Managerial economics strategy by m perloff and brander chapter 7 organization and market structure

– In the pursuit of their main goal, such as maximizing profit, owners and managers must make decisions about the nature of the firm, such as the make or buy decision.. 7.1 Ownership & G

Chapter 7

Firm Organization

and Market Structure

Table of Contents

• 7.1 Ownership & Governance of Firms

• 7.2 Profit Maximization

• 7.3 Owner’s vs Manager’s Objectives

• 7.4 The Make or Buy Decision

• 7.5 Market Structure

– Owners have to decide what objectives the firm should pursue, and they need to

structure incentives to induce managers to pursue these objectives In addition, managers need to decide which stages of production the firm should perform and which to leave to others

• Empirical Methods

– Ownership and governance of firms affect the firm’s objectives.

– The owner-manager relationship is one of principal-agent relationship where the principal delegates tasks to an agent This delegation creates a transaction cost called an agency cost and many features of the firm’s organization try to minimize it.

– In the pursuit of their main goal, such as maximizing profit, owners and managers must make decisions about the nature of the firm, such as the make or buy decision Market structures affect such a decision.

7.1 Ownership & Governance of Firms

• Private, Pubic and Non-Profit: The Private Sector

– Consists of firms that are owned by individuals or other non-governmental entities and whose owners may earn a profit

– Examples are Apple, Heinz, and Toyota In almost every country, this sector

provides most of that country’s gross domestic product (75% of GDPUSA).

• Private, Pubic and Non-Profit: The Public Sector

– Consists of firms and other organizations that are owned by governments or

government agencies, called state-owned enterprises – Examples are the armed forces, the court system, most schools, colleges,

universities, and Amtrak This sector may be small or large (12% of GDP USA ).

• Private, Pubic and Non-Profit:The Non-Profit Sector

– Consists of organizations that are neither government-owned nor intended to earn a profit, but typically pursue social or public interest objectives (non-government, not- for-profit sector)

– Examples include Greenpeace, Alcoholics Anonymous, the Salvation Army, and

other charitable, educational, health, and religious organizations.

7.1 Ownership & Governance of Firms

• Ownership of For-Profit Firms: Sole Proprietorships

– Firms owned and controlled by a single individual

• Ownership of For-Profit Firms: Partnerships

– Businesses jointly owned and controlled by two or more people operating under a partnership agreement.

• Ownership of For-Profit Firms: Corporations

– Firms owned by shareholders, who own the firm’s shares or stocks

– Each share is a unit of ownership in the firm Therefore, shareholders own the firm in proportion to the number of shares they hold

– Shareholders elect a board of directors to represent them In turn, the board of directors usually hires managers who manage the firm’s

operations

– The legal name of a corporation often includes the term Incorporated

(Inc.) or Limited (Ltd) to indicate its corporate status.

7.1 Ownership & Governance of Firms

• Publicly Traded Corporation

– Corporations whose shares can be readily bought and sold by the general public – Stocks may be available at the New York Stock Exchange, the NASDAQ, the Tokyo Stock Exchange, the Toronto Stock Exchange, or the London Stock Exchange.

• Closely Held Corporation

– Shares not available for purchase or sale on an organized exchange

– Typically its stock is owned by a small group of individuals (private equity).

• From Publicly Traded to Closely Held Corporation

– To make the transition the closely held firm makes an initial public offering (IPO) of its shares on an organized stock exchange.

– One major advantage of going public is to raise money However, a major

disadvantage is that ownership of the firm becomes broadly distributed, possibly causing the original owners to lose control of the firm.

– It is also possible for a publicly traded firm to go private and convert to closely held status Examples are Toys-R-Us and Burger King

7.1 Ownership & Governance of Firms

• Liability and Ownership

– Owners of a corporation are not personally liable for the firm’s debts; they have limited liability: The personal assets of the corporate owners cannot

be taken to pay a corporation’s debts even if it goes into bankruptcy.

– Traditionally, the owners of sole proprietorships and partnerships were fully liable, individually and collectively, for any debts of the firm Now they can be a limited liability company (LLC) The precise regulations that apply to LLCs vary from country to country and from state to state within the United States.

• Firm Size and Ownership

– Most large firms are corporations According to the U.S Statistical

Abstract 2012, U.S corporations are only 18% of all nonfarm firms but

make 81% of sales revenue and 58% of net income Nonfarm sole proprietorships are 72% of firms but make only 4% of the sales revenue and earn 15% of net income

– Corporations that earn over $50 million are less than 1% of all

corporations, but they make 77% of revenue.

