Theory of the Firm 2003

7/30/2019 Theory of the Firm 2003

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THE THEORY OF THE FIRM

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Although managerial economics is not concerned solely with the

management of business firms, this is its principal field of application. Toapply managerial economics to business management, we need a theory of

the firm, a theory indicating how firms behave and what their goals are.

The concept of the firm plays a central role in the theory and practice of

managerial economics. An understanding of the reason for the existence of

firms, their specific role in the economy, and their objective provides a

background for that theory.


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Reasons for the Existence of Firms and Their Functions

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Firm exist because it would be very inefficient and costly for entrepreneurs to

enter into and enforce contracts with workers and owners of capital, land,

and other resources for each separate step of the production and distribution

process.

Firms often hire labour for long periods of time under agreements that

specify only that a wage rate per hour or day will be paid for the workers

doing what they are asked. The two parties do not have to negotiate a new

contract every time the worker is given a new assignment.

The saving of the transactions costs associated with such negotiations is

advantageous to both parties.

A firm is an organization that combines and organizes resources for thepurpose of producing goods and/or services for sale.



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A second explanation for the existence of firms is that some governmentinterference in the market-place applies to transactions among firms rather

than within firms.

For example, sales taxes usually apply only to transactions between one firm

and another.

By internalizing some transactions within the firm that would otherwise be

subject to those interferences, production costs are reduced.

Because this is a secondary factor, firms would exist in the absence of such

interference, but it probably contributes to the existence of more and larger

firms.

Given that production costs are reduced by organizing production factors

into firms, why wont this process continue until there is one large firm?




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There are at least two reasons: why wont the process continue until thereis one large firm?

First, the cost of organizing transactions within the firms tends to rise as the

firm gets larger. At some point, these internal transactions costs will equal

the cost of transacting in the market. At that point, the firm will cease to

grow.

A second factor constraining firm size is the limitation of an managements

ability to effectively control and direct the operation of the firm as it

becomes larger and larger.

Both of these reasons for a limit on the size of the firm fall under the

heading of what economists have termed diminishing returns to

management. Stated another way, production costs per unit of output will

tend to rise as firms grow larger, because of limited managerial ability.




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The Objective of the Firm

To be able to discuss efficient or optimal decision making requires that a

goal or objective be established. That is, a management decision can only

be evaluated against the goal that the firm is attempting to achieve.

Originally, the theory of the firm was based on the assumption that thegoal of the firm was to maximize current or short-run profits. Firms,

however, are often observed to sacrifice short-term profits for the sake of

increasing future or long-term profits.

Since both short-term as well as long-term profits are clearly important,

the theory of the firm now suggests that the primary goal of the firm is to

maximize the wealth or value of the firm.



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The Objective of the Firm (contd.)

Put briefly, a firms value will be defined here as the present value of its

expected future cash follows. For present purpose, we can regard a firms

cash flow as being the same as its profit.

Thus, expressed as an equation, the value of the firm equals

=

= + ... +

(1)

Present value of

expected profits

Where is the expected profit in the year t, iis the appropriate discount

rate used to find the present value of future profits, and t goes from 1

(next year) to n (the last year in the planning horizon).



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Because profit equals total revenue (TR) minus total cost (TC), this

equation can also be expressed as

Present value of

expected profits= (2)

Where is the firms total revenue in year t, and

is its total cost in year t.

To repeat, managerial economists generally assume that firms want to

maximize their value, as defined in equations (1) and (2).

However, this does not mean that a firm has complete control over its

value, and that it can set it at any level it chooses. On the contrary, firms

must cope with the fact that there are many constraints on what they can

achieve.



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The constraints that limit the extent to which a firms value can be

increased are of various kinds as given below:

i. Input Constraints: - The amount of certain types of inputs may be

limited. In the relevant period of time, the firm may be unable to obtain

more than a particular amount of specialized equipment, skilled labour,

essential materials, or other inputs.

ii. Legal Constraints: - Another important type of constraint that limits

what firms can do is legal in nature. A wide variety of laws (ranging from

environmental laws to antitrust laws to tax laws) limit what firms can do,

and the contracts and other legal agreement made by firms further

constrain their actions.

