Jessame C.

Molina

Jessie Lyn C. Molina

2. GOALS OF THE FIRM – THEORY OF THE FIRM

2.1 INTRODUCTION

The neoclassical theory of the firm is sometimes called a “black box”. It means that
the firm is seen as a monolithic entity; there is no attempt to probe inside the box and
explain why firms exist in the first place, or how the individuals who constitute firms
are motivated and interact.

There are six main areas of economic theory that are involved in the examination of
the nature of the firm: transaction cost theory, information theory, motivation theory,
agency theory, property rights theory and game theory.

a. Transaction Cost Theory

- This examines the costs of undertaking transactions in different ways.
These include trading on spot markets, long-term contracts with external
parties and internalizing transactions within the firm.
b. Information Theory
- This examines the concept of bounded rationality, and the associated
aspects of incomplete contracting, asymmetric and imperfect information.
c. Motivation Theory
- This examines the underlying factors that cause people to behave in
certain ways. In economic terms we are searching for general principles
which can be used to explain and predict behavior.
d. Agency Theory
- This examines the situation where one party, an agent, is involved in
carrying out the wishes of another, a principal. This happens very
frequently in all sorts of transactions; indeed it is the cornerstone of
democracy, where people elect a government to govern on their behalf.
e. Property rights Theory
- This examines the nature of ownership, and its relationship with incentives
to invest and bargaining power.
f. Game theory
- This examines the strategic interaction of different agents. The key to
understanding this strategic interaction is that the behavior of one party
affects the behavior of other parties, and the first party must consider this
in determining their own strategy.

2.2 THE NATURE OF THE FIRM

Managers manage organizations; therefore we must first ask the fundamental

questions: what are organizations and why do they exists? The answers to these
questions lead to a discussion of transaction cost theory, since by then the context
and importance of transactions will have become apparent.

2.2.1 Economic Organizations

Organizations occur at many different levels; the most comprehensive economic

organizations are worldwide, for example the United Nations, World Trade
Organization and the International Monetary Fund. All of these organizations are
ultimately composed of individuals and are created by individuals in order to serve
particular purposes, which are ultimately some compromise of individual purposes.

The main types of organization that we are concerned with examining are business
organizations, consisting of corporations, partnerships and sole proprietorships. In
order to understand why such organizations exist we first need to consider the
benefits of co-operation and specialization. In any organization different people
perform different functions, each specializing in some particular activity. Adam Smith
gave the famous example of the pin factory, where workers specialized in pulling
wire, straightening it, cutting it to a specific length, sharpening it to a point, attaching
the head, or packaging the final product.

The discussion so far illustrates that the most appropriate level of analysis for most
economic behavior is the individual and the transaction. A transaction refers to an
exchange of goods or services.

2.2.2 Transaction Cost Theory

Transaction costs are related to the problems of co-ordination and motivation. Costs
will occur whichever method of transaction is used, spot markets, long- term
contracts or internalization within the firm, but will vary according to the method.

a. Co-ordination costs
- Sometimes referred to as Coasian costs. The following categories of costs
can be determined here:
1. Search costs. Both buyers and sellers have to search for the
relevant information before completing transactions. Such
information relates to prices, quality, delivery and
transportation; in markets this search is external, while within
organizations, information held in different parts of the
organization must be transmitted through the relevant channels
to the decision-makers. Even in highly efficient markets like
stock exchanges a large amount of resources, in terms of
physical assets like buildings and computers and human assets
in the form of brokers, is devoted to providing the relevant
information.
2. Bargaining costs. These are more relevant when markets are
involved, where negotiations for major transactions can be
 protracted, but even within the firm, salary and wage
negotiations can also be costly in terms of the time and effort of
the parties involved.
3. Contracting costs. These are costs associated with drawing
up contracts; these take managerial time and can involve
considerable legal expense.
b. Motivation costs
- These costs are often referred to as agency costs. This area is discussed
in more detailed in the topic agency problem, but at this stage we can
observe that there are two main categories of such costs.
1. Hidden Information. This relates to asymmetries referred
earlier. One or several parties to a transaction may have more
information relevant to the transaction than others. Example is
the secondhand car market, where sellers have a big
advantage over buyers.
2. Hidden Action. Even when contracts are completed the parties
involved often have to monitor the behavior of other parties to
ensure that the terms of the contract are being upheld.

2.2.3 Motivation Theory

Economists tend to assume that people in general act in such a way as to maximize
their individual utilities, where these utilities are subjective measures of value or
satisfaction. Thus the fundamental pillar in the basic economic model of behavior is
that people are motivated by self- interest. The economic model is too narrow and
ignores altruistic behavior and spiteful behavior.

a. Altruistic behavior
- According to Hirshleifer and Collard, altruism refers to motivation rather
than action. Examples of altruistic behavior frequently mentioned are
charitable gifts, tipping waiters and endangering oneself to help others,
particularly nan-relatives, in distress; helping relatives would be an
example of kin selection rather than strict altruistic behavior.
b. Spiteful behavior
- Viewed as the flip side of altruistic behavior. This is a behavior which
imposes a cost on others, while also involving a cost to the originator of
the behavior, with no corresponding material benefit. An example is
vandalism, which damages the property of others, while incurring the
possibility of being caught and punished. In the business context it is
possible that some industrial strikes and stoppages also feature spiteful
behavior, if labor unions are prepared to forgo income in order to damage
the welfare of the management.

2.2.4 Property Rights Theory

The focus is on the issue of ownership; the nature of ownership and its relationship
with incentives to invest and bargaining power are the key features of this model.
The institution of private ownership and the associated property rights is one of the
most fundamental characteristics of any capitalist system. Its main advantage
compared with the state ownership of the majority of assets found in communist
countries is that it provides strong incentives to create maintain and improve assets.

There are two main issues involved: residual control and residual returns.

a. Residual control
o Owner’s decisions regarding the asset’s use are circumscribed by
law and by any other contract involving the rights of other parties to
use of the asset. Therefore property rights are limited in practice,
even in a capitalist system.
b. Residual returns
o It is a fundamental feature of ownership of an asset that the owner
is entitled to receive income from it.

The ownership of a complex asset like a firm is a difficult concept since four parties
have different types of claims regarding control and returns: shareholders, directors,
managers and other employees.

1. Shareholders. In legal terms shareholders own the company, but in practice

their rights are quite limited. They have voting rights on issues such as
changing the corporate charter, electing and replacing directors, and, usually,
mergers. However, they have no say in other major strategic issues, such as
hiring managers, determining pay levels, setting prices or budgets, or even
determining their own dividends.
2. Directors. The board of directors certainly appears to have residual control,
making many of the major strategic decisions of the firm, including hiring the
managers and setting their pay levels. However, the directors do not have a
claim to the residual returns; these essentially belong to the shareholders.
3. Managers. In practice the senior managers may have effective control over
many of the major strategic decisions of the firm. This is because they control
the flow of information within the firm and set the agenda for many board
decisions; because shareholders rely on information from mangers in electing
the board, the managers may effectively determine board nominations. Thus
there is a problem in asymmetric information in terms of managers having
more information regarding the firm’s operations than either board members
or shareholders. There is also a problem of moral hazard in that it is difficult
for either directors or shareholders effectively to monitor the activities of
mangers.
4. Other employees. This relates to non-managerial workers; again managers
rely on such workers to provide them with information, and also to carry out
managerial decisions. Thus, although like managers they have no residual
 claims of the firm, they do exercise some control. Once more the problems of
hidden information and hidden action are present; in this case the other
employees have more information than managers, and the managers are not
able to observe their behavior easily.

