Industry 1

Chapter Two
The Theory of the Firms
By Tolera M (MSc), Lecturer, DaDU 1

2.1 The Neoclassical Theory of the firm
 It is also called Microeconomic theory of the
firm.
 The firm is taken here as purely profit
maximizing economic agent.
 Behavior of a firm in pursuit of profit
maximization can be analyzed in terms of:
 the quantities of its inputs it utilizes
 production techniques it employs
 the quantity of outputs it produces, and
 the prices it charges

 It suggest that firms generate goods to a point
where ,MC=MR.
 Uses factors of production to the point where
their MRP is equal to the EC incurred in
employing the factors.
 It shows the marginal cost curve and the
average cost curve as distinctly U-shaped. A
typical drawing of marginal and average cost
curves is given by the following figure.

 Even if we accept the underlying concepts of
diminishing marginal productivity, there is a
mathematical relationship between marginal cost
and variable cost which ensures that only trivial
levels of output can generate curves that look like
this. Look at previous page.
The Short Run Output Level
 The neoclassical theory of the firm divides
production time periods into 3 classes:
 the market period, when output cannot be altered
 the short run, when all but one factor of production can
be altered and
 the long run, when all factors can be altered

• As per the theory, the supply curve in the short
run is vertical which implies that only the amount
already produced can be offered.
• The supply curve in the short run is the sum of the
marginal cost curves of all firms in a competitive
market that lie above the minimum of the average
variable cost.
• The marginal cost curve is presumed to fall at first
due to increasing production efficiencies, then to
rise as diminishing marginal productivity sets in.
This results in both the marginal cost and the
average cost curves being "U-shaped".

• The theory of the firm has evolved from
representing the firm as:
 a purely profit maximizing automation
 operating in a spaceless and
 timeless environment (neoclassical theory).
• The objective determining the behavior of the
firm is maximization of profits.
– That is, the firm is an abstraction, an idealized
form of business, whose existence is solely
explained by the purely economic motive of
generating a profit.

• The firm is a profit-maximizing (or cost-
minimizing) entity operating in an
exogenously given environment, which lies
beyond its control.
• Profit is also maximized under conditions of
perfect knowledge (information) about
demand (which yields marginal revenue, MR)
and cost conditions (from which marginal cost,
MC, is derived).
• That is, when MR = MC, then profit is said to
be maximized.

Criticism of neoclassical theory of the firm
1. Firms may not aim at profit maximization by equating
MR and MC; instead the right price might be based on
recovering full cost (including a conventional
allowance for profit).
2. Imperfect information, and thus uncertainty, is not
taken as a relevant factor in this theory since the firm
operates in a timeless environment.
3. The organizational complexity of firms may impede
the application of the profit maximization principle.
4. The motivation and decision-making of individuals
are more fundamental than that of the organizations
which they form.
 So as to overcome such drawbacks of the neoclassical
theory of the firm, the modern theory of the firm is
developed as discussed in the following section.
2.2 The Modern Theory of the Firm
 The theory of the firm has evolved from representing;
the firm as a purely profit maximizing operating in a
spaceless and timeless environment (Neoclassical
theory).
 Neoclassical theory treats the firm as a producing unit.
• By stressing the technological and cost constrains faced
by business organisations in transforming scarce
productive resources into outputs valued by consumers,
neoclassical theory takes the firm pretty much for
granted.
• The firm emerges as an economic entity for purely
technological reasons (scale economies in production)
in the neoclassical model.
• The modern theories are developed because some important
questions are left unanswered in the neoclassical theory,
which led to the so-called modern theory of the firm which
can be further classified as: Managerial theory, Principal-
Agent Theory and Transactions Cost Theory.
• Some economic activities are co-ordinated by the price
system and some are administered explicitly within business
organisation.
• But it is essential to question:
 Which economic functions will firms perform?
 What forces determine the size of firms?
 What types of organisational form will a firm adopt?
• Thus, the modern theory of the firm addresses these and
other crucial questions in studying industrial economics.

2.2.1 Managerial theory
• This theory relates the developments in the legal forms
of firms, which have evolved from Sole Proprietorship
to Partnership and then to Liability limited companies.
• The Liability Limited Business Organizations are
gaining importance, measured by their contribution to
total output, investment in research and Development
and hence the source of industrial dynamism.
• One major feature of the Liability Limited Corporations
is that they are usually managed by professional
managers.
• Ownership does not entitle one to managerial capacity,
especially in the Share Holding Companies.

