Theories of Firm

Dr. Mohsina Hayat

 Nature Of The Firm
• A firm is an association of individuals who have organized themselves for the purpose of turning inputs into output.
• The firm organizes the factors of production to produce goods and services to fulfill the needs of the households.
• Each firm lays down its own objectives which is fundamental to the existence of a firm.
• The major objectives of the firm are:
• To achieve the Organizational Goal
• To maximize the Output
• To maximize the Sales
• To maximize the Profit of the Organization
• To maximize the Customer and Stakeholders Satisfaction
• To maximize Shareholder’s Return on Investment
• To maximize the Growth of the Organization
Firms are established to earn profit, to keep the shareholders happy. To increase their market share, they try to maximize their sales.
In the present business world firms try to produce goods and services without harming the environment. Firms are not always able to
operate at a profit. They may be facing the operating loss also.
Economists believe that firms maximize their long run rather than their short run profit. So managers have to make enough profit to
satisfy the demands of their shareholders and to maximize their wealth through the company.
Managerial theories of the firm
• Firm act as a coalition = managers+ workers+ stocks-holders+ suppliers+
customer+ tax collectors
• All have different Goal (conflicts)that reconciled if the firm is to survive
• (Top management)  Members of coalition power of decision
making and access to information.
• Basic characteristics of managerial business:
• Divorce of ownership from management
• It permits the top management to deviate from profit maximisation
(owner’s utility maximisation) and pursing the goals of utility
maximisation of managers.
Other goals of managers
• Minimum level of profit that is required for dividend policy by shareholders
• Necessary Investment for satisfactory operation of the firm
• Maintaining good reputation among the shareholders, banks etc.
• Maintain the share prices on the stock exchange
• Risk of take-over
• If these condition are not satisfied , top management traps in risk of
job security.
• Managers can pursue goal of own welfare along the above objective.
Basic feature of managerial theories

The managers maximise their own utility,

subject to a minimum profit constraints
(adequate to the other objectives) necessary
for the job security of the top managers.
Managerial theories of the firm
Profit theory
• Economist  profit is pure profit economic profit …… just profit.
• Pure profit is a return over and above the opportunity cost i.e. the
income which a businessman might expect from the second best
alternative use of his resources.
• Profit = revenue – (explicit cost + implicit cost)
• Profit max. is important concept to built price and production theories
• It helps in predicting the behaviour of business firms in the real world
and also the behaviour of price and output under different market
conditions
Profit maximizing conditions
• Total
  profit = total revenue – total cost
• to be maximum when
1. Necessary condition MR = MC
2. Sufficient condition decreasing MR and rising MC.
• Suppose, TR and
•
• First order condition of profit maximisation is that the first derivative of
profit function must be equal to zero
• - =0
• this condition holds only when
• =  MR = MC
••  Second order condition requires that the second
derivative of the profit function is negative
• - <0
•<
• Slope of MR < slope of MC
• It implies that
• MC must have a steeper slope that MR
• MC must intersect the MR from below
Example
•• Suppose
  demand function for a product is given
• Derive the price (P) function , profit maximisation point, output at maximum profit

=(
price function
Profit max. , MR= MC
=
=
Q = 20
Q= 20 satisfies the second order condition also. i.e. <
<
-4 < 1 , satisfied at output 20.
Baumol’s Hypothesis of Sales Maximisation
• According to Baumol, sales revenue maximization is the most
important goal of managers. i.e manager’s utility functions is
maximization of the sales revenue.
• Because salary ,bank finance, brand, profit max. is difficult objective,
and growing sales increase competitive spirit.
BAUMOL THEORY

Models

Static Model of Sales Dynamic Model of

Maximization Sales Maximization

Without With
Advertisement Advertisement
STATIC MODEL OF SALES MAXIMISATION

Given minimum acceptable level of profit

• Basic assumptions of the model are :-
1. The time horizon of the firm is a single period.
2. The firm is aiming for only that particular period it ignores what will
happen in the subsequent periods as a result of decision taken in
current period.
3. The certain minimum profit constraint is determined by the market
conditions.
4. Demand curve is downward sloping curve and average unit curve is
U-shape.
STATIC MODEL WITHOUT
ADVERTISEMENT
In figure TC – Total Cost, TR – Total Revenue ∏- Profit. X1 – Output level where
profit level is maximum.X2 – Output level where profit is less than at X1 but sales
are more.
• Sales maximiser sells at price lower than
profit maximiser.

