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Value Maximization in Neoclassical Theory of the Firm

Describe about the Business Economics for Neoclassical Business Theory.

Value of the firm is calculated by measuring current value of cost flows of profits of the firm over several years in the future. However, it is difficult to overemphasize the importance of value maximization in the neoclassical theory of the firm. However, it is considered as the essential core of the neoclassical theory of the firm. It helps to maximize the total market value of the firm thereby, maximizing social welfare of the firm.

Value of the firm = Present value of expected future profits

Value maximization is considered as a useful descriptive theory that helps to describe the behavior of a firm.  The value of the firm is considered as the wealth of a shareholder that is given by the current value of all anticipated future profits of the firm. The key objective is to maximize the value of the firm that includes the wealth of shareholders. Subject to the several constraints, a firm seeks to maximize its marginal profits (Deng, Kang and Low 2013).

The factors other than price impacts demand in the following way:

Tastes and Preferences: It is considered as one of the most imperative factor that determines the demand for goods. In other words, if customers have higher preferences for a particular good, the demand for the good will be higher. The change in demand mostly takes place due to changes in fashion as well as types of advertisements.

Income of the people: If the income of the people is high, the demand for the product will also increase. In other words, the greater the income of an individual, the greater will be the demand for a product. Greater income also signifies greater purchasing power of an individual. As a result, if income of an individual increase, they can afford to purchase more. On the other hand, if income of an individual decreases the demand for goods will also decrease (Bowen and Sosa 2014).

The number of customers in the market: The market demand for a particular product depends on the addition of the individual demand. The larger the number of customers in the market, the greater will be the demand for a product. As a result, the sellers become profitable as succeed to find out new markets for his commodity.

The two terms, change in quantity demanded and change in demand are two dissimilar perceptions in economics. On one hand, change in quantity demanded indicates the changes in quantity purchased. On the other hand, change in demand indicates the rise or fall in demand of a manufactured goods due to several determinants of demand, keeping price constant. The movement of the demand curve can calculate change in quantity demanded. However, changes in demand are calculated by shifts in demand curve. Change in quantity demanded is characterized by development and reduction of demand. Expansion of demand refers to the stage when quantity demanded is more due to fall in prices of a commodity. On the other hand, reduction of demand occurs when quantity demanded is less due to increase in the price of a good (Phlips 2014).

Factors Impacting Demand

 Expansion and contraction of demand

Figure 1: Expansion and contraction of demand

(Source: Created by Author)

The diagram shows that when price changes from P to P1, the demand curve also gets shifted from Q1 to Q2. P denotes the equilibrium price whereas; the equilibrium quantity is denoted

Similarly, change in demand is characterized by increase or decrease in demand that takes place due to changes in several factors such as change in income as well as change in taste and preference of a customer.

  Increase or decrease in demand

Figure 2: Increase or decrease in demand

(Source: Created by Author)

The diagram shows that the movement from to D to D1 indicates increase in demand, whereas; the movement from to D1 to D indicates decrease in demand.

The law of diminishing returns is described as the law of economics that states a rising number of new workers cause the marginal product of a different worker to be smaller as compared to the marginal commodity of the previous worker at the similar point. It states that in all productive procedures, the addition of more of one factor of production will at some point bring subordinate incremental per-unit return. Diminishing returns takes place mostly in the short run when capital is fixed. On the other hand, if the variable factor is augmented, it leads to a point where the factors become less productive. As a result, there will be a decreasing marginal product. Diminishing returns is mostly related to the short-run higher SRAC. On the other hand, diseconomies of scale are related to the long-run. It also takes place when increased output leads to an increase in LRAC. One of the good examples of diminishing returns is that of chemical fertilizers. A small amount of chemical fertilizers leads to a large amount of output. On the other hand, the further usage of chemical fertilizers will lead to diminishing marginal product as the effectiveness of the chemical diminishes. Another example is that of a café. In other words, a café may desire to serve more individuals during the busy months of summer. However, hiring extra employees may lead to difficulties due to lack of space in the café (Real 2013).

Law of diminishing returns 

Figure 3: Law of diminishing returns

(Source: Created by Author)

The graph shows that as labor usage rises from L to L1, total output gets increased by the amount shown in the figure. On the other hand, if usage of labor is increased by the similar amount again, output increases by lesser amount. This indicates that the diminishing marginal returns to the use of labor as an input. The diagram shows that the marginal product of labor is diminishing all over to the right of point A. The defining characteristics of diminishing marginal returns indicate that with the augment in total investment, the total return on investment as a proportion of the total investment reduces (Murray, Dixon and Johnson 2013).

Diminishing Returns and Short-run Production Costs

The cost in the long-run is accumulated when firm changes level of production over time in response to predictable economic profits or losses. There are mostly no fixed costs of production in the long-run. The long-run is considered as a planning and accomplishment stage for producers. The combinations of outputs that are produced by a firm mostly analyze the present and predictable condition of the market in order to make decision related to production. Costs under long-run indicates to a period during which all inputs can be differed (Varian 2014).

On the other hand, in the short-run, costs are accrued in real time all through the process of production. There is no impact of fixed costs on short-run costs however; variable costs and revenues affect the short-run costs. Based on the variable cost and the rate of production, the short-run costs get increased or decreased. Under the short-run costs, output is zero whereas; the cost is always positive as the fixed cost is incurred regardless of output. Examples of such costs include reduction charges, rent of land as well as loan interest. These type of costs are also referred to as unavoidable contractual costs as they stay contractually fixed and cannot be neglected in the short-run.

