1.2.

An overview of Economic Agents and

Flows of the Economics Activities

Major DMU
are,
Who are
Decision Making Households

Units (DMU)? Business

Economic Agents Firms

(participants)?
Government
1
 Households
 are consumers of goods and services
 are assumed to own economic resources
•Most people own labor
• many own capital and
• some natural resources that are rented, or
sold.
 The objective of the households is to
maximize their utility
Household play a dual role in economic activity.
They consume goods and services
(demanders)
They supply economic resources
(suppliers)
2
 Business Firms
These are producing unit of the economy
 They will employee economic resources
and pay for their use to household

 They will produce good and services

needed by household
Firms can come up in different size.
Regardless of their size they share common
objective of profit maximization
3
 Government
 Government assumed to play limited role
in market economy system.

 It only provide legal frame-work for

proper functioning of the market system.

 The objective of the government is not

clearly defined
4
The interdependence of goods and factors
markets

FIRMS
suppliers of goods and services,
demanders of factor services
HOUSEHOLDS
demanders of goods and services,
suppliers of factor services

5
 The Circular flow of economic activities

Birr Birr

Factor Goods
services
(3) (2)
P P Products
Factors S
market S
market
PF2
P2
PF1 P1
D2 D2
D1 D1
O QF1QF2 Q O Q 1 Q2 Q

Factor
services Goods
(4)
(1)
Factor
Birr Birr Consumer
supply 6
demand
1.2. Firms as an Economic Agents
 Firms organize factor of production to
produce goods/ services that will meet the
need (demand ) of individual consumers and
other firms.

 A large part of this course focus on this

part of economic agents
 Understanding of
the reasons for their existence
their specific role and their objective
will provide a ground for their further analysis
7
 Why firms exist?
In market economy the organization and
interaction of producers and consumers is
accomplished through the price system.
• There is no need for any central
direction by the government
However,
Within the firm transactions and organization
of productive factors are generally carried
out,
• by a central control of one or
more mangers
8
 Why firms exist? (cont. … )
It seems that there is a dichotomy in the
organization of production in the market
economy.
because,
o The price system guide the
decentralized interaction among economic
agents

o Where as central planning and controlled

interaction within the firm
9
 Why firm exists?
 Why the production system is
not completely guided by price
signals ?
That is,
 Why do firms exist in a market
economy?

10
 Why firm exists? (Cont …)
 Firms exist as organization because,
 The total cost of producing any
rate of output is lower than if they
do not exist.
There are several reasons why costs
are low.
i. Transaction costs are reduced
ii. Costs related to government
intervention are reduced
11
 Why firm exists? (Cont …)

i. Transaction costs are reduced

There are transaction costs of using the price
system like,
 Cost of information
 Cost of negotiation
 Cost of concluding separate contract for
each step of the production process
The existence of firms would significantly
reduce such transaction costs.
As a result all economic agents would be
benefited.
12
 Why firm exists? (Cont …)
ii. Costs related to government intervention
are reduced. This because,
Government intervention applies only to
transaction among firms
Sales taxes usually apply only to transaction
among firms not within the firm
E.g. If a firm purchases say, cabinets or seek
services on automobile repair from another
firm it has to pay tax.
But by employing a person who can provide
the needed service such tax is avoided and
the cost of production will be reduced. 13
 Why firm exists? (Cont …)
Thus, by internalizing some transactions
within the firm production costs are
reduced

The question here is that, if costs are

reduced by organizing production factors
within firms,

Why not this process continue until there

is just one large firm,
that produce all goods and services for the
entire economy?
14
 Why firm exists? (Cont …)
There are at least two reasons
1.The cost of organizing transactions, within
the firm increases as the firm gets
larger.

The logic is that,

 Firms will internalize the lower cost
transaction first and then the highest-
cost transaction –
 At some point, these internal transaction
cost will be equal to the cost of
transacting in the market.
At that point the firm will cease to grow
15
 Why firm exists? (Cont …)
2. The other reason is the limitation of
management organizations skill

 Resource in the company may not be

efficiently allocated if firm’s size
exceeds the managers ability to
control the operation.
• To overcome this problem many
large firms are organized into
groups of divisions referred to
profit centers
16
 1.3. The Objective of the Firm
 The efficiency of management
decision can only be evaluated against
the goal achieved
 Traditionally economics assumes
that the objective of the firm is
to maximize profit
 That means management
consistently make decisions that
maximize profit

17
 The objective of the firm (cont…)
The question , however is that, to maximize profit
in which period?
This Year?
The next five years?

 Often, Mangers are observed making decision

that reduce current year profits in an effort
to increase profits in future years.

Expenditure for
Research and Development
Capital equipment and
Major marketing program 18
 The objective of the firm (cont…)

It seem that both current and future

profit maximization is important.