• The focus is on the firm (same as the neoclassical
theory) particularly:
 the relationship between owners and managers and
 the possible deviation of objectives (but not necessarily
deviation of interest) between managers and owners.
• The managerial theory emphasises on the complex
nature of the modern corporate firm.
• The theory is based on two major principles/premises:
– There is separation of ownership and control: in a today‟s
firm, ownership (by shareholders) is distinct from control
(exercised by managers). Because of this, it is possible to
conceive of a divergence of objectives between owners and
controlling managers. Hence, there is a possibility of
setting growth or revenue maximisation objectives as
priority instead of profit maximisation.

– Firms operate in an environment that affords them
an area of discretion in their behaviour. That is,
firms are considered as active entities that make a
difference in their economic performance. They
are not considered as passive entities as the
Neoclassical School of thought implies.
 Following the separation of ownership and control, it
is based on the premise that there is diminishing
influence of shareholders in the decision making
process.
 Much of the decision-making is left to the manager.
 There are Variants of the Managerial Theory. We
consider here: Baumol‟s model and Marris‟s model.

2.2.1.1 Baumol’s Model
• As this model the objective of firms is sales/revenue
maximization.
• It supposes that hired managers may be more
preoccupied by sales or revenue maximisation instead
of profit maximisation.
• The justification of the theory is that:
 Sales performance is equated with the performance in
market share and market power.
 If sales decreases or fail to rise, this is often equated
with reduced market share and market power, and
consequently, with increased vulnerability to the actions
of competitors.
 Market share =firm’s sales/ total sales of a given
market.

• The typical performance report of a firm is
usually in terms of sales not profit.
– When asked about the way company performs, an
executive would typically reply in terms of what
the firm‟s level of sales is.
– Sales data are easily accessible and hence one can
have daily, weekly and monthly sales reports,
while it requires some period of time (say three
months or a year) to get reports on profitability.
• The financial market and retail distributors
are more responsive to a firm with rising sales.

• Baumol argues that even if there is divergence
of objectives between the owners and their
managers, the objectives are reconcilable, as
this divergence of objectives is not based on
the divergence of interest and existence of
vested interests on the part of the managers.
• Basically, it is argued that the managers are
loyal to the success of the firm and set
objectives professionally.

• The model attempts to reconcile the behavioural
conflict between profit maximisation and sales
maximisation (i.e. its total revenue).
• It assumes that the firm maximises sales revenue
subject to a minimum profit constraint.
• The revenue-maximising level of output is the
level at which the marginal revenue is zero and
the elasticity of demand is unity.
• This level of output that can be produced when
constrained by minimum level of profit could be
different from the revenue-maximising level of
output.

• Baumol calls the difference between the
maximum possible level of profit and minimum
constrained profit ‘sacrificeable’.
• In his view, this profit will be voluntarily given up
by the firm in order to increase sales revenues.
• If the voluntarily given up level of profit is too
apparent, it would tend to attract other firms
operating in the same market, and would tend to
create the ultimate threat of take-overs. This is
why the sacrifice will be done quietly and only in
a way which doesn‟t look like sacrificing.
• In any event, the profit maximising output will
generally be less than the revenue-maximising level of
output.
• The profit-constrained revenue-maximising output (Qc)
may be greater than or less than the revenue-
maximising output (Qr).
• If Qc < Qr, then the firm will produce Qc. If Qc > Qr,
then the firm will produce Qr.
• Baumol argues that the unconstrained equilibrium
position never occurs in practice.
• N:B: Qp = profit maximising output; Qr = revenue-
maximising output; Qc = revenue-maximising output,
subject to a minimum profit constraint, Πc

2.2.1.2 Marris’s Model
• Marris suggest that managerial control would
lead to growth as an objective, showing that
shareholders were a less important constraint on
such firms than financial markets.
 The model is dynamic in the sense that it
incorporates the issue of growth of the firm.
• Like Baumol‟s model, it assumes that managers
will act to maximise their utilities rather than
profits, but in contrast to Baumol, it assumes that
this will be achieved through growth rather than
sales.

• At its simplest the model has two curves one
supply growth and one demand growth.
• In the Marris model, where the supply-growth
and demand-growth relationships are satisfied,
there will be a unique state of growth and
profit equilibrium.
• The rate of growth of demand will match the
rate at which investment in the firm provides
the volume and range of products required to
meet this demand.

