which may not be maximised by the pursuit of maximum profits.
Marris - Growth Maximisation
Marris, like Williamson, suggests that managers have a utility function in which salary, prestige, status, power, security, etc., are important. The owners of the firm are, however, likely to be more concerned with profits, market share, output, etc.
Marris - Growth Maximisation
In contrast to Williamson, Marris argues that the owners and managers have one aspect of the firm in common; namely, its size. He therefore postulates that managers will be primarily concerned with maximisation of the rate of the growth of size rather than absolute firm size.
Marris - Growth Maximisation
The attraction of the growth rate of size is thought to stem from the positive effect growth has upon promotion prospects. Stress is put on an alleged preference of managers for internal promotion and this is made easier if the firm is seen to be expanding rapidly.
Marris - Growth Maximisation
Managerial utility function may be written as follows: Um = f (gD,s) where gD = rate of growth of demand for the products of the firm; s = a measure of job security.
Marris - Growth Maximisation
Owners utility function may be written as
U0 = f *(gc)
where gc = rate of growth of capital.
Marris - Growth Maximisation
s can be measured by a weighted average of three ratios: the liquidity ratio, the leverage debt ratio and the profit-retention ratio.
Marris - Growth Maximisation
S can be measured by weighted average of liquidity ratio, debt ratio and profit retention ratio Liquidity ratio = Liquid assets Total assets Value of debt Total assets Retained profits Total profits
Debt ratio
=
Retention ratio
=
Marris - Growth Maximisation
• Too low liquidity ratio may lead to insolvency and bankruptcy and there is a threat of take-over in case it being too high. • Too low Retention ratio may upset shareholders and too high ratio may inhibit growth.
Cyert and March Behavioural Theory
1. The Firm as a Coalition of Groups with Conflicting Goals
based on a large multiproduct group operating under uncertain conditions in an imperfect market - difference between ownership and control - firm treated as a multi-goal, multi-decision organisational coalition of managers, workers, shareholders, customers, suppliers, bankers.
Cyert and March Behavioural Theory 2. Goal Formation – The Concept of the Aspiration Level
Individuals may have (and usually do have) different goals to those of the organisation-firm.
Cyert and March Behavioural Theory
3. The Goals of the Firm: Satisficing Behaviour
Goals set management. by top
Cyert and March Behavioural Theory The main goals:
• Production goal - smooth running. • Inventory goal - adequate stock of suitable raw material. • Sales goal - from sales department. • Share of the market goal – also from sales department. • Profit goal – shareholders, finances.
Cyert and March Behavioural Theory 4 Means for the Resolution of Conflict Conflict is inevitable. Nevertheless the groups and the firm as a whole may remain in a stable position - limited time to bargain, etc. Behaviour, goals and decisions are largely based on past history.
Cyert and March Behavioural Theory
5. The Theory of Decision Making
- At Top Management Level Resource allocation - implemented by the budget - share of budget taken by each department. Largely determined by bargaining power which is itself determined by past performance.
Cyert and March Behavioural Theory
6. Uncertainty and the Environment of the Firm Two types of uncertainty: - market (cannot be avoided) - competitor's reactions (overcome by tacid collution, eg. trade associations)
Problem
• What is the relation between production functions and cost functions? Be sure to include in your discussion the effect of competitive conditions in input factor markets. • With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck and must meet an annual deductible of a few hundred dollars. After that, insurance picks up most of their health care costs. Companies complain that this gives workers little incentive to help control medical insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers better ince3ntives to control employer medical insurance costs?
Problem
• Is use of least-cost input combinations a necessary condition for profit maximization? Is it sufficient condition? Explain. • “Output per worker is expected to increase by 10 percent during the next year. Therefore, wages can also increase by 10 percent with no harmful effects on employment, output prices, or employer profit.” Discuss this statement. • Explain why the MP/P relation is deficient as the sole mechanism for determining the optimal level of resource employment.
SESSION-VII OVER
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