CENTRE FOR POLICY STUDIES UNIVERSITY COLLEGE CORK EC2204TUTORIAL #2 W/S 22/10/2012 Academic Year: 2012/2013 Instructors: Brenda Lynch/P J Hunt Contact: email@example.com or firstname.lastname@example.org
The Decision-Making ModelDecision making is the responsibility ofmanagement. It involvesa; establishing objectivesb; reviewing possible strategiesC; evaluating the costs/benefits of eachstrategy
•d; selecting the best strategy•e; implement and monitor the strategy•f; are the objectives being met•(See p9 of course book).
Objectives of the FirmFirms can have several objectives, one ofwhich is to maximise profits. Profit is thedifference between total revenue and totalcosts. Profits can be maximised by usingthe concepts of marginal cost (MC) andmarginal revenue (MR).•MC is the change in total cost resultingfrom a decision•MR is the change in total revenueresulting from a decision
Using the above a decision to allocateresources by management in a specific waywill be profitable if;•MR increases more than MC•Some MC’s decrease more than othersincrease assuming MR remains the same•Some MR’s increases more than othersdecrease assuming MC remains the same. The profit maximisation model treats all profits the same i.e. €1,000 in one years time is the same as €1,000 now. This is clearly not the case. Also risk is not taken into account.
Both of these shortcomings are overcome by… The Shareholder Wealth-MaximisationModel of the Firm...Which states that the objectives of a firm’smanagement is to maximise the presentvalue of all expected future cash flows tothe firm’s owners (the shareholders). In otherword this profits are discounted (reduced) fortime and risk. The mathematical formula is;
i. V 0 * Shares Outstanding = 1 1 2 2 3 3 ... = (1 k e ) (1 k e ) (1 k e ) (1 k e ) t t (1.1) t 1 (1 k e )See p10 of course bookAnd is composed ofV0 is the current value of a shareΠ is the profit expected in each futureperiodk is the investors required rate of return
t takes into account the time issue ofpayments with each increasing time periodattracts an increasing power value.Also k increases in value if perceived riskincreases or decreased if risk has decreasesallowing an investor to place a lower valueon a high-risk investment and vice versa.
ProfitEconomic profit is the difference betweentotal revenue and economic cost.Economic cost includes a ‘normal’ rate ofprofitTypes of Profits•Dynamic Equilibrium (Friction) Theory ofProfitA long-run equilibrium normal rate of profitexists. However at any time an individualfirm in an individual industry can earn a profitabove or below this level. Examples; Airlinesafter 9/11 or oil producers at the moment.
Profits eventually return to normal.•Monopoly Theory of ProfitA firm can earn above normal profits for along time due to dominance in the market.Example; Sky TV, OECD•Innovation Theory of ProfitA firm with a successful innovation can earnabove normal profits. Example; Pfizer andViagra
•Managerial Efficiency Theory of ProfitExceptional managerial skills can give riseto abnormal profits.•Risk Bearing Theory of ProfitThe greater the risk the higher the potentialprofit and vice versa.