Figure 2.3: Marris’s Model

• The demand growth curves show the maximum
profit rate consistent with each growth of demand.
With demand growth, growth is seen as
determining profits, rather than – as in the supply
growth-profit maximizing growth.
• Growth arises through diversification into new
products, rather than expansion of output.
• The supply growth is the maximum growth of
supply that can be generated from each profit rate,
given management‟s attitudes to growth and job
security. Supply growth is directly related to
profit because higher profit implies higher
retained earnings, which in turn implies
investment.

2.2.2 The Principal - Agent Theory
• It also known as the Agency Theory
• There are two main actors
 Principal: is the owner of an asset
 Agent: is a decision makers
 it affect the value of that asset on behalf of the
principal.
 The key features of principal-agent problems
are:
 Principal knows less than the agent about something
important, and their interest conflict in some way.

Three types of problems
 1st is problems where agents can do some costly
action to improve outcomes for the principal but
the principal can‟t observe the action.
– These are known as effort aversion/moral hazard
problems.
 2nd is one includes problems where agents and
principals can’t express the difference among
them.
 These are known as adverse selection when the types
are fixed and the question is which agents will
participate.

 3rd is hidden information models, but this
category does not seem very well-defined.
• For example, managers in firms who take actions
that advance their own careers but hurt
shareholders, sounds like an effort aversion
problem with a different definition of effort.
• Rather than encouraging the agent to undertake a
certain action that will more likely lead to good
outcomes for the principal, the principal instead
wants to discourage the agent from taking certain
actions that will more likely lead to bad outcomes
for the principal.
• Agents act differently when they are insured than they
would otherwise.
• For instance, insured patients make more trips to the
doctor than they would without insurance, banks make
more risky loans than they would if there were no bank
bailouts.
• One of the purposes of insurance is to reduce the
private cost of going for help in event of accident, but it
could be argued that when there is overuse of this kind
the private cost should be increased, for example by
increasing the co-payment for doctor visits or
completely replacing bank leadership in the event of
bank failure. At any rate, these examples are
traditionally referred to as “moral hazard”.

• Agency theory focusing on contracts between
the principal and the agent.
• The agency theory focuses on the design and
improvement of contracts between principal
and agent.
• It is based on the following assumptions:
 There is separation of ownership and control: in a
firm, the ownership by shareholders is distinct from
control exercised by managers.
 Because of this separation, it is possible to conceive of a
divergence of interests between owners and controlling
managers and hence, the possibility of having a growth
objective or revenue maximisation objective instead of
profit maximisation.

 Firms operate in an environment that affords them
an area of discretion in their behaviour.
 That is, firms are considered as active entities that
make a difference in their economic performance.
 They are not considered as passive entities as the
Neoclassical School of Thought implies.
 Information asymmetry:
 The theory assumes that both the principal and its
agent are well informed but that each has a
different set of partial information.
 So there is recognized problem of information
asymmetry, though it is considered as a partial
problem.

• Moral Hazard: Conflict of interest and the
existence of information asymmetry lead to the
problem of moral hazard.
• Where interests and objectives of the agent are
different from that of the principal, and the
principal cannot easily tell to what extent that
agent is acting self-interestedly in ways diverging
from the principal‟s interests, and then the
problem of moral hazard arises.
• In the literature, terms such as: shirking, hidden
action problem and post contract opportunism are
used interchangeably with the concept of Moral
Hazard.

 Shirking is the moral hazard arising from the
employment contract.
• Principal-agent theory is more concerned with
implications for shirking, i.e., a reduction in
effort by an agent who is part of a team.
• There may be a slight declining in total output as
a result, but the cause will usually be
unidentifiable.
• The shirking manager knows that his/her
diminished effort is unobservable.
• What the principal can do, in the formulation of
contracts, to offset shirking (and other types of
management misbehaviour), is the key problem of
principal - agent theory.

 Thus, it is essential to think about contracts
between principals and agents in two parts:
(i) Risk-sharing: With fixed probabilities and
payoffs, the agent‟s expected utility will be a
decreasing function of his risk aversion.
 To convince the agent to sign a contract,
therefore, the principal must offer payoffs that
are either more generous or more equal as the
agent becomes more risk averse.

• (ii)Incentives: By specifying different payments
for different outcomes, the contract sets up
incentives for the agent as he chooses an effort
level.
• If under a given contract payments are larger for
higher outcomes, there will be higher effort.
• The agency theory is based on the assumption of
unbounded rationality, which refers to the ability
of those designing the contract to take all
possible, relevant, future events into
consideration.
• The agency theorists may be different from neoclassical
theorists in coping up with problems of asymmetric
information, measuring performance, and incentives.
• These three agendas of agency theory are considered as
issues of a contract.
• Agency theory focuses:
– on the contractual aspects of that relationship, and often
adopts game-theoretic methods.
• Agency theory sees:
– the firm – as does the neoclassical theory - as a legal entity
with a production function, contracting with outsiders
(including suppliers and customers) and insiders (including
owners and managers), emphasizing on internal contracts,
as it is the internal contracts that is meant to enter and
manage the contracts with outsiders.

• The problem with the agency theory is how to
formulate a contract such that shareholders (the
principal) will have their interests advanced by
managers/the agents/, despite the fact that the
manager‟s interests may diverge from those of the
shareholders.
• In other words, the problem „is whether there exists
any class of reward schedule for the agent /the
manager/ such as to yield a Pareto-efficient solution
for any pair of utility functions both for the agent and
the principal‟.
• The main difference between principal–agent theory
and transaction cost theory is that the former focuses on
the contract, the latter on transaction.
• The Contracts: The theories of industrial
organisation can be classified on the basis of the
views/positions on contracts.
• There are two main such approaches:
 Monopoly: which views contracts as a means of
obtaining or increasing monopoly power; and
Efficiency: which views contract as a means of
economising. The earlier works on Structure - Conduct
- Performance and particularly on barriers to entry
belongs to monopoly branch of contracts.
• Both Transaction Cost and Principal-Agent
theories belong on the efficiency branch together
with most of the proponents of the New
Institutional Economics.

• How to address the problem of moral hazard/shirking/?
• How to ensure that we have an effective internal contract?
• What factors should a contract incorporate to address the
shirking problem that the principal is facing?
• The agency theory promotes the idea that the market
mechanism can take care of the problem.
• According to this theory, there are a number of ways of
controlling moral hazard:
• By making the manager‟s salary be equal to the expected
value of his/her marginal product.
 That is, setting wages of the agent to be equal to the marginal
value product of the agent W (wage) = MVP (marginal value
product). However, the importance of the team element in
managerial jobs discredits the notion of a manager‟s marginal
product.

 To design contracts on the basis of which there will be an
incentive for the manager to act in the shareholders‟
interests.
 It includes providing incentive contracts which reward
agents only on the basis of results, bonding where the agent
makes a promise to pay the principal a sum of money if
inappropriate behaviour by the agent is detected and
mandatory retirement payments.
 Rather than attempting to calculate the value of each
manager‟s marginal product, managers could each be paid
a salary plus a bonus based on the performance of the
company.
 The problem here is that if the utility of leisure is different
for different managers, then again some may work more and
others less at maximising the long-run value of the firm.
That is, in the managerial team, there will be „free rider
problem‟ in the team.

• Other suggested solutions is the development of
efficient ways of monitoring the performance of
individual managers (or management team).
• Hostile take-overs can be taken as a corrective
response to managerial moral hazard: the take-
overs can be used to displace deep-rooted
managers who were pursuing their own interests
at the expense of the stockholders.
Policy implication
• The policy implication of the agency theory is
that there is no need for government intervention.
• There are inherent mechanisms that address the
problem and the principal can manage it with the
market mechanism.

2.2.3 The Transaction Cost Theory
• The neoclassical school is based on the
assumption of zero transaction cost.
• Decision makers can acquire and process any
information they wish instantly and costlessly.
• They possess perfect foresight and, hence, are
able to write complete contracts that can be
monitored and enforced with absolute
precision.

