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Objectives of a firm. Traditional, Managerial and Behavioral theories of the firm.
Theory of a Firm
• Definition : A collection of resources that is transformed into products demanded by consumers. • The firm buys and coordinates the services of production factors such as land, labour and capital along with its organization for producing a commodity and sells it in the market to the households. • Firm controlled by entrepreneur who takes major decisions like: – What to produce? – Where to produce? – How and how much to produce? – Whom to sell and at what price?
– Same type of products – substitutes – Use common raw materials – Use similar processes. .Industry • It is a set of firms producing homogenous goods and is spread over a wide region. – Have similar trade and services policies. • Noticeable traits /characteristics are: – An industry produces homogenous products.
Objectives of a Firm • • • • • • • • Profit Maximization Sales Maximization Increasing Market Shares Building Good business Reputation Financial Stability and Liquidity Maintenance of Good Labour Relations Job Satisfaction Leisure and Peace of mind. .
Principal-Agent Problem by Oliver Williamson. . • The behavioral Theories or Models Satisficing Behavior also known as Behavioral Approach by Richard Cyert and James G March.Theories of the Firm • The Profit Maximization Model Total Revenue and Total Cost Approach Marginal Revenue and Marginal Cost Approach • • • • The Theory of Value or Wealth Maximization The Economist Theory of the Firm Growth Maximizing Model of Robin Marris The Managerial Theories or Models Maximization of sales (Managerial Theory of Firm) by William Baumol The Maximization of Management Utility.
TC • P= TR. – Variable – changes with the level of OP • To obtain the profit minimizing OP quantity we start by recognizing that profit is equal to TR.TC . it aims at maximization of the profits. • For equilibrium of a firm. • Two costs are incurred by a firm – – Fixed (at any or even zero level of OP – Maintenance). • The best decision is the one that produces result most consistent with managerial objectives. • Optimization is a process by which a firm determines the output level at which it maximizes the total profits when alternate courses of action are available.Profit Maximization by TR and TC Approach • PM implies earning highest possible amount of profits.
•Coz Profit = TR. •Thus. the price at which the quantity demanded equals profit maximizing OP. the tangent on the TC curve is parallel to the TR curve. the line segment CB= the length of line segment AQ.TC.e. •An entrepreneur aims at maximizing profits i. . the firm would not be interested either to expand or contract its Output.Two Graphical Ways of determining Q is optimal •Profit curve is at Max at point A •At B. it is the optimum price to sell the product. the surplus of revenue net of cost (B. TR>TC. •For comparing demand. it is supernormal profits.C) is the greatest.
Profit Maximization by TR and TC Approach TC C TR B A O Q TFC Qt/ Period of time Profit .
Behavioral Rule of Profit Maximization by MC-MR Approach Market Price /unit 10 10 10 10 Units of OP sold (Q) 0 1 2 3 TR=PQ TC Profit/Loss = TR-TC -10 -6 0 9 MR MC 0 10 20 30 10 16 20 21 10 10 10 10 0 >6 >4 >1 10 10 10 10 10 4 5 6 7 8 40 50 60 70 80 22 25 30 37 47 18 25 30 33 33 10 10 10 10 10 >1 >3 >5 >7 =10 10 10 9 10 90 100 61 81 29 19 10 10 >14 >20 .
e TC/ Q = MC.e. slope of TR curve i.e. •Uses price as explicit variable. Profit Maximizing condition is the rate of OP at which the difference between TR and TC is the greatest or at a point at which MR= MC. the slope of TR = slope of TC curve. Hence. Means MR= MC. the slope of TC i. instead of TR and TC.MC-MR Approach •Informative method to determine a firm’s equilibrium OP is the comparison of MC and MR at each successive unit of OP. . i. •MC: MR = TC: TR •Acc to TR:TC at Profit Maximizing level of OP. TR/ Q is MR .
firm will go on expanding its OP as long as every +nal unit produced adds more to its total revenues that what it adds to costs. •i.Observations •MR= MC is the condition of PM OP as well as the equilibrium of the firm. •It will not produce if TC > TR coz it would be loss. .e. not less than or more would be produced coz total residua profits would be less than Maximum. •Firm expands till MR= MC.
Profit Maximization A P T F E S G MC MR O Q1 Q Q2 .
then MC > MR = loss i. •At point E. •At E.e. •Area lying under MR curve measures the TR of the OP and the area underlying the MC curve measures TC. •Thus MR= MC is maximum profit position.e. MC=MR when OP= OQ. •If OP is less. till OQ1. then increase OP further . area EST. •If the firm increases OP to OQ2. Total profits added would be the area FGE as MR>MC. i.Profit Maximization MR=MC curve •MC= MC Curve •MC intersects MR from below at point E. •Hence the firm reduces OP to OQ. •OQ is the equilibrium OP with Max profits. but the theory is logical. the profit area. .e. •Though firm in actual is not aware of this. MC = MR. •Difference between TR and TC is AGEF. profit is maximized. i.
