The Firm And Its Existence Economics Essay
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Published: Mon, 5 Dec 2016
Business is considered as going to be more and more complex day by day with the advent of new economic reforms and globalization. On each and every stage of business effective analysis, strategic thinking and management is essential to get succeeded. Economics is considered as the study of behavior of people in creating, distributing and consuming goods and services within the whole world having the limited resources. Managerial economics is considered as the use of such economic analysis to make the business decisions so as to effectively utilize all the limited resources of the organization and the global business environment which results to reduced cost and high profitability. Managerial economics also helps in implication of economic analysis in formulating and designing business policies. Managerial economics helps to implement the theoretical models of economic in the practical business decisions so as to design the policies and regulations in the most effective way which results to effective profitability and ultimately the competitive advantage for the company (Concepts of Managerial Economics).
The project aims to analyze different aspects of managerial economics through analyzing the firm and its goals to operate business within the business and economic environment. The project analyzes the firm and its goals through analyzing the reasons for the existence of the firms, its economic goals and optimal decisions making. The project also throws light on the goals of the firm which are other than profit and also analyses the economic profits of the Firm. The project also analyze two main goal of the firm i.e. profit maximization and wealth maximization.
The Firm and its existence:
Traditionally firm is considered as the integration of resources that are being converted to the products as per the demand of the customers. The cost incurred by the Firm in converting the resources in to product depends on the technology used and the amount of the products produced. The prices fixed for such products are influenced by the forces of market. The difference between the revenue and the cost of the firm is termed as the profit for the firm. But the modern theory believes in the existence of firm. The main focus of the modern theory is on the questions such as why the firm performs certain functions internally and other function with the help of the market. The size of firm are also put on question mark by such theories as the size is not being decided by the technological factors. Within its dealing with the market, the firm incurs transaction cost, which is incurred when the firm enters in contract with other entities. The transaction cost is high when the opportunistic behavior is shown by either party which means that one party efforts to take the advantage of the other party. Thus it could be said that firm efforts to minimize its cost that are incurred within its transactions with the market through minimizing the internal cost (Paul G. Keat).
The Economic Goal of the Firm and Optimal Decision Making:
The businessmen operate any business with a specific or various goals. Most of the people believe that businesses are being operated to earn profit. The economic theory of the firm on which the foundation of managerial economics depends also supposes that main objective of the firm to maximize its earnings and profits. Thus the economic goal of the firm is to earn profit and maximize it profitability through various measures (Paul G. Keat).
In general terms profit is defined as the amount left after deduction of cost from the profit. These costs also involve the opportunity cost and thus answer to this question results to analysis that whether the firm has taken optimal decision or not. The optimal decision refers to the price and quantity chosen by the firm, the combination of which results to the enhancement of profitability for the firm. The optimal decision taken by the firm can be assessed on three major grounds:
If the economic profit is positive, the firm’s decision is considered as the optimal as the combination of price and output so selected by the firm is large as compared to the alternative combination available for the firm to choose.
If the economic profit incurs to be zero, the firm’s decision is considered to be satisfactory as the combination of the price and the output so selected by the firm is able to earn as much profit as the best combination can earn.
If the economic profit is negative, the firm’s decision for choosing the combination of price and the output is not optimal as there exist a alternative that can results to profit for the firm if it was chosen (William J. Baumol, 2011).
The role of opportunity cost in deciding that whether the decision is optimal or not is very significant as it not only depends on the price and quantity but also on the other factors of consideration. The economic profits are given by:
Economic profit= Accounting Profit- Opportunity cost.
Thus economic profit can be defined as net accounting earnings minus the opportunity cost of the capital and other resources supplied by the owner of the firm (William J. Baumol, 2011).
But the optimal decisions not only depends on the economic profit, price and quantity but also on various other factors such as total, average and marginal revenue and total, average and marginal cost.
