MODULE

4

Concepts, firm & Industry

Introduction

An economy is a system of production and distribution of goods. This production is carried out by what are known as business units. In the field of production, the firmly permanent and regular groups are plants, firms and industries.

Plant or Factory or Establishment

Prof. Sargent Florence defines as ´a body of persons engaged in production or distribution at a given time and place, housed in contaguous buildings and controlled by a single firmµ.

A plant is a Technical Unit Within Technical Sphere, a Plant enjoys considerable autonomy. A plant is a body of persons who work at a given time and place A plant is controlled by a single firm

in economic theory. .Firm A firm may own one or more than one plant A firm exercises a unified control over its plants A firm organises the resources and plans their use A firm may be unitary or federal A firm is a separate legal entity A firm. undertakes production to maximise profits.

There has to be some common factor among all the firms that make up an industry. . Three such factors can be distinguished raw material used production technique similarity among the products produces.Industry An industry is a group of firms but it is not easy to decide what types of firms should be grouped together to make a particular industry.

every firm is assumed to be a one-man firm. Thus behavior of the firm is studied as the behavior of the entrepreneur. The assumption of rationality here implies that the businessman or the firm strives to seek maximum money profits. The entrepreneur is the owner and controller of the individual firm.Objectives of firm In economic theory. For over a century in economic theory the maximization of profits is regarded as the sole objective of a rational firm . He is suppose to act rationally.

Simon. we must adopt the goal of ´satisfactory profitsµ For instance.On practical observations. . an appreciation from the public as a quality producer also gives an immense psychological satisfaction to the entrepreneur. this assumption has been questioned in recent years. In reality it is found that the entrepreneurs generally do not care to maximise profits. but simply strive to earn a satisfactory return. earning a reputation as a good businessman by maximisng sales rather than profits Sometimes. says that instead of profit ¶maximisation·.

Alternative Objectives There are a multiple objectives of a business firm: y y y y y y y y Profits Sales maximisation Increasing market share Building good business reputation Financial stability and liquidity Maintenance of good labor relations Job satisfaction Leisure and peace of mind .

Other Objectives of Firms Sales maximisation: y Attempts to maximise the volume of sales rather than the revenue gained from them Pursuing policies aimed at increasing the share price Generating sufficient profits to satisfy shareholders but maximising the rewards to the managers/board and avoiding attention from rivals or regulatory authorities Share Price Maximisation: y Profit Satisficing: y .

Behavioural Objectives Modern firms have to attempt to match competing stakeholder needs: y y y y y y y Shareholders Employees Consumers Suppliers Government Local communities Environment .

etc. plans and actions .Behavioural Objectives Firms may have to balance out their responsibilities: y y y y y y Management rewards ² bonuses. Social and environmental audits Employee welfare Meeting consumer needs Paying suppliers on time Satisfying shareholders about its policies.

Thus. the necessity for theories of the firm.Theories of the firm Different firms belonging to the same industry. The traditional theory of the firm deals with this aspect. . The purpose of the theory of the firm is to provide models for the analysis of the decision making in the firm in various market structures. behave differently. In general. facing the same market environment . firms strive for profit maximization.

The firm has a single goal. W S Jenons and Alfred Marshall. Basic assumptions of the theory The marginalist theory was developed during 1980·s by Leon Walrus. that of profit maximisation 3. The entrepreneur is also the owner of the firm.Profit maximising theory (marginalist theory of the firm) Profit is defined as revenues minus costs.MC=MR . This goal is attained by application of the marginalist principle.the basic assumptions of this theory can be listed as follows: 1. 2.

. the nature and gestation period of the product. the capital intensity of the methods of production.full performance. Certainty. the present conditions and the future developments in the environment of the firm The firm acts with a certain time horizon which depends on various factors such as the rate of technological progress.

There are various theories to explain profitmaking by firms. the important ones are presented below: Innovation theory Risk-bearing theory Monopoly theory Managerial efficiency theory .

Profit Maximisation Profit maximisation ² assumed to be the standard motive of firms in the private sector Profit maximisation occurs where Marginal Cost = Marginal Revenue MC = MR The firm will continue to increase output up to the point where the cost of producing one extra unit of output = the revenue received from selling that last unit of output This assumes that firms seek to operate at maximum efficiency .

The unit. output is where MR = that 100th unit to MC. profit (130). more to produce unit toProvidedextra than it total cost is nowis producing MC from The in received earns MRrevenue (-105) less than to total the additionthe of th it more unit MR unit of production selling that this output reduce total willwould ± 100 price be worth revenue is 140 ± the firm the can is 150. of addition ± the ONE the one 18. cost this101producing unit result would last unit unit the a isst20. worth expanding sellingand the that extra the between the two is output. Theoutput as firm profit and so from notit expanding to profit ± will add 128 would of received add difference the be worth difference is the cost producing.Profit Maximisation ² Diagrammatic Representation Cost/Revenue 150 145 140 Total added to profit 120 Added to total Added profit to total profit 40 30 20 18 Reduces total profit by this amount Assume output is at MC If100 process addition the firmdecides If The firm the continues the units. produce one revenuethas± ofproduced. MR 104 Output 100 101 102 103 . The totoof MC ± were th MR ± The MC cost produce thethe 100 forto total more unit each successive producing 104 unit. received from profit revenue maximising ADDED to total profit.

