4-2 THE THEORY OF THE FIRM ce their xamine first the reason for the existence of firms and efine the value ofthe frm and the constraints un- se the limitations of the theory of the firm. of firm behavior is the center- In this section, we © principal functions. Then we der which it operates. Finally, we discu: This is a most important section since the theory piece and central theme of managerial economics. Functions Reasons for the Existence of Firms and Th A firm is an organization that combines and organizes resources for the purpose of producing goods and/or services for sale. There are millions of firms in the United States. These include proprietorships (firms owned by one individual), partnerships (firms owned by two or more individuals}, and corporations (owned by stockholders). Firms produce more than 80 percent of all goods and services consumed in the United States. The remainder is produced by the government and not-for-profit organizations, such as private colleges, hospitals, museums, and foundations. Firms exist because it would be very inefficient and costly for entrepreneurs to enter into and enforce contracts with workers and owners of capital, land, and other resources for éach separate step of the production and distribution process, Instead, entrepreneurs usually enter into longer-term, broader contracts with la, bor to perform a number of tasks for a specific wage and fringe benefits. Such » Beneral contract is much less costly than numerous specific contracts and is highlyChapter 1: The Nature and Scope of Managerial Economics @ advantagedus hoth to the entrepreneurs and to the workers and other resource ‘owners. The firm exists in order to save on such transaction costs. By internaliz- ing many transactions (ie. by performing many functions within the firm), the . firm also saves on sales taxes and avoids price controls and other government reg ulations that apply only to transactions among, firms. On the other hand, firms do not continue to grow larger and larger indefinitely because of limitations on management ability to effectively control and direct the ‘operation of the firm as it becomes larger and larger. I is true that up to.a point, a firm can overcome these internal disadvantages of large size or diseconomies of scale by establishing a number of semiautonomous divisions (ie, by decentraliz~ ing). Eventually, however, the increased communication traffic that is generared, coupled with the further and further distancing of top management from the op- eration of each division, impose sufficient diseconomies of scale to limit the growth of the firm, Furthermore, the firm will reach a point where the cost of sup- plying additional services within the firm exceeds the cost of purchasing these se vices from other firmis. An example is provided by some highly technical (legs! ‘medical, or engineering) service that the firm may need only occasionally. ‘The function of firms, therefore, is to purchase resources or inputs of labor services, capital, and raw materials in order to teansform them into goods and services for sale. Resource owners (workers and owners of capital, land, and raw: materials) then use the income generated from the sale of their services or other resources to firms to purchase the goods and services prochiced by firms. The cir- cular flow of economic activity is thus complete. In the process of supplying the goods and services chat society demands, firms provide employment to workers and pay taxes that government utilizes to provide services (such as national de. fense, education, and fire protection) that firms could not provide at all or efficiently, . . 3 a ‘The Objective and Value of the Firm Managerial economics begins by postulating a theory of the frm, which it then uses to analyze managerial decision making. Originally, the theory of the fem was hased on the assumption that the goal or objective of the frm weas to mmaen ‘mize current or short-term profs. Firms, however, ae often observed ve sxcrince shore-term profits for the sake of increasing future or longeteem profits Sane cae amples ofthe ate expenditres om research and development, new capital eauip sem anda erkanedprmvionl Campaign Since both shore-term as well 35 longterm profits are clearly important, the theory ofthe firm now pecralare the primary goal ot obysive ofthe frm ite mame the aeahae the fm. This is ven bythe present value ofall expected future prof othe mane store, Microccommes,2al el. (New Vrks Harper: anager howeve. tpi that she p (ores them to ake actions which ate detanerat neConstraints on the Operation of the Firm We have seen above that the goal or objective of the firm is to maximize wealth or the value of the firm. In trying to do this, however, the firm faces many con- straints, Some of these constraints arise from limitations on the availability of es- sential inputs. Specifically, a firm may not be able to hire as many skilled work- cers as it wants, especially in the short