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Business Economics
Theory of the Firm
Topic #3
Associate Professor
Sarath Divisekera
Lecture Outline
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Theory of the firm
Objective and value of the firm
Motives of the firm
Growth of the firm
Efficiency and
Key Issues
Alternative theories of the firm
Function of profit
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The Theory of the Firm
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A firm is an organisation that combines
and organises resources for the
purpose of producing goods and/or
service.
The theory of the firm is the single
most important element in Business
Economics.
Theory of the firm stipulates how
firms/businesses behave and what their
goals are.
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TheoryoftheFirm
The firm combines inputs to produce outputs
after choosing some available technology
Labor
Materials
Capital (plant,
equipment)
Components
Production
Process
(technology)
O
u
t
p
u
t
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Business Economics
The Growth of Firms
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The Growth of Firms
Internal Growth:
Generated through increasing sales
To increase sales firms need to:
Market effectively
Invest in new equipment and capital
Invest in labour
The Growth of Firms
External Growth:
Through amalgamation, merger
or takeover (acquisitions)
Mergers agreed amalgamation
between two firms
Takeover One firm seeking control
over another - Could be friendly or
hostile
External Growth
Vertical Integration
Horizontal Integration
Conglomerate Merger
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The Growth of Firms: External growth
Vertical integration amalgamation, merger or
takeover at different stages of the productive process
When a company expands its business into areas that are
at different points on the same production path, such as
when a manufacturer owns its supplier and/or distributor.
The key point is that the two companies have a buyer-
seller relationship
Examples Shell from production, refinery and
distribution
Vertical mergers are more likely to be approved by
regulatory authorities. Consumers can benefit from the
increased efficiencies that result from supply chain
integration--- often in the form of lower prices and/or
better service.
Vertical Integration
Primary
Secondary
Tertiary
Retail Stores
Manufacturer
Vertical Integration Backwards
acquisition takes place
towards the source
Backward and forward integration are types of vertical integration.
A company that expands backward on the production path has
backward integration, while a company that expands forward on the
production path is forward integrated
Dairy Farming Co-operative
Cheese Processing Plant
Vertical Integration Forwards
acquisition takes place
towards the market
Horizontal Integration
A horizontal merger is a merger between two
competitors.
Suppose, for example, that tomorrow Pepsi
were to buy Coca-Cola. This would be a
horizontal merger.
Horizontal mergers may negatively affect the
competitive situation in an industry. Therefore,
they frequently run afoul of regulatory officials.
A horizontal merger often increases the degree
of concentration in an industry.
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Conglomerate Mergers
Amalgamation, merger or takeover of firms in
different lines of business.
A conglomerate merger is a union of two companies
that
a.) are not competitors, and
b.) not part of the same supply chain.
If Microsoft were to purchase a fast food chain, this
would be a conglomerate merger. Software has no
relationship to fast food; fast food has no
connection to software.
Do you think that the two major retail business in
Australia engaged in this types of mergers at
present?
Integration in Media Industry
http://wikimassmedia.tripod.com/conglomeration.htm
Conglomeration in the Media Industry Conglomeration in the Media Industry is when
corporations own many media assets across many different industries. Some examples of
media conglomerates are:
General Electric, which in 1986 purchased the National Broadcasting Corporation (NBC) and
in 2004 purchased Vivendi Universal's television and movie assets to make it the third
largest media conglomerate in the world.
The Walt Disney Company which owns film studios (Miramax, Walt Disney, etc) radio
stations (ABC Radio Network, etc), television stations (ABC, A&E, Biography Channel, ESPN,
etc), Book Publishing (Hyperion, etc), and much more.
A major benefit for media conglomerates is that they can integrate their assets to create
more streams of revenue and more successful products. There are two types of integration,
vertical and horizontal.
Vertical Integration
Vertical integration is when a conglomerate owns all of the processes involved in the
production of a product. An example of this would be, in the book publishing industry,
having contracted authors, literary agencies, publishers, paper mills and printers, book
clubs, and sales outlets.
Horizontal Integration
Horizontal integration is when a conglomerate owns many different types of media across
many industry. This is a particularly significant one because it is the one that is the most
visible and often results in mutually supporting products. An example of this can be seen
with the Harry Potter books. AOL Time Warner which owns the Harry Potter franchise used
its website (MovieFone.com) to sell tickets to the movies its studio (Warner Brothers)
produced and promoted it in their magazines (Time, People, Entertainment Weekly).
Business Economics A/P Sarath Divisekera
Motives
Cost Savings
External growth may be
cheaper than internal
growth acquiring an
underperforming or
young firm may
represent a cost
effective method of
growth
Managerial Rewards
External growth may
satisfy managerial
objectives power,
influence, status
Shareholder Value
Improve the value of the
overall business for
shareholders
Asset Stripping
Selling off valuable parts
of the business
Economies of Scale
The advantages of large
scale production that
lead to lower unit costs
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Motives
