Theory of the Firm by V64xsRZ9


									Theory of
the Firm
 In developing the supply
and demand approach to
  economics, economists
first worked out the basis
   of the demand curve.
   As a first step, we need to think
    about the decision-makers in
 supplying goods and services, and
    what a "rational decision"
to supply goods and services would
  mean. In economics, this is often
 called the "Theory of the Firm."
 A proprietorship (or proprietary
 business) is a business owned
by an individual, the "proprietor."
  Many "Mom and Pop stores" -
    and other "Mom and Pop"
 businesses, as Americans call
   them - are proprietorships.
A partnership is a business
jointly owned by two or more
persons. In most
partnerships, each partner is
legally liable for debts and
agreements made by any
A corporation has two
characteristics that distinguish
it from most proprietorships
and partnerships:

Limited liability
Anonymous ownership
Traditional Theory
   of the Firm

 This assumes that
firms aim simply to
 maximise profits.
Traditional Theory
   of the Firm
The classical theory of the firm
 relied heavily on the notion that
 firms are small, owner-managed
 organisations, such as
 proprietorships, operating in highly
 competitive markets whose
 demand functions are given and
 where only normal profits can be
Traditional Theory
   of the Firm
   If the firm did not
  therefore maximise
 profits it would fail to
  survive under these
Traditional Theory
   of the Firm
There are two main objections
to this notion:
1. The model of a profit-maximising
   firm is an owner-managed firm
   producing only one good, which
   knows all future cost and revenue
   streams with certainty.
Traditional Theory
   of the Firm
Such a firm could indeed choose the
levels of output and price that would
maximise its profits.

But, in fact, firms are faced with
much more complex decisions,
to be taken in a dynamic and
uncertain environment, and in
this case it is far less clear how
a profit-maximising firm will behave.
  Traditional Theory
     of the Firm
2. Firms may be aiming to do something
   completely different; for example to
   maximise sales or growth.

  Such an objection may well apply to
   modern joint-stock companies or to
   any other company that is not
   managed by its owners.
What does a supplier
The operations of the firm will, of
course, depend on its objectives.
One objective that all three kinds
of firms share is profits, and it
seems that profits are the
primary objective in most cases.
 What does a supplier
There are two reasons for this

1. First, despite the growing importance
   of nonprofit organizations and the
   frequent calls for corporate social
   responsibility, profits still seem to be
   the most important single objective of
   producers in our market economy.
What does a supplier
2. Second, a good deal of the
   controversy in the
   reasonable dialog of
   economics has centered
   on the implications of
   profit motivation.
Profit is defined as revenue
minus cost, that is, the price of
output times the quantity sold
(revenue) minus the cost of
producing that quantity of
However, we need to be a little
careful in interpreting that.
Remember, economists
understand cost as
opportunity cost –
the value of the opportunity given
up. Thus, when we say that
businesses maximize profit, it is
important to include all costs --
whether they are expressed in
money terms or not.
Because accountants traditionally
considered only money costs, the
net of money revenue minus money
cost is called "accounting profit."
(Actually, modern accountants are
well aware of opportunity cost and
use the concept for specific
The economist's
concept is
sometimes called
"economic profit."
The John Bates Clark
Like any other unit, a firm is
limited by the technology
available. Thus, it can increase
its outputs only by increasing
its inputs. As usual, this will be
expressed by a production
The John Bates Clark
 The output the firm can
 produce will depend on
   the land, labour and
 capital the firm puts to
The John Bates Clark
In formulating the Neoclassical
 theory of the firm, John Bates
  Clark took over the classical
 categories of land, labour and
 capital and simplified them in
            two ways.
The John Bates Clark
1. First, he assumed that
   all labour is
   homogenous -- one
   labour hour is a perfect
   substitute for any other
   labour hour.
The John Bates Clark
2. Second, he ignored the
  distinction between land and
  capital, grouping together both
  kinds of nonhuman inputs
  under the general term
  "capital." And he assumed that
  this broadened "capital" is
The John Bates Clark
Some inputs can be varied
flexibly in a relatively short
period of time.
We conventionally think of
labour and raw materials as
"variable inputs" in this sense.
The John Bates Clark
Other inputs require a
commitment over a longer
period of time. Capital goods
are thought of as "fixed
inputs" in this sense.
 More Simplifying
The John Bates Clark model of the
firm is already pretty simple.
We are thinking of a business that
just uses two inputs, homogenous
labour and homogenous capital, and
produces a single homogenous kind
of output.
 More Simplifying
The output could be a
product or service, but in any
case it is measured in
physical (not money) units
such as bushels of wheat,
tons of steel or minutes of
local telephone calls.
     More Simplifying
  We will add two more
  simplifying assumptions:
The price of output is a given
The wage (the price of labour
 per labour hour) is a given
The Firm's Decision
In the short run, then, there
are only two things that are
not given in the John Bates
Clark model of the firm.
They are the output produced
and the labour (variable)
The Firm's Decision