• The zero transaction cost implies that institutional
arrangements play an inconsequential role in the
economic process.
• There is recognition that political, legal, monetary, and
other institutions exist, but they are regarded as neutral in
their effect on economic outcomes and largely ignored.
• In other words, institutions are taken as “allocationally
neutral.”
• In such a situation, decision makers operate with perfect
information and perfect foresight.
• It should be noted that in neoclassical theory, the price
system is the only (explicitly modeled) device that is
identified as a means for coordinating different
activities.
• Administrative coordination is disregarded because it is
generally not thought to be necessary in a market-driven
system.
2.2.3.1 What is transaction?
• why the existence of positive transaction costs
makes it necessary to view institutions as
endogenous variables in the economic model?
• In the real world institutional structure affects
both transaction costs and individual incentives
and hence economic behavior.
• A distinguishing feature of the New Institutional
Economics is its insistence on the idea that
transactions costs are costly.
• Transaction costs are encountered universally
because of the character of the individuals who
make decisions. The imperfection of human
agents calls for the costs of running an economy.

• It appears that real resources are required in order
to create and operate any institution (or
organization) and guarantee obedience to its rules.
• In the process costs are involved, and these costs
are referred to, broadly, as transaction costs.
• A transaction occurs when a good or service is
transferred across a technologically separable
interface i.e. when one stage of activity terminates
and another begins.
• The definition is meant to the „delivery‟ of goods
and services within firms and/or across markets.
• The scope of transactions is therefore limited by
the prevailing division of labor, which, in turn is
delimited by the market.

• Economic transactions are social actions that are
necessary for the formation and maintenance of
the institutional framework in which economic
activity occurs.
• They include formal or informal rules, and their
enforcement characteristics. Political transactions
are especially significant.
• These refer to the transactions between
politicians, bureaucrats, and interest groups and
the bargaining and planning of these groups about
the exercise of public authority or political
exchange.

• Production costs are associated with the production
activity and transaction costs can be considered to be
costs associated with the activity transaction. Then, if
productive activity is described by a production
function, transaction activity can be described by a
transaction function.
• In general transaction costs are costs of running the
economic system. These costs arise from the
establishment, use, maintenance, and change of:
– Institutions in the sense of law;
– Institutions in the sense of rights;
– Transaction costs arising from informal activities connected
with the operation of the basic formal institutions.

• We can identify three types of transaction costs. Each of the
three may have two cost elements, fixed transaction costs,
the specific investments made in setting up institutional
arrangements, and the variable transaction costs that depend
on the number of volume of transactions.
• Market Transaction Costs: Market Transaction Costs
include:
– cost of screening and selecting a buyer or seller;
– the cost of preparing contracts which includes the cost of
obtaining information on the good or service;
– the cost of bargaining & negotiating a contract;
– cost of monitoring & enforcing the contractual obligations.
• Managerial Transaction costs: The costs of implementing
the labor contracts that exist between a firm and its
employees. The costs in connection to implementation are
part of market transaction costs. Managerial transaction
costs encompass:

 The costs of setting up, maintaining or changing an
organizational design: such costs relate to wide array of
operations: personal management, investment in
information technology, defense against takeovers,
public relations, and lobbying. These are fixed
transaction costs.
 The costs of running an organization that fall largely
into sub categories :
– Information costs – the costs of decision making,
monitoring the execution of orders, and measuring the
performance of workers, agency costs, costs of information
management, etc.
– The costs associated with the physical transfer of goods and
services across a separable interface. For example, costs of
idle time in the handling of semi-finished products, the
costs of intra-firm transport, etc.

• Political Transaction costs: market and managerial
transactions are assumed to take place against a well-
defined political background; institutional arrangements
consistent with a capitalist market order.
• The political transaction costs are costs of supplying
public goods by collective action, and they can be
understood as analogous to managerial transaction
costs.
• Specifically, these are: the costs of setting up,
maintaining and changing a system‟s formal and
informal political organization; costs of establishment
of the legal framework; the administrative structure; the
military; the educational system; the judiciary; and so
on. In addition, there are costs associated with political
parties and pressure groups in general.

2.2.3.2 Characteristics of Transactions
• Generally, transactions can be characterized by the
following critical features:
– Uncertainty,
– The frequency with which transactions occur, and
– The degree to which transaction-specific investments are
involved.
• Neoclassical theory does recognize uncertainty as a feature
of transactions but disregards the other two features. Under
the (New Institutional Economics) all three dimensions of
transactions are understood to exert systematic influence on
economic behavior.
• The central message of the New Institutional Economics is
that institutions matter for economic performance.
• The fundamental idea is that transaction costs do exist, are
significantly large and they can shape the structure of
institutions and the specific economic choices people make
(i.e. Economic behavior of economic agents such as firms).
Policy Implication
• The role of the state is significant.
• It sets the formal rules and regulations that shape the
behaviour of economic agents. It enforces the formal rules
and regulations.
• Failure in these rules leads to institutional environment
which is not conducive. Thus, institutional development is
instrumental to socio-economic development.
• The New Institutional Economics is a useful tool to
address policy issues in developing countries because:
– Frequent occurrence of market failure & incomplete or
imperfect markets;
– Many of the formal rules of behavior that are taken for
granted in developed economies do not exist in developing
countries

