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Modern takes on the theory of the firm sometimes distinguish between long-run
motivations, such as sustainability, and short-run motivations, such as profit
maximization. The theory is always being analyzed and adapted to suit changing
economies and markets. Early economic analysis focused on broad industries, but as
the 19th century progressed, more economists began to look at the firm level to
answer basic questions about why companies produce what they do and what
motivates their choices when allocating capital and labor.
Behavioural Theory of the Firm
Stakeholders are groups made up of people who each have a vested interest in the
activity of a business. Examples include:
The dominant group at any moment can focus on their own objectives. For
example price and output decisions may be taken at a local level by managers, with
shareholders taking only a distant view of the company's performance and strategy.
Satisficing behaviour
Selling as much as you can without making a loss. At sales maximisation there are
normal profits or no supernormal profits.
Annual salaries and perks are linked to sales revenue rather than profits
Companies geared towards maximising revenue are likely to make frequent
use of price discrimination to extract extra revenue and marginal profit from
consumers
A business might also aim to maximise sales revenue rather than profits
because it wishes to deter the entry of new firms
If a firm decides to aim to maximise sales revenue rather than profits, one of
the consequences might be a reduction in the price of the firm's shares since
the rate of profit is likely to be lower
According to traditional theories, the firm is controlled by its owners and thus wishes
to maximise short run profits. The more contemporary managerial theories of the
firm examine the possibility that the firm is controlled not by its owners, but by its
managers, and therefore does not aim to maximise profits. Although profit plays an
important role in these theories as well, it is no longer seen as the sole or dominating
goal of the firm. The other possible aims might be sales revenue maximisation or
growth.
Economics Theories
The concept of profit entails several different meanings. Profit may mean the
compensation received by a firm for its managerial function. It is called normal profit
which is a minimum sum essential to induce the firm to remain in business. Profit
may be looked upon as a reward for true entrepreneurial function. It is the reward
earned by the entrepreneur for bearing the risk. It is termed as supernormal profit
analysis.
Profit may imply monopoly profit. It is earned by a firm through extortion, because
of its monopoly power in the market. It is not related to any useful specific function.
Thus monopoly profit is not a functional reward. Profit may sometimes be in the
nature of a windfall. It is an unexpected reward earned by a firm just by mere chance,
an inflationary boom.
Profit is the earning of entrepreneur. To the economist, the most significant point
about profit is that it is a residual income. However, the term profit has different
connotations.
In short, the following are the distinctive features of profit as a factor reward:
(i) It is not a predetermined contractual payment.
(iv) It is uncertain.
(v) It may even be negative. Other factor rewards are always positive.
Gross Profit and Net Profit:
In ordinary parlance, profit actually means gross profit.
Gross profit is a term in which the following items are included in addition to
the net profit due to the entrepreneur:
(i) Remuneration for factors of production contributed by entrepreneur himself.
Net profit is the exclusive reward for the entrepreneur for the following
functions performed by him:
(i) Reward for co-ordination
In short,
Gross Profit = Net profit + implicit rent + implicit wages + implicit interest + normal
profit + depreciation and maintenance charges + non-entrepreneurial profit.
Net Profit = Gross profit – (implicit rent + implicit wages + implicit interest + normal
profit + depreciation and maintenance charges + non-entrepreneurial profit)
In fact, Net Profit = economic profit or pure business profit. It is the net profit which
may be positive or negative. A negative profit means a loss.
For the business firm, accounting profit is very important. Accounting profit is
defined as the revenue realised in a given period after providing for expenses
incurred during the production of a commodity. A firm while making accounting
profits may be incurring economic losses. Such a firm would have to withdraw from
business in the long run. In the balance sheet of a firm, accounting profit occupies
an important place.
The economist, however, does not agree with the accountant’s approach to profit.
The accountant would only deduct the explicit or actual costs from the revenues to
determine profit. The economist points out that in addition to the deduction of
explicit cost, imputed cost, i.e., the cost that would have been incurred in the absence
of the employment of self owned factors, should also be deducted.
(ii) Rental income on self-owned land and building employed in the business, and
(iii) Interest on self owned capital that could have been earned by investing it
elsewhere.
Thus the profit arrived at after deducting both explicit and imputed costs may be
called economic profit. From the managerial point of view, economic profit is very
important because this alone shows the viability of a firm.
When competition among entrepreneurs is perfect, the market price of the product
is equal to average cost which itself includes ‘normal profit’. Normal profit is the
minimum to induce the entrepreneur to remain in the business in the long run.
It is possible that the entrepreneur may not get normal profit in the short run and may
have to sell his product at a loss, but in the long run every entrepreneur must get at
least the normal profits. It is assumed to be part of the price. In the words of Mrs.