2.3 THE BASIC PROFIT- MAXIMIZING MODEL

In economic analyses the most common objective that firms are regarded as
pursuing is profit maximization. The basic profit maximizing model prescribes that a
firm will produce the output where marginal cost equals marginal revenue. Figure 2.1
illustrates a rising marginal cost (MC) curve, where each additional unit costs more
than the previous one to produce, and a falling marginal revenue (MR) curve,
assuming that the firm has to reduce its price to sell more units. The output Q* is the
profit-maximizing output. If the firm produces less than this it will add more to
revenue than to cost by producing more and this will increase profit; if it produces
more than Q* it will add more to cost than to revenue and this will decrease profit.

Although there is much intuitive appeal in the assumption of profit maximization, it

should be realized that it, in turn, involves a number of other implicit assumptions.
These assumptions now need to be examined, considering first of all their nature,
then their limitations, and finally their usefulness.

2.3.1 Assumptions

The basic profit- maximizing model incorporates the following assumptions:

1. The firm has a single decision- maker.

2. The firm produces a single product.
3. The firm produces for single market.
4. The firm produces and sells in single location.
5. All current and future costs and revenues are known with certainty.
6. Price is the most important variable in the marketing mix.
7. Short-run and long-run strategy implications are the same.
a. Single decision- maker
 - The meaning of this assumption is self-explanatory. It is also obvious that
it is not a realistic assumption since in any firm above a small size the
owner, or anyone else, is not going to have time to be able to make all
decision. Thus the decision-making process involves delegation, so that
decisions of different importance and relating to different functional areas
are taken by different managers and other employees, while the board of
directors and shareholder still make some of the most important decisions.
This leads to an agency problem.
b. Single-product
- Self-explanatory in meaning, as long as we remember that the majority of
products sold now are services rather than goods. It is also clear that this
assumption has even less basis in reality than the first one. Even small
firms may produce many products, while large firms may produce
thousands of different products. Given this situation the assumption may
seem hard to justify, yet all analysis at an introductory level implicitly
involves it.
c. Single market
- To an economist a market involves an interaction of buyers and sellers. A
market does not necessarily have to involve a physical location; the
internet provides a market. However, businessman and managers often
are referring only to buyers or potential buyers when they use the term
market.
d. Single location
- Some firms produce in many different countries and sell in many different
countries. The reason for using different locations is the differences in
costs and revenues involved.
e. All current and future costs and revenues are known with certainty
- One might expect a well-managed firm to have accurate, detailed and up-
to-date records of its current costs and revenues. This is necessary in
order to determine a firm’s cost and revenue functions, in terms of the
relationships between these and output; in theory it is necessary to know
these to determine a profit- maximizing strategy. In practice it can be
difficult to estimate these functions, especially in a constantly changing
environment. Even if these can be reliably estimated on the basis of
historical data, it still may be difficult to estimate reliably what these will be
in the future. This has important implications for any decision or course of
action that involves future time periods, since risk and uncertainty are
involved.
f. Price is the most important variable in the marketing mix
- Marketing mix define as, the set of marketing tools that the firm uses to
pursue its marketing objectives in the target market. McCarthy has
developed a classification that is frequently used, the four Ps: product,
price, promotion and place. Not all marketing professionals agree on the
components of the marketing mix, but they and business managers agree
 that price is not the most important of these. Aspects of the product are
normally regarded as the most important factor.
g. Short-run and long-run strategy implications are the same.
- This assumption means that any strategy aimed at maximizing profit in the
short-run will automatically maximize profit in the long run and vice versa.

2.3.2 Limitations

1. In the real world, it is not so easy to know exactly your Marginal Revenue
and Marginal Cost of the last products sold. For example, it is difficult for
firms to know the price elasticity of demand for their good – which
determines the MR.
2. The use of the profit maximization rule also depends on how other firms
react. If you increase your price, and other firms may follow, demand may
be inelastic. But, if you are the only firm to increase the price, demand will
be elastic.
3. It is difficult to isolate the effect of changing the price on demand. Demand
may change due to many other factors apart from price.
4. Increasing price to maximize profits in the short run could encourage more
firms to enter the market. Therefore firms may decide to make less than
maximum profits and pursue a higher market share.