2.3 The Growth of the Firm
• 2.3.1 The Rationale for Growth of the Firms
• Growth is one of the performance indicators of a firm.
• The question of what explains growth performance
include:
• The alternative objectives of a firm that induce it to
work and grow.
• The empirical observation that shows firms grow as a
natural process over time.
• An inherent drive for market power and hence for
growth
• External pressure/market competition and change in
demand/ shape the behavior of firms.

2.3.1.1 Alternative Motives for Growth
 Growth as a Natural Process
• Growth is an empirically established trend and
daily-observed phenomena.
• Most large firms that we see around were small
when they were established, grew continuously
and attained present status in the course of time
• If this is a common observation then growth is a
natural process as observed in biological growth
of organisms, which are born, grow to maturity
and die.
 Growth as External Pressure
• There are certain external forces which compel a firm to grow over
time.
• Development of Needs: Needs, which are the basis for demand for
a product/service does change over time. Thus, firms have to cope
up with the changes in the market;
• Dynamism of Competition: Competition is dynamic. Survival and
growth are not one-time achievements. Survival calls for
continuous effort to ensure competitiveness. This implies for the
need to invest in Research and Development, advertise, etc.
 The Drive for Market Power
• Firms aspire for market power, which is the leverage in decision-
making in the market in areas such as: prices, output and other
related ones.
• The larger the firm, the more perfect the control it assumes over its
industry, environment and market.

2.3.2 The Determinants of the Growth of the Firm
• There are four theories that attempt to explain

the determinants of the growth of the firm.
They are:
 Life-Cycle Theory
 Downie‟s Theory
 Penrose‟s Theory and
 The Marris‟s Theory

2.3..2.1 Life – Cycle Theory
• The theme of the theory is that growth is a
natural process.
• A firm is created, grows, matures and finally dies
out like any biological species.
• This is captured by the product-life cycle or the
Sigmoid Curve / S-Curve/.
• There is short hierarchy in the organizational
structure of a young firm.
• Young firms allow management economies.
• It is easier to handle and transmit information
concerning the company‟s product or idea at the
early stage of a firm.

• There is high communication in the firm,
which implies prompt and flexible decision-
making.
• As a result of such managerial attributes and
hence competence, firm’s growth rate
accelerates  the objective of management
and shareholders coincides  profit raises
 Managerial diseconomies of older firms
arise  Growth slows.
• The Life – Cycle Theory can be depicted by
the following diagram.

Figure: 2.4 Sigmoid Curves

Criticism of the Life -Cycle Theory
• Growth at any point in time may be exogenously given – not
determined from within by age of the firm.
• For instance, growth of market demand can create
opportunities for expansion.
• Equally, developments in the supply side (such as discovery of
new sources of inputs, development of new inputs/process
technology, etc) could trigger high growth rates.
• Needs never die they rather develop over time. New ways of
satisfying needs and changes in consumption behavior, say due
to purchasing capability, lead to need developments;
• Management‟s deliberate move, vision and success in
Research and Development can change the growth pattern.
• For Example, firms can consider the developments in the
telecommunication and electronics industries as an opportunity
and further develop.

2.3.2.2 The Theory of Profit Constraint
• It also called Downie‟s theory in the literature.
• it is concerned with the way in which alternative
forms of market structures and the “rules of the
game” lead to the divergences in efficiency and
the rate of technical progress among firms.
• Some firms have greater efficiency than the
industry average while some others have lower
efficiency.
• Efficiency variation is attributed to variation in
technical progress.
• Firms with superior technology are assumed to be
more efficient.

• The process of growth according to Downie‟s
model starts with steady encroachment on the
market share of less efficient firms by more
efficient firms.
• Efficient firms take over large market
shares of less efficient firms.
• These can be examined from the supply and
demand sides of growth of a firm.

