1. EC2204- Economics of Enterprise
1: Goals of the Firm

2. Learning Outcomes
Upon completing this section, you should be able to:
• Describe the four dimensions to the business environment
(PEST).
• Illustrate and describe the decision-making process.
• Describe the objectives of the firm.
• Explain the shareholder wealth maximization model of the firm.
• Differentiate between the various theories of profit.
• Describe the goals in the not-for-profit sectors of the economy.
• Identify the criteria used in estimating expenditures in the
public sector.
• Calculate profit maximization and cost minimization levels of
output for the firm.
• Distinguish between economic and accounting cost.

3. What Is Business Economics?
• It deals with the application of microeconomic reasoning to real-
world decision-making problems faced by private, public, and
not-for-profit institutions.
• It extracts from microeconomic theory the concepts and
techniques that enable a decision maker to select strategic
direction, to allocate efficiently the resources of the organization,
and to respond effectively to tactical issues.
Economics of Enterprise aims to:
• To identify the alternative means of achieving given
objective(s), and
• To select the alternative that accomplishes the
objective(s) in the most resource efficient manner,
talking into account the constraints and the likely
actions and reactions of interdependent rival decision
makers.

4. The Business Environment (PEST Analysis)
• There are generally 4 dimensions to the business
environment:
1. Political/legal, (P)
2. Economic, (E)
3. Social/cultural and (S)
4. Technological (T)

5. 1. Political/legal factors (P)
• Firms will be directly affected by the actions of government and
other political events - These might be major events affecting the
whole of the business community, such as the collapse of
communism, global banking/financial crisis, the Gulf War or a
change of government.
• Alternatively, they may be actions affecting just one part of the
economy - for example, an anti-smoking campaign by the
government will affect the tobacco industry.
• Similarly, businesses will be affected by the legal framework in
which they operate - Examples include industrial relations
legislation, product safety standards, regulations governing
pricing in the privatised industries and laws preventing collusion
(Anti-thrust) between firms to keep prices up.

6. 2. Economic factors (E)
A firm typically operates a two levels:
• The microeconomic environment – which includes the economic
factors that are specific to a particular firm operating in its own particular
market. Thus one firm may be operating in a highly competitive market,
whereas another may not; one firm may be faced by rapidly changing
consumer tastes (e.g. a designer clothing manufacturer), while another
may be faced with a virtually constant consumer demand (e.g. a potato
merchant); one firm may face rapidly rising costs, whereas another may
find that costs are constant or falling.
• The macroeconomic environment. This is the national and
international economic situation in which business as a whole operates.
Business in general will fare much better if the economy is growing than
if it is in recession. Taxation- corporate tax rate influence FDI, interest
rates influence investment and exchange rates have a major impact on
firms competiveness especially exporters [€1 = $1.38 Sept 2011]

7. 3. Social/cultural factors (S)
• Social attitudes and values include attitudes towards working
conditions and the length of the working day, equal opportunities
for different groups of people (whether by ethnicity, gender,
physical attributes, etc.), the nature and purity of products, the
use and abuse of animals, and images portrayed in advertising.
• The social/cultural environment also includes social trends, such
as an increase in the average age of the population, or changes
in attitudes towards seeking paid employment while bringing up
small children.
• In recent times, various ethical issues, especially concerning the
protection of the environment, have had a big impact on the
actions of business and the image that many firms seek to
present.

8. 4. Technological factors (T)
• Over the last decade the pace of technological change has
quickened leading to a huge impact not only on how firms
produce products, but also on how their business is organised.
• The use of robots (FIAT factory in Turin) and other forms of
computer-controlled production has changed the nature of work
for many workers.
• It has also created a wide range of new opportunities for
businesses, many of which are yet to be realised.
• The information-technology revolution is also enabling much
more rapid communication (e-mail) and making it possible for
many workers to do their job from home or while travelling.

9. The Firm
• The traditional (neoclassical) theory of economics
defined the firm as a collection of resources that is
transformed into products demanded by consumers.
• The costs at which the firm produces are governed by
the available technology, and the amount it produces
and the prices at which it sells are influenced by the
structure of the markets in which it operates.
• The difference between the revenue it receives and
the costs it incurs is profit - it is the aim of the firm to
maximize its profit.

