Business objectives Flashcards
Define firm
An organisation that brings together factors of production in order to produce output
What is normal profit
the return needed for a firm to stay in the market in the long run. Equal to opportunity cost
What is supernormal profit
profits above normal profit (includes opportunity cost)
When does profit maximisation occur
MC=MR. Long-run ovjective
Where does sales revenue maximisation occur
MR=0. Production is increased to a point where additional sales would reduce overall revenue because to make an extra sale the price of all such goods would have to be reduced
Where does sales volume maximisation occur
AC=AR. A higher level of sales would cause AR
Maximise growth
Increase market share and the size of the firm. Cutting prices below cost will lead to a loss in short run but may lead to even higher long run profits due to increased brand recognition and increased economies of scale. Higher sales may make it easier to borrow money.
What does conventional theory of the firm assume
Businesses have enough information, market power and motivation to set their own prices, that maximise their total profit. We assume firms profit maximise and stay in the market making SNP.
Profit maximisation realistic assumptions
Information: know costs and revenue so can calculate MC=MR.
Single product businesses: may only make a single product
Profit maximisation unrealistic assumptions
Imperfect information: Hard to pinpoint MC=MR as can not accurately calculate MR and MC. Prices are on basis of ‘estimated demand’.
Multi-product businesses: have a lot of information to handle and must keep track of changing preferences.
Ignores time: to capture long-run market, in the short-run requires not to produce MC=MR to capture market share
Order of speed of growth (fastest-slowest)
growth max, sales volume max, sales revenue max, profit max
Order of profits (greatest to lowest)
Profit max(+), sales revenue max(+), sales volume max (zero profit), growth max(negative profit)
What is the principle agent problem
Arises because of information asymmetry between managers and owners , meaning that managers may not be viewed by shareholders as maximising profit, if objectives of managers are different to shareholders the managers may not achieve the same objective.
utility maximisation
Managers may enjoy status of running a large team, having a large office, company car
Profit satisficing
Lazy managers mey want to have an easier time at work so acept lower profits that are still acceptable to shareholders
Social welfare
the frim exsists to benefit wider society, may donate % of profit
Corporate social responsibility (CSR)
businesses doing/sponsoring charity work or encouraging employees to volunteer
How does a firm choose an objective
It reflects the objectives of the owners. E.g. shareholders usually profit maximise whereas government may want to increase social welfare
How do owners minimise principle agent problem
By aligning incentives of managers with owners with performance related pay, so managers want to maximise profit
Adavantage of utility maximisation
+ ‘traffics of power’ may be necessary to recruit most productive and effective employees
Disadvantage of utility maximisation
‘Trappings of power’ may be expensive and unecessary
Adavantage of social welfare
Popular with customers, increasing sales
Disadvantages of social welfare
High opportunity cost of not earning more profit
Advantage of CSR
Popular with customers, happier and more productive employees
Disadvantage of CSR
Expensive and divert attention form more profitable endeavours
Advantage of profit satisficing
Prevent unscrupulous behaviour that can lead to new legislation being imposed
Disadvantage of profit satisficing
Lower profits than possible
What does the objective the firm choose depend on
The extent to which principle agent problem exsists, the larger the problem the more objectives diverge
The extent to which social welfare benefits form over profit max depends on
Preferences of target market, the more strongly target market feel about cause the greater the benefit
What is total average costs
Total cost divided by the quantity produced often called unit cost
What is marginal costs
Cost of producing an additional unit of output
Why is the short run different for different businesses
because of the marginal cost curve decrease at first as the output increases
Why must MC cross AC at the lowest point on AC
- When MC below AC, cost of one more unit brings AC down.
- MC above AC, cost of one more unit increases AC
- So when MC=AC. MC is not changing AC
Define short-run
Period of rime over which a firm is free to vary its input of one factor of production (labour), but faces fixed inputs of the other factors of production
Define long-run
Period over which the firm is able to vary the inputs of all its factors of production
What is the law of diminishing marginal utility
If a firm increases its inputs of one factor of production while holding inputs of other factors of production fixed, eventually the firm will get diminishing marginal returns from the variable factors
What are sunk costs
Costs incurred by a firm that cannot be recovered if the firm ceases trading e.g. advertising
What does a short run average cost curve show
relationship between the volume of production and costs under the assumption that the quantity of capital and other inputs are fixed - to change the output, the firm has to vary the amount of labour
What does the position of cost curve depend on
quantity of capital and ,in the long-run, this (along with labour, land and enterprise) can change
in the long run how can the SRAC be shifted
changes in the amount of capital available. Increasing returns to capital cause SRAC to shift down as output increases. The locus of SRAC minima are taken to describe LRAC curve
Why is the law of diminishing returns not important
small firms may not need to consider it, as a firm with a small number of staff or a small amount of capital may only see increasing returns to scale
Why is the law of diminishing returns important
- Explains why no infinite profits can be made
2. Results in there being a level of production at which profits are maximised (profit maximisation)
Define economies of scale
Occur for a firm when an increase in the scale of production leads to production at lower long-run AC
What are internal economies of scale
economies of scale that arise from the expansion of a firm
What are external economies of scale
economies of scale that arise from the expansion of the industry in which a firm is operating
What are technical efficiency
attaining the maximum possible output from a given set of inputs
What are cost efficiency
the appropriate combination of inputs of factors of production, given the relative prices of those factors
Technical economies of scale (internal)
production line methods, specialised equipment, specialisation to a greater extent in larger firms, containerisation
Purchasing economies of scale (internal)
bulk buying, larger firms need large quantities of raw materials so can negotiate discounts
Managerial economies of scale (internal)
specialist managers (finance, production, customer service) gain expertise and experience leading to better decisions, number of managers needed increase more slowly than output, lowering AC
Financial economies of scale (internal)
larger firms can borrow money at a lower interest rate as banks pass on their own economies of scale and lending is less risky
Risk bearing economies of scale (internal)
Larger firms can diversify into different product areas, confident that some will succeed - only large firms can afford to take the risk
Marketing economies of scale (internal)
advertising is a fixed cost, so more output is produced, the cost to advertise per unit falls.
