THEORY OF FIRM

WHAT IS A FIRM?
• An organization that combines and organizes resources
for the purpose of producing goods and services for
sale.

• Different types include:

▫ Propriertorships
▫ Partnerships
▫ Corporations

▫ 70 % of goods and services consumed in India held by

firms
 REASONS FOR EXISTENCE OF FIRMS

• Reduction in transaction costs by entering into

long- term broader contracts.
• Internalizing transactions saves on sales taxes
and other government regulations.
• Limited sizes in firms become possible.

▫ Due to management’s ability to control.

▫ Due to possibility of distancing of top management
from operational activities.
▫ Cost of providing services > cost of purchasing them.
FUNCTIONS OF FIRMS
Circular flow of Economic activity:

• Purchase
Resource owners
resources and then use the income
transform them generated from sale
of their resources to Employment to
workers. Taxes
into goods and buy the goods and
services provided by
services for the firm.

sale.
 OBJECTIVE AND VALUE OF FIRM
• OBJECTIVE: To maximize wealth and value of the FIRM.

• VALUE OF THE FIRM:

▫ Present value of all expected future profits of the firm.
▫ Future profits must be discounted to the present.
▫ Mathematically,

PV =

∏-expected profit in each on the n years.

r – rate used to find present values of the future profits.
 VALUE OF FIRM
 
Now,

PROFITS = TOTAL REVENUE(TR) – TOTAL COST(TC)

Value of the firm =

Total Revenue (TR) - depends on sales and firms pricing decisions.

Total Cost (TC) - depends on technology of production and resource prices.
r depends on perceived risk of the firm and cost of borrowing funds.
 CONSTRAINTS ON OPERATION OF FIRM

• Unable to hire as many skilled workers especially in

short run.
• Unable to acquire all the specific raw materials in
demands.
• Limitations on factory and warehouse space.

• Legal constraints.
 LIMITATIONS OF THEORY OF FIRM

• The objective is criticized to be too narrow and

unrealistic.

 SALES MAXIMIZATION MODEL: By William Baumol

▫ Maximum sales after adequate rate of profit have been

earned to satisfy stockholders.
 LIMITATIONS OF THEORY OF FIRM

 MODEL OF MANAGEMENT UTILITY: By Oliver Williamson.

• Principal – agent problem: Manager(agent) is more interested in maximizing

his or her benefits than maximizing the owner’s(principal) benefit.

 SATISFICING BEHAVIOR: By Richard Cyert & James March and Herbert

Simon.

• Managers unable to maximize profits but strive only for satisfactory goals .
THANK YOU !!