• Firm will not increase its sales beyond X2,

because if profit is less than ∏ SM , It will
not be acceptable to share holder and
other lending Institutions and Managers.
STATIC MODEL WITH ADVERTISMENT
• Assume that sales revenue increases with advertising expenses.
• An Oligopolistic firm will prefer to go for sales maximization via an
increase in advertisement rather than a price cut.
• The sales maximiser decides on optimum advertisement by examining
its impact on sales revenue.
TC – Total cost (CC1+AC), BC – Production cost, TR – Total Revenue, ∏ - Profit (TR-TC), ∏max -
Maximum Profit, ∏SM =Sales maximization profit, A ∏ = Advertisement expenditure
incurred by a profit maximiser, AS = Advertisement expenditure incurred by a sales
maximiser.
• This implies that with increase in advertisement expenditure, total
cost, sales revenue and hence profit, all increase proportionately.
• Production cost shown by BC line is assumed to be independent of
advertising cost.
• If price is such as to enable the firm to sell an output yielding profit
above the minimum acceptable profit level, firms will go for higher
advertisement expenditure and yield greater revenue.
• However, if profit falls below ∏ SM , the firms cost become too high
and firm will cut back on advertisement.
• Thus sales maximiser will spend more on advertisement than a profit
maximiser.
LIMITATIONS OF STATIC MODEL
• Assumption of constant price for all product is not realistic.
• Production cost is assumed to be independent of advertising
expenditure. However with advertisement, the sales increase and
physical volume of output increases leading to economies of sale, a
firm already producing at maximum possible efficiency may face
diseconomies of sale. This will effect the production cost of the firm,
whether it strives for sales maximisation or profit maximisation.
DYNAMIC MODEL OF SALES
MAXIMISATION
• Assumption:-
The objective of the firm is to maximise the rate of growth of sales
revenue over its lifetime. Sales revenue (R) grows at the rate of ‘g’
percent.
Profit is not taken as a given exogenous variable, which acts like a
constraint in the static.
Demand and cost curves have traditional shapes as in the static
model.
• R,R(1+g), R(1+g)2, ----R (1+g)n

The present value of this stream of future revenue is

estimated by discount formula.
2 n
1 g  1 g  1 g 
R, R  
, R  ,    R  
 1  i   1  i   1  i 
Where i is rate of discount. The total present
(discounted) value of all future revenue is
t
n
1 g 
S  R  (n  0,1,2,- - - - n)
t 0  1 i 
S = Future stream of sale
• The growth function is derived from profit function, as
growth of firm is mainly financed by retained profits.
• Highest attainable growth rate is achieved when profit
is maximised.
• To find equilibrium a firm, we will use iso present
value curve, which shows all present value of g & R
which yield same value of S.

S  a1 g  a 2 R
1 a2
g S- R
a1 a1
1 a1
R S g
a2 a2
• Point E in the figure represents the point of tangency of iso present value curve to the growth
curve . Thus firm will choose ge & Re to get the highest possible level of S subject to the
growth constraint.
LIMITATIONS
• It try to explain long run behaviour of sales
maximising firm. However in long run market
demand, prices of factors of production etc. change.
This model does not take these changes into account.
MARRIS MODEL OF MANAGERIAL
ECONOMICS
• Aim – firm’s aim at balanced rate of growth (G)
• This can be achieved by maximization of rate of growth of demand for
the product of firm (GD) and the rate of growth of capital supply (GS)
• To achieve the above growth management faces two types of
constraint on its growth-
Managerial Constraint
Financial constraint
Managerial Constraint
• Decision making and planning skills of the manager

• Co-ordination, cooperation and good team work – this requires

experience

• Research and development

Financial Constraint
• Job security
• Fear of takeover and merger
To avoid these risk, manager should choose a prudent financial policy
consisting of three financial ratios –
Debt equity ratio – value of debts to total assets
Lower the value better it is
Liquidity ratio – total liquid assets to total assets
ratio is too low – risk of insolvency
ratio is too high – risk of take over
Retention ratio – retained profit to total profit
important source of finance for growth of capital, but firms needs
to distribute a part to satisfy the shareholders
Equilibrium of firm
• U managers = f(GD)
• U owners = f(GS)
• Condition of equilibrium is G D = GS = G
Where GD = f(d,k)
and GS = r(∏)
d= diversification / differentiation of product
k= success rate of new product
r= financial security ratio assumed to be constant proportion of profit(∏)
Critical Evaluation
• Marris assumes cost structure and price to be given,
thus profit as given which is not true
• Marris theory does not account for the
interdependence in firm’s decision making
• During industrial slowdown the manager’s aim will be
to retain the existing power in the market rather than a
balanced rate of growth
• During industrial slowdown process firm may not be
doing well not because of managerial inefficiency but
because the overall atmosphere is not conducive to
business
• Marris talks about only two constraint. In real life –
firm face social, cultural, environmental etc
BEHAVIOURAL MODEL
• Behavioral theory view business firm engaging in non- maximizing
behavior. Firm emerges as a satisfier rather than maxi miser.