10. The Decision-Making Model
•The ability to make good decisions is the key to successful
managerial performance.
•In the private sector decisions have to be made on pricing,
product choice, cost control, advertising, capital investments,
dividend policy etc.
•In the not-for-profit sectors decisions must be made on budget
allocation - The Head of College has to make decisions on academic programs,
timetabling, computer facilities, number of lectures required etc .
•All decision making shares several common elements.
•The decision maker must establish or identify the objectives of
the organization.
•The failure to identify organizational objectives correctly can
result in the complete rejection of an otherwise well-conceived
and well-implemented plan.

11. The Decision-Making Model
To Increase Profit/ Establish
Objectives
market share e.g. profit, sales, etc
1. Advertising
Review Possible
Strategies Campaign
2. Reduce price
Consider Societal Evaluate Consider
Constraints Cost/Benefits of Organisational
each strategy Constraints
Will society accept an
Ad Campaign? Does the firm have
maybe we are a Select the ‘best strategy’ the skills, resources
tobacco or drinks firm To maximise key objective for an Ad Campaign?
Implement and Monitor
the Strategy
If No
If Yes Are objectives achieved? review
Revise implementation
objectives and/or
upwards alternatives

12. The Decision-Making Model
In 2008, INO took industrial action against the HSE
INO objectives
Establish Enter talks with HSE
1. Pay increase Objectives
e.g. profit, sales, etc All out strike
2. Reduce their working week
to 35 hours Work to rule
Picketing
Review Possible
Strategies No Action
Consider Societal Evaluate Consider
Constraints Cost/Benefits of Organisational
each strategy Constraints
Select the ‘best strategy’ They decided to work to rule, no
To maximise key objective answering phones, putting in light
bulbs etc
Picketing would also take place
Implement and Monitor
the Strategy
If No
If Yes Are objectives achieved? review
Revise implementation
objectives and/or
upwards alternatives

13. Objectives of the Firm
Assuming that the objective of the firm is to maximize profits,
marginal (incremental) decision rules provide guidelines for
making resource-allocation decisions - for example, if marginal
cost is defined as the change in total cost resulting from a decision,
and if marginal revenue is defined as the change in total revenue
resulting from a decision, then any business decision is profitable if
one of these results occurs:
1. It increases marginal revenue (MR) more than marginal costs
(MC), (MR > MC)
2. It decreases some MC’s more than it increases others
(assuming revenues remain constant).
3. It increases some MR’s more than it decreases others
(assuming costs remain constant).
4. It reduces MC’s more than MR, (MC < MR)

14. The Shareholder
Wealth-Maximization Model
• Shareholder wealth is a measure of the value of a firm.
• Shareholder wealth is equal to the value of a firm's common
stock, which, inVturn, is equal to the present value of all future
cash returns expected to he generated by the firm for the
0
benefit of its owners.
i. V * Shares Outstanding = =
(1.1)
where V is the current (present) value of a share of stock,
π , represents the profits expected in each of the future periods, and
ke equals the investors' required rate of return.
i.e. Share Price * No. of Shares issues = Sum of Future Profits/ investors required
rate of return

15. The Shareholder
Wealth-Maximization Model
Additional insight regarding the achievement of the shareholder wealth-maximization goal can
be gained by decomposing the profit concept, Π, into its important elements.
Profit (π) is equal to total revenue (TR) minus total costs (TQ),
π = TR – TC (1.2)
Similarly total revenue equals price per unit (P) times the number of units of output sold (Q)
or
TR = P * Q (1.3)
Total cost equals variable cost (VC) times the number of units of output sold (Q) plus fixed
costs (FC) or
TC = VC * Q + FC (1.4)
By combining equations 1.2, 1.3 and 1.4 with equation 1.1, we get
V * Shares Outstanding = (1.5)
V * Shares Outstanding = (1.6)

16. The Role of Profits
• Economic profit is the difference between total revenue
and total economic cost.
• Total revenue is measured as the sales receipts of a
firm, that is, price times quantity sold.
• The economic cost of any activity may be thought of as
the highest valued alternative opportunity that is
forgone. - To attract economic resources to some activity, the firm must
pay a price for these factors (labour, capital, and natural resources) that is
sufficient to convince the owners of these resources to sacrifice other
alternatives and commit the resources to this use.
• Thus, economic costs may be thought of as opportunity
costs, or the costs of attracting a resource from its next
best alternative use. - The term economic cost refers to all costs,
both explicit and implicit, including a normal return (profit) for owners of
the financial resources.

