Chapter 2 The Theory of the Firm

What is the Theory of the Firm?

The traditional theory of the firm provides a starting point for investigating the behavior of firms. It attempts to explain why
firms exist and operate as they do. The traditional theory of the firm is based on classical economics and the work of early
economists, such as Adam Smith, David Ricardo, and John Stuart Mill. The basic assumptions of the traditional theory of
the firm are:
 Firms seek to maximize profits.
 Information symmetry - Owners and workers of the firm have access to good information which enables them to
maximize profits.
 Firms act as a homogenous unit with owners wishing to maximize profits and these aims being achieved by
managers and workers.
 To maximize profits a firm makes use of marginal analysis. In particular profit maximization occurs at an output
where marginal revenue = marginal cost.
 Firms and managers are rational. With their rational objectives being to maximize profits.

Whilst The traditional theory of the firm provides a starting point for investigating the behavior of firms, the traditional theory
of the firm is increasingly questioned by modern economists.

The authors and scholars such as William Stanley Jevons, Carl Menger, and Leon Walras were said to have developed
neoclassical economics. The theory of the firm devised in neoclassical economics refers to the microeconomic concept that
every firm exists & operates in order to make and maximize profits. Companies ascertain the price and demand of the
product in the market, and make optimum allocation of resources for increasing their net profits.

Criticisms of the traditional theory of the firm include Behavioral economics. Recent behavioral economists, Thaler and
Aversky state the importance of human psychology in determining the behavior of firms – a much more complex set of
circumstances than simple profit maximization.

How Does the Theory of the Firm Work?

According to the theory of the firm, every business organization is driven by the motive of maximizing profits. It is assumed
that firms wish to maximize profits because this will enable the owners and managers to maximize their own salary, bonus
and dividends. To maximize profits, they will seek to cut costs and set the profit maximizing price and level of output. This
theory influences decisions for allocating resources, methods of production, adjustments in prices, and manufacturing in
huge quantum.

Both the theory of the firm and the theory of the consumer go hand in hand. As per the theory of the consumer, the
customer tends to enhance their total utility to the fullest. In economic terms, utility refers to the estimated value a customer
uses for measuring the level of happiness or satisfaction derived from the consumption of a specific product or service. For
instance, if a customer buys a product worth $5, he or she expects to receive utility of at least the same amount, that is $5 in
this case, from the bought product.

Expansion on the Theory of the Firm

According to the contemporary approach, there is a difference in the short-run motivation and long-term motivation for a
company. While long-run motivation involves growth and sustenance of a firm, short-run motivation involves objectives like
maximizing profits. Economists still analyze and make revisions to this theory so as to make it adaptable to the changing
economic and market environment. Earlier, economists emphasized on wider sectors. But with advancements made in the
19th century, economists have started analyzing and observing at the base level in order to find answers to questions like
what organizations do, why they are in a specific business, and what is the motivation for their decisions regarding capital
and labor force allocation.

Alternative Theories of the Firm

The dominant Theory of the Firm poses that markets act perfectly to maximize the well- being of society when people act to
maximize the personal utility of their individual purchases and firms act to maximize financial returns to their owners.
However, burgeoning evidence and discourse across the scientific and policy communities suggests that the economic,
social, and environmental consequences of accepting and applying this theory in the organization of business and society
threaten the survival of the human species, among countless others. The following are some alternatives to the traditional
theory of the firm:

1. Sales maximization/market share - With sales maximization, firms sell at lower prices and seek to increase sales.
They may have a constraint to make a minimum amount of profit to keep owners happy. But, they may go for sales
maximization for various reasons:
a) Increase market share and therefore monopoly power. This can enable long-term profit maximization
b) Gives a greater sense of prestige to be at the head of a big company and dominate the market
c) Gaining market share gives a sense of success that may be more measurable in the world than profit.
d) Managerial salaries are likely to increase in a bigger company.

2. Growth maximization - Growth maximization is similar to sales maximization, but growth implies increasing size of
firm and this may involve the firm taking on risky expansion, borrowing to invest in new capital. This may make the
firm less financially secure, but offers prospect of rapid growth through investment and acquisition. The traditional
theory of the firm underplays the role of mergers and acquisitions as a way for firms to increase in size and gain
more market share and prestige.

3. Managerial utility maximization - A limitation of the traditional theory of the firm is that it equates utility maximization
with profit maximization, but in the real world it is much more complex and there are many things that determine a
managers utility:
a) Getting on with workers. A boss doesn’t want to annoy his fellow workers just to make more profit for owners.
The boss may sacrifice some profits to make his fellow workers happy, for example avoiding job losses.
b) Fringe benefits. Managers may get a lot of utility from fringe benefits like having fun at work, lavish offices and
taking time off to play golf.
c) If the direction of firms is governed by managers, there may be a form of profit satisficing – where managers do
enough to keep the owners happy but then pursue these other objectives.

4. Corporate responsibility and social welfare - The fourth model assumes that firms have a mixture of objectives.
Profit may be one, but the firm may have a mission statement to priorities environmental welfare or offer some
services to the local community. Therefore, the firm may invest surplus profit in community schemes which benefit
local stakeholders rather than shareholders. For example, a football club may choose a price lower than market
equilibrium to keep matches affordable to local supporters and it may re-invest profits in community schemes.
Sometimes corporate responsibility may be masked as clever marketing strategy and the percentage of profit
invested in the community/charity is actually very low. Different potential business objectives

Risks Associated With the Theory of the Firm’s Profit Maximization Goal
There are a few beliefs such as having less stake in company that are associated with the theory of the firm. Some believe
the chief executive officers of public companies not only focus on profit maximization, but also emphasize on increasing
sales, maintaining public relations, and having a good market share. If their goal is only profit maximization, the public will
be suspicious about their intentions, and the company’s reputation or goodwill in the market will be highly affected.
 In case, a company follows a single strategy for running its operations, there can be many risks associated with it.
 In case, a business depends on just one product for building its revenues, and that very product eventually fails to
make adequate sales in the market, the whole financial structure of the business will be affected, or at least one
department of the company.
For instance, there was a gaming console manufacturing company named Sega that gained popularity with its Sega
Genesis console. Seeing its success, it also launched Dreamcast in Japan in the year 1998, and in the USA in the
subsequent year where it was able to make revenues of $100 million on the first day. But, the problem started when the
Dreamcast was not able to beat its competitor PlayStation 2 when it was about playing DVDs. This ultimately resulted in the
gradual failure of the Dreamcast in the international market. Customers were not ready to buy the product in spite of
lowering the prices, and hence, the gaming console department of Sega got shut down.