And that is not actually two
decisions, but just one,
since labour input and
output are linked by the
"production function."
The Firm's Decision
the output is decided, and the labour
input will have to be just enough to
produce that output
the labour input is decided, and the
output is whatever that quantity of
labour can produce.
The Firm's Decision
     Thus, the firm's
 objective is to choose
  the labour input and
 corresponding output
that will maximize profit.
Labour Input and Profits
 Problems with Profit
Returning to the concept of
Profit Maximisation
we'll now take a closer look
at the problems associated
with it and, perhaps more
importantly, its alternatives.
Problems with Profit
Firstly the problems,
the existence of
the complexity of large
 1. Uncertainty
The Profit maximising model is
 a static one in which the firm
  knows its revenue and cost
   curves with certainty and
maximises profits by equating
  marginal cost and marginal
 1. Uncertainty
   In practice firms make
   decisions in a dynamic
context. Therefore, revenue
 and cost calculations must
    take into account the
     dimension of time.
 1. Uncertainty
  Future cost and revenue
streams must be discounted
   to yield the Net Present
Value (NPV) associated with
    each course of action.
1. Uncertainty

  Profit maximisation
 means choosing the
course of action which
yields the highest NPV.
Net Present Value
     n      pi
     i=1                 (1 + r)i

Where   p i = Ri - C i
         r = discount rate
         n = time horizon
  With uncertainty
(NPV) =       S            E(pi)
             i=1          (1 + r)i
(NPV) =       S            pi p(Hi)
             i=1            (1 + r)i

Where p(Hi) = probability attached to
              each value that profits may
              take in year i
         Risk Minimisation v.
         Profit Maximisation
      Policy A                        Policy B
Profit              Prob        Profit               Prob
0                   0.25        0                    0.50
40                  0.50        100                  0.50
100                 0.25

A = 0 x 0.25 + 40 x 0.5 + 100   B = 0 x 0.50 + 100
    x 0.25 = 45                     x 0.50 = 50

But 50% probability of zero profits with policy B.
   2. Organisational
The owners of the modern firm are a
 large number of share-holders, who
 have nothing to do with the running
of the firm, while the main decisions
are made by the board of directors of
      the firm and implemented by
managers and workers all through the
  different levels and departments of
                 the firm.
 2. Organisational
This has two main implications
for the profit maximisation
1. even if managers do
   wish to maximise profits,
   this objective will often
   be difficult to achieve in
   a modern firm;
  2. Organisational
2. the managers who take
   the decisions may be
   interested not in
   maximising profits but
   in some other goal.
Baumol’s Static Sales Revenue Maximising
Model without Advertising
    TR                                 TC

                                   p max
      0                                             Q
                                Qs revenue max
                         Qp constraint
Dr J. R Anchor, HUBS
                       Qp max
  Alternatives to
Profit Maximisation
 Baumol's Theory
 of Sales Revenue
 Baumol's Theory of Sales
  Revenue Maximisation
Two basic models:
static single-period model;
multi-period dynamic
 growth model.

