Lecture-Chapter 2, Keat and Young

The Firm and Its Goals

THE SITUATION: What are the company's goals and how does entry into the soft drink market suit those goals?

The firm is traditionally defined as a collection of resources that is transformed into products demanded by consumers. The definition of the firm begs the question as to why firms exist at all. Production does not have to take place in something called a firm. The alternative to having production organized into firms would be to simply use the market. One could wake up each day, find workers to hire, buy materials, and rent space and equipment for production. Obviously, there are costs associated with all of this hunting for resources. These costs of using the market are called transactions costs-they are the costs of making transactions in the market (search and information costs, bargaining and decision costs, policing and enforcement costs). The alternative to using the market is to have contracts and establish a firm. There are also certain risks associated with having contracts and relying on a single supplier. So there is the free market and there are contracts. Wise managers will choose the least expensive organizational structure, with some combination of contracts and some market transactions.

Obviously, different goals lead to different decisions. In economics, we typically assume the goal of the firm is profit maximization, where profits are a residual defined as the difference between total revenue and total cost (opportunity cost). We expect our firm to make decisons with this goal of profit maximization in mind.

Goals are sometimes stated as a) increasing revenues, b) minimizing costs, c) staff growth, d) orders for new equipment, e) target return on assets, and many others. These all only tell part of the story. Whatever is the stated goal, to make economic sense the goal should be consistent with profit maximization.

What about noneconomic objectives of firms? Often firms state that they actually have objective other than profit maximization. For some, stating profit maximization as a goal might not be cool. Ronnie Davis incoming freshman story. Let us consider some possible noneconomic objectives of a firm.

1) "A good place for employees to work." This is related to wages and benefits. Happy workers will probably be more productive and loyal. Firm may be able to avoid possible high cost of retraining workers. May be a direct effect on wages through the theory of compensating wage differences. This goal certainly may be consistent with the goal of profit maximization (it does sound nicer), and if not, we would not see it.

2) "Provide good products/services to our customers." Well only up to a point, surely. Companies will spend on quality and satisfaction only until is is not profitable to do so.

3) "Act as a good citizen in our society." (Refer to Ronnie Davis, again).

a) Pollution and pollution. Property rights problem is why we have legislation, otherwise there is no way to force the firm to stop polluting. So the government passes laws forcing firms to clean up some pollution. The firm is still profit maximizing, but under a constraint. Not as much profit will be earned under this restriction, but the firm will still try to ear as much as possible.

b) Monopoly power. A firm grows large and has few, if any, competitors. There are few options for consumers. In this situation, there are government laws to limit the behavior of these monopolies. Given these constraints, firms maximize profits. Aside: most economists would probably contend that the regulation in the economy is probably more of a problem than the monopoly power. Most economists today believe that the one true source of monopoly power is the government. (Tell story of Chinese economist man).

Once Again-Do Companies Maximize Profits?

Some have argued that the goal of the firm is not profit maximization. They argue the the aim of the firm is to "satisfice." This argument is based on an understanding of the relationship between ownership and control in most firms today. Two specific relationships are important here.

1) The position and power of stockholders in today's corporation.

2) The position and power of professional management in today's corporation.

First, unlike the past most owners are stockholders own only a minute piece of a corporation. These owners also typically diversify so that one individual may own small pieces of several corporations. The argument is made that most shareholders are well-informed about how well an individual corporation is doing or can do. Thus, shareholders may be satisfied with an adequate dividend and some reasonable growth. Also, individuals owning shares of many corporations are more concerned with the performance of their entire stock portfolio than the performance on an individual stock. After all, there may be some offsetting gains in other stocks. Shareholders are not in a good position to know whether management is doing the best possible managing job and will probably be satisfied with satisfactory performance-hence satisficing.

Second, because the managers run the firm, they may have some discretion to pursue their own objectives rather than those of the owners. Some argue that managers may be more interested in revenue growth since that is what their compensation based upon.

On the one hand we have small, relatively uninformed owners and on the other hand we have managers with some discretion to pursue their own objectives. Well, the situation is not really as far from our profit maximizing model as might appear. Much stock is held by institutions in accounts which are professionally managed. If firms are not performing well, their stocks get weeded out and stock prices, which reflect company profitability, will fall. This fall in stock prices can make the corporation a target for a takeover. Managers are not insulated from competition with other managers. If firms do not perform well, managers may lose jobs or compensation, or both. All these factors help bring the managers interest in line with the owners.

Firms may not have enough information to maximize profits all the time, but they should always be trying to do better.

Although we will use period profit maximization as the goal of our firm, another view is taken by those in finance. The stated goal there is maximizing shareholder wealth. This maximization over time only further serves to bridge the ownership/control gap because many executives are paid in stock options.

When economists talk of profits they mean the difference between total revenue and total cost. Total revenue is the amount of money the firm is taking in from the sale of a good or service. Total costs from the economist are different from the accountant's view. Economists include explicit costs and implicit costs. Explicit costs are out-of-pocket costs and implicit costs are the opportunity costs of resources owned by the producer (owner's time and money).

When dealing with foreign corporations, many other legal, social, political and economic considerations must taken.

HOMEWORK: pg. 41 1,2,7,10