run, Similarly, the firm may not be able to acquire all the specific raw materials it demands, It may also face limitations on factory and warchouse space and in the quantity of capital funds available for a given project or purpose. Government agencies and not-for-profit organizations also face similar resource Constraints. Besides resource constraints, the firm also faces many legal constraints. These take the form of minimum wage laws, health and safety standards, pollution cmission standards, as well as laws and regula- mo tions thar prevent firms from employing unfair business practices. In general, so- ciety imposes these constraints on firms in order to modify their behavior and make it more nearly consistent with broad social welfare goals. So important and pervasive are the constraints facing firms that we speak of constrained optimization.’ That is, the primary goal or objective of the firm is ro maximize wealth or the value of the firm subject to the constraints it faces. The existence of these constraints restricts the range of possibilities or freedom of ac- tion of the firm and limits the value of the firm to a level that is lower than in the absence of such constraints (unconstrained optimization). Within these con- straints, however, the firm secks to maximize wealth or its value. While govern- ment agencies and not-for-profit organizations may have goals other than wealth or value maximization, they also face constraints in achieving their goals or ob- jectives, whatever these goals or objectives might be. Most of the discussion in the rest of the text will be in terms of constrained optitnization, and we will de, velop and use powerful techniques such as linear programming to examine how. the firm achieves consteained optimization. ts Limitations of the Theory of the Firm The theory of the firm which postulates thar the goal or objective sw maximize wealth orth vale ofthe frm has been ertcied ae being nachna narrow and unrcalistic. In its place, road theories ofthe fem have heen pee ‘most prominent among these are mexlels that postulate thar the men eee of the fig the maximization of ses, the Sedition are ‘and sanshicing. be = “We retro “opuminacon” rather shan mex 8840 imate cans a ue alerives fod salle for cases where the fem Une constants tasesne: Introduction According tothe sales-maximization model introdueed by William Baumol and others, managers of modern corporations seck to maximize sales after an ad- equate rate of profit has been earned to satisfy stockholders. Indeed, some early empirical studies found a strong correlation between, executives’ salaries and sales, but not between salaries and profits. More recent studies, how. the opposite, : Oliver Williamson and others have introduced a model of management util- ity maximization, which postulates that with the advent of the modern corpora: tion and the resulting separation of management from ownership, managers are ‘more interested in maximizing thet utility, measured in terms of their compen: sation (salaries, fringe benefits, stock options, etc.), the size of their staff, extent ‘of control over the corporation, lavish offices, etc., than in maximizing “>-rorate Profits” This is referred to as the principal-agent problem, That is, the agent , (manager) may be more interested in ‘maximizing his or her benefits than maxi- ‘izing the principal’ (the owner's) interest. This principal-agent problem can be resolved by tying the manager's reward to the firm’s performance in relation to ther ims in the same industry. Managers who maximize their own imerens father than the corporation's profits are also more likely to be replaced either by the stockholders of the ‘Cofporation oF as a result of the corporation's being taken es ‘er (merged) with another firm that sees the unexploited profit potential of the 3 Finally, Richard Cyert and J ‘Simon, pointed out that because rever, found Profits but can only strive for some éatisfac. tory poal in terms of sales, profits, growth, markers rs hare, and so on, Simon ealled hi stscing behavior That isthe lt comporations a satsheng eae 2 mgnimiaing rzaniation? This, howeve, not necessary meee Proft or value maximization, and, presumably, with more-aed hogs? data and “iee Rrosedures, the modeen corporation could conceivably spree h profit or value maximization. While these alternative and broader theories of the frm stress some rel- Stam aarect of the operation of the modern corporation, they do pro- ve 2 sausfaciory alternative to the theory of the fm posted ae ‘Section 1.2, Indeed, the suff competition prevailing in most prods seg resource mathe a well asin managerial and enteprenural talent tad fore oe ager to pay close attention to profits the fim go out at beeen they be replaced. As a result, we of the firm (in terms of profit or value maxim a8 the basis for anal Jing managenal decisions, because itis from this vamage pen inte ert an J.G March, Vheory uf he Horm, 30 WA Sn, “Theo mst Amara Fosinvn Bass V4 ane Toe