MANAGERIAL ECONOMICS

An Analysis of Business Issues

1
Lecture 2:
Business Objectives
and Basic Models of the Firm
Objectives:
After studying the chapter, you should
understand:
1. the assumptions of the neo-classical (or profit-
maximising) model of the firm and the limitations
of the model
2. the differences between the profit-maximising
model and the managerial models of the firm
3. the differences between the profit-maximising 2
model and the behavioural model of the firm
 The Assumptions of the Neo-
classical Model of the Firm

1. The firm is a profit-maximiser - it

optimises
2. The firm can be treated in a holistic
way
3. There is perfect certainty

3
Assumption 1:
The firm is a profit-maximiser: it is assumed
to make as much profit as possible.
This means that the model is an optimising
model: the firm attempts to achieve the best
possible performance, rather than simply
seeking feasible performance which meets
some set of minimum criteria.

4
The profit-maxing assumption can be
interpreted in two ways:
1. Maximisation of profit in the short-run
i.e. the firm has a given set of plant and equipment and
makes as much profit as it can with that
2. Long-run profit maximisation
i.e. maximise the wealth of the shareholders
In most situations these are consistent with each other.
Shareholder wealth is maximised by selecting the most
profitable set of plant and equipment and then operating it
in the most profitable way. BUT THERE MAY BE
EXCEPTIONS - making maximum short term profit
might trigger entry or government intervention
5
Assumption 2:
It is a holistic model: the firm is a single entity
which has objectives of its own and which can be
said to take decisions.

6
Assumption 3:
It assumes perfect certainty. Cost and
demand conditions are perfectly known.

7
The Basic Model of the Firm
The neo-classical model
The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
STEP BY STEP TO THE MODEL
$

P1

Demand: Average Revenue

P2

Quantity
Produced
Q1 Q2

8
The Basic Model of the Firm
The neo-classical model
The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
STEP BY STEP TO THE MODEL
$

Demand: Average Revenue

Quantity
Produced
Marginal Revenue

9
 The Basic Model of the Firm
The neo-classical model
The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
WHAT IS THE EQUILIBRIUM?
Marginal Cost
$

Profit
maximising
price Demand: Average Revenue

Quantity
Marginal
Profit Revenue Produced
maximising
output 10
 The Basic Model of the Firm
The neo-classical model
The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
MORE DETAIL ON THE EQUILIBRIUM
$ Marginal Cost

Average Cost
Profit
maximising
price Demand: Average Revenue

Quantity Produced
Profit
Marginal Revenue
maximising
output 11
What Can We Do With This Model?
Comparative Statics
begin with an initial equilibrium position - the starting point
change something
identify the new equilibrium, e.g:
When demand increases?
When costs rise?
When a fixed cost increases?
This is the main purpose of the model -what it was designed to do
Normative prescriptions
it will cost me $30 per unit to supply something which will give me
$20 per unit in revenue- should I do it?
I must pay $20 billion to set up in my industry. Should I charge
higher prices to get that money back?
Positive and Normative are linked by if? IF the aim of the firm
is to maximise profit what will it do/what should it do?
12
The assumptions of profit-maximisation
has been criticised in a number of ways; so
we have:
1. The Managerial School
2. The Behavioural School

13
Managerial Criticisms of the
Profit-Maximising Model
Berle and Means (1932)
firms are owned by shareholders but
controlled by managers
owners and managers interests are
different
managers have discretion to use the firms
resources in their own interests

14
The Managerial School argues that:
1. Ownership and control are in the hands of different
groups of people.
2. The interests of owners (shareholders) and
Controllers (managers) are different.
3. Managers have the power to let their interests over-
ride those of the shareholders.
4. Therefore firms are run in the interests of the
managers.
In place of the profit-maximising model, the managerial
school substitute a variety of alternatives - sometimes
referred to as managerial discretion models
Sales-revenue maximising (Baumol)
Managerial utility maximising (Williamson)
15