Chapter 3 Performance

Copyright © Houghton Mifflin Company.All rights reserved. 3–23–2 Market Process Recall the survey -- scarce goods and resources can be allocated in many ways. The PRICE is one allocation device -- to those willing and able to pay the price.

Copyright © Houghton Mifflin Company.All rights reserved. 3–33–3 Miata

Law of one price: Miata

Big Macs

professors loaded down with Big Macs

Copyright © Houghton Mifflin Company.All rights reserved. 3–73–7 Law of one price: The Market Process Identical goods (resources) sell for identical prices in different markets once transportation and other transactions costs are accounted for. WHY?

Copyright © Houghton Mifflin Company.All rights reserved. 3–83–8 Prices as Allocation Devices Let’s consider some examples of the price system functioning...

Copyright © Houghton Mifflin Company.All rights reserved. 3–93–9 Answer the following: (1) You are shopping at a store for a radio. The price is $50. You are told that the identical radio is only $45 at a store just a block away. What do you do?

Copyright © Houghton Mifflin Company.All rights reserved. 3–10 Consider the second situation: (2) You are shopping at a store for a home theater. The price is $3000. You are told that a block away the same system is $2995. What do you do?

Copyright © Houghton Mifflin Company.All rights reserved. 3–11 Most people change in the 1st case but not the 2nd. Did everyone act the same in both instances? How many chose to go to the other store in one but not the other instance-- which did you choose?

Copyright © Houghton Mifflin Company.All rights reserved. 3–12 Why Can We Feel Confident that the Law of One Price Occurs? What explains the behavior of individuals? Self-interest

Copyright © Houghton Mifflin Company.All rights reserved. 3–13 Self-Interest People want to make themselves as happy as possible -- by ensuring that benefits exceed costs, they act in their self-interest. Firm executives and managers behave similarly.

Let’s Now Examine the Firm We are always keeping in mind the behavior of people -- what we have just discussed.

Copyright © Houghton Mifflin Company.All rights reserved. 3–15 What is a firm? I want you to think about the individual sellers along Silk Road or the individual vendors throughout Beijing. Now think about the huge firms like Motorola, Coca-Cola, and Samsung. How do they differ?

Copyright © Houghton Mifflin Company.All rights reserved. 3–16 Why do “firms” exist? Why aren’t firms just the individual proprietors or vendors rather than institutions with hundreds of employees? Because exchange within them is more efficient than the same exchange carried out in the open market What does efficient mean?

Copyright © Houghton Mifflin Company.All rights reserved. 3–17 Why do the “firms” exist? Are all firms efficient? No, at any one time some are successful and some are not. Which is which?

Copyright © Houghton Mifflin Company.All rights reserved. 3–18 Adding Value Successful firms add value to the inputs (resources) they use. Microsoft bought $1.6 billion in materials, had a wage and salary bill of $400 million, and used capital worth about $50 million. Sales were $2.75 billion -- $650 million more than it cost to produce the output. This $650 billion is a measure of the value that Microsoft added. Added Value = value of output - full cost of inputs.

Copyright © Houghton Mifflin Company.All rights reserved. 3–19 Adding Value Profit Maximizing is the same as adding value or value maximization for a for-profit firm. Adding value for a not-for-profit firm depends on what the objectives of the firm are. For instance, what about a charity? What would adding value mean? What about the SOE?

Copyright © Houghton Mifflin Company.All rights reserved. 3–20 Adding Value Measuring Added Value: It is easier for the for-profit firms than the not-for-profit firms. Nevertheless, the approach is the same.

Copyright © Houghton Mifflin Company.All rights reserved. 3–21 Adding Value Added Value -- accounts fully for the inputs a firm uses: In other words, the costs of the inputs are subtracted from the value of output. Inputs: What are they? Land, Labor, Capital Added Value = Value of Output - Cost of Land - Cost of Labor - Cost of Capital.

Copyright © Houghton Mifflin Company.All rights reserved. 3–22 Adding Value What is the cost of labor? It is the amount that must be paid to an employee to ensure that the employee remains with the firm. What is cost of land? It is the amount that must be paid to the owner of land to ensure that the land is retained in its use by the firm.

Copyright © Houghton Mifflin Company.All rights reserved. 3–23 Adding Value What is the cost of capital? It is the amount that must be paid to the owners of capital in order for the capital to be retained in the firm.

Copyright © Houghton Mifflin Company.All rights reserved. 3–24 Adding Value In every case, the cost is the return the best alternative use of the funds would have yielded. This is easy to measure for labor and land. Labor is the salary (benefits etc.). Land is the rent on the land. The cost of capital accounts for the alternatives or opportunities that are missed or forgone in order to invest in the firm.

Copyright © Houghton Mifflin Company.All rights reserved. 3–25 Adding Value Added value < operating profit Operating profit = value of output - cost of materials, land, and labor inputs. Thus: added value = Operating Profit - cost of capital.

Copyright © Houghton Mifflin Company.All rights reserved. 3–26 Economic Profit Suppose Wal-Mart indicated an operating profit of $120 million. What would that mean to you as an investor? As an investor, you are a supplier of capital -- an owner of capital. What return do you want for letting others use your capital? You must earn at least what you could get elsewhere or else you will not leave your capital with that firm or that investment.

Copyright © Houghton Mifflin Company.All rights reserved. 3–27 Economic Profit Operating profit does not tell us much unless we know the alternatives. Operating profit is referred to as “accounting profit.” It is the profit reported in financial statements and annual reports. But, without accounting for all opportunity costs, the profit measure does not provide much information. Thus, we want a profit measure that accounts for all opportunity costs.

Copyright © Houghton Mifflin Company.All rights reserved. 3–28 Economic Profit This is what economic profit does. Economic profit is revenue less all costs. Economic profit can be positive, zero, or negative. What does positive economic profit mean? What does zero economic profit mean? What does negative economic profit mean?

Copyright © Houghton Mifflin Company.All rights reserved. 3–29 Economic Profit Why don’t accountants report economic profits? 1.Too subjective. 2.Too difficult to measure. But, there is a strong move to come closer to economic profit.

Copyright © Houghton Mifflin Company.All rights reserved. 3–30 Measures In recent years (last decade) measures of economic profit have become increasingly popular -- examples include economic ralue added or EVA; free cash flow; and residual profit. Each is a one-year measure of the difference between the value of output and the full cost of inputs.

Copyright © Houghton Mifflin Company.All rights reserved. 3–31 Short Termism In the chapter we talk about two firms, A and B, with different strategies. A is short-term, generating profits today but at a cost tomorrow. B is looking long-term, giving up profit today for more in the future. So -- should you purchase firm A now and sell it in a year to purchase firm B? This won’t work -- market looks ahead and reflect the long term in today’s prices.

A firm that adds value above opportunity cost is providing a return to shareholders that exceeds any return it could get in an alternative investment of comparable risk. This is economic profit or excess shareholder value.

Copyright © Houghton Mifflin Company.All rights reserved. 3–33 Summary of Economic Profit Positive economic profit: returns exceeding opportunity costs. Negative economic profit: returns less than opportunity costs. Zero economic profit returns equal to opportunity costs.

Copyright © Houghton Mifflin Company.All rights reserved. 3–34 Implications Positive economic profit: others want to do the same thing. Negative economic profit: owners/investors want to take their money elsewhere. Zero economic profit: owners/investors are indifferent between leaving their money where it is and moving it.

Copyright © Houghton Mifflin Company.All rights reserved. 3–35 Example