The major differences between costs in the short run and long run are that in the long-run, there are no fixed factors. However, in the short-run, there are both fixed and variable factors. The general level of price adjusts completely to the state of the economy in the long-run, however; in the short-run the general level of price does not always adjust due to the reduced period of time (Allcott and Rogers 2014).

 The relationship between long-run and short-run costs

Figure 4: The relationship between long-run and short-run costs

(Source: Created by Author)

Market structure is defined as a particular combination of features that determines the type of competition as well as pricing in the market. Monopolistic competition is one of the major type of market structure that takes place when there are several sellers who are attempting to be different from each other. Another type of market structure is that of oligopoly under which the market is operated by a small number of firms that controls the majority of the market share together. On the other hand, under natural monopoly, a firm is able to provide the entire market demand at a lower cost. The imperfectly competitive market structure is almost similar to the realistic market circumstances where monopolistic competition, oligopolists as well as monopoly exists. The major features of the major market structure types are as follows:

Short-run and Long-run Costs

Number of firms in the market: Under perfect competition, monopoly, oligopoly and monopolistic competition market structures are ordered by several sellers from very large number of sellers to just a single seller (Dunne et al. 2013).

The degree of equivalence of product: Under oligopoly market structure, firms sell either an equivalent or a differentiated commodity. However, firms under perfect competition and monopoly market structure, always sell an equivalent commodity whereas; under monopolistic market structure firms always sell differentiated commodities.

Largest firms and their market share: A single firm has full share of market under pure monopoly. On the other hand, under oligopoly market structure, there is less number of firms, which have majority of market share. Lastly, under perfect competition, the market share of a single firm is insignificant.

Barriers to Entry: Under perfect competition, monopoly, oligopoly and monopolistic competition, market structures are characterized by severity of barriers to entry.

Pricing: Under monopolistic market structure, firms have insignificant control over price due to differentiation of product as well as advertisement. However, the control over price relies on whether the firm is selling an equivalent or a differentiated product, under monopolistic competition (Stiglitz and Rosengard 2015).

As per the case, the demand for apartments will be relatively inelastic as there are hardly any substitutes for the apartments in this area. However, it is also argued that demand can also be relatively elastic due to the fact that rent is a high proportion of the income of the renter. As a result, an increase in rent will make the renters leave the city on the whole or stay on the streets.

The supply of apartments will be comparatively inelastic. According to the case study, the area is defined as a low-income area and there is less probability to avail free lands. As a result, the quantity supplied of apartments will increase in a negligible way. Similarly, the apartment owners will not make any investment in low-income areas with increase in rents (Havranek, Irsova and Janda 2012).

Supply and Demand 

Figure 5: Supply and Demand

(Source: Created by Author)

P denotes the initial equilibrium price and both the demand and supply curve is relatively steeper.

If the government decides to provide a building subsidy, it will indicate a fall in costs of production. As a result, supply is likely to increase with lower costs of production. This will in turn create surplus that will indulge the apartment owners to minimize the rents.

 Shift of the supply curve

Figure 6: Shift of the supply curve

(Source: Created by Author)

The graph shows that the quantity supplied of apartments will increase. In other words, the supply curve shifts towards right from S1 to S2. As a result, price also falls from P to P1 and quantity gets increased from Q to Q1. On the other hand, if demand is perfectly inelastic in that case, the greatest impact will be the reduction in rents. This in turn increases the quantity supplied of the apartments by only a negligible amount. This helps the renters and the owners of the apartments to gain from the program. However, in this scenario the renters gain the maximum profit.

References

Allcott, H. and Rogers, T., 2014. The short-run and long-run effects of behavioral interventions: Experimental evidence from energy conservation. The American Economic Review, 104(10), pp.3003-3037.

Bowen, W.G. and Sosa, J.A., 2014. Prospects for faculty in the arts and sciences: A study of factors affecting demand and supply, 1987 to 2012. Princeton University Press.

Deng, X., Kang, J.K. and Low, B.S., 2013. Corporate social responsibility and stakeholder value maximization: Evidence from mergers. Journal of Financial Economics, 110(1), pp.87-109.

Dunne, T., Klimek, S.D., Roberts, M.J. and Xu, D.Y., 2013. Entry, exit, and the determinants of market structure. The RAND Journal of Economics, 44(3), pp.462-487.

Havranek, T., Irsova, Z. and Janda, K., 2012. Demand for gasoline is more price-inelastic than commonly thought. Energy Economics, 34(1), pp.201-207.

Murray, A.L., Dixon, H. and Johnson, W., 2013. Spearman's law of diminishing returns: A statistical artifact?. Intelligence, 41(5), pp.439-451.

Phlips, L., 2014. Applied Consumption Analysis: Advanced Textbooks in Economics (Vol. 5). Elsevier.

Real, L.A., 2013. On Uncertainty and the Law of Diminishing Returns in. Limits to action: The allocation of individual behavior, p.37.

Stiglitz, J.E. and Rosengard, J.K., 2015. Economics of the Public Sector: Fourth International Student Edition. WW Norton & Company.

Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.

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