Total, Average and Marginal Revenue:
In order to analyze that how the total profit depends on total revenue, the concept of total revenue, total cost and the total profit must be made clear and there behavior with the change in output must be analyzed. The total cost and the total revenue both depends on the combination of price and output combination as considered for the optimal decisions. The total revenue is the product of the price offered to the customers to buy and quantity that consumer buy and is given by:
Total Revenue = Price * Quantity.
Source: (William J. Baumol, 2011)
As in the price is denoted as the revenue per unit and thus the demand curve in the above figure is termed as the Average revenue curve. The average revenue is given by:
Average revenue= Total Revenue/Quantity= P* Q/Q
Thus Average revenue= Price per unit of the quantity.
Marginal revenue can be defined as the addition to the total revenue with the addition of one unit of total output. The marginal revenue is denoted as the slope of the total revenue curve.
Thus the price output combination decides the total, average and marginal revenue which ultimately results to analyze the optimal alternatives and decisions (William J. Baumol, 2011).
Total, Average and Marginal Cost:
The total cost, average cost and marginal cost are shown with the help of following figures:
Source: (William J. Baumol, 2011)
It is considered as the universal fact that the objective of maximizing profit will never be eradicated from the firm’s area of interest. However the lack of financial success of the company cannot be considered as the area of controversy on the later principle. Within few conditions, the main aim of the firm can be replaced by the loss minimization but alternatively the firm’s aims to enhance its profit. As long as the companies’ efforts enough to enhance profit minimize loss and minimize cost, the assumption that profit maximization is the major goal of the firm cannot be avoided. The attainment of such objectives results to various decisions such as revenue increase more than cost increase or revenue decrease less than cost decrease or maintaining constant revenue with decrease in cost results to the profit maximization of the firm (Paul G. Keat).
Goals other than Profit:
The traditionally ultimate goal of the firm is “profit Maximization” i.e. maximize the profit or loss minimization. The role of the profit maximization is that it enhances the firm’s capacity to have competitive advantage in the market. So, if managers pursue profit maximization they can maintain their position as well as financial benefits in the firm. It also highlights voluntary social responsibilities and plays vital role in achieving fair distribution of income and in enhancing efficiency (Chapter:1 Introduction).
At the same time, as per the author of “Managerial Economics” the goal of the firm is not only profit maximization but it also refers to growth rate, profit margin as well as return on assets. Thus, the company’s economic environment, technological advances, markets potential and competition brings to the conclusion that profit maximization can be achieved by the combination of profit measures and growth and thus, the specific objective of the firm is considered as over all objective of the profit maximization. The profit maximization can be measured at the end of the fiscal year that includes performance of executives and department, their contribution towards the profits which is determined and rewarded by the bonus or incentives plan (Paul G. Keat). The companies also have two types of goals other than profit maximization as:
Non Economic Goals
Profit maximization includes maximization of profits from each department of the firm with achieving respective targets of the department. The firm’s manager may adopt varieties of other targets as per the different requirements of the growth of the life cycle of the firm. The different targets lead to take different decision or may be same decision with the context of same resources. In order to identify the efficiency of the goal, managers have to break down the over all goal of the profit maximization into intermediate targets in respect to various department or division of the firm and thus, known as Economic Goals. The firm’s economic goals includes the process of input procurement targets, sales growth rate, sales procurement targets, production targets, required growth in R&D, wage bill, advertising budget etc. The economic goals of the firms are as follows:
Maximizing Market Share
Maximizing Revenue Growth
Maximizing share holder value
Maximum earning per share.
The economic goals help in profit maximization either directly or indirectly.
Non Economics Goals:
At the same time, companies also adopt some goals which are out of the economical thinking but directly and indirectly beneficial for the company. Some of the non economic goals are
Labor Lifetime Contracts
Safety and Healthy Work Environment
Provide good products and services to customers
The non economic objectives are considered as costly and at first glance, it seems interfering in the economic goals or in profit maximization but it supports firm efforts in order to achieve the goal of profit maximization.
