This document summarizes key concepts from Chapter 2 of the textbook ECON340: Managerial Economics. It discusses the goals of the firm, including profit maximization, and how firms make optimal decisions. Transaction costs and the tradeoff between internal and external production are also examined. While profit maximization is traditionally the primary goal, firms may also consider other objectives like social responsibility and customer satisfaction. Managers aim to maximize profits in both the short-run and long-run through setting targets and incentives. Economic profit differs from accounting profit by considering opportunity costs and normal profits.

1. ECON340: Managerial Economics Ch.2 Dr. Mohammed Alwosabi
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CHAPTER TWO
THE FIRM AND ITS GOALSTHE FIRM AND ITS GOALS
Dr. Mohammed Alwosabi 1
The Firm
• The firm is an organization, which brings
resources together to produce a good or
service that is demanded in the market.
• The firm bears costs of production. These
costs are influenced by the available
technologytechnology
• The amount to produce and the price to
charge are affected by the market
structure in which the firm operates.
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• Dealing with others in the market, the firm
incurs transaction costs
• Transaction costs are the costs incurred
when making an exchange (buying and
selling). This includes the costs of
(1)search and investigation,
(2) ti ti d(2)negotiation, and
(3)enforcement of contracts and coordinating
transactions.
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• Transaction costs are influenced by
1.Uncertainty, which refers to the inability to
know the future perfectly, particularly in
the long term.
2.Frequency of recurrence, which refers to
how many times these transaction are
repeatedrepeated.
3.Asset specificity, which refers to the
extent to which the parties are "tied in" in
a two-way or multiple-way business
relationship. This might lead to an
opportunistic behavior, when one party
seeks to take advantage of the other. 4
• Managers of profit maximizing firms
always face the question of whether it is
more profitable to produce all its products’
components (goods and services)
internally or to order some of parts from
other firms, through what is known as
outsourcing.
• Firms usually outsource the peripheral,
non core activitiesnon-core activities.
• Company chooses to allocate resources
so total cost is minimum
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• There is a tradeoff between the cost of
external transactions and the cost of
internal operations of the firm.
• When the (external) transaction cost of an
item is higher than its internal operation, the
firm will provide that item internally.
• The opposite is true• The opposite is true.
• Internet has caused the transaction costs to
decrease drastically, making it easier for the
firm to outsource some of their job to
specialized and more efficient companies
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2. ECON340: Managerial Economics Ch.2 Dr. Mohammed Alwosabi
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The Economic Goal of the Firm and Optimal
Decision Making:
• Profit Maximization (or loss minimization,
when there is a loss) is traditionally known
to be the ultimate goal of the firm.
• Profit is the difference between revenue
received and costs incurredreceived and costs incurred.
π = TR – TC
• To maximize profit, the firm should produce
the quantity of output which equates the
revenue generated with the cost incurred of
the last unit produced.
MR = MC 7
• For public sector or not-for-profit
organization, the usual assumption will be
that the organization wants to use its
resources efficiently to maximize the
benefits that this organization was
established to achieve.
Wh th th fi t t i i fit• Whether the firm wants to maximize profit
or achieve other goals, the optimal
decision is the one that brings the firm
closest to its goals.
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• Along with the discussion of the firm’s goal
it is important to distinguish between short-
run and long-run.
• This distinction in economics has nothing to
do directly with months or years
• Short-run (SR): when the firm can vary the
amount of some resources but not othersamount of some resources but not others
• Long-run (LR): when the firm can vary the
amount of all resources
• The firm’s goal is to maximize profit in SR
and LR,
• However, at times short-run profitability will
be sacrificed for long-run purposes
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Goals Other than Profit Maximization:
• Firms’ managers may adopt a variety of
other targets as well, according to the
different stages of the firm life cycle.
• Different goals may lead to different
managerial decisions given the same
amount of resourcesamount of resources.
Economic Goals
• If maximizing profit is the firm goal, how
could the manager be sure that the actions
taken in the present will result in the largest
possible profit?
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• Manager of the firm has to break down the
overall goal of profit maximization into some
intermediate targets to be adopted by
various divisions or department of the firm.
• The manager has to define production
targets, input procurement targets, sales
growth rate, required growth in R&D,growth rate, required growth in R&D,
maximum allowed increase in wage bill,
needed increase in advertising budget.
• Against these targets, department heads will
be accountable, and incentives will be
payable only to those who accomplished
their targets. 11
• Some of economic goals that, at the end,
results in maximizing profit might include:
Firm’s Goal Managerial Decision
Maximum market share Reduce the selling price,
advertising, promotions
Maximum revenue growth Produce the maximum
level of output
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level of output
Maximum shareholder
value
Maximizing present
value of profits
Advanced technology Investment in R & D
Customer satisfaction Quality product at low
prices
Maximum earning per
share
Higher leverage (debt
finance)

3. ECON340: Managerial Economics Ch.2 Dr. Mohammed Alwosabi
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• Nevertheless, all of the above goals result,
directly or indirectly, in maximizing the profit
of the firm.
