ME- Theories of Firm Module 4

8/2/2019 ME- Theories of Firm Module 4

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MODULE 4

Concepts, firm & Industry


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Introduction

An economy is a system of production anddistribution of goods.

This production is carried out by what are knownas business units.

In the field of production, the firmly permanent

and regular groups are plants, firms andindustries.


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P lant or Factory or Establishment

P rof. Sargent Florence defines as a body of persons engaged in production or distribution ata given time and place, housed in contaguous

buildings and controlled by a single firm.

A plant is a Technical UnitWithin Technical Sphere, a P lant enjoys

considerable autonomy. A plant is a body of persons who work at a giventime and place

A plant is controlled by a single firm


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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, in economic theory, undertakes

production to maximise profits.


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Industry

An industry is a group of firms but it is not easyto decide what types of firms should be groupedtogether to make a particular industry.There has to be some common factor among allthe firms that make up an industry.Three such factors can be distinguished

raw material usedproduction techniquesimilarity among the products produces.


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O bjectives of firm

In economic theory, every firm is assumed to be aone-man firm. The entrepreneur is the owner andcontroller of the individual firm.

Thus behavior of the firm is studied as thebehavior of the entrepreneur. He is suppose toact rationally.The assumption of rationality here implies thatthe businessman or the firm strives to seekmaximum money profits.For over a century in economic theory themaximization of profits is regarded as the soleobjective of a rational firm


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O n practical observations, this assumption hasbeen questioned in recent years.In reality it is found that the entrepreneursgenerally do not care to maximise profits, butsimply strive to earn a satisfactory return.Simon, says that instead of profit maximisation;we must adopt the goal of satisfactory profitsFor instance, earning a reputation as a good

businessman by maximisng sales rather thanprofitsSometimes, an appreciation from the public as aquality producer also gives an immensepsychological satisfaction to the entrepreneur.


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Alternative O bjectives

There are a multiple objectives of a business firm:

y P rofitsy Sales maximisationy Increasing market sharey Building good business reputationy Financial stability and liquidityy Maintenance of good labor relationsy Job satisfactiony Leisure and peace of mind


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O ther O bjectives of Firms

Sal es m ax imis a tion:y Attempts to maximise the volume of sales rather than the

revenue gained from themSha re Price M ax imis a tion :

y P ursuing policies aimed at increasing the share priceProfit Sa tisficing:

y G enerating sufficient profits to satisfy shareholders butmaximising the rewards to the managers/board and avoidingattention from rivals or regulatory authorities


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Behavioural O bjectives

Modern firms have to attempt to match competingstakeholder needs:

y Shareholdersy Employeesy Consumersy Suppliersy G overnmenty Local communitiesy Environment


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Behavioural O bjectivesFirms may have to balance out their responsibilities:

y Management rewards bonuses, etc.

y Social and environmental audits

y Employee welfare

y Meeting consumer needs

y P aying suppliers on time

y Satisfying shareholders about its policies, plans and actions


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Theories of the firm

Different firms belonging to the same industry,facing the same market environment , behavedifferently. Thus, the necessity for theories of thefirm.The purpose of the theory of the firm is to providemodels for the analysis of the decision making inthe firm in various market structures.In general, firms strive for profit maximization.The traditional theory of the firm deals with thisaspect.


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P rofit maximising theory (marginalisttheory of the firm)

P rofit is defined as revenues minus costs.

Basic assumptions of the theory

The marginalist theory was developed during1980s by Leon Walrus, W S Jenons and AlfredMarshall.the basic assumptions of this theorycan be listed as follows:

1. The entrepreneur is also the owner of the firm.2. The firm has a single goal, that of profit

maximisation3. This goal is attained by application of the

marginalist principle- MC=MR


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Certainty- full performance, the presentconditions and the future developments in theenvironment of the firm

The firm acts with a certain time horizon whichdepends on various factors such as the rate of

technological progress, the capital intensity of themethods of production, the nature and gestationperiod of the product.


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There are various theories to explain profit-making by firms, the important ones arepresented below:

Innovation theory

Risk-bearing theory

Monopoly theory

Managerial efficiency theory


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P rofit Maximisation

P rofit maximisation 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


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Profit M ax imis a tion Di a gr a mm a tic Represent a tion

Cost/Revenue

Output

MR

MR the additionto total revenue asa result of

producing onemore unit of output the pricereceived fromselling that extraunit.

MC MC T he costof producingONE extra unitof production

100

Assume output is at100 units. T he MC of producing the 100 thunit is 20.

T he MR received fromselling that 100 th unitis 150. T he firm canadd the difference of the cost and therevenue received from

that 100th

unit toprofit (130).20

150

T otaladded

to profit

If the firm decides toproduce one more unit the 101 st the addition

to total cost is now 18,the addition to totalrevenue is 140 the firmwill add 128 to profit itis worth expandingoutput.

101

18

140

Added tototalprofit

30

120

Addedto totalprofit

T he process continuesfor each successiveunit produced.Provided the MC isless than the MR itwill be worthexpanding output asthe differencebetween the two isADDED to total profit.

102

40

145

104103

Reducestotalprofit bythisamount

If the firm were toproduce the 104 th unit,this last unit would costmore to produce than itearns in revenue (-105)this would reduce totalprofit and so would notbe worth producing.

T he profit maximising

output is where MR =MC.


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Revenue Maximisation

Total Revenue

Average Revenue

Marginal Revenue

In this model the policies to achieve revenue maximisation maybe different to those adopted to maximise profits


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Criticism of the theory

The following arguments are put forward to showthat the assumptions of profit maximisation amplyborne out by business behaviour.