Joan Robinson, “Normal profit is that profit which neither attracts a new firm to
enter into the industry nor obligates the existing firm to go out of the industry.”
Supernormal profit is defined as the surplus over the normal profit. It is obtained by
the super marginal firms. The marginal firm gets only the normal profit, but
determines the supernormal profit of the intra marginal firm.
They say that since the entrepreneur takes risks in business, he earns profit.
Schumpeter said that the entrepreneur is performing the role of an innovator and
therefore profit is a reward for his innovation. Prof. Knight opined that profit is due
to his risk taking and uncertainty bearing.
Monopoly Profit:
When a firm possesses monopoly power, it can restrict output and obtain a higher
profit than it could under competitive conditions. Profit is the result of continued
scarcity. It can exist only in an imperfect market where output is for various reasons
restricted and the consumers are deprived of the opportunity of alternative sources
of supply.
Sources of such powers are usually found in legal restrictions, sole ownership of raw
materials or access of sale to particular markets. Even some degree of uniqueness in
a firm’s product confers some monopoly power. Summarising, it can be said that
profits may come to exist as a result of monopoly.
Windfall Profit:
Some consider profit as a windfall gain. According to them, profit is not a reward
for any entrepreneurial function or monopoly power. It is merely a windfall gain. It
arises due to changes in the general price level in the market. If the producer or trader
buys his inputs and raw materials when the prices are low and sells the output when
the prices have abruptly gone up due to some unforeseen external factors, we call
the profit as windfall profit. This is also included under net profit.
Earning of Management:
The entrepreneur having good bargaining power, purchases raw materials at
reasonable prices. He makes suitable arrangements to store the raw materials
properly. By proper inventory building, he maintains the supply of raw materials
regularly.
He hires labour at normal wages and borrows working capital at reasonable rates of
interest. Thus he manages and controls explicit costs. Ensuring of supply of capital
is the most important function of profit. A certain percentage of net profit is set apart
for better management of business.
2. Profit Policies:
It is generally held that the main motive of a firm is to make profits. The volume of
profit made by it is regarded as a primary measure of its success. Economic theory
advocates profit maximisation as the chief policy of a firm. Modem business
enterprises do not accept this view and relegate the profit maximisation theory to the
back ground. This does not mean that modem firms do not aim at profits. They do
aim at maximum profits but aim at other goals as well. All these constitute the profit
policy.
Here, two players have to coordinate a night out to either the opera or the
movies. One of the players has a slight preference for the opera and one of
them has a slight preference for the movies. The game is asymmetric
because, while both players have access to the same options, the
corresponding rewards for each are different based on the players
preferences. In order to maintain their friendship - or equilibrium - the
players should choose the same activity (hence the zero payoff for separat e
activities).
This game has three equilibria: (i) both players deciding to go to the opera,
(ii) both deciding to go to the movies, and (iii) a final, mixed option, where
each player will opt for their preferred option three fifths of the time. This
last option, which is said to be “unstable”, can be rapidly uncovered using
our method by simplifying - or decomposing - the asymmetric game into its
symmetric counterparts. These counterpart games essentially considers the
reward table of each player as a separate symmetric 2-player game with
equilibrium points that coincide with the original asymmetric game.
In the plot below, the Nash equilibrium is plotted for the two, simple
counterparts allowing us to quickly identify the optimal strategy in the
asymmetrical game (a). The reverse can also be done, using the asymmetrical
game to identify the equilibrium in its symmetrical counterparts.
The red dot represents the Nash equilibrium. For the asymmetric game (a), this can
easily be derived from the plots of the two symmetric counterparts (b) and (c). In all
plots, the x-axis corresponds to the probability with which player 1 chooses opera,
and the y-axis corresponds to the probability with which the 2nd player chooses
opera.
This method can also be applied to other games, including Leduc poker,
which is described in detail in the paper. In all of these situations, the method
proves to be mathematically simple, allowing a rapid and straightforward
analysis of asymmetric games that we hope will also help our un derstanding
of various dynamic systems, including multi-agent environments.
If this game was played with both players acting rationally, the optimal
solution is for them both to invest. This is because "Invest" is a dominant
strategy for P2. We can see this by finding P2's best response to P1.
If P1 uses the strategy "Don't Invest" it is best for P2 to play "Invest" since $15
> $10.
If P1 uses the strategy "Invest" it is best for P2 to play "Invest" since $20 > $0.
Therefore it always the best strategy for P2 to play "Invest". Now, given that
P2 would know this (using the same logic that we both did), they just need to
compare the options of "Invest" v "Don't Invest" assuming that P2 plays
"Invest". Since $20 > $15, we can conclude the optimal solution is for both
players to use the strategy "Invest" and thus they will both receive a payoff of
$20.
