CHAPTER 3 ECONOMIC THEORIES
RELATED TO BUSINESS
THEORY OF THE FIRM
- Consists of a number of economic
theories that explain and predict the
nature of the firm including the
existence, behavior, structure and
relationship of the market
Overview
1. Existence
2. Boundaries
3. Organization
4. Heterogeneity of firm actions/
performances
5. Evidence
- Firm exists as an alternative system
to the market-price mechanism when
it is more efficient to produce in non-
market environment
Background
Industry-Level Analysis – analyzing markets to
analysis at the level of the firm, as it became
increasingly clear that perfect competition was
no longer an adequate model of how firms
behaved.
Economic Theory - Focused on trying to
understand market alone and there had been
little study on understanding why firms and
organizations exist
Transaction Theory
- According to Ronal Coase, people begin
to organize their production in firms
when the transaction cost of
coordinating production through the
market exchange, given imperfect
information, is greater than within the
firm
- The model shows institutions and
market as a possible form of
organization to coordinate economic
transactions.
- The main reason to establish a firm is to
avoid some of the transaction costs of
using price mechanism
Reconsideration of Transaction Cost
Theory
- Louis Putterman said most economist
accept distinction between intra- firm
and inter firm transaction.
- Klein (1983) – Transaction Cost is the
cost that involved in such transaction
within or between firms.
Managerial and Behavioral Theories
- Managerial Theory of the firm-Managers
would seek to maximize their utility and
consider the implications of this for firm
behavior.
- 1960- Neo classical Theory of the firm
was seriously challenged.
Behavioral Approach – People possess limited
cognitive ability and so can exercise only
bounded rationality when making decisions in
complex, uncertain situations.
Team Production
- According to Arman alchain and Harold
demsetz firm emerges because extra
output is provided but the success of
this depends on being able to manage
the team.
- Attendant shirking can be overcome, by
estimating marginal productivity,
observing or specifying input behaviour.
however, can only be effectively if the
monitor is the recipient of the activity’s
residual income.
Weakness in argument of Alchain and
Demsetz
- According to Williamson, is that their
concept of team production has quite a
narrow range of application.
 - it assumes outputs cannot be related to
individual inputs. This may have limited
applicability since most outputs are
separable, so that individual inputs can
be rewarded on the basis of outputs.
Hence team production cannot offer the
explanation of why firms exist and etc.
Asset Specification
- According to Oliver E. Williamson existence of
firms derives from asset specificity in
production where assets are specific to each
other, their value is much less than in second-
best use. This causes problems if the asset is
owned by different firms.
- If the transaction is a lengthy one, re-
negotiation may be necessary as a
continual power struggle takes places
concerning the gains from trades, further
increasing the transaction cost.
- The most efficient way to overcome the
continual conflict of interest between the
two agents, may be the removal of one
of both physical and human capital.
Firm Economics
- The theory of the firm considers what
bounds the size and output variety of
firms, how firms may be able to combine
labour and capital to lower the average
cost of output (increasing, decreasing, or
constant returns) to scale one product
line or for more than one product line.
Other models
- Shapiro and Stiglitz (1984) suggest wage
rents as an addition to monitoring, since
this gives employees an incentives not
to shirk.
- Williamson, Wachter and Harris (1975)
suggest promotion incentives within the
firm as an alternative to morale-
damaging monitoring, where promotion
is based on objectively measurable
performance.
- Leibenstein (1966) sees a firm norms or
conventions dependent on its history of
management initiative, labour relations
and other factors, as determining the
firms “culture” of effort.
- George Akerlof (1982) develops gift
exchange model of reciprocity,
employees offer wages unrelated to
variations in output and above the market
level, and workers have developed a
concern for each other welfare
Grossman-hart-moore Theory
- Known as “Property rights approach” that
was developed by Sanford J. Grossman,
Oliver D. Hart and John H. Moore.
- They argue that if contracts cannot specify
what is to be done given every possible
contingency, then property rights (and
hence firm boundaries) matter.
BEHAVIORAL THEORY OF THE FIRM
- First appearance in 1963 book by Richars
M. Cyert and James G. March
- The work in theory started in 1952 when
March, a political scientist joined Carnegie
mellon university where cyert was an
economist.
- Before the model, the existing theory of
the firm had two main assumptions:
profits maximization and perfect
knowledge. Cyert and March questions
these two critical assumption.
Background
- A behavioural model of rational choices by
Herbert A. Simon paved the way for the
behavioural model. Neo-classical economists
assumed that firms enjoyed perfect
information.
- Advocates of the behavioural approach also
challenged the omission of the element of
uncertainty from the conventional theory.
For example the managerial model of
Williamson and Marris, Considers large
corporate business firm in which the ownership
is separate from the management.
Cyert and March
Research offered four major research themes
1. A small number key economic decisions
2.Development of general theory, generalizing
result from studies of specific firms
3. Linkage of empirical data to models
4. Orientation towards process rather than
outcomes
Model Framework
Theory Construction
- It attempts to predicted behaviour with
respect to price, output and resource
allocation decision. It emphasizes the
decision making progress.
The firm as a Coalition of group
- These larger firms are coalitions of individuals
or groups, which may include managers,
stockholder, works, suppliers and so on.
- According to Cyert and March, these groups
participate in setting goals and making
decisions priorities and information may vary
by group, potentially creating conflict.
- They mentioned five goals firms generally
posses: production; inventory; market share
sales and profit
 Satisfying Behaviour- Real firms aim
at satisfying rather than maximizing their
results. This came from a concept
known as bounded rationality, which
was developed by Herbert Simon.
 Process of decision making- top
management set the goals of the
organization. Implemented through
decision making at two levels (top and
lower management levels)
 Organizational Slack- Payments had to
be excess of what was required for the
efficient working of the firm.
 Critical Evaluation- It gave insight in
the process of goal formation and
fixation as aspiration levels and
resource allocation.
 Later Research- The behavioral theory
of the firm has become important for
much later research in organization
theory and management.
PRODUCTION THEORY
- Economic process of converting inputs into
outputs.
- Economic well being is created in production
process.
3 aspect of production process
 Quantity of goods or service produced
 Form of the goods or service created
 The temporal and spatial distribution of
the good or service produced.
3 most important forms of production
 Market Production
 Public Production
 Household Production
Production as a source of economic well
being- Well being is made possible by efficient
production and by the interaction between
producers and consumers.
Stakeholders of production-
The stakeholders of the companies are
economic actors which have an economic
interest in a company.
Customers- The customers of a company are
typically consumers, other market producers or
producers in the public sector.
Suppliers- The suppliers of the companies are
typically producers of materials, energy,
capital, and services.

Inputs 4 categories
 Raw materials
 Labor services
 Capital goods
 Land

Producer Community- The incomes are

generated for those participating in production.

MAIN PROCESS OF A PRODUCING

COMPANIES

Real Process- Generates the production

output from input, and it can be described by
means of production function.

Income distribution process- Refers to a

series of events which the unit prices of
constant-quality products and inputs alter
causing a change in income distribution among
those participating in the exchange.

Production process- Consists of the real

process and income distribution process. A
result of criterion of success of the owner is
profitability.

Monetary process- Refers to event related to

the financing the business.

Production growth and performance

- production increase of an output of a
production process.
- expressed as a growth percentage depicting
growth of the real process output.