 Each model can include advertising
          activity or not.
1. Rationalisation of the Sales
  Maximisation Hypothesis

     - There is evidence that salaries and other
       (Mach) earnings of top managers are
       correlated more closely with sales than
       with profits.
     - Banks and other institutions, which keep a
       close eye on the sales of firms, are more
       willing to finance firms with large and
       growing sales.
      1. Rationalisation of the Sales
        Maximisation Hypothesis
- Personnel problems are handled more
  satisfactorily when sales are growing.
  Employees of all levels can be given
  higher earnings and better terms of
  work in general. Declining sales make
  the converse and lay-offs more likely.
- Large sales, growing overtime, give
  prestige to managers; large profits go
  into the pockets of shareholders.
1. Rationalisation of the Sales
  Maximisation Hypothesis
- Managers prefer a steady performance with
  satisfactory profits to spectacular profit
  maximisation projects. If they realise high
  profits in one period, they might find
  themselves in trouble in other periods when
  profits are less than maximum.
- Large, growing sales strengthen the power to
  adopt competitive tactics, while a low or
  declining share of the market weakens the
  competitive position of the firm and its
  bargaining power vis-à-vis its rivals.
 1. Rationalisation of the
    Sales Maximisation
The implication of
Baumol’s model is that
risk avoidance has a
statistical effect upon
economic activities, eg.
R&D in large firms.
 2. Baumol’s Static
The basic assumptions of the
       static models:
- The time-horizon of a firm is a
  single period.
- During this period the firm
  attempts to maximise its total
  sales revenue (not physical
  volume of output) subject to a
  profit constraint.
2. Baumol’s Static
 - The minimum profit constraint is
   exogenously determined by the
   demands and expectations of the
   shareholders, the banks and other
   financial institutions. The firm must
   realise a minimum level of profits to
   keep shareholders happy and avoid a
   fall of the prices of shares on the
   stock exchange.
   2.   Baumol’s Static
- Conventional cost and revenue
  functions are assumed - cost
  curves are ill-shaped and the
  demand curve of the firm is
  downward sloping.
  2. Baumol’s Static
Four models:
- A single-product model, without
- A single-product model, with
- A multi-product model, without
- A multi-product model, with
   3. Baumol’s
  Dynamic Model
The most serious weakness of the
static model is the short-time losses
of the firm and the treatment of the
profit constraint as an exogenously
determined magnitude. In the
dynamic model the time horizon is
extended and the profit constraint is
endogenously determined.
  The assumptions of
  the dynamic model
- The firm attempts to maximise the
  ratio of growth of sales over its

- Profit is the main means of financing
  growth of sales, and as such is an
  instrumental variable whose value is
  endogenously determined.
  The assumptions of the
     dynamic model
- Demand and of cost have the traditional
  shape - demand is downward-sloping and
  costs are U-shaped. Profit is not a constraint
  (as in the static model) but an instrumental
  variable, a means whereby the top
  management will achieve its goal of a
  maximum rate of growth of sales.