Let's suppose now that P1 decides to use a Maximin strategy but P2 continues
to play rationally. In this case, we play the game as follows:
If P1 invests, the worst scenario is P2 doesn't invest in which case player 1 gets
a payoff of -$100.
If P1 doesn't invest, the worst case scenario is that P2 doesn't invest in which
case P1 gets a payoff of $10.
Since $10 > -$100, playing the strategy "Don't Invest" maximizes the minimum
payoff for P1, so P1 plays "Don't invest".
It is also worth noting that even if P2 used a Maximin strategy they would still
choose to invest since that is a dominant strategy, which means it maximizes
their payoff regardless of the other players actions. Clearly this also maximizes
their minimum payoff.
This strategy is typically only used when one player believes that another
player will not play rationally. The fear for P1 would be that if they play the
strategy "Invest" and the other plays irrationally and chooses "Don't Invest",
P1 would lose $100.
The Battle of the Sexes is a simple example of a typical non-zero-sum game. In this
example a man and his wife want to go out for the evening. They have decided to go
either to a ballet or to a boxing match. Both prefer to go together rather than going
alone. While the man prefers to go to the boxing match, he would prefer to go with
his wife to the ballet rather than go to the fight alone. Similarly, the wife would
prefer to go to the ballet, but she too would rather go to the fight with her husband
than go to the ballet alone. The matrix representing the game is given below:
Husband
The wife's payoff matrix is represented by the first element of the ordered pair while
the husband's payoff matrix is represented by the second of the ordered pair.
From the matrix above, it can be seen that the situation represents a non-zero-sum,
non-strictly competitive conflict. The common interest between the husband and
wife is that they would both prefer to be together than to go to the events separately.
However, the opposing interests is that the wife prefers to go to the ballet while her
husband prefers to go to the boxing match.
Communication
Restricting Alternatives
If the game is played only once, players do not have to fear retaliation from
their opponents, so they may play differently than they would in a game
played repeatedly.
Examples of Typical Non-Zero-Sum Games:
The Prisoner's Dilemma game was first proposed by Merrill Flood in 1951. It was
formalized and defined by Albert W. Tucker. The name refers to the following
hypothetical situation:
If neither prisoner confesses, both will be convicted of the lesser offense and
sentenced to a year in prison. If both confess to murder, both will be sentenced to 5
years. If, however, one prisoner confesses while the other does not, then the prisoner
who confessed will be granted immunity while the prisoner who did not confess will
go to jail for 20 years
Schumpeter has developed a model in two stages, i.e. first approximation, and
second approximation, in order to further explain his business cycle theory of
innovation. The first approximation lays emphasis on the primary impact of
innovatory ideas while the secondary approximation deals with the subsequent
responses obtained from the application of the innovations. Let’s study these stages
in detail:
But after a certain level, with an increase in the level of output the price and
profitability decreases. This is because the further innovation does not come by
quickly and thus, there will be no additional demand for the funds. Instead, the
firms which borrowed the funds from the bank start paying it back. This results
in the contraction in money supply and hence the prices fall further. The process
of recession begins and remains until the equilibrium in the economy is restored.
It is not only difficult but also unavailing to perform the objective evaluation of
Schumpeter’s theory of the business cycle because its arguments are more based
on the sociological factors rather than the economic factors.
Schumpeter’s theory is not basically different from the over-investment theory; it
differs only in the respect of the cause of variation in investment when the
economy is in stable equilibrium.
Like other theories of the business cycle, this theory also leaves out other factors
that cause fluctuations in the economic activities. Innovation is not the sole factor,
rather is only one of the factors that cause fluctuations in the economy.
In spite of these shortcomings Schumpeter’s theory of innovation is widely
acceptable in the modern economy and is used to determine the economic
fluctuations.
The Harrod Domar Model suggests that economic growth rates depend on two
things:
• This is the growth rate at which all saving is absorbed into investment. (e.g. £80bn
of saving = £80bn of investment.
• Let us assume, the saving rate is 10%. the Capital output ratio is 4. In other words,
£10bn of investment increases output by £2.5bn
• In this case, the economy’s warranted growth rate is 2.5 percent (ten divided by
four).
• This is the growth rate at which the ratio of capital to output would stay constant
at four.
Importance of Harrod-Domar:
This creates a vicious cycle of low investment, low output and low savings. To boost
economic growth rates, it is necessary to increase savings either domestically or
from abroad. Higher savings create a virtuous circle of self-sustaining economic
growth.
The transfer of capital to developing economies should enable higher growth, which
in turn will lead to higher savings and growth will become more self-sustaining.
• It assumes the existences of a reliable finance and transport system. Often the
problem for developing countries is a lack of investment in these areas.