Wealth maximization refers to the maximization of share holder’s wealth with maximizing the net worth of the firm (Paul G. Keat). It is considered as the most operational goal of the firm which includes all crucial idea of time value of money which includes the following factors.
Wealth for the long term
Risk or uncertainty
The timing of returns
The stock holders returns
The wealth maximization criterion emphasizes that a firm should evaluate the expected profit, cash flow, discounts as well as the risks associated with running the business. The company’s long term survival can be assured with analyzing for avoidance or minimizing the risk rather than adopting factors for the maximization of profit (Paul G. Keat).
The discount and risk is associated with the two specific types of risk i.e. business risk and financial risk. The business risk involves fluctuations in the return due to vary economy, industry as well as the fluctuate firms while the financial risk refers to the changes in returns that is persuaded by leverage as it moves directly with a company’s leverage (Wealth Maximization)
The measure of stake holders’ wealth can be obtained by discounting to the present cash streams that is expected to receive in future. Present value is the expected value of future cash flow which is apposite of determining the compounded future value while the interest rate is referred as discount rate and can be obtained as
At maximizing the wealth of the shareholder, the company efforts to administer its business in such a manner that dividends over time period and the risks always create the highest price and resulted in the maximum value for the company’s stock (Paul G. Keat).
With the end of every fiscal year, the company calculates it’s earning and accountant constructs state of earning known as profit. The accountant reports level of profits and also confirm that everything done in the accounting statement is according to the accounting principles. Accountant has leverage to use various methods such as
There are different method of calculating depreciation such as the sum of the year’s digit method, the straight line method, the declining balance method, etc. as pet the present tax law, the most frequent used method is MACRS i.e. the Modified Accelerated Cost Recovery System.
Similarly, there are two ways of recording inventories such as LIFO (Last in- First Out) and FIFO (First in- First out).
Patents and good wills are recorded differently.
The above are the better known alternatives treatments by accountant in conformance with the GAAP (Chapter:1 Introduction). The economists of the company also calculate the profit. In terms of calculating costs, two differences basically exist between economics and accounting because of differences in the method of calculations such as follows:
Historical Cost vs. Replacement Cost
As accountant calculate on the basis of capital depreciation and inventories based on historical costs at the same time, economists neglects historical cost which is known as sunk cost which should not affect decisions while considers the replacement cost (Paul G. Keat).
Implicit Cost and Normal Profit
Generally, account considers explicit cost while economists concerned with the opportunity cost which includes both explicit as well as implicit costs. Implicit cost includes the resources value without monetary payments while part of the implicit cost is the normal profit i.e. an average return which can be obtained by doing another business. It covers the opportunity cost of running business (Paul G. Keat).
Economic profit refers to the extra profit and above all the incurred cost including normal profit. It consider as a reward that is rewarded to the entrepreneur for taking risk of running the business. It is accountable for all the resources. Economic profit can also be defined as total revenue minus all the economic cost (Paul G. Keat).
Economic Profit = TR- TEC
The term TR and TEC is refereed as:
TR= Total Revenue
TC= opportunity cost =Explicit Cost + Implicit cost
The economic profit only can be earned after emphasizing more than the opportunity cost because if opportunity cost is zero, the firm only earns firm earns normal profit, if its value is positive the firm is earning more than the normal profit while if the economic profit is negative the firm is in the economic loss. All firms are not able to ear n economic profit as there are many constraints I the market that prevent the firm from earning Economic profit (Paul G. Keat; Chapter:1 Introduction)
Businesses now a day are going to be more and more complex, enhancing the objective and goals of the firm with multi targets and yardsticks. Traditionally the firm is considered as the integration of resources exploited to produce products as demanded by the customers. But gradually the thinking has been changed and the businesses are considered as the source of transaction between the market and internal organization to attain various objectives. The firms basically have two objectives i.e. profit maximization and wealth maximization. Though there are various other objectives of firm which are other than profit such as economic and non economic objective yet the major objective so considered is the profit maximization on which other objectives and decisions are depended and so as to achieve the competitive advantage of global market.
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