7.1 Ownership & Governance of Firms

• Firm Governance: Small Firms

– In a small private sector firm with a single owner-manager, the governance of the firm is straightforward: the owner- manager makes the important decisions for the firm.

• Firm Governance: Publicly Traded Corporation

– The shareholders own the corporation However, most of them play no meaningful role in day-to-day decision-

making or even in long range planning.

– Shareholders elect a board of directors and delegate many

of their ownership rights to them

– The board of a large publicly traded corporation normally includes outside directors and inside directors, such as the chief executive officer (CEO) of the corporation and other senior executives

7.2 Profit Maximization

• Revenue (R) is price times quantity.

• Cost(C), the correct measure is the opportunity cost: the value of

the best alternative use of any input the firm employs The full opportunity cost of inputs used might exceed the explicit or out-of-pocket costs recorded in financial accounting statements

• Profit (π) is Revenue minus Cost If π < 0, the firm makes a loss

• To add profits over time calculate the present value, in which

future profits are discounted using the interest rate

7.2 Profit Maximization

• Two Steps to Maximize Profit: π (q) = R (q) – C (q)

– Profit varies with the level of output because both revenue and cost vary with output.

– There are two key decisions to maximize profit.

• First Step: Output Decision

– What is the output level, q, that maximizes profit or

minimizes loss?

• Second Step: Shutdown Decision

– Is it more profitable to produce q or to shut down and

produce no output?

7.2 Profit Maximization

• Rule 1: Set output where profit is maximized

– If the firm knows its entire profit curve (Figure 7.1), it sets output at q*to

get π*.

• Rule 2: Set output where Mπ = 0

– Marginal profit , p/∆q, where ∆q = 1, is the slope of the profit curve The

maximum profit occurs where the slope is zero

• Rule 3: Set output where MR(q)=MC(q)

– Marginal Profit = MR - MC The extra income raises profit but the extra

cost reduces profit Maximum profit occurs at MR(q) = MC(q).

– Using calculus: dπ (q)/ddq = dR (q)/ddq – dC (q)/ddq = 0; MR(q)=MC(q)

7.2 Profit Maximization

Figure 7.1 Maximizing Profit

7.2 Profit Maximization

• Shutdown Rules

– Should the firm shut down if its profit is negative? It

depends

• Shutdown Rule 1: Shut down only if loss is reduced

– This rule applies to the short run and long run alike.

• Shutdown Rule 2: Shut down only if revenue < avoidable cost

– In the short run, variable costs are avoidable but fixed

costs are unavoidable (sunk costs)

– As long as revenue covers variable costs and some fixed costs, no shut down occurs.

– In the long run all costs are avoidable; shutting down

eliminates all costs.

7.2 Profit Maximization

• Profit Over Time

– Firms maximize profit not only for the current period They are normally interested in maximizing profit over many periods

– The difference between maximizing the current period’s profit and long-run profit is important in some situations

• Present Value: PV = FV / (1+i) t

– Compound Interest Rate: $100 today (PV) at a 10% interest rate has a future value (FV) of $110 in one year, and $121 in two

years In general FV = PV (1+i) t , where t is the number of years.

– Money in the future is worth less than money today: $100 in one

year is less than $100 today In general, PV = FV / (1+i) t

– Shareholders of a firm may value a stream of profits over time by calculating the present value, in which future profits are

discounted using the interest rate (see Appendix 7 for more

detail)

7.3 Owners’ vs Managers’

Objectives

• Consistent Objectives: Principal-Agent Problem

– Owners (principal) delegate tasks to managers and other workers (agent) in most firms

– If the principal wants to maximize profit and agents want to

maximize their own incomes or perks the resulting profit is not the maximum (agency cost)

• Consistent Objectives: Contingent Rewards

– To make the owner and manager objectives more closely aligned, many firms use contingent rewards: higher pay if the firm does well

– A year-end bonus based on the performance of the firm or a

group of workers within the firm– A stock option or the right to buy a certain number of the firm’s

shares at a pre-specified exercise price within a specified time

7.3 Owners’ vs Managers’

Objectives

• Consistent Objectives: Profit Sharing

– If profit is easily observed and the owner and manager want to maximize their own earnings, pay the manager a share of the firm’s profit

• Graph Application

– In Figure 7.2, the manager (agent) earns 1/3 of the joint profit,

shareholders (principals) get 2/3 The output level, q*, maximizes

both shares No conflict

– By 2005 over 70% of firms provided annual stock options to their top three executives, compared to virtually none in 1950 and

about 50% in 1970

– 75% of total compensation of a chief executive at S&P 500 firms came from incentives in 2009

7.3 Owners’ vs Managers’ Objectives

Figure 7.2 Profit Sharing

7.3 Owners’ vs Managers’

Objectives

• Conflictive Objectives: Revenue Objectives

– Sometimes profit can be manipulated by owners or managers So profit sharing is not possible.