- Growth may be financed by internal and
  external sources. However, there are limits
  to the external sources of finance.Thus
  profits will be the main source for financing
  the rate of growth of sales revenue.
   The assumptions of
   the dynamic model
Growth may be financed by
 internal and external sources.
 However, there are limits to the
 external sources of finance.
 Thus profits will be the main
 source for financing the rate of
 growth of sales revenue.
Williamson's Model of
Managerial Discretion
Williamson argues that managers
   have discretion in pursuing
  policies which maximise their
own utility rather than attempting
the maximisation of profits which
 maximises the utility of owner-
Williamson's Model of
Managerial Discretion
Profit acts as a constraint to this
managerial behaviour, in that the
financial markets and share-
holders require a minimum profit
to be paid out in the form of
dividends, otherwise the job
security of managers is
Williamson's Model of
Managerial Discretion
 The managerial utility function
   includes such variables as
 salary, security, power, status,
prestige, professional excellence.
Expense preference is defined as
the satisfaction which managers
   derive from certain types of
Williamson's Model of
Managerial Discretion
Staff expenditures on emoluments,
and funds available for discretionary
investment give to managers a positive
satisfaction (utility) because these
expenditures are a source of security
and reflect the power, status, prestige
and professional achievement of
Williamson's Model of
Managerial Discretion
     Staff expenditures, salary and
       benefits, emoluments and
 discretionary investment expenses
 are measurable in money terms and
    can be used to replace the non-
    operational concepts of power,
  status, prestige and professional
   excellence in a managerial utility
Williamson's Model of
Managerial Discretion
 The latter may be written:
      U = f1 (S, M, ID)
 S = staff expenditure, including
      managerial salaries
 M = managerial emoluments
 ID = discretionary investment
  Marris - Growth
Model highlights two important
factors as far as management is
concerned: the attitude to risk
and uncertainty and the desire
for utility which may not be
maximised by the pursuit of
maximum profits.
 Marris - Growth
Marris, like Williamson, suggests
   that managers have a utility
     function in which salary,
prestige, status, power, security,
 etc., are important. The owners
of the firm are, however, likely to
be more concerned with profits,
    market share, output, etc.
   Marris - Growth
In contrast to Williamson, Marris
argues that the owners and managers
have one aspect of the firm in
common; namely, its size.
He therefore postulates that
managers will be primarily concerned
with maximisation of the rate of the
growth of size rather than absolute
firm size.
   Marris - Growth
The attraction of the growth rate of
size is thought to stem from the
positive effect growth has upon
promotion prospects. Stress is put
on an alleged preference of
managers for internal promotion
and this is made easier if the firm
is seen to be expanding rapidly.
   Marris - Growth
Managerial utility function may be
written as follows:
     Um = f (gD,s)
gD = rate of growth of demand for the
     products of the firm;
s = a measure of job security.
   Marris - Growth
           Owners utility function
             may be written as

             U0 = f *(gc)

where gc = rate of growth of capital.
  Marris - Growth
  s can be measured by a
 weighted average of three
 ratios: the liquidity ratio,
the leverage debt ratio and
 the profit-retention ratio.
    Marris - Growth
S can be measured by weighted average of
liquidity ratio, debt ratio and profit retention

Liquidity ratio   =    Liquid assets
                       Total assets

Debt ratio        =    Value of debt
                       Total assets

Retention ratio   =    Retained profits
 Marris - Growth
Too low liquidity ratio may
 lead to insolvency and
 bankruptcy and there is a
 threat of take-over in case it
 being too high.

Too low Retention ratio may
 upset shareholders and too
 high ratio may inhibit growth.
     Cyert and March
    Behavioural Theory
       1. The Firm as a Coalition of
          Groups with Conflicting
  based on a large multiproduct group
operating under uncertain conditions in
an imperfect market - difference between
ownership and control - firm treated as a
multi-goal, multi-decision organisational
 coalition of managers, workers, share-
holders, customers, suppliers, bankers.
    Cyert and March
   Behavioural Theory
    2. Goal Formation – The
   Concept of the Aspiration
     Individuals may have (and
usually do have) different goals
to those of the organisation-firm.
 Cyert and March
Behavioural Theory

3. The Goals of the Firm:
  Satisficing Behaviour
    Goals set by top
     Cyert and March
    Behavioural Theory
The main goals:
Production goal - smooth running.
Inventory goal - adequate stock of
 suitable raw material.
Sales goal - from sales department.
Share of the market goal – also from
 sales department.
Profit goal – shareholders, finances.
     Cyert and March
    Behavioural Theory
    4 Means for the Resolution of
         Conflict is inevitable.
 Nevertheless the groups and the
 firm as a whole may remain in a
  stable position - limited time to
bargain, etc. Behaviour, goals and
  decisions are largely based on
           past history.
    Cyert and March
   Behavioural Theory
5. The Theory of Decision Making
    - At Top Management Level
 Resource allocation - implemented
  by the budget - share of budget
taken by each department. Largely
 determined by bargaining power
 which is itself determined by past
  Cyert and March
 Behavioural Theory
       6. Uncertainty and the
      Environment of the Firm
Two types of uncertainty:
- market (cannot be avoided)
- competitor's reactions
(overcome by tacid collution, eg.
trade associations)

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