Unit -3 Theory of Firm

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?

Industry
It is a set of firms producing homogenous goods and is spread over a wide region. Noticeable traits /characteristics are: An industry produces homogenous products. Same type of products substitutes Use common raw materials Use similar processes. Have similar trade and services policies.

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.

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- 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.

Profit Maximization by TR and TC Approach

PM implies earning highest possible amount of profits. 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. The best decision is the one that produces result most consistent with managerial objectives. For equilibrium of a firm, it aims at maximization of the profits. Two costs are incurred by a firm
Fixed (at any or even zero level of OP Maintenance). 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 P= TR- TC

Two Graphical Ways of determining Q is optimal

Profit curve is at Max at point A At B, the tangent on the TC curve is parallel to the TR curve, the surplus of revenue net of cost (B,C) is the greatest. Coz Profit = TR- TC, the line segment CB= the length of line segment AQ. For comparing demand, the price at which the quantity demanded equals profit maximizing OP, it is the optimum price to sell the product. An entrepreneur aims at maximizing profits i.e. TR>TC, it is supernormal profits. Thus, the firm would not be interested either to expand or contract its Output.

Profit Maximization by TR and TC Approach

TC C TR

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

MC-MR Approach
Informative method to determine a firms equilibrium OP is the comparison of MC and MR at each successive unit of OP, instead of TR and TC. Uses price as explicit variable. MC: MR = TC: TR Acc to TR:TC at Profit Maximizing level of OP, the slope of TR = slope of TC curve. i.e. slope of TR curve i.e. TR/ Q is MR , the slope of TC i.e TC/ Q = MC. Means MR= MC. Hence, 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.

Observations
MR= MC is the condition of PM OP as well as the equilibrium of the firm. i.e. 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. It will not produce if TC > TR coz it would be loss. Firm expands till MR= MC, not less than or more would be produced coz total residua profits would be less than Maximum.

Profit Maximization

A P

T F E S G

MC

MR

Q1

Q2

Profit Maximization
MR=MC curve MC= MC Curve MC intersects MR from below at point E. At point E, MC=MR when OP= OQ. OQ is the equilibrium OP with Max profits. Area lying under MR curve measures the TR of the OP and the area underlying the MC curve measures TC. Difference between TR and TC is AGEF, i.e. the profit area. If OP is less, i.e. till OQ1, then increase OP further , Total profits added would be the area FGE as MR>MC. At E, MC = MR, profit is maximized. If the firm increases OP to OQ2, then MC > MR = loss i.e. area EST. Hence the firm reduces OP to OQ. Thus MR= MC is maximum profit position. Though firm in actual is not aware of this, but the theory is logical.

Theory of Value or Wealth Maximization

At simplest level, 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. This mode of business is called the economist theory of the firm. Today, the emphasis on profits has been broadened to encompass uncertainty and the time value of money. In this more complete model primary goal is long term expected values maximization.
SOCIETY

SUPPLIERS

INVESTORS

FIRM
MANAGEMENT EMPLOYEES

CUSTOMERS

Theory of Value or Wealth Maximization

The value of the firm is the present value of the firms expected future net cash flows. If cash flows = profits, the value of the form today, or its present value is the value of expected profits or cash flows, discounted back to the present at an appropriate interest rate. Model can be expressed as Value of Firm = Present value of Expected

Future Profits =

1
(1 + I ) t

1 , 1 etc

= expected profits in each

=N

1
t= 1 t (1 + I )

year (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 . Coz (profits) = TR-TC, then Value = N
t= 1

TRt-TCt (1 + I ) t

 This equation can be used to examine how the expected value maximization model relates to a firms various functional departments like sales (TR), Production (TC), Finance (discount factor capital i) in denominator, accounting, HR, etc. 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. Also, managerial decisions are made in the light of constraints imposed by technology resource scarcity, contractual obligations, laws and regulations (constrained optimization) i.e.. maximization of wealth or value of the firm subject to constraints it faces.

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. According to this theory, a traditional firm is a group with a particular organizational and management structure having command over its own property rights. It is a legal entity on the basis of ownership and contractual relationship organized for production and business concerns etc.

The Economist Theory of the Firm

The firm is formed, run and managed by an owner, 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. Can direct and dictate suppliers Can change the nature of the management Can take final decisions

The Economist Theory of the Firm

All the above to ensure wealth creation and surplus creation.

Surplus generation is possible when the firms produces maximum output with minimum costs by working out the most ideal factor combinations. Thus it reaches the equilibrium position where TR= TC or MR=MC. At this point the firm is maximizing profits.

The traditional or classical theory of firm aims at profit maximization and over the years this objective has been replaced by profit optimization.

Limitations or Other Theories Postulated

The Traditional/Classical theories of Firm are criticized as being very narrow and unrealistic. Broader theories or models postulate that primary objective of the firm is:

Growth Maximization Model - Robin Marris. 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. Satisficing Behavior also known as Behavioral Approach by Richard Cyert and James G March.

Growth Maximization Model - Robin Marris

A firm has to maximize its balanced growth rate over a period of time. Ownership and control in the hands of two groups of people - owners and managers. Both have two distinct utilities.
Uo = f(size of OP, market share, volume of profit, capital, public esteem, etc.) Um=f(salaries, power, status, prestige, job security, etc.)

Growth Maximization Model - 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. 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

Maximization of Sales (Managerial Theory of Firm) by William Baumol

1. 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). According to this, Managers of modern corporations seek to maximize sales after an adequate rate of profit has been earned to satisfy share/stock holders. A strong correlation exists between executives salaries and sales but not between salaries and profits. But more recent studies have found the opposite.

The Maximization of Management Utility or Managerial Discretionary Theory- Principal-Agent Problem

This theory postulates that with the advent of the modern corporation and the resulting separation of management form ownership, managers are more interested in maximizing their utility, measured in terms of their compensation, size of the staff, extent of control over the corporation, lavish offices etc, than maximizing corporate profits. Managers utility function U= f(S, M, Id)
S= Additional Expenditure of staff M= Managerial Emoluments Id= Discretionary Investment

This problem is referred to as Principal-Agent Problem. It can be resolved by tying the managers salary/reward to firms performance in relation to other firms in the same industry. Such managers might be replaced by stockholders of corporation or might be merged to utilize unexploited profit potential of the firm.

Satisficing Behavior /Behavioral Approach by Richard Cyert and James G March.

Explains how decisions are taken within the firm. People posses limited cognitive ability and so can exercise only bounded rationality when making decisions in complex and uncertain situations. Thus individuals and groups tend to satisfice i.e. to attempt to attain realistic goals, rather than maximize a utility or profit function. Cyert and March argued that a firm cant be regarded as a monolith, 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. 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. There is an organizational slack.