• Increasing capital stock can lead to diminishing returns. Domar was writing during
the aftermath of the Great Depression where he could assume there would always
be surplus labour willing to use the machines, but, in practice, this is not the case.
• The Model explains boom and bust cycles through the importance of capital, (see
accelerator theory) However, in practice businesses are influenced by many things
other than capital such as expectations.
• Harrod assumed there was no reason for the actual growth to equal natural growth
and that an economy had no tendency to full employment. However, this was based
on the assumption of wages being fixed.
• The difficulty of influencing saving levels. In developing economies it can be
difficult to increase savings ratios – because of widespread poverty.
• The effectiveness of foreign capital flows can vary. In the 1970s and 80s many
developing economies borrowed from abroad, this led to an inflow of foreign capital
however, there was a lack of skilled labour to make effective use of capital. This led
to very high capital-output ratios (poor productivity) and growth rates didn’t increase
significantly. However, developing economies were left with high debt repayments
and when interest rates rose, a large proportion of national savings was diverted to
paying debt repayments.
• Economic development implies much more than just economic growth. For
example, who benefits from growth? does higher national income filter through to
improved health care and education. It depends on how the capital is used.
The break-even point (BEP) or break-even level represents the sales amount—in
either unit (quantity) or revenue (sales) terms—that is required to cover total costs,
consisting of both fixed and variable costs to the company. Total profit at the break-
even point is zero. It is only possible for a firm to pass the break-even point if the
dollar value of sales is higher than the variable cost per unit. This means that the
selling price of the good must be higher than what the company paid for the good or
its components for them to cover the initial price they paid (variable costs). Once
they surpass the break-even price, the company can start making a profit.
The break-even point is one of the most commonly used concepts of financial
analysis, and is not only limited to economic use, but can also be used by
entrepreneurs, accountants, financial planners, managers and even marketers. Break-
even points can be useful to all avenues of a
Either option can reduce the break-even point so the business need not sell as many
tables as before, and could still pay fixed costs.
Purposes (Uses)
The main purpose of break-even analysis is to determine the minimum output that
must be exceeded for a business to profit. It also is a rough indicator of the earnings
impact of a marketing activity. A firm can analyze ideal output levels to be
knowledgeable on the amount of sales and revenue that would meet and surpass the
break-even point. If a business doesn't meet this level, it often becomes difficult to
continue operation.
The break-even point is one of the simplest, yet least-used analytical tools.
Identifying a break-even point helps provide a dynamic view of the relationships
between sales, costs, and profits. For example, expressing break-even sales as a
percentage of actual sales can help managers understand when to expect to break
even (by linking the percent to when in the week or month this percent of sales might
occur).
The break-even point is a special case of Target Income Sales, where Target Income
is 0 (breaking even). This is very important for financial analysis. Any sales made
past the breakeven point can be considered profit (after all initial costs have been
paid)
Break-even analysis can also provide data that can be useful to the marketing
department of a business as well, as it provides financial goals that the business can
pass on to marketers so they can try to increase sales.
Break-even analysis can also help businesses see where they could re-structure or
cut costs for optimum results. This may help the business become more effective
and achieve higher returns. In many cases, if an entrepreneurial venture is seeking
to get off of the ground and enter into a market it is advised that they formulate a
break-even analysis to suggest to potential financial backers that the business has the
potential to be viable and at what points.
In the linear Cost-Volume-Profit Analysis model (where marginal costs and
marginal revenues are constant, among other assumptions), the break-even point
(BEP) (in terms of Unit Sales (X)) can be directly computed in terms of Total
Revenue (TR) and Total Costs (TC) as:
where:
The quantity, , is of interest in its own right, and is called the Unit
Contribution Margin (C): it is the marginal profit per unit, or alternatively the
portion of each sale that contributes to Fixed Costs. Thus the break-even point
can be more simply computed as the point where Total Contribution = Total
Fixed Cost:
R=C,
Where R is revenue generated, C is cost incurred i.e. Fixed costs +
Variable Costs or
The Break-even analysis is only a supply-side (i.e., costs only) analysis, as it tells
you nothing about what sales are actually likely to be for the product at these various
prices.
It assumes that fixed costs (FC) are constant. Although this is true in the short run,
an increase in the scale of production is likely to cause fixed costs to rise.
It assumes average variable costs are constant per unit of output, at least in the range
of likely quantities of sales. (i.e., linearity).
It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning
of the period and the quantity of goods held in inventory at the end of the period).
(ii) It helps in the fixation of sales volume to cover a given return on capital
employed.
It assumes that the quantity of goods produced is equal to the quantity of goods sold
(i.e., there is no change in the quantity of goods held in inventory at the beginning
of the period and the quantity of goods held in inventory at the end of the period).