THE THEORY OF THE FIRM

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THE THEORY OF THE FIRM

Theory of the Firm – the interpretation of the of firm’s behavior (the decisions
about pricing and output)

A firm is an organisation that converts inputs such as labour, materials, and capital into
outputs, the goods and services that it sells.

There are three views of the firm:

 Theories that consider satisfactory behaviour of firms and in the centre of their research is
firm’s internal organization. These theories partly rely on psychology.

 Theories that assume maximising behaviour of some objective function:

 Classical or traditional theory
 Managerial theories of firm:
 Baumol’s theory
 Williamson’s theory
 Marris theory
profit maximisation
revenue maximisation
utility maximisation
growth maximisation

 Agency theory

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 Economic model
A model is a description of the relationship
between two or more economic variables.

Profit Mmaximisation Model

N TC
max Pf  TR  TC TR
dTR dTC
 0
dQ dQ
dTR dTC

dQ dQ
TPf
MR  MC
0 Q
Q
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ACCOUNTING VERSUS ECONOMIC
PROFIT
 The OPPORTUNITY COST of a choice is the value of the best alternative
forgone

 EXPLICIT COSTS are opportunity costs that involve direct monetary

payment by producers.

 IMPLICIT COSTS (also called implied, imputed or notional costs) are the
opportunity costs not reflected in cash outflow but implied by the failure of
the firm to allocate its existing (owned) resources, or factors of production to
the best alternative use.

 Accounting Profit = Total Revenue – Explicit Costs

 Economic Profit = Total Revenue – Total Costs

The Goal and the Value of the Firm

Theory of the Firm

 Assumption: firm wants to maximise current or short run profits

 New theory of the firm ASSUMPTION: the goal of the firm is

to maximise the value of the firm

The value of the firm – equals present value of all it's future
profit cash flows

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The Goal and the Value of the Firm

Future value of cash flow:

FVn = PV (1 + i )n

FVn – future value

PV – present value
i – interest rate
n – total periods in the future

EXERCISE:
You can choose to take 100$ today or 130$ in three years from now. The
interest rate amounts 10% for the entire period. Which alternative you are going
to choose?
The Goal and the Value of the Firm

Present value of the future deposit:

PV = FVn * 1/(1 + i)n

1/(1 + i)n – discount factor

i – interest rate (discount rate)

 With the increase of interest rate and the lenght of period, present value of money in
the future decreases

EXERCISE:
Calculate present value of the future 130$ from the previous exercise.

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The Goal and the Value of the Firm

Value of the Firm

n
Pf t
PV  
t 1 (1  i ) t

PV - present value of all expected future profits of the firm

Pf1, Pf2,…., Pfn - expected profit in each of n observed years
i - discount rate
t - time (it can have values from 1 till n observed years)

 Dimension of time uncertainty; it is included in Firm Value Model

through the adjusted discount rate

 Greater uncertainty greater discount rate smaller present value

of the firm

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THEORIES AND AIM OF PROFIT

 Profit rates differentiate between firms in the same industry, and even
more between different industries.

PROFIT THEORIES:
1. Profit as the reward for bearing risks and uncertainty
2. Frictional profit theory
3. Monopoly profit theory
4. Innovative theory of profit (profit is a reward for introducing successful
innovation)
5. Managerial efficiency theory of profit

 The fundamental aim of profit is: efficient allocation of national resources