Mod 1 - Topic 1 - The firm & its goals

Question 1

What is the study of economics?

Answer 1

How people make choices to use scarce resources.

Question 2

What are the three economic questions?

Answer 2

1) What G and S should be produced and in what quantities?
2) How should these G and S be produced?
3) For whom should these G and S be produced?

Question 3

What is the definition of scarcity?

Answer 3

Where resources are limited relative to the demand for their use.

Question 4

What is the definition of resources?

Answer 4

These are the factors of production and include land, labour, capital and entrepreneurship

Question 5

What is the definition of opportunity cost?

Answer 5

The amount or subjective value forgone in choosing one activity over the next best alternative.

Question 6

What is managerial economics?

Answer 6

The use of economic analysis to make business decisions involving the best use of a firm’s scarce resources.

Question 7

What are the three economic decisions a firm needs to make?

Answer 7

1) What G and S to produce - product decision
2) How to produce G and S - Hiring and capital budget decision
3) Whom to produce G and S for - Market segmentation decision

Question 8

How does economics relate to other business disciplines, give 3 examples.

Answer 8

• Marketing - demand, price elasticity
• Finance - capital budgeting, breakeven analysis
• Management science - linear programming, regression analysis, forecasting
• Strategy - competition, structure/conduct/perf analysis
• Managerial accounting - relevant cost, incremental cost analysis

Question 9

Managers must answer the question, what are the economic conditions in our particular market, to do this, what must they consider? (7)

Answer 9

• Market structure?
• Supply and demand?
• Technology?
• Government regulations?
• International dimensions?
• Future conditions?
• Macroeconomic factors?

Question 10

Managers must also answer the question ‘should our firm be in this business?’, to do this what must they consider? (2)

Answer 10

• If so, at what price?

* If so, at what output level?

Question 11

Managers must answer the question ‘How can we maintain a competitive advantage over other firms?’, to do this they must consider? (5)

Answer 11

• Cost-leader?
• Product differentiation?
• International perspective?
• Market niche?
• Outsourcing, alliances and mergers?

Question 12

Managers must answer the question ‘What are the risks involved?’, to do this they must consider? (6)

Answer 12

• Shifts in demand/supply conditions?
• Changing interest and inflation rates?
• Technological changes?
• The effect of competition?
• Exchange rates?
• Political risk?

Question 13

What are the three ways that a country can answer the three economic questions?

Answer 13

1) The Market Process
2) The Command Process
3) The Traditional Process

Question 14

What is the Market Process?

Answer 14

Use of supply, demand and material incentives to answer what, how and for whom. Market forces decide.

Question 15

What is the Command Process?

Answer 15

Use of central planning and the directives of government authorities to answer the question of what, how and for whom.

Question 16

What is the Traditional Process?

Answer 16

The use of customs and traditions to answer the questions of what, how and for whom, eg religious belief

Question 17

What does the term ‘economics of a business’ refer to and what are the three most important factors?

Answer 17

Refers to the key factors that affect the firms ability to earn an acceptable rate of return on its owner’s investments. The three most important factors are competition, technology and customers.

Question 18

Briefly describe each stage of the four stage change model for a business?

Answer 18

• Stage 1 - the good old days - market dominance, high profits: changes are required to competition, technology and customers to move to stage 2
• Stage 2 - crisis - cost management, downsizing and restructure: re-engineering is required
• Stage 3 - reform - revenue management, cost cutting complete - focus on top-line growth
• Stage 4 - recovery - revenue plus - revenue grows profitability.

Question 19

What is the ‘firm’?

Answer 19

An organisation that transforms resources into products demanded by consumers

Question 20

What is the definition of profit?

Answer 20

It is the difference between revenue received and costs incurred.

Question 21

What are transaction costs and what do they include?

Answer 21

Costs incurred when dealing with another firm and include investigation, negotiation and enforcement of contracts.

Question 22

What is opportunistic behaviour?

Answer 22

Where one party to a contract seeks to take advantage of the other. Occurs where a party is contracted to one provider and therefore may be reliant upon them.

Question 23

How do companies approach the decision to stay internal or go external?

Answer 23

By determining the trade off between transaction costs and internal operating costs. The company will choose to allocate resources so total costs are minimised.

Question 24

What is the profit maximisation hypothesis?

Answer 24

That a company will strive to attain the highest economic profit in each period. It is the primary objective of a company.

Question 25

What is the ‘optimal decision’?

Answer 25

The decision that enables the firm to meet its desired objective more closely.

Question 26

What other economic goals may be pursued by a company? (7)

Answer 26

• Market share
• Revenue growth
• Profit margin
• Return on investment
• Technology
• Customer satisfaction
• Shareholder value

Question 27

How are other economic goals generally perceived in consideration of the goal to maximise profit?

Answer 27

As proxies for the overall objective of profit maximisation.

Question 28

What are non-economic objectives? Provide three examples.

Answer 28

Objectives that do not appear to be governed by economic thinking but define how a business should act

1) good work environment
2) quality products and services
3) good corporate citizen, socially responsible

Question 29

In considering whether companies ‘really’ try to maximise profits, what are the two questions that are asked?

Answer 29

1) Are shareholders satisficing?

2) Are managers serving their own self-interest?

Question 30

What is the definition of ‘satisficing’?

Answer 30

A concept in economics based on the principle that owners of a firm (particularly shareholders) may be content with adequate return and growth since they cannot judge when or if profits are maximised.

Question 31

What is the counter argument to those who may say a company is not maximising profits because they can rely on shareholders satisficing?

Answer 31

Underperforming companies will generally have lower share prices and are then likely to become the target of a takeover.

Question 32

What is the principal-agent problem?

Answer 32

Refers to the possible divergence of objectives between the owners and the managers of an enterprise. Stockholders are interested in increasing company value, but manages may be more interested in revenue growth, stability and attaining other incentives.

Question 33

What is ‘wealth maximisation’?

Answer 33

This concept values the stream of cash flow received but also factors in the time value of money.

Question 34

What is the ‘time value of money’?

Answer 34

It recognises that a dollar in the future is worth less than a dollar today, so a discount rate is used.

Question 35

Which is the better objective: profit maximisation or wealth maximisation and why?

Answer 35

Shareholder wealth maximisation is more comprehensive. Profit maximisation is a period of value that may be obtained by short-term management action which could be detrimental to profits in future periods.

Question 36

In determining the discount rate to apply in using a wealth maximisation, what two risks are considered?

Answer 36

1) Business risk - variability of returns (or profits) due to fluctuation in economic conditions affecting the firm
2) Financial risk - the variability of returns (or profits) induced by leverage (ie the proportion of a company financed by debt).

Question 37

How is shareholder wealth measured as a formula?

Answer 37

P = D1 / (k-g)       where:
P- present price of stock
D1 - dividend to be paid in coming year
k- discount rate
g- annual constant growth rate of dividend expressed as a percentage.

Question 38

What are two other types of economic valuations that may be used to value a company?

Answer 38

• Market value added (MVA) - Difference between market value (equity + debt) and amount of capital investors have paid into the company
• Economic value added (EVA) - Difference between a company’s return on total capital and its cost of capital

Question 39

How do economic and accounting profits differ?

Answer 39

Accountants measure only explicit incurred costs and the use of historical cost of machines, where as economists are ALSO interested in implicit costs (opportunity costs).

Question 40

What is economic profit?

Answer 40

It is the total revenue minus all economic costs.