• Simaon Satisfying Model

• Cyert and March Model
Simon Satisfying Model
• Constraint of incomplete information, imperfect data and uncertainty
about future creates difficulty for managers to get to optimum
decision
• Thus managers look for the second best situation, which is called the
satisfying behavior.
• Thus manager look for satisfactory level of profit rather than profit
maximizing behavior and satisfactory level of cost rather than cost
minimizing behavior.
Critical Evaluation
• Simon assumed that organizational behavior and
individual behavior are comparable.
• Model is not concrete – talks about incomplete
knowledge and information but doesn’t specify the
kind of information
• Model talks about satisfactory level – subjective
concept
Model of Cyert and March
• They have stressed on decision making process of multi product firm
under uncertainty in an imperfect market
• Assumptions –
In a firm there are many groups with conflicting behavior on interest.
One has to develop the goals of various groups
One has to develop the overall environment of the firm
There has to be treatment of uncertainty
Goals of individual group
• Firm is considered to have multi- goal
• Organization comprises of workers, managers, shareholders,
suppliers, customers, bankers, tax collectors each having different
goals.
• To know the goals one needs to know the origin and decision making
process which leads to their formation
 Goal of the firm

Demand of the members of the coalition

Factors such as aspirations of the members, past

achievements, their expectations, the achievements
of other groups in same or other firms, the
information available to them.
• The demand of the different groups are competing for the given
resources of the firm, and there is a continuous conflict
• The relationship between demand (aspirations ) and the past
achievements depends on the performance of the firm and the changes
in the environment
Steady situation – aspirations tend to be equal to past achievements.
Dynamic situation – aspirations lag behind achievements
excess profit / surpluses.
Recession situation - aspirations are larger than past achievements
Goal of the firm
• The main goal set by the firm are –
Production goal
Inventory goal respective dept.
Market share goal
Profit goal top management
Resolution of conflict
• Money payments
• Side payments monetary
• Slack payments
• Sequential hearing to demand
• Decentralizing decision making qualitative
Treatment of uncertainty
• Market uncertainty
Due to - incomplete information about changing
taste & preferences, changes in methods
of production.
Minimize -market survey and R& D
• Uncertainty about competitor’s reaction
Minimize – by forming collusion with rivals
Critical Evaluation
• The model fails to address as to how interdependence of firms will
influence the action taken by top management to solve various
conflicting situations.
• Cyert and March deal with one form of slack i.e. the managerial slack.
Other important forms of organizational slacks were ignored by them.
WILLIAMSON MODEL
• Managers have discretion in pursuing policies which
maximise their utility rather than that of owner
shareholder.
• Profit acts as a constraint to this exercise.
• The utility function includes one measurable variable
namely, salary and other non-measurable ones like
security, power, status, prestige, professional
excellence.
• To formalize the model, one has to take proxy
variables to these non-measurable ones.
WILLIAMSON MODEL
• These proxy variables taken are emoluments of managers or
slack in the form of luxury offices, company car, etc. or the
expenditure which are incurred at the discretion of the
managers. This reflect their power, status, prestige,
professional excellence.
• These remunerations have their own advantage (comparison
to salaries), as the person getting these will get tax benefits.
• Such payments catch less attention from the shareholders and
labour force.
• Also, status & power of managers is associated with the
discretion they have in undertaking investment. Discretionary
investment expenditure gives satisfaction to manager because
it allows them to materialize their personal favorite projects.
WILLIAMSON MODEL
The model can be written as follows:

Um ~f (s,m,i).
s = staff expenditure, including managerial salary.
m = managerial remunerations (slack).
i = discretionary investment.
The aim is to maximize the value of Um.
Critical Evaluation
• Model is valid for large firms where there is scope of product
differentiation an discretionary investment
• This model doesn’t talk about the managerial behavior of firm in
relation to the rival firms and its impact on utility function