Welcome back. This presentation is about firms. It gives you a general overview of what firms are and what they do. Of course, they produce and sell stuff. This presentation gives you a view behind the stage of how firms do this. Firms can be defined as hierarchical organizations which overcome transaction costs and uncertainties in production processes. This is a typical economist's assumption because it explains why firms processes occur internally, rather than being outsourced to the market. The objectives of firms can be very diverse. They include continuation, conditional on sufficient profit, obtain market power, growth in market share and serving stakeholder interests. Stakeholders, by the way, are shareholders, lenders, workers, communities, and the natural environment. But none of these objectives are automatic or transparent. Some firms focus entirely on shareholder interest by giving priority to short-run profit maximization. There is a wide variation between firms and why they do what they do. From the Body Shop to Shell, and from the local bakery shop to software firms like Coursera. Accounting is all about keeping track of financial stocks and flows. This is required for a firm's accountability with stakeholders. Of course, we want to know where the money comes form and what is done with it. Part of it is our money. A key accounting device is the balance sheet. It shows the firm's net worth. It's the difference between assets and liabilities. Another key accounting device is the profit and loss account. This shows the net profit of a firm over the period of a year, sales minus cost and minus indirect expenses. After tax, we call the result net profit and before tax, it's called gross profit. With these two accounts, stakeholders have an insight in a firm's money flows, which is the basis for their tax payments, wage rises, or dismissal of personnel. Of course, production has cost. For a good understanding of the cost structure of the firm, we make a distinction between fixed costs, such as a factory that exists without producing anything. And variable costs, such as the material input, which vary per unit of production. The total cost is the sum of the two, fixed cost plus variable cost. From the total cost, we can calculate the average costs, which are the total costs per unit produced. Finally, we used the concept of marginal costs. These are the additional costs when producing one additional unit of output. Remember, the marginality concept from the videos about consumption? It's the same idea. The last two cost concepts, average and marginal cost, help firms to measure their economies of scale. Are you still following me? Very well, there is one more concept to go. Economies of scale are cost advantages per unit due to increased production size. How does it work? If you produce more units of output, say bicycles in the same factory, the cost per bicycle will go down because you divide the fixed cost over more units of output, as long as you do not need to build a new factory or hire expensive managers. Of course, you will need to spend money on material inputs and labor. As long as the marginal cost for each expansion of production go down, you are benefiting from economies of scale. The more bikes you produce, the cheaper the production cost per bike until the factory becomes too small, of course. The bottom line is that with economies of scale, your profit margin increases. Production has not only costs but also a benefit for firms, namely profit. Business profit is calculated as revenue minus total cost. In an equation R equals Y minus TC. Remember from the chapter on consumption that Y stands for income. In a case of a firm, this is earned by selling a quantity of product Q against market price P. In other words Y = P x Q. Big R refers to profit, and small r refers to the profit rate. This is the ratio of profit over the value of the capital stock, R over K. For capital, we use K, why not letter C? Remember from Chapter 3 of the book that c is already used for consumption, so we use the first letter of the German word for capital, made famous by the economist Karl Marx book title, Das Kapital Firms don't only have capital, but also labor. Now, machines stand to be pretty obedient but workers, not necessarily. That's why firms do not only have a production department, and an accounting department but also a personnel department. Here, they hire, pay, and fire workers. Plus they manage them so that they are useful for the firm. I would therefore go a bit into the topic of human resource management, in short, HRM. Let's start from a combined social and institutional approach. Social, economic, and institutional approaches to management imply that the interest of all stakeholders must be balanced. In other words, shareholder interest must be balanced by other interests, workers, clients, and nature, for example. Mangers and workers are motivated in diverse ways according to social economics and institutional economics. Here we distinguish two types of human resource management, top-down and bottom-up. Top-down HRM works as a bureaucracy with strict, universal rules. Bottom-up HRM recognizes intrinsic motivation of employees and is based on what they find meaningful, challenging, and gives space for taking own initiative. The neoclassical approach to management assumes that everybody is motivated by self-interest. This leads to the principle aging problem for firms. The principle aging problem is the potential gap between the interest of the principles, the owners of the firm, such as shareholders, who delegate tasks to agents and the interest of the agents who are the managers of the firm. Are their interests aligned? Or do managers do what is good for them such as earning a lot of money and driving a big company car? The neoclassical economic solution to this problem is to have a supervisory board in-between the principals and the agents and to provide financial incentives to the agents for serving the interests of the principals. These incentives are bonuses and stock options. The principal agent problem forms the basis of HRM policy in a neoclassical perspective. It uses performance targets. They function as the stick of labor control and the carrot of incentives. To be more precise, you are out if you don't achieve your targets and you get rewarded when you meet or exceed them. Even if that implies that you take high risk or give bad service to client. It's happened in banks before the crisis, or perhaps it still happens. Do you trust bankers to always serve your interests? Thanks for watching this video. I hope that this business perspective has shown you a bit of what happens inside firms. Now you are ready for the next two videos, each providing a very different perspective on why firms do what they do.