Revenue Maximisation Total Revenue Average Revenue Marginal Revenue In this model the policies to achieve revenue maximisation may be different to those adopted to maximise profits .

rather than of an individual firm determines the flow of products and demand for inputs.Criticism of the theory The following arguments are put forward to show that the assumptions of profit maximisation amply borne out by business behaviour. The postulate of profit maximisation certainty applies to industries and it is the behaviour of the industry. . Businessmen sometimes assert that it is their business to look after social welfare. rather than personal gain.

one without advertisement expenditure and one with advertisement . result in increase in compensation. expand the size of organisation.Baumol·s Theory of Sales Revenue Maximization Baumol argues that it is quite irrational for managers to maximize profits for shareholders when they will hardly get anything themselves. Baumol suggested two basic models: y y static single period multi-period dynamic model Each model has 2 versions. enhance status of managers as well as their prospects. Sales maximisation will.

Maximize sales revenue subject to minimum profit constraint Why sales revenue and not profits?? Sales are good general indicator of organizational performance y Executive power. status tend to be linked to the sales performance y Lenders tend to rely on sales data y . influence.

.Single product model Basic assumptions of Static Model The firm operates in a single period During this period the firm·s objective is to maximize sales revenue (value rather than volume of sales) There is profit constraint. minimum profit is determined by demands and expectations of shareholders Cost curves are U-shaped and demand curve of the firm has negative slope.

whereas for a sales revenue maximisation.Under single product firm without advertisement the firm may maximize total revenue by setting marginal revenue equal to zero. MR=0. Under single product firm with advertisement . it is assumed that advertising always increases sales revenue and total costs are independent of advertisement expenses . Thus a profit maximizing firm flows the principle where MR-MC.

. Profit is the main means of financing growth of sales Demand and costs have the traditional shape.Dynamic model Basic assumptions of multi-period model: The objective of the firm is to maximize the rate of growth of sales revenue over its life cycle.

Criticisms of Baumol·s model In the long run. It ignores actual competition Increased outlay on advertisement will not always yield desired result of increase in sales. both the objectives of sales maximisation and profit maximisation result in same solution It does not distinguish between a firm and industry. .

Marris tried to improve upon Baumol·s model. market share.Marris model of managerial enterprise The Marris· model of managerial enterprise is based on one of the important aspects of the firm i. Also suggested that managers have utility function in which salary.etc . He offered a variation of Baumol·s model that stressed the maximization of growth subject to the security of management·s position.e. It is based on the fact that ownership and control of the firm is in hands of two different set of people. prestige are important variables. objectives and constraints. output. status. Owners of the firm are more concerned about profits. power.

extensive advertisements May be harmful due to: y y Managerial constraint on growth Financial constraint on growth . further price reductions. Marris (1964) and Williamson (1963) suggest that managers may pursue a strategy of maximum growth of the firm Growth of firm :Max. Growth of demand => advertising expenditures.Marris·s Theory of Growth Maximization Baumol (1962). Managers strive for growth rather than profit max. Growth at the expense of firms· future profit streams.

2 Marris¶s growth maximization model .Figure 3.

As the rate of growth of demand is increased. The maximum growth of capital function shows the relationship between the firm·s rate of profit and the maximum rate at which the firm is able to increase its capital This model suggests several testable hypothesis one of which is: ´owner controlled firms achieve lower growth and higher profitsµ. Then managerial constraints on growth tend to take place. . profitability is increased as well until a certain point.

either by expanding the range of products. Objectives are dependent upon: The rate of growth of demand for firm·s product The rate of growth of capital supply. . The firm can decide its diversification rate. or by merely affecting a change in the style of its existing range. Policy variables: The firm has freedom to choose its financial policy.

. price is not a policy variable of the firm.Policy variables: In Marris model. It is in fact a parameter. The firm has freedom to decide the level of its advertising and the extent of its research and development activities.

security. prestige and professional excellence. status. The managers self interest depends upon many other things besides salary. managers are free to pursue their own self interest once they have achieved a level of profit that will pay satisfactory dividends to shareholders and still ensure growth. power. .Williamson·s Model of Managerial Utility In the Williamson·s model. Included in the managerial utility function are salary.

Ownership of the firm and management of the firm are divorced from each other A minimum profit constraint is imposed on the managers by the capital market which cannot be ignored by the management .Assumptions of the model Market is non-perfectly competitive.

Hence Williamson uses measurable variables like staff expenditure. managerial emoluments in utility function of managers on the assumption that these are the source of the job security and reflect power. managers have the discretion to pursue policies which maximise their own utility rather than aiming to maximise profits. prestige. status. Of the managerial utility functions only salary is measurable others are not.Framework of the Model According to Williamson. .

S= Staff expenditure including managerial salaries M= Managerial emoluments ID= Discretionary investment .ID) Where.M. The utility function of the manager may be written as: U= f (S.

managerial discretion is limited. This model does not explain hoe price is determined in the market . For small firm.The theory is suitable for large firms where there is scope for product diversification.

These decision relates to price of the product. sales strategy etc« .BEHAVIOURIAL MODEL OF THE FIRM (SATISFICING THEORY) These behaviourial theories visualize that firms do not aim to maximize anything. level of output. neither profits. that is how they really take decisions in practice. nor sales and not even utility. The approach is that instead of hypothesizing about how business firms respond to various situations or how they should respond It considers how the firms actually behave.

A. sales etc. normally satisfice. that is seek to have satisfactory performance with regards to profit.Simon. He first put forward the view that the firms instead of maximizing profits..CONTD« The behaviourial model of the firm is based on the pioneering works of H. market shares. .

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