As indicated in figure given below, these constraints limit how much

profit a firm can make, as well as the value of the firm itself.



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Value of Firm

Input, legal and

other constraints

The value ofidepends on:

1 Riskiness of firm

2 Conditions in capital

market

The value of depends on:

1 Demand and forecasting

2 Pricing

3 New product development

The value of depends on:

1 Production Techniques

2 Cost of Production

3 Process Development



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Limitations of the Theory of the Firm

The theory of the firm, which postulates that the goal or objective of

the firm is to maximize wealth or the value of the firm, has been

criticized as being much narrow and unrealistic.

In its place, broader theories of the firm have been proposed. The

most prominent among these are models that postulate that the

primary objective of the firm is the maximization of sales, the

maximization of management utility, and satisficing behaviour.


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Sales Maximization Model


According to the sales-maximization model introduced by William Baumol

and others, managers of modern corporations seek to maximize sales after

an adequate rate of profit has been earned to satisfy stockholders.

Baumol argued that a larger firm may feel more secure, may be able to getbetter deals in the purchase of inputs and lower rates in borrowing money,

and may have a better image with consumers, employees, and suppliers.

Indeed, some early empirical studies found a strong correlation betweenexecutives salaries and sales, but not between salaries and profits. More

recent studies, however, found the opposite.


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Williamsons Model of Managerial Discretion

The managerial theory of firm developed by Oliver E. Williamson states that

managers apply discretion in making and implementing policies to

maximize their own utility rather than trying for the maximization of profit

which ultimately maximizes the utility of owner shareholders. This is known

as the management utility maximization.

It postulates that with the advent of the modern corporation and the

resulting separation of management from ownership, managers are more

interested in maximizing their utility, measured in terms their compensation

(salaries, fringe benefits, stock options, etc.), the size of their staff, the

extent of control over the corporation, lavish offices, etc., than in

maximizing corporate profits.

This is referred to as the principal-agent problem. That is, the agent

(manager) may be more interested in maximizing his or her benefits than

maximizing the principals (the owners) interest.


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Theory of Satisficing

The advocates of satisficing theory say that firms goal should be satisficing

rather than optimizing. Satisficing means acceptance of less than the best.

They argue that the behavior of real-world managers is not always

consistent with the profit-maximization goal.

Because of the great complexity of running the large modern corporation a

task often complicated by uncertainty and a lack of adequate data

managers are not able to maximize profits but can only strive for some

satisfactory goal in terms of sales, profits, growth, market share, and so on.

Simon called this satisficing behaviour. That is, the large corporation is a

satisficing, rather than a maximizing organization.


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Cyert and Marchs Behavioral Theory

Cyert and March opined that a large-scale corporate type of firm exists these

days. Hence, entrepreneur cannot alone be a decision maker. The decision-

making involves a complex group or organization. It consists of various

individuals whose interest may conflict with each other.

The group is called organizational coalition and includes managers,

stockholders, workers, consumers and so on. All of these individuals participate

in setting the goals of an organization.

Unlike conventional theory of single goal, behavioral theory states that an

organization has multiple goals. The real world firm generally possesses the

following five goals:

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Cyert and Marchs Behavioral Theory (contd.)

1. Production Goal: According to this goal, production should notfluctuate too much nor fall below an acceptable level. Because this

ensures stable employment, maintenance of adequate cost performance

and growth, the workers and those in production department have this

goal.

2. Inventory Goal: This goal originates mainly from the inventory

department, or from the sales and production departments. The sales

department needs enough stock of output for the customers, while the

production department requires adequate stocks of raw materials and

other items necessary for a uniform flow of the output.

3. Sales Goal: The sales goal is simply an aspirations with respect to the

level of sales. Particularly, this goal arises from salesmen, since their

success depends on their ability to maintain or expand the sales.


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4. Market-share Goal: This goal is an alternative to the sales goal andarises from the sales department. This department decides on the

advertising campaigns, the market research programmes, and so on.

5. Profit Goal: This goal is set by the top management in order to satisfy

the demands of shareholders and the expectations of bankers; and alsoto generate funds with which they can achieve their own goals and

projects, or satisfy the other goals of the firm.