17. Theories of Profits
• The existence of profits determines the type and quantity of goods
and services that are produced and sold, as well as the demand
for various factors of production—labour, capital, and natural
resources.
• Because of the important role played by profits in our system, we
will review the following theories of profit:
1. Risk-Bearing Theory of Profit
2. Dynamic Equilibrium (Friction) Theory of Profit
3. Monopoly Theory of Profit:
4. Innovation Theory of Profit
5. Managerial Efficiency Theory of Profit

18. Risk-Bearing Theory of Profit
• Risk-Bearing Theory of Profit is the economic profits above a
normal rate of return are necessary to compensate the owners of
the firm for the risk they assume when making their investments.
• Because a firm's share­holders are not entitled to a fixed rate of
return on their investment—that is, they are residual claimants to
the firm's resources—they need to be compensated for this risk
in the form of a higher rate of return.
• The risk-bearing theory of profits is explained in the context of
normal profits, where normal is defined in terms of the relative
risk of alternative investments. Normal profits for a high-risk firm,
such as a casino operator, should be higher than normal profits
for firms of lesser risk, such as water utilities.

19. Dynamic Equilibrium (Friction)
Theory of Profit
• All firms should tend to earn a long-run equilibrium normal rate of
profit (adjusted for risk).
• At any point in time an individual firm or the firms in a specific
industry might earn a rate return above or below this long-run
normal return level.
• This can occur because temporary shocks in various sectors of
the economy - For example, firms that produced oil and natural gas
experienced a dramatic increase in profits in response to supply shortages
following the invasion of Kuwait by Iraq in 1990 a during the general strike in
Venezuela in 2002, and also in 2008 (Price of barrel of crude oil in June 2008 =
$138). Rates of return rose substantial However, those high returns declined
shortly after the war and strike ended, when market conditions led to excess
supplies.
• Similarly, if a new, inexpensive, and readily available energy
source were to be discovered, oil prices would decline
substantially - Over time, some producers would leave this increasingly
unprofitable market until a normal rate of profit was restored for the remaining
firms. The inability of our economic system to adjust instantaneously to changes
in market conditions may result in short-term profits above below normal levels.

20. Monopoly Theory of Profit
• In some industries, one firm is effectively able to dominate the
market (Guinness in the stout market, Intel in microprocessor
industry) and potentially earn above-normal rates of return for a
long period time.
• This ability to dominate the market may arise from economies of
scale (a situation in which one large firm can produce additional
units of output at a lower cost than can smaller firms), control of
essential natural resources (Bord na Mona), control of critical
patents (Pfizer with Viagra) or governmental restrictions that
prohibit competition.
• The conditions under which monopolist can earn above-normal
profits are discussed in depth later.

21. Innovation Theory of Profit
• The innovation theory of profit suggests that above-normal
profits are the reward for successful innovations.
• Firms that develop unique high-quality products (such as
Microsoft in the computer software industry] firms that
successfully identify unique market opportunities (such as
Federal Express are rewarded with the potential for above-
normal profits.
• Indeed, the patent system is designed to ensure that these
above-normal return opportunities furnish strong incentives for
continued innovation.

22. Managerial Efficiency Theory of Profit
• Closely related to the innovation theory the managerial efficiency
theory of profit.
• This theory maintains that above-normal profits can arise
because of the exceptional managerial skills of well-managed
firm.
• The ability to earn above-normal profits by exercising high-
quality managerial skills is a continuing incentive for greater
efficiency in any economic system.

23. Not-For-Profit Sectors
• There are 3 characteristics of NFP organizations that
distinguish them from for-profit enterprises and influence
decision making in the enterprise:
1. First, no one possesses a right to receive profit or surpluses in
an NFP enterprise. The absence of a profit motive can have a
serious impact on the incentive to be efficient.
2. NFP enterprises are exempt from taxes on corporate income.
3. Many NFP enterprises benefit from the fact that donations to
them are tax deductible. These tax benefits give NFP
enterprises an advantage when competing with for-profit
enterprises.
Not-for-profit organizations include performing arts groups, museums, libraries,
hospitals, churches, volunteer organizations, cooperatives, credit unions, labour
unions, professional societies, foundations-Westgate,

24. Not-For-Profit Objectives
For NFP organizations, such as GOAL, Trocaire, etc. that rely
heavily on external contributions, the over-riding objective is to
satisfy current and prospective contributors. It is common to
find NFP organization that seeks to satisfy its contributors by:
(1) Efficiently managing its resources,
(2) Increasing its capacity to supply high-quality goods or services
and
(3) Providing a rewarding work environment for its administrators.

