Summary of motivation of firms

  • Traditional economic analysis assumes that firms set out to maximise profits, where profits are defined as the excess of total revenue over total costs.
  • This analysis treats the opportunity cost of a firm’s resources as a part of its fixed costs. The opportunity cost (both explicit and implicit) is known as normal profit.
  • Profits above this level are known as supernormal profits.
  • A firm maximises profits by choosing a level of output such that marginal revenue is equal to marginal cost.
  • For many larger firms, where day to day control is delegated to managers, a principal-agent problem may arise if there is a conflict between the objectives if owners (principals), and those of the managers (agents).
  • This may lead to satficing behaviour and X-inefficiency.
  • Satisficing behaviour is where an does just enough to satisfy the principal.
  • X-inefficiency is when costs for a given level of output are above the long run average costs for that level of output. Alternatively, it can be expressed as when a company is producing within its PPF curve.
  • William Boumal suggested that managers may set out to maximise revenue rather than profits; others have suggested that sales or growth of the firm may be the managers objectives.
  • For an individual firm, productive efficiency can be regarded as having been achieved when the firm is operating at minimum long run average cost.
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