Chapter 7: The firm and its goals
Short Answer Questions
1. Define the term transaction costs. Use examples to illustrate your answer.
Answer: Transaction costs are the costs of conducting an economic exchange
between the two parties. For example, the cost of writing a contract between the two
parties is considered to be transaction cost.
2. Explain what is meant by “economic profit”. How is it estimated?
Answer: Economic profit is the income that that is left over for the owners of the firm
after they pay for the factors of production they use. It can be expressed as follows:
Economic profit = Total Revenue – Total Economic Cost
3. What does the Marginal Output Rule imply about the production decisions of
firms?
Answer: If the firm doe not shut down, then to maximise its profit, it should produce
output at a level where marginal revenue is equal to marginal cost.
4. Why firms need to have internal control mechanisms in place?
Answer: The managers may have different interests and objectives from the owners of
the firm. So, the owners try to make the managers pursue the owners’ goal of profit
maximisation by using the internal control mechanisms.
5. What is a principle-agent relationship?
Answer: It is the economic relationship in which one party (the principal) hires a
second party (the agent) to perform some task on the first party’s behalf.
For the remaining questions support your answers with the aid of appropriate
diagrams.
6. Using the MC and MR curves, identify diagrammatically the profitmaximising output of a firm, conditional on being in business.
Answer: According to the Marginal Output rule, to maximise its profit, the firm
should produce output at a level where marginal revenue is equal to marginal cost
which is represented by point X1 in the figure.
7. Explain what would be the level of output produced if the manager is trying to
maximise total revenue.
Answer: If the manager is trying to maximise total revenue, he will choose to
produce at X r instead of at X π which is the profit-maximising output level.
8. What is the shutdown rule? Show under what conditions a firm should decide
to shutdown.
Answer: The shut down rule states that if for every level of output, the firm’s average
revenue is less than its average economic cost, the firm should shut down.
9. Using appropriate diagrams show how the Total Revenue and Total Cost
curves can be used to derive the profit function.
Answer: The profit is equal the vertical distance between the total revenue curve (R)
and the total cost curve (C) in Figure A. The distance for each level of output is then
graphed in Figure B to show the profit function of the firm.
10. What does the shutdown rule imply about the decision of a firm’s to stay open,
depending on the relative positions of the Average Cost and Demand curves?
Answer: A firm should not shut down if the average economic cost curve crosses the
demand curve because the firm can earn economic profit by producing output.
Essay questions
1. Discuss the information conveyed in the total economic cost curve. What
assumptions one needs to make when assuming that cost depends solely on
output?
Brief answer: The total economic cost curve shows the relationship between the
firm’s amount of output produced and the resulting level of total economic cost.
When the cost depends solely on output, we are assuming that factor prices,
production technology and product characteristics are held constant.
2. Discuss the mechanisms that can be used to make the managers to purse the
shareholders’ goal of profit maximisation.
Brief answer: There is variety of control mechanisms through which the shareholders
try to keep the managers in line with their goal. These mechanisms can be divided
into two main groups: internal and external control mechanisms. The reader should
discuss the difference between the two mechanisms and also provide examples which
can be found in chapter 7, p 240-244.
3. Explain carefully why at the profit maximising output level of a firm’s that
chooses to stay open, its marginal revenues must be equal to its marginal
costs.
Brief answer:
Consider the figure above, when MR is greater than MC, the firm should increase its
output because the amount of money that the sale of the additional output will bring
into the firm (MR) exceeds the additional costs that the firm incurs to produce it (MC).
When MR is less than MC, the firm should not increase its output further because the
additional revenues would be less than the additional costs. So, the profit–maximising
output level occurs where MC=MR.
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4. Discuss how the separation of ownership and control in modern firms may
give rise to a principle-agent conflict of interest.
Brief answer: The fact is that most large companies are by a professional management
team, not by the shareholders, the people who own them. These two groups may have
strongly differing goals. Because ownership gives a person a claim on the profit of the
firm, the greater the firm’s profit, the higher the owners’ income. Hence, the owners
of the firm want the firm to maximise its profit. However, the goal of the managers is
to maximise their own well-being which may depend on several factors: income, how
hard she has to work, the working conditions, and the prestige attached to her job.
This suggests that if managers were left to make business decisions, their pursuit of
their own utility maximisation might conflict with profit maximisation.
5. What is it meant by shareholders’ myopia and how it may affect the long-run
performance of a firm? Give examples.
Brief answer: The term “shareholders’ myopia” is used to call the situation in which
the shareholders are concerned only the short-term performance of the firm and hence
do not maximise the present value of the firm’s profit. One explanation is that the
shareholders tend to hold stock in a given firm for only a short period, but they want
big profit. In response to shareholders’ want, the managers may take actions that are
profitable in the short term but possibly detrimental to the long-term profitability.