25. Accounting Versus Economic
Costs
• Accountants have been primarily concerned with measuring
costs for financial reporting purposes. As a result, they define
and measure cost by the historical outlay of 'funds that takes
place in the exchange or transformation of a resource.
• Economists include some additional costs that are typically not
reflected in the cost figures appearing in the financial reports of
the firm.
• Both the accounting cost and the economic cost of a product will
include such explicit costs as labor, raw materials, supplies,
rent, interest, and utilities.

26. Accounting Versus Economic
Costs
• Economists also include several implicit costs.
• The implicit costs consist of the opportunity costs of time and
capital that the owner-manager has invested in producing the
given quantity of output.
• The opportunity cost of the owner's time is measured by the
most attractive salary or other form of compensation that the
owner could have received by operating or managing a similar
kind of firm for another investor.
• The opportunity cost of the capital employed in producing the
given quantity of output is measured by the profit or return that
could have been received if the owner had chosen to employ
capital in the best alternative investment of comparable risk.

27. Profit Maximisation
Suppose the profit, π, of the ESB can be represented as a function of the output level Q using
the expression
π = -40 + 140Q – 10Q2
we wish to determine the profit maximising level of output for the ESB
= 0, Q = 7
How do we know if a maximum or a minimum?
, because , we know that a maximum-profit has been obtained
Profit is maximised at Q = 7
Note: if > 0, if the 2nd derivative is positive, a minimum point is obtained.
Calculate the profit at the profit maximising level of output? π = -40 + 140(7) – 10(7)2
π = 450 at Q = 7

28. Cost Minimisation
Suppose the variable costs, VC, of the ESB can be represented as a function of the output
level Q using the expression
VC = 200Q – 9Q2 + 0.25Q3
FC = 150
TC = 200Q – 9Q2 + 0.25Q3 + 150
we wish to determine the cost minimising level of output for the ESB
δTC
= 200 – 18Q + 0.75Q2 = Marginal Cost Function
δQ
δMC
= -18 + 1.5Q
δQ
Q = 12
nd δ 2 MC
2 derivative = 1.5
δQ
2
δ 2 MC
because > 0, we know its a minimum cost at Q =12.
δQ
2
Calculate the total cost at the cost minimising level of output?
TC = 200(12) – 9(12)2 + 0.25(12)3 + 150
TC =1,686

29. Calculating Present and Future Values
• The technique of discounting is used to determine the
current value of an asset or business.
PV = FV / (1 + r) n
where PV = Present value, FV = Future value, r = rate of interest, n = number of years
What is the Present Value of an investment that is expected to £500,000 in 5 years if the constant rate of interest over the period is 6%?
• The technique of compounding is used to determine
the Future value of an asset or business.
FV = PV * (1 + r) n
where PV = Present value, FV = Future value, r = rate of interest, n = number of years
What is the Future Value of a business in 5 years if £500,000 is invested and the constant rate of interest over the period is 6%?
It is important to note that this formula can only be used if

30. Discounting - bringing an amount backwards in time
• PV = FV / (1+r)n
What is the present value of one million pounds in
benefits from a current project that will occur in 10
years if the discount rate of interest is expected to be
4%?
• PV = £1,000,000 / (1.04)10
• PV = £675,564.17
• If average interest rates increase to 6%, how will this
affect the outcome?
• PV = £1,000,000 / (1.06)10
• PV = £558,394.78
• (So if Interest rates are higher the PV of a Project or investment is lower)
• Implication for Economic Policy – More investment likely if interest rates are lower.

31. Recall Our Learning Outcomes
You should now be able to:
• Describe the four dimensions to the business environment
(PEST).
• Illustrate and describe the decision-making process.
• Describe the objectives of the firm.
• Explain the shareholder wealth maximization model of the firm.
• Differentiate between the various theories of profit.
• Describe the goals in the not-for-profit sectors of the economy.
• Identify the criteria used in estimating expenditures in the
public sector.
• Calculate profit maximization and cost minimization levels of
output for the firm.
• Distinguish between economic and accounting cost.