Larger firms benefit from brand awareness so need to advertise less
More skilled labour economies of scale (external)
A larger industry has a larger pool of skilles labour so a firm can hire labour more cost effectively because spending on training will be lower. e.g. silicon valley
Local colleges may start to offer qualifications needed by big local employers, reducing firms’ training costs e.g. worcester bosch
More regional capital (external)
large companies relocating may lead to improvements in road networks or local public transport. Improvements in local infrastructure, firms that have similar activities may share resources e.g. research facilities. Suppliers may locate near to large firms to reduce transport costs
Economies of scale that are not dependent on specialization
risk bearing, financial economies, managerial economies, marketing economies
Analysis of internal economies of scale
As firms grow and sales increase, it can bulk buy factor inputs at a lower AC - and so the firm benefits from purchasing economies of scale
Analysis of external economies of scale
When a firm expands and becomes large enough, it can benefit from regional capital by working with local educators to design training courses for potential employees. This leads to more highly skilled workers for the firms at lower cost
Causes of economies of scale
Larger industries tend to have more scope for economies of scale, firms can benefit from more economies of scale, and there is more scope to benefit from each. (There are no large hairdressing firms but several large oil firms)
Significance of economies of scale
The existence of economies of scale and, over time, the more successful utilisation thereof, is a major part of why standards of living continue to rise
What are diseconomies of scale
occur for a firm when an increase in the scale of production leads to production at higher LRAC
What are internal diseconomies of scale
diseconomies of scale that arise from the expansion of a firm
What are external economies of scale
diseconomies of scale that arise from the expansion of the industry in which a firm is operating
Control diseconomies of scale (internal)
managers find it harder to control what workers do due to the complexity of monitoring large numbers of workers (similar to the principle-agent problem)
Coordination diseconomies of scale (internal)
Managers find it harder to coordinate the activities of workers and between teams due to the complexity of communicating with large numbers of people. May take place over several countries and time zones, increasing the difficulty.
Cooperation diseconomies of scale (internal)
Workers in large firms may develop a sense of alienation and loss of morale if they do not feel listened to, leading to wastage of factor inputs and higher costs. May be caused by office politics
Factor inputs diseconomies (external)
As the industry grows from a single, or many, growing firms, the increased demand, ceteris paribus, leads to increased prices of factor inputs e.g. Li shortage for electric cars
Exhausted local supplies diseconomies (external)
Bulk buying may exhaust nearby, local supplies which leads to increased transport costs of additional supplies bough from further away e.g. tech workers
Analysis of diseconomies of scale
When a firm expands coordination diseconomies can occur because managers find communicating more complex
Causes of diseconomies of scale
different types of market experience diseconomies of scale at different points. The greater the proportion of a firm’s costs that are variable costs, the more quickly a firm may hit decreasing returns to scale
Significance of diseconomies of scale
The more quickly incumbent firms experience diseconomies of scale, the more potential there is for new firms to enter the market and complete
What is total revenue
revenue received by a firm from its sales of a good or service it is the quantity sold, multiplied by the price - assuming there is one type of product selling at one price
what is average revenue
received by a firm per unit of output; TR/Q0. AR=P0. Assuming there is one type of product selling at one price
What is marginal revenue
additional revenue received by a firm if it sells an additional unit of output
Where is TR shown on a graph
area of the rectangle on a graph inside the equilibrium (QxP)
Why does D=AR
because AR that a firm receives for a given number of sales is equal to the price that leads to those sales
Why is MR steeper than the demand curve
because MR=0 when PED on the demand curve is unitary. MR becomes negative when the price increases lead to lower TR; PED is inelastic
Why does AR=MR
because each extra unit sold brings the same revenue as all the previous sales. AR is constant so TR increases proportionately with sales, this is true for firms that are price takers
Features of price takers
They have no market power, when setting prices; they accept the market clearing price because there are a large number of firms all making the same good (among other features)
Define accounting profit
TR-TC
Define economic cost
TC+ opportunity cost
What do firms need to stay in the market
make enough profit to cover the opportunity cost. If accounting profit is lower than opportunity cost, the firm would be better off using their resources elsewhere; they would leave the market.
Why does profit maximisation occur at MC=MR
If MR from the next sale is greater than MC of that sale, the next sale is contributing to profits so should be made. If MR from the next sale is less than the MC of that sale, the next sale makes a loss so should not be made. Production should therefore be increased until the MR of production equals the MC of production to maximise profits.