– Revenue sharing: executive compensation is primarily determined by the firm’s revenue But, managers prefer to maximize revenue rather than profit.

• Graph Application

– In Figure 7.3, the manager is paid a share of revenue It is best for the

manager to set output at q = 5, where revenue is 25 and profit just 5 The output that maximizes profit, q = 3, where profit is 9 and revenue is

21, is not chosen.

7.3 Owners’ vs Managers’ Objectives

Figure 7.3 Revenue Maximization

7.3 Owners’ vs Managers’

Objectives

• Conflicting Objectives: Personal Effort and Earnings

– A manager who receives a fixed salary or a compensation not tied to

performance and who values leisure may not work hard to maximize profit

– If a board insists on a profit target, a manager may only satisfice it.

• Conflicting Objectives: Social Objectives

– Corporations often make large contributions to hospitals, universities,

environmental projects, disadvantaged groups, or other causes Are these managers pursuing social policy with shareholders’ money?

• Conflicting Objectives: Perks

– Some perks save a manager’s time and increase productivity However, some managers unilaterally grant themselves perks with little or no

tangible advantage to the firm If the firm reduces the manager’s salary

by the cost of such benefits, then these benefits do not harm the firm’s bottom line

7.3 Owners’ vs Managers’

Objectives

• Monitoring & Controlling Manager’s Actions: Direct Monitoring

– If the owner and manager work side by side, monitoring the manager

is easy

– However, most of the time the owner cannot observe the actions of the manager; profit is subject to uncertainty; and parties cannot write an enforceable contract

• Monitoring & Controlling Manager’s Actions: Indirect Monitoring

– Board and Managers: Senior executives are restricted in their ability

to carry out activities outside the firm (disclosure conflict of interest)– Shareholders and Board: rules may require to have outside directors; nature and frequency of elections But, difficult to specify or legally enforce what constitutes appropriate effort for board members

– Say-on-Pay (SOP), the Dodd–Frank Wall Street Reform, and

Consumer Protection Act of 2010: shareholders vote periodically on compensation going to senior executives

7.3 Owners’ vs Managers’

Objectives

• Takeovers & the Market for Corporate Control

– Managers can be disciplined through the market for

corporate control: outside investors buy enough shares to take over control of an under-performing publicly traded firm.

• Poison Pill Defense

– Firms can defend with a shareholder rights plan (poison pill) in the United States.

– Poison pills may not prevent a takeover, but usually

benefits the original managers or board of directors to induce them not to further fight the takeover.

7.4 The Make or Buy Decision

• Horizontal and Vertical Dimensions

– Managers make decisions that affect the structure of the firm in two dimensions

– Horizontal dimension: size of the firm in its primary market

– Vertical dimension: stages of the production process in which the firm participates

• Supply Chain Management

– To produce and sell a good involves many sequential stages of production, marketing, and distribution activities

– A manager decides how many stages the firm will undertake itself– Also, at each stage, whether to carry out the activity within the firm or to pay for it to be done by others

7.4 The Make or Buy Decision

Figure 7.4 Vertical Organization

• Stages of Production

– Figure 7.4 illustrates the sequential

or vertical stages of a relatively

simple production process (such as

bread)

– At the top of the figure, in the

upstream, firms use raw inputs

(such as wheat) to produce

semi-processed materials (such as flour)

– Then, in the downstream, the same

or other firms use the

semi-processed materials and labor to

produce the final good (such as

bread), q = f(M, L)

– In the last stage, the final

consumers buy the product

7.4 The Make or Buy Decision

• Vertical Integration

– A firm that participates in more than one successive stage

of the production or distribution of goods or services is vertically integrated

– A firm may vertically integrate backward and produce its own inputs, or forward and buy its former customer.

– A firm can be partially vertically integrated It may produce

a good but rely on others to market it Or it may produce some inputs itself and buy others from the market.

– Some firms buy from a small number of suppliers or sell through a small number of distributors These firms often control the actions of the firms with whom they deal by writing contractual vertical restraints that create quasi- vertical integration (franchisor and franchisee)