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While making decisions, firms are guided by these five goals. The conflictamong different goals may come up. For example, sales goal may require

a lower price whereas the profit goal a higher price. Sales and production

goal may require high inventories whereas profit goal may require low

inventories. Such conflicts among coalition members are resolved within

the firm as a result of persuasion and accommodation of each others

viewpoint.

The firm in the behavioral theories seeks to satisficeoverall performance,

rather than maximize profits, sales or other magnitudes. The firm is a

satisficing organization rather than a maximizing entrepreneur. The top

management, accountable for the coordination of the activities of the

various members of the firm, want:


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to attain a satisfactory level of production,

to attain a satisfactoryshare of the market,

to earn a satisfactory level of profit

to divert a satisfactory percentage of their total receipts to research

and development or to advertising,

to acquire a satisfactory public image, and so on.

But, it is not clear in the behavioral theories what is a satisfactory and

what an unsatisfactory attainment is.

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Means for the Resolution of Conflicts:

The top management uses different methods to resolve the

conflicts within the firm. The means for the resolution of conflicts are:

delegation of authority,

budget determination, monetary payments like wages, salary and dividend,

side payment given to the scientist of research department in addition to

regular salary,

slack payments it is defined as payments to the various groups of thecoalition above than the payments required for efficient working of the

firm.

fulfilling demand according priority,

decentralization of decision-making.

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THE CONCEPT OF ECONOMIC PROFIT

Practically all published profit figures are based on the accountants

definition of profits. This notion of profit is relatively straightforward: Profit

is defined as total revenue minus explicit costs. This is known as accounting

profit.

When economists speak of profit, they mean profit after taking account

foregone incomes - interest, salary and rent of the resources owned and

used by entrepreneur of which there is no direct payment. They are

included in implicit cost. The implicit cost means opportunity cost.

The profit arrived at by deducting imputed costs from accounting profit can

be called as economic profit.

Economic profit = Accounting profit Imputed cost (Implicit cost).

Following example makes clear the underlying difference between these

two concepts accounting and economic profit.


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Robin Singh, a SMC graduate, has planned to invest Rs 2, 00, 000, which he has

kept in a bank at 5% interest rate, in a poultry firm in Gitanagar in own land. The

accountant prepares such income statement for one year:


The use of this concept may lead to wrong decision. The firm making profit from

accounting viewpoint may have been incurring loss from economic viewpoint.

Hence, only the concept of economic profit is relevant in decision-making.

The implicit cost considered by the economist is related to the opportunities

foregone. Hence such costs should be included for rational decision-making. Three

important implicit costs in above example are:

Sales Rs. 50,000

Less: Cost of goods sold Rs. 20,000

Gross profit Rs. 30,000

Less: Advertising Rs. 1,000

Depreciation Rs. 1,000Utilities Rs. 1,000Miscellaneous expenses Rs. 2,000 Rs. 5,000

Net accounting profit Rs. 25,000


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a. The investment of Rs. 2, 00,000 investment would return Rs. 10,000

annually @ 5% interest rate. Thus, Rs. 10, 000 should be considered as theimplicit or opportunity cost of having the Rs. 2, 00,000 invested in the

poultry firm.


b. Second implicit cost is the management's time and talent. If the annual

wage return of Robin is Rs 90, 000. This is the implicit cost of managing

this business rather than working for someone else.

c. Forgone annual rent is Rs. 24, 000 of the house owned and used by

Robin.

Hence, the above income statement should be amended in the following

way in order to determine economic profit:


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Net economicprofit Rs. (-) 99, 000

Sales Rs. 50,000

Less: Cost of goods sold Rs. 20,000

Gross profit Rs. 30,000

Less: Advertising Rs. 1,000

Depreciation Rs. 1,000

Utilities Rs. 1,000

Miscellaneous expenses Rs. 2,000 Rs. 5,000Net accounting profit Rs. 25,000

Return on invested capital Rs. 10, 000

Foregone wages Rs. 90, 000

Foregone rent Rs. 24, 000 Rs. 1, 24,000

Less: Implicit costs:

From this broader prospective, the business is projected to lose Rs. 99, 000 in

the first year. The Rs. 25, 000 accounting profit disappears when all relevant

costs are included.

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Theory of the Firm 2003