Businessmen sometimes assert that it is theirbusiness to look after social welfare, rather thanpersonal gain.

The postulate of profit maximisation certainty

applies to industries and it is the behaviour of theindustry, rather than of an individual firmdetermines the flow of products and demand forinputs.


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Baumols Theory of Sales RevenueMaximization

Baumol argues that it is quite irrational formanagers to maximize profits for shareholders whenthey will hardly get anything themselves.

Sales maximisation will, expand the size of organisation, enhance status of managers as well astheir prospects, result in increase in compensation.Baumol suggested two basic models:

y static single periody multi-period dynamic model

Each model has 2 versions, one withoutadvertisement expenditure and one withadvertisement


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Maximize sales revenue subject to minimumprofit constraint

Why sales revenue and not profits??y Sales are good general indicator of organizational

performancey Executive power, influence, status tend to be linked

to the sales performancey Lenders tend to rely on sales data


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Single product model

Basic assumptions of Static ModelThe firm operates in a single periodDuring this period the firms objective is to

maximize sales revenue (value rather thanvolume of sales)There is profit constraint, minimum profit isdetermined by demands and expectations of shareholdersCost curves are U-shaped and demand curve of the firm has negative slope.


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Under single product firm without advertisementthe firm may maximize total revenue by settingmarginal revenue equal to zero.

Thus a profit maximizing firm flows the principlewhere MR-MC, whereas for a sales revenuemaximisation, MR=0.Under single product firm with advertisement , itis assumed that advertising always increasessales revenue and total costs are independent of advertisement expenses


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Dynamic model

Basic assumptions of multi-period model:The objective of the firm is to maximize the rateof growth of sales revenue over its life cycle.

P rofit is the main means of financing growth of salesDemand and costs have the traditional shape.


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Criticisms of Baumols model

In the long run, both the objectives of salesmaximisation and profit maximisation result insame solution

It does not distinguish between a firm andindustry.It ignores actual competitionIncreased outlay on advertisement will notalways yield desired result of increase in sales.


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Marris model of managerial enterprise

The Marris model of managerial enterprise is based on one of theimportant aspects of the firm i.e. objectives and constraints.

Marris tried to improve upon Baumols model. He offered avariation of Baumols model that stressed the maximization of

growth subject to the security of managements position.It is based on the fact that ownership and control of the firm is inhands of two different set of people.

Also suggested that managers have utility function in which

salary, status, power, prestige are important variables. O wnersof the firm are more concerned about profits, market share,output.etc


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Marriss Theory of G rowth Maximization

Baumol (1962); Marris (1964) and Williamson (1963)suggest that managers may pursue a strategy of maximumgrowth of the firm

G rowth of firm :Max. G rowth at the expense of firmsfuture profit streams.

Managers strive for growth rather than profit max.

G rowth of demand => advertising expenditures; further

price reductions; extensive advertisementsMay be harmful due to:

y Managerial constraint on growthy Financial constraint on growth


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Figure 3.2 Marriss growth maximization model


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As the rate of growth of demand is increased, profitabilityis increased as well until a certain point. Then managerial

constraints on growth tend to take place.

The maximum growth of capital function shows the

relationship between the firms 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 profits.


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Objectives a re dependent upon:

The rate of growth of demand for firms productThe rate of growth of capital supply.

Po l icy v a ri a b l es:

The firm has freedom to choose its financialpolicy.

The firm can decide its diversification rate, eitherby expanding the range of products, or by merelyaffecting a change in the style of its existingrange.


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Po l icy v a ri a b l es:

In Marris model, price is not a policy variable of the firm. It is in fact a parameter.

The firm has freedom to decide the level of itsadvertising and the extent of its research anddevelopment activities.


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Williamsons Model of ManagerialUtility

In the Williamsons model, managers are free topursue their own self interest once they haveachieved a level of profit that will paysatisfactory dividends to shareholders and stillensure growth.The managers self interest depends upon manyother things besides salary.Included in the managerial utility function aresalary, security, power, status, prestige andprofessional excellence.


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Assumptions of the model

Market is non-perfectly competitive.O wnership of the firm and management of thefirm are divorced from each other

A minimum profit constraint is imposed on themanagers by the capital market which cannot beignored by the management


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Framework of the Model

According to Williamson, managers have thediscretion to pursue policies which maximisetheir own utility rather than aiming to maximiseprofits.O f the managerial utility functions only salary ismeasurable others are not.Hence Williamson uses measurable variables likestaff expenditure, managerial emoluments inutility function of managers on the assumptionthat these are the source of the job security andreflect power, prestige, status.


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The utility function of the manager may bewritten as:

U= f (S,M,I D)

Where, S= Staff expenditure including managerialsalaries

M= Managerial emolumentsID= Discretionary investment


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The theory is suitable for large firms where thereis scope for product diversification.For small firm, managerial discretion is limited.

This model does not explain hoe price isdetermined in the market


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BEHAVI O URIAL M O DEL O F THE FIRM(SATISFICIN G THE O RY )

These behaviourial theories visualize that firmsdo not aim to maximize anything, neither profits,nor sales and not even utility.

The approach is that instead of hypothesizingabout how business firms respond to varioussituations or how they should respondIt considers how the firms actually behave, thatis how they really take decisions in practice.These decision relates to price of the product,level of output, sales strategy etc


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C O NTD

The behaviourial model of the firm is based onthe pioneering works of H.A.Simon.He first put forward the view that the firms

instead of maximizing profits, normally satisfice,that is seek to have satisfactory performancewith regards to profit, market shares, sales etc..

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ME- Theories of Firm Module 4