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MANAGERIAL ECONOMICS




                       1
Chapter 2:
  Business Objectives
  and Basic Models of the Firm
Objectives:
After studying the chapter, you should
understand:
1. the assumptions of the neo-classical (or profit-
maximising) 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   2
model and the behavioural model of the firm
The Assumptions 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


                                           3
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.



                                                4
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
                                                           5
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.




                                                      6
Assumption 3:
It assumes perfect certainty. Cost and
demand conditions are perfectly known.


.




                                         7
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
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
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
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
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
The assumptions of profit-maximisation
has been criticised in a number of ways; so
we have:
1. The “Managerial School”
2. The “Behavioural School”




                                              13
ABC TELECOM
                          Chief Executive

 Finance      Executive     Deputy        Deputy       Director of
 Director      Director      Chief         Chief        Human
              Customer     Executive     Executive     Resources
               Service
Director of                                            Director of
  Group                    Director of Director of     Corporate
Accounting                   Inter-    Corporate        Affairs
 Services                   national    Market
& Property Director of
            Customer                                   Director of
             Service                     Director of    Regional
                            Director of Information     Business
Director of                 Regulatory Technology
Corporate                    Affairs                       Chief
 Finance                                               Representa-
& Treasury                                              tive China
                                                           Team 14
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
“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
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)
                                                          17
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
Baumol’s Model
$
                     TR

                                TC




                            Profit


                     Level of
                     Output
                                     19
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
Comparative Statics of
         Baumol’s Model
 What if demand rises?
 What if fixed costs change?
 What if variable costs change?




                                   21
Williamson’s Managerial Utility
      maximising Model
 What do managers want?
   UTILITY = happiness, satisfaction
 What gives them utility?
   Utility = f(S, M, D)




                                        22
Williamson’s Managerial Utility
           Maximising 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”                                     23
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
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
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                  26
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
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
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
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
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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Managerial economics ppt @ mba 2009

  • 2. Chapter 2: Business Objectives and Basic Models of the Firm Objectives: After studying the chapter, you should understand: 1. the assumptions of the neo-classical (or profit- maximising) 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 2 model and the behavioural model of the firm
  • 3. The Assumptions 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 3
  • 4. 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. 4
  • 5. 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 5
  • 6. 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. 6
  • 7. Assumption 3: It assumes perfect certainty. Cost and demand conditions are perfectly known. . 7
  • 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. 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. 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. 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. 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. The assumptions of profit-maximisation has been criticised in a number of ways; so we have: 1. The “Managerial School” 2. The “Behavioural School” 13
  • 14. ABC TELECOM Chief Executive Finance Executive Deputy Deputy Director of Director Director Chief Chief Human Customer Executive Executive Resources Service Director of Director of Group Director of Director of Corporate Accounting Inter- Corporate Affairs Services national Market & Property Director of Customer Director of Service Director of Regional Director of Information Business Director of Regulatory Technology Corporate Affairs Chief Finance Representa- & Treasury tive China Team 14
  • 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. “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. 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) 17
  • 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. Baumol’s Model $ TR TC Profit Level of Output 19
  • 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. Comparative Statics of Baumol’s Model  What if demand rises?  What if fixed costs change?  What if variable costs change? 21
  • 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. Williamson’s Managerial Utility Maximising 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” 23
  • 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. 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. 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 26
  • 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. 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. 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. 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. 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