Managerial economics ppt @ mba 2009


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Managerial economics ppt @ mba 2009

  2. 2. Chapter 2: Business Objectives and Basic Models of the FirmObjectives:After studying the chapter, you shouldunderstand:1. the assumptions of the neo-classical (or profit-maximising) model of the firm and the limitationsof the model2. the differences between the profit-maximisingmodel and the managerial models of the firm3. the differences between the profit-maximising 2model and the behavioural model of the firm
  3. 3. The Assumptions of the Neo- classical Model of the Firm1. The firm is a profit-maximiser - itoptimises2. The firm can be treated in a holisticway3. There is perfect certainty 3
  4. 4. Assumption 1:The firm is a profit-maximiser: it is assumedto make as much profit as possible.This means that the model is an ‘optimising’model: the firm attempts to achieve the bestpossible performance, rather than simplyseeking “feasible” performance which meetssome set of minimum criteria. 4
  5. 5. The profit-maxing assumption can beinterpreted in two ways:1. Maximisation of profit in the short-runi.e. the firm has a given set of plant and equipment andmakes as much profit as it can with that2. Long-run profit maximisationi.e. maximise the wealth of the shareholdersIn most situations these are consistent with each other.Shareholder wealth is maximised by selecting the mostprofitable set of plant and equipment and then operating itin the most profitable way. BUT THERE MAY BEEXCEPTIONS - making maximum short term profitmight trigger entry or government intervention 5
  6. 6. Assumption 2:It is a holistic model: the firm is a single entitywhich has objectives of its own and which can besaid to take decisions. 6
  7. 7. Assumption 3:It assumes perfect certainty. Cost anddemand conditions are perfectly known.. 7
  8. 8. 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 Quantity Produced Q1 Q2 8
  9. 9. 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 Quantity Produced Marginal Revenue 9
  10. 10. 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 Quantity Marginal Profit Revenue Produced maximising output 10
  11. 11. 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 Marginal Revenue maximising output 11
  12. 12. 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? 12
  13. 13. The assumptions of profit-maximisationhas been criticised in a number of ways; sowe have:1. The “Managerial School”2. The “Behavioural School” 13
  14. 14. ABC TELECOM Chief Executive Finance Executive Deputy Deputy Director of Director Director Chief Chief Human Customer Executive Executive Resources ServiceDirector of Director of Group Director of Director of CorporateAccounting Inter- Corporate Affairs Services national Market& Property Director of Customer Director of Service Director of Regional Director of Information BusinessDirector of Regulatory TechnologyCorporate Affairs Chief Finance Representa-& Treasury tive China Team 14
  15. 15. Questions for Discussion:p What are the objectives of different divisions or departments?p Are these objectives compatible?p If not, how to resolve conflicts? 15
  16. 16. “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 16
  17. 17. The Managerial School argues that:1. Ownership and control are in the hands of differentgroups of people.2. The interests of owners (shareholders) andControllers (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 themanagers.In place of the profit-maximising model, the managerialschool substitute a variety of alternatives - sometimesreferred to as managerial discretion modelsSales-revenue maximising (Baumol)Managerial utility maximising (Williamson) 17
  18. 18. 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 18
  19. 19. Baumol’s Model$ TR TC Profit Level of Output 19
  20. 20. 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 20
  21. 21. Comparative Statics of Baumol’s Model What if demand rises? What if fixed costs change? What if variable costs change? 21
  22. 22. Williamson’s Managerial Utility maximising Model What do managers want?  UTILITY = happiness, satisfaction What gives them utility? Utility = f(S, M, D) 22
  23. 23. Williamson’s Managerial Utility Maximising ModelManagers have “expense preferences”,maximisation of utility derived froma) amount spent on staff (S)b) additions to managers’ salaries and benefitsin the form of “perks” (M)c) discretionary profit (D) which exceed theminimum required to satisfy the shareholders;available as a source of finance for “petproject” 23
  24. 24. Williamson’s Managerial Utility maximising Model How to solve the model? What gives them utility?  Maths must be used, more complex What results does it give? The comparative statics? 24
  25. 25. 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 25
  26. 26. Behavioural Model of the Firm [Simon (1959),Cyert and March (1963)]• the firm hardly exists; it consists of a group ofpeople 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 ofthe firm and the people within it• organisational learning: meeting all objectives;then raising aspiration levels. If cannot meet;then reducing aspiration levels 26
  27. 27. 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 27
  28. 28. 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” 28
  29. 29. 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 29
  30. 30. A comparison of alternative models of the firm Profit-max Managerial Behavioural Objective Profit- maximising Ownership Same management Decision- Optimising making Environment Certainty Holistic? Yes 30
  31. 31. Which Approach is Most Useful? 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. 31
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