Therefore, it is fair to assume that the

goal of the firm is rather to
maximize the present value of all
future profits.
It can be formally stated as, Maximize
PV 
)   a t
(1 i )t
t 1 19
 The objective of the firm (cont…)
Present value of all future profit can also be
interpreted as the value of the firm

Thus, to maximize the present value of all future

profit is equivalent to maximizing the value
of the firm. Or

the objective of the firm is maximizing

shareholders value
This is simply another way of stating the goal of
profit maximization
20
 Alternative Objectives
Money people argued that the behavior
of most mangers is not consistent
with the profit maximization
objective of the firm
Some of the alternative objectives
observed are
 Maximizing total revenue
 Maximizing employment tenure and
departmental budget
 Maximizing the manger’s individual
utility function
 Maximizing market share subjected to a
satisfactory profit constraint
21
 Agent – Principal Problem
In modern corporation the owners are
stockholders and these are
principals.
 The owners elect a board of directory
which hire mangers and these are
agents.
 The managers or agents carry out day
– to – day operation of the firm and
are paid a salary,
 They will represent the interest of the
owners and maximize profits.
 The board of directors meet regularly
with the management to oversee their
activity 22
Agent – Principal Problem (Cont…)

and to ensure that the mangers are

acting in the best interest of the
Owners.
Because of the difficulty in monitoring
mangers,
it is observed that different goals
are pursued.
 the manger may seek to enhance their
position by spending corporate fund on
23
 Agent-Principal problem (cont..)
 fancy offices
 excessive and expensive travel
 and so on
This requires owners to take action to
align the interest of owners with the
interest of the managers.
 One of such action is arranging
compensation to managers attached to
the financial performance of the firm.

The manager may be given a basic

salary 24
 Agent-Principal problem (cont..)
plus potentially large bonuses for meeting the
objective of the firm or
for meeting such goals like,
 Attaining a specific return on capital
 Growth in earnings and/or
 Increase the price of firm’s stock
Example
Awarding stock options to top managers
as effective approach! 25
 Agent-Principal problem (cont..)

How ?
 The manager will receive an option to buy
a specific number of shares of common stocks
at the current market price for a specific
number of years
 The only way he can benefit from such an
arrangement is if the price of stock rises
during the specific term.
The option is exercised by buying shares at
the specified price, and
 the gain equals the increase in share price
multiplied by the number of share purchased.
26
 Agent-Principal problem (cont..)
This option arrangement makes the mangers
de-facto owner, even if the option has not
been yet exercised
Consider the following example
 Assume that there exists a secondary
capital market in Ethiopia.
 Further assume that there is also a market
for derivatives like options.
 Suppose Mr. X is hired as a Director
General of BGI Ethiopia at monthly salary of
birr 15,000
plus a five year option to buy 10, 000 shares
of stock at the current market price of birr
1000 per share.
27
 Agent-Principal problem (cont..)
Assume that within five years the price of the
BGI stock has increased to say,
1200 per share tanks to his diligent and creative
management.
 Mr. X now can exercise the option by buying
10,000 shares for birr 10,000000 (1000 x
10,000) which has a market value of
12,000,000
In the year the options are exercised, Mr. X
has a gain or additional compensation of birr
2,000,000.
However, if the price of the stock had remind
unchanged or had declined, his option would
have no value. 28
 The Concept of profit
If profit maximization is the objective of the
firm it is necessary to define the term profit.

Profit is defined as revenue minus costs.

However, the definition of cost is quite
different for the economist than for an
accountant.

Consider an individual who has MBA degree

and is considering investing birr 200,000 in
retail store that he would manage.
29
 The Concept of Profit (Cont …)
The projected income statement for the year
as prepared by an accountant is shown as
follows
Sale 110,000
Less cost of goods sold 60,000
Gross profit 50,000
Advertising expense 10,000
Depreciation 10,000
Utilities 3,000
Property tax 2,000
Miscellaneous expense 5000 30,000
Net accounting profit 20,000 30
 The Concept of Profit (cont..)
 Such Accounting and Business profit is
often reported in quarterly and annually
financial reports of the firm and other
publications.
 Though it is a useful concept it does not
go far enough and may lead to a wrong
decision.

However, Economists recognize other cost

components called Implicit cost
 Implicit costs are opportunity costs of
using resources owned by the firm. 31
 The Concept of Profit (cont..)
Such costs are not reflected in cash outlay by
the firm
but are costs associated with forgone
opportunity and are not included in the accounting
statement
But must be considered in any rational decision
making.
• There are two major implicit costs in the above
example
i.The owner has invested birr 200,000 in
the business
The best alternative use for this money is say,
a bank deposit with 5% interest rate.
32
 The Concept of Profit (cont..)

 Thus, birr 10000 should be

considered as the implicit cost of
investing birr 200, 000 in the
business
ii. Implicit cost includes managers time
and talent.
 The annual average salary for a MBA
degree holder may be birr 5000.
 This is an implicit (opportunity) cost
of managing the business rather than
working for some one else.
33
 The Concept of profit (cont..)
Thus, the above income statement can be modified as
follows in order to determine economic profit
Sale 90,000
Less cost of goods sold 40,000
Gross profit 50,000
Explicit Cost
Advertising expense 10,000
Depreciation 10,000
Utilities 3,000
Property tax 1000
Miscellaneous expense 5000
30,000
Accounting profit 20,000
Implicit Cost
Return on 200,000 10,000
Forgone salary 60,000
70,000
Economic Profit -50,000 34
 The concept of Profit (cont..)
Conclusion
• From broader perspective the business is
rather projected to loss birr 50, 000 in the
first year.
•The 20, 000 accounting profit disappears when
all relevant costs are included.
Another way of looking at the problem of
implicit cost is to assume that,
 200,000 birr is borrowed at market rate and
 The MBA graduate hired at birr 60,000 per
year to run the business
In this case the implicit costs will become
explicit and accounting profit will be equal to
economic profit 35
36
37
 The circular flow of income

Firms

Consumption of
Factor domestically
payments produced goods
and services (Cd)

Households
 The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS