Chapter 3
Performance
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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.
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Miata
Law of one price: Miata
$0
$5,000
$10,000
$15,000
$20,000
$25,000
DETROIT
L. A.
Big Macs
$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
Price
LondonNew YorkTokyoPhoenix
professors loaded down with Big Macs
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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?
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Prices as Allocation Devices
• Let’s consider some examples of the price system functioning . . .
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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?
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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?
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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?
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Why Can We Feel Confident that the Law of One Price Occurs?
• What explains the behavior of individuals?
• Self-interest
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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.
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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?
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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?
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Why do the “firms” exist?
• Are all firms efficient?
• No, at any one time some are successful and some are not.
• Which is which?
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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.
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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?
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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?
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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.
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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.
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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.
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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.
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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.
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Example
http://www.eva.com/evaluation/overview.shtml#