SOCIETY SUPPLIERS INVESTORS FIRM MANAGEMENT EMPLOYEES CUSTOMERS . • Today. a business enterprise represents a series of contractual relationships that specify the rights and responsibilities of various parties and thought to have PM as it goal. the emphasis on profits has been broadened to encompass uncertainty and the time value of money.Theory of Value or Wealth Maximization • At simplest level. In this more complete model primary goal is long term expected values maximization. • This mode of business is called the economist theory of the firm.
discounted back to the present at an appropriate interest rate. Coz ╥ (profits) = TR-TC. then Value = N∑ t= 1 TRt-TCt (1 + I ) t . i= appropriate interest or discount rate. N ∑ = add together as ‘t’ goes from 1 to n t=1 the values of the term on the right . ╥1 etc = expected profits in each =N ∑ ╥1 t= 1 t (1 + I ) year (t). the value of the form today. Model can be expressed as Value of Firm = Present value of Expected Future Profits = ╥1 (1 + I ) t ╥1 . or its present value is the value of expected profits or cash flows.Theory of Value or Wealth Maximization The value of the firm is the present value of the firm’s expected future net cash flows. If cash flows = profits.
. Finance (discount factor – capital – i) in denominator. HR. • An important concept in ME is that managerial decisions should be analyzed in terms of their effects on value as expressed in the above formula.• This equation can be used to examine how the expected value maximization model relates to a firm’s various functional departments like sales (TR).e. laws and regulations (constrained optimization) i. maximization of wealth or value of the firm subject to constraints it faces. etc.. Production (TC). accounting. • Also. contractual obligations. managerial decisions are made in the light of constraints imposed by technology resource scarcity.
• According to this theory.The Economist Theory of the Firm • A firm is a producing unit which transforms all kinds of inputs into outputs i. .e. producing goods and services as per consumers demand and expects profits. • It is a legal entity on the basis of ownership and contractual relationship organized for production and business concerns etc. a traditional firm is a group with a particular organizational and management structure having command over its own property rights.
run and managed by an owner. – Can direct and dictate suppliers – Can change the nature of the management – Can take final decisions .The Economist Theory of the Firm • The firm is formed. employer or a entrepreneur which has the following characteristics. – He has the legal permission to run the enterprise. – Can enter into contract with any productive resources supplier – Takes his own decisions to maximize his economic gains – Entitled to enjoy residual income – Can transfer rights and obligations to others on contracts.
The Economist Theory of the Firm • All the above to ensure wealth creation and surplus creation. • The traditional or classical theory of firm aims at profit maximization and over the years this objective has been replaced by profit optimization. At this point the firm is maximizing profits. Thus it reaches the equilibrium position where TR= TC or MR=MC. . • Surplus generation is possible when the firms produces maximum output with minimum costs by working out the most ideal factor combinations.
Broader theories or models postulate that primary objective of the firm is: – Growth Maximization Model . – Satisficing Behavior also known as Behavioral Approach by Richard Cyert and James G March.Limitations or Other Theories Postulated • The Traditional/Classical theories of Firm are criticized as being very narrow and unrealistic. – Maximization of sales (Managerial Theory of Firm) by William Baumol – The Maximization of Management Utility or Managerial Discretionary Theory. .Principal-Agent Problem by Oliver Williamson.Robin Marris.
• Ownership and control in the hands of two groups of people . – Uo = f(size of OP. public esteem.) – Um=f(salaries. volume of profit.Growth Maximization Model . capital. status. job security. market share. power.Robin Marris • A firm has to maximize its balanced growth rate over a period of time.) . • Both have two distinct utilities. prestige. etc. etc.owners and managers.
• Two variables affect the Maximum Growth Rate: – The rate of demand for the products= Gd)(diversification rate and Average profit margin) – Growth rate of capital = Gc .(issuing new shares or generation of more internal surplus) Equilibrium position = Gd + Gc .Robin Marris • Managers aim at maximizing the rate of the firm rather than growth in absolute size of the firm as this increases the promotional opportunities of managers and shareholders.Growth Maximization Model .
• According to this. But more recent studies have found the opposite. • A strong correlation exists between executive’s salaries and sales but not between salaries and profits.Maximization of Sales (Managerial Theory of Firm) by William Baumol 1. Managers of modern corporations seek to maximize sales after an adequate rate of profit has been earned to satisfy share/stock holders. Static Model ( applicable for a particular time period aiming at sales revenue subject to a minimum profit constraint) 2. . Dynamic Model (Impact of advertisement expenditure on sales in the long run).
managers are more interested in maximizing their utility.Principal-Agent Problem • This theory postulates that with the advent of the modern corporation and the resulting separation of management form ownership. Id) – S= Additional Expenditure of staff – M= Managerial Emoluments – Id= Discretionary Investment • This problem is referred to as Principal-Agent Problem. size of the staff. M. • Managers’ utility function U= f(S. • Such managers might be replaced by stockholders of corporation or might be merged to utilize unexploited profit potential of the firm. lavish offices etc. • It can be resolved by tying the managers salary/reward to firm’s performance in relation to other firms in the same industry.The Maximization of Management Utility or Managerial Discretionary Theory. extent of control over the corporation. . than maximizing corporate profits. measured in terms of their compensation.
.Satisficing Behavior /Behavioral Approach by Richard Cyert and James G March. There is an organizational slack. • Explains how decisions are taken within the firm. coz different individuals and groups within it have their own aspirations and conflicting interests and the firm behavior is the weighted outcome of these conflicts.e. • Cyert and March argued that a firm cant be regarded as a monolith. • Thus individuals and groups tend to satisfice –i. rather than maximize a utility or profit function. to attempt to attain realistic goals. • Organizational mechanisms (satisficing and sequential Decision Making) exist to maintain conflicts at levels that are not unacceptably detrimental compared to ideal state of production efficiency. • People posses limited cognitive ability and so can exercise only bounded rationality when making decisions in complex and uncertain situations.
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