Efficiency
Improve technical,
productive or allocative
efficiency
Synergy
The whole is more
efficient than the sum
of the parts (2 + 2 =
5!)
Control of Markets
Gain some form of
monopoly power
Control supply
Secure outlets
Risk Bearing
Diversification to spread
risks
Key Issues of Modern cooperations
Key Issues of Modern corporations
Divorce between ownership and control
who runs the business?
Shareholders?
Board of Directors?
Principal-Agent Relationship:
Shareholders act as principals, Board as agents
principals expect agents to act in their interest
Sub-contracting work operates on a similar basis
Contracts and compensation procedures to ensure
agents act on behalf of principals
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Efficiency
Productive
Lowest Cost
Productive efficiency can be achieved
where the same output could be
produced at lower total cost
Achieved through re-organisation (e.g.
to cell production), investment in new
technology, training for staff and so on
Technical
Minimum inputs
Technical efficiency can be achieved
if the same output can be produced
using fewer inputs
Can be achieved using labour saving
devices, more efficient machinery, more
effective re-organisation of restructuring
and so on
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Allocative
Needs of Consumers (P = MC)
Allocative efficiency occurs where the goods
and services being produced match the
demand by consumers
P = MC the value placed on the product
by the buyer (the price) = the cost of the
resources used to generate the good/service
Social
MSC = MSB
Social efficiency occurs where the private
and social cost of production is equal to the
private and social benefits derived from their
consumption
A measure of social welfare
Motives of Firms
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Profit Maximisation
Profit maximisation assumed to be the
standard motive of firms in the private sector
Profit maximisation occurs where Marginal
Cost = Marginal Revenue
MC = MR
The firm will continue to increase output up
to the point where the cost of producing one
extra unit of output = the revenue received
from selling that last unit of output
This assumes that firms seek to operate at
maximum efficiency
Revenue Maximisation
Total Revenue
Average Revenue
Marginal Revenue
In this model the policies to achieve
revenue maximisation may be different
to those adopted to maximise profits
Other Objectives of Firms
Sales maximisation:
Attempts to maximise the volume of sales
rather than the revenue gained from them
Share Price Maximisation:
Pursuing policies aimed at increasing the
share price
Profit Satisficing:
Generating sufficient profits to satisfy
shareholders but maximising the rewards to
the managers/board and avoiding attention
from rivals or regulatory authorities
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Behavioural Objectives
Modern firms have to attempt to match
competing stakeholder needs:
Shareholders
Employees
Consumers
Suppliers
Government
Local communities
Environment
Behavioural Objectives
Firms may have to balance out
their responsibilities:
Fat cat pay
Management rewards bonuses, etc.
Social and environmental audits
Employee welfare
Meeting consumer needs
Paying suppliers on time
Satisfying shareholders and The City about
its policies, plans and actions
The Objective and the Value of the Firm
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The theory of the firm assumes that the
goal or objective of the firm is to
maximise current profits.
However, firms/businesses, in reality,
may not necessarily maximise profits
always, sometimes they sacrifice short-
term profits for the sake of increasing
future profits.
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The Objective and the Value of the Firm
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Thus, the version of the theory used
here assumes that the primary goal of
the firm is to maximise the wealth or
value of the firm.
Value of the firm is defined as the
present value of its expected future
profits (cash flows).
Present Value, PV = The value today of an
amount of money to be received later
This imagecannot currently be displayed.
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Profit Maximisation
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Maximising profit means maximising the value
of the firm, which is the present value of all
future profit/cash flows.
Profit = Revenue - Cost (t = R - C)
Where PV is the present value of expected
profits of the firm, t
t
is the expected profits
in year t
t = R
t
- C
t
, and r is the interest (discount)
rate.
( ) ( ) ( )
n
r 1
......
r 1 r 1
PV
n
2
2
1
1
+
+
+
+
+
=
t t t
( )
t
t
n
1 t
r 1+
t
=
=
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Why Discounting?
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The formula implies that we discount
future profits/cash flows
We discount because a dollar tomorrow
is less worth today (i.e., time value of
money)
Note: Future cash flows must be
discounted to find their present
equivalent value
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Maximizing the wealth of stockholders
The discount rate (r) is affected by
risk
Two major types of risk:
business risk
financial risk
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Maximizing the wealth of stockholders
Business risk involves variation in
returns due to the ups and downs of
the economy, the industry, and the
firm
All firms face business risk to
varying degrees
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Maximizing the wealth of stockholders
Financial risk concerns the
variation in returns that is induced
by leverage
Leverage is the proportion of a
company financed by debt
the higher the leverage, the
greater the potential fluctuations in
stockholder earnings
financial risk is directly related
to the degree of leverage
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Value of the Firm
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As profit (t) = Total revenue (TR) -
Total Costs (TC), thus:
The above formula provides a unifying
theme for the analysis of business
decision making.
( )
t
t t
n
t
TC TR
r 1
Firm the of Value
1 +