• The economists, generally, lean toward the
profit-maximization hypothesis, which
means that a firm is unlikely to survive in the
long run if it is not profitable.long run if it is not profitable.
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Non-Economic Objectives
• In today’s world, firms are concern with
workers and customers’ satisfaction, and
how to be socially responsible more than in
the past.
• Therefore, Firms may announce the
adoption of objectives that apparently notadoption of objectives that apparently not
economical or has no relation with profit
maximization such as:
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1. Corporate citizenship and social
responsibility
2. Firms’ programs for pollution abatement.
3. Labor lifetime contracts.
4. Firms’ guarantee of none-genetic
engineered product
5. Good work environment and higher safetyg y
standards
6. Quality products and services
• These objectives are costly. However, all
these objectives would in some way or
another support firms’ efforts toward their
goals of profit maximization.
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Do Companies Maximize Profits?
• First Argument: Against (Principal- Agent
Problem)
• This argument is known as “principal-agent”
problem or “agency problem”
• High-level managers who are responsible for
j d i i ki littl fmajor decision making may own very little of
the company’s stock and may be more
interested in maximizing their own income
and perks, not to maximize profit because
they know that:
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1.Medium-sized or large corporations are
owned by thousands of shareholders who
have no time or resources to follow closely
the firm’s performance.
2.Shareholders, usually, hold portfolios of
diversified stocks in many firms and
normally own a small number of any firm’snormally own a small number of any firm s
stocks. So, they are concerned with
performance of their entire portfolio and not
individual stocks.
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3.Most stockholders are not well informed on
how well a corporation can do and thus are
not capable of determining the effectiveness
of management.
4.Shareholders will be satisfied with an
adequate dividend that grows over time and
will not likely to take any action as long aswill not likely to take any action as long as
they are earning a “satisfactory” return on
their investment.
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4. ECON340: Managerial Economics Ch.2 Dr. Mohammed Alwosabi
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• For these reasons, managers act in
accordance with their own interest, save
their jobs, protect their benefits, while,
shareholders are quite happy as long as
they receive some reasonable return on their
capital.
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Second Argument: With the profit
maximization hypothesis
• Manager’s objective is to maximize profit
because:
1.Financial institutes mostly hold the largest
portion of firms’ stocks. They keep close eye
on managerial performance with the help ofon managerial performance with the help of
specialized consulting companies, and
external auditors.
2.In the presence of efficient financial
markets, managers’ misconducts would be
reflected on stock prices in the market.
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This will have a negative effect on
stockholders wealth.
3.Competition between firms secures that
inefficient managers will soon be discovered
and forced out of their jobs.
4.The compensation of many executives is
tied in a way or another to stock price
performance in terms of attained profits.
• For the abovementioned reasons, manager’s
objectives coincide shareholders’
objectives; managers would do their best to
maximize firms’ profits.
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Economic Profit:
• Although firms prepare their financial
statements according to GAAP recording
items, profit numbers are not definitive
because there are different ways of
recording depreciation and inventories; and
amortization of such items as goodwill andamortization of such items as goodwill and
patents can be recorded differently
• When it comes to calculating costs, two
basic differences do exist between
accounting and economics:
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1. Accountants base their assessments of
capital depreciation and inventories on
historical costs, while economists, on the
other hand, neglect historical costs and call
it sunk costs that should not affect
decisions. Instead, they consider
replacement cost.p
2. Accountants are generally concerned with
explicit costs, while economists are
concerned with the opportunity costs which
include both explicit and implicit costs.
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• Implicit costs include the value of resources
owned by owners of the firm even if there
are no monetary payments.
• Part of the economic cost (part of implicit
cost) is the normal profit.
• Normal profit is the average return that
could be obtained from running anotherg
business. It is an amount equal to what the
owners of a business could have earned if
their resources including entrepreneurial
abilities and talent had been employed
elsewhere.
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5. ECON340: Managerial Economics Ch.2 Dr. Mohammed Alwosabi
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• Normal profit covers the opportunity cost of
running the firm.
• Normal profit is the minimum return a firm's
owner must earn in order to stay in
operation. A lower rate would cause some of
the established firms to leave; a higher one
would cause new firms to enter.
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• Economic profit represents an extra profit
over and above all costs including normal
profit.
• It is regarded as a reward (compensation) to
the entrepreneur for taking the risk of
running a business that might reap profit or
suffer loss.suffer loss.
• It accounts for all resources.
• Economic Profit = TR - TEC
= TR – Opp. Cost
= TR – (Explicit Cost + Implicit cost)
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• A firm earns an economic profit only if it
earns more than its opportunity cost.
• If economic profit is zero ⇒ firm earns
only normal profit
• If economic profit is positive ⇒ firm earns
more than normal profit
If i fit i ti fi• If economic profit is negative ⇒ firm earns
less than normal profit (economic loss)
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• A firm that makes zero economic profit
covers all its costs including a normal profit.
In other words, a firm making just a normal
profit is making zero economic profit.
• Not every business has an equal chance to
earn economic profit. There are many
constraints in the market prevent the firmconstraints in the market prevent the firm
from maximizing its economic profit.
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