• Supply side: investment in new technology:
Finance is needed for expansion, which in turn
depends on the rate of profit generated. The rate
of capacity expansion is positively related to the
rate of profit and/or efficiency.
• Demand Side: an efficient firm, according to
Downie, must offer price discounts to attract
new customers.
• If the firm is to grow, then it has to be price
competitive, in terms of selling at lower prices.
However, lower prices mean lower profit for the
firm. Sometimes high profit may be accompanied
by loss of customers. Then growth will be broken
down.
• Hence, there are two opposite forces in the growth
process of the firm - the supply side (the capacity)
of growth, which varies positively with the rate of
profit and the demand side, which varies inversely
with the rate of profit after some level of profit.
• The two opposite trends set the upper limit on the
rate of growth of the firm.
• At that limiting point, the rate of profit and the
product price of the firm should enable capacity
and market of the firm to grow at the same rate.

Fig: 2.5: The Downie’s Model representation
• At point „G‟ the capacity and the market growth
curves intersect. This is called Downie’s
Equilibrium Point.
• An efficient firm will be able to sustain a
higher rate of growth than an inefficient firm
because of its initial higher rate of profit:
rapidly growing market or customer expansion
curve and expanding capacity of production.
• Hence, financial constraints, (specifically
profitability, which is the source of own finance)
play the crucial role in the process of the growth
of the firm in Downie’s framework.

Criticism of the Theory
• Downoe‟s theory ignores the possibility that
inefficient firms might react positively and
aggressively to declining market share.
• Compelled to initiate innovations, firms can
reverse the efficiency difference. As a result,
inefficient firms may become efficient over time
and vice versa.
• If Downie were right, there would have been ever
growing concentration in different industries,
which however is not empirically supported.
• The implication is that if one efficient firm
controls a market, then there will not be any
chance for inefficient firms to catch up.
– The argument that new customers are attracted through
price-reduction ignores non-price competition
strategy like: advertisement, new product
development and so on.
– The model has not taken into account the managerial
restraint, which plays very important role in limiting
the growth of the firm.
– The model undermines the role of other sources of
financing: Issuing of new shares, borrowing from
banks, issuing bonds and related others. Though
profitability affects the credibility of the firm in front
of the other sources of money, it should not be
exaggerated. A modest performance in profitability
and managerial capacity to show prospect into the
future could convince other sources of finance.

2.3.2.3 The Theory of Management Constraint
• It is also known as Penrose’s Theory in the literature.
• Penrose suggested that growth of a firm continues unless
some factors restrain opportunities for expansion.
• These restraints can be of two types:
• 1. Internal Constraints:
• Managerial capacities: if both administrative and
entrepreneurial capacities are inadequate, the firm cannot
sustain high rate of expansion. It may be possible to recruit
new mangers, but newly appointed managers require time to
gain experience and run the firm efficiently.
• Financial restraints: adequate resources are required to
invest for expansion. Penrose treated financial constraint as
relatively less important compared to managerial restraints.

2. External Obstacles:
 These refer to both demand- and supply-side factors.
• Fall in demand for the product under consideration;
• Competition from rivals leading to narrow market;
• Patent or other restrictions on the adoption of new
technologies;
• Lack or shortage of inputs, escalation of costs of
major inputs, etc.

• However, Penrose treated external factors
relatively less important as far as expansion is
concerned.
• Penrose argued that external factors together with
financial limitations can be easily handled if the
management is strong.
• The main task of management is to tackle
marketing, financial, technological, and other
related problems.
• For example, engage in diversification to
overcome demand constraint. Hence, Penrose
concluded that the most important constraint to
growth is shortage of competent and
dependable managers.

• This may be related to imperfection in the market
for management skills- especially in developing
countries.
• One study (Richardson, 1964) also observed that
among a number of managers contacted none felt
restricted by shortage of labor, materials or
equipment. Only two were held back by shortage
of finance.
• These were small firms and were subsequently
taken over by strong and large firms. Most firms
expressed the view that availability of competent
management is the major resource required for
growth.

• Criticism of the Theory
– The theory gave marginal attention to financial
and external constraints. That is one should not
undermine the role of financial and external
constraints. If these problems are severe they can
be real hindrances.
– Management is not a perfect substitute to the other
inputs. Rather management is a capacity to manage
and deal with such problems.

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Chapter Two

The Theory of the Firms

By Tolera M (MSc), Lecturer, DaDU 1

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• There are four theories that attempt to explain

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