=

=
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Which area specialists contribute to
maximising PV?
( )

n
1 = t
t
t t
+ 1
TC TR
= PV
i
Production manager,
MIS engineer,
Human resources manager,
Accountant,
Business Economist
Financeofficer,
Business administrator,
Business economist
Marketing manager,
Business Economist
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Dr Sarath Divisekera
Business/Managerial Decision Making
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TR (TR = P*Q) depends on sales of the firms
output (Q) and the firms pricing (P) decisions.
These are the responsibility of marketing
managers and sales representatives who attempt
to increase firms revenue.
The TC depends on the technology and the cost of
inputs. These are the responsibilities of
production and personnel departments who
attempt to reduce total costs.
The discount rate (r) depends on the perceived
risk of the firm and the cost of borrowing funds.
These are the major responsibilities of the finance
department.
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Function of Profit
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Profit serves a crucial function in a free-
market economy.
High profits are the signal that consumers
want more of the output of the industry.
So, high profits provide an incentive for firms to
expand output and for more firms to enter the
industry in the long-run.
For a firm of above average efficiency, profits
represent the reward for the greater
efficiency.
Thus, profits provide the incentive for firms to
increase efficiency. 17/07/2013
Dr Sarath Divisekera
Calculating present value: an example
Suppose you were offered an investment that would pay you a cash flow stream
over the next 7 years of 100, 200, 300, 400, 500, 600, 700. The total of these
cash flows is 2,800 but if your required return on any investment is 11%, what is
the maximum you should be willing to pay for this investment?
The present value, PV, of a series of cash flows is the sum of the present value of
each cash flow, t, where r is the interest (discount) rate in decimal form and n is
the period. The equation for the present value of each cash flow in the series is:
PV
n
= t
n
/ (1 + r)
n
For example, r = 11% = 0.11 and for period n = 5, t = 500.
Therefore,
PV
5
= t
5
/ (1 + 0.11)
5
PV
5
= 500 / (1 + 0.11)
5
PV
5
= 500 / (1.11)
5
PV
5
= 500 / 1.685058
PV
5
= 296.73
Calculating the PV for each cash flow in each period and sum up the individual
cash flows to get your final answer. If you wish to get a minimum return of 11%
annual return on your investment your should pay, at most, $1,689.94 lump sum
for this investment at the beginning of period 1 (time 0).
Business Economics A/P Sarath Divisekera
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An al t er nat i ve f or mul a f or
t he val ue of t he f i r m
Where t
0
=is the current level of profits
g =growth rate; r =interest rate
this method is frequently used by long-term planners
within a firm and by securities analysts (to determine
whether a companys stock is under- or overvalued).
|
|
.
|

\
|

+
=
g r
r
PV
Firm
1
0
t
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An alternative formula for the value of the
firm: Example
Suppose the interest rate is 10% (r =10%)
and the firm is expect to grow at an annual
rate (assume growth rate is constant) of 5%
(g =5%) for the foreseeable future. If the
current profits of the firm are $100 million,
what is the value of the firm?
200 , 2 $ 100 ) 22 (
05 . 0 1 . 0
1 . 0 1
100 = = |
.
|

\
|

+
=
Firm
PV
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Function of Profit
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Lower profits or losses are the signal
that consumers want less of that
commodity and/or that production is
not efficient.
So profits provide the incentive for firms to
increase efficiency and/or produce less of the
commodity, and for some firms to leave the
industry for more profitable ones.
Profits, therefore, provide the
crucial signals for the reallocating
societys scarce resources to reflect
societys needs.
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The Nature and Function of Profits
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Business vs Economic Profit
Business Profit = Revenue - Explicit or
Accounting Costs (wages, rental on land
and buildings, interest on borrowed capital,
cost of raw materials).
Economic profit = Revenue - Explicit
Costs + Implicit Costs (opportunity cost)
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The Nature and Function of Profits
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The concept of BF may be useful for
accounting and tax purposes, it is the
concept of economic profit that must
be used in order to reach correct
investment decisions.
Implications:
It is the economic, rather than the
business, concept of profit that is
important in directing resources to
different sectors of the economy.
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The Nature and Function of Profits
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If a firm is trying to decide whether it
should continue in business with the goal of
making as much money as possible, the
answer depends on the firms profits
measured in terms of economic profits (and
not business profits).
If the firms economic profits are > or = 0,
the firm should continue (otherwise
shutdown).
Note: Throughout this course, we will use
the term Profit to mean economic profit and
Cost to mean the sum of explicit and
implicit costs.
17/07/2013 Dr Sarath Divisekera
The Nature and Function of Profit:
Example
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Suppose the firms business profit = $ 30,000. [50,000
(TR) - 20,000(EC)].
Suppose also that the entrepreneur could have earned
$35,000 by managing another firm (instead of managing
his own) and $10,000 by lending out his capital to another
firm.
Thus the implicit cost facing this firm = 45,000, and
Economic profits = 50,000 - 20,000 - 45,000= -15,000.
I.e., a business profits of $30,000 corresponds to an
economic loss of $15,000. Even if the entrepreneur owns
no capital, he would incur an economic loss of $5000 by
continuing to operate his own firm and earning BF of
30,000. So, the entrepreneur should close his firm and
work in his best alternative occupation.
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