The Behaviour of Firms

9.1) Problems with Traditional Theory

Difficulties in maximizing profit:

- Firms do not use MR and MC concepts

- Lack of information
- Difficulties in identifying demand and MR
- Failure to understand or use opportunity cost
- Difficulties in deciding the time period for maximizing profit
- Deciding on profit-maximizing price and output

Alternative aims:

- Firms do not aim to maximize profits.

- complex structure of many public limited companies
- separation of ownership and control
- multi-divisional structures
- complex objectives and the interests of managers
- profit ‘satisficing’
- types of alternative theory of the firm
- single aim maximising; multiple aims
- managers may have different aims (e.g., higher salaries, prestige)
- Yet managers will have to ensure sufficient amount of profits

Public limited company: A company owned by its shareholders.

Shareholders’ liability is limited to the value of their shares. Shares may
be bought and sold publicly – on the stock market.
Profit satisficing: Where decision makers in a firm aim for a target level
of profit rather than the absolute maximum level.

9.2) Behavioural Economics of The Firm

Is firm behaviour consistent with the rational choice model?

Behavioural economics is relevant for understanding why and how the
aims and strategies of firms deviate from traditional profit maximization.
This deviation is in part explained by managers using various mental
shortcuts or heuristics to simplify complex decisions made in conditions
of uncertainty. Some examples include imitation and focusing on
performance.

Some potential heuristics:

Firms operate in complex environments, dealing with imperfect
information and uncertainty about both the present and the future.
Rather like consumers, managers may respond by using heuristics (rules
of thumb/mental shortcuts) to simplify things.

Heuristics:
1) Copying the strategy of the most profitable businesses in the
market.
- This is only possible if a firm can observe the actions and the profits
made by its rivals.
- In an oligopolistic market, it might lead to more intense
competition, with lower prices and higher output.

2) Focusing on relative rather than absolute profits.

- Aggressive price war

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 3) Making a satisfactory / target level of profit
- Managers may instead only change a firm’s strategy when its profits
fall below some target level.

Managerial preferences for fairness:

- Some managers may have preference for fairness.

- Desire for equitable distribution of profits between firms in their
industry.
- Firms may seek to punish aggressive rivals.
- Preferences for fairness may increase the chances of collusive
oligopoly by reducing the likelihood of cheating.

Some potential biases:

- Over-optimism.
- Taking account of sunk costs.

Use of behavioural economics:

¡ firms taking consumer behaviour into account when devising
products and marketing strategies
¡ understanding motivation of employees and devising
appropriate incentives

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9.3 Alternative Maximising Theories

Long-run profit maximization: An alternative theory which assumes that

managers aim to shift cost and revenue curves so as to maximise profits
over some longer time period.

- implications for investment and short-run pricing and output

- impossibility of setting long-run profit maximising price and
output
- difficulties in testing the theory

Managerial utility maximization:

After achieving satisfactory levels of profit, managers often have the
discretion to choose what policies to pursue. Hence, they are free to
pursue their own interest. And the managers’ interests are to maximise
their own utility.

Factors that affect managers’ utility: Salary, job security, dominance

(status, power and prestige) and professional excellence.

Sales revenue maximization: An alternative theory which assumes that

managers aim to maximise the firm’s short-run total revenue.

- Identifying the price and output is easier in the short-run

- Sales revenue is at maximized at the top of the TR curve.

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 - Sales revenue maximization will tend to lead to a higher output and
a lower price than profit maximization.

- Sales revenue maximization will tend to involve more advertising

than profit maximization. (with the surplus from the profits)
- The firm will continue advertising until surplus profits above the
minimum have been used up.

Growth maximization: An alternative theory which assumes that

managers seek to maximise the growth in sales revenue (or the capital
value of the firm) over time.

- If a firm is to maximise growth, it needs to be clear about the time

period over which it is setting itself this objective.

- Prospects of promotion, increased salaries, and power for

managers

- Growth like to be measured by growth of the sales

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Growth by internal expansion:
- Internal growth requires an increase in sales, which requires an
increase in the firm’s productive capacity.
- Increasing sales requires extensive product promotion and
launching new products.
- Increasing productive capacity requires investment.
- Extra funds are needed for new investment

Takeover constraint: The effect that the fear of being taken over has on
firm’s willingness to undertake projects that reduce distributed profits.

Growth through vertical integration:

Advantages:
- Economies of scale. (These can occur by the business performing
complementary stages of production within a single business unit)

- Reduced uncertainty.

- Barriers to entry.

Disadvantages:
- It may reduce the firm’s ability to respond to changing market
demands.

Growth through diversification:

If the current market is saturated or in decline, diversification might be
the only avenue open to the business if it wishes to maintain a high
growth performance.

Diversification also has the advantage of spreading risks.

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Growth by merger:
A merger may be the result of the mutual agreement of two firms to
come together.

Types of mergers:
1) Horizontal merger: Is where firms in the same industry and at the
same stage of production merge. (e.g., Coca Cola and Pepsi merges)

2) Vertical merger: Is where two firms in the same industry but at

different stages in the production process merge. (e.g., owner of
satellite and cable tv acquires Warner Bros)

3) Conglomerate Merger: Where two firms in different industries

merge.

Motives for merger:

- For growth
- For economies of scale
- For monopoly power
- For increased market valuation
- To reduce uncertainty
- Due to opportunity

Mergers and the relationship between growth and profit:

In order for a firm to be successful in a takeover bid, it must be
sufficiently profitable to finance the takeover. Thus, the faster it tries to
grow and the more takeovers it attempts, the higher must be its
profitability.

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Growth through strategic alliances:

Strategic alliance: Where two firms work together, formally or informally,

to achieve a mutually desirable goal.

Joint venture: Where two or more firms set up and jointly own a new
independent firm.

Consortium: Where two or more firms work together on a specific

project and create a separate company to run the project.

Franchise: A formal agreement whereby a company uses another

company to produce or sell some or all of its product.

Subcontracting: Where a firm employs another firm to produce part of

its output or some of its inputs.

Network: An informal arrangement between businesses to work together

towards some common goal.

Growth through going global:

Opening to global markets can provide an obvious means for business to
expand its markets and spread its risks.

- Reducing costs through economies of scale

- Accessing cheap sources of supply
- Low wage production facilities

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Difficulty in identifying equilibrium for a
growth-maximising firm:
¡ depends on strategies pursued to achieve growth
¡ depends on assessment of market opportunities
¡ growth-maximising firms tend to be more diversified

Alternative maximising theories and the public interest:

¡ depends on strategies pursued

9.4 Asymmetric information and the principal-agent

problem

One of the features of a complex modern economy is that people

(principals) have to employ others (agents) to carry out their wishes.

Agents have specialist knowledge about their industries.

Asymmetric information: Where one party in an economic relationship

(e.g., an agent) has more information than another (e.g., the principal).

So asymmetric information creates a problem for principals-known as the

‘principal-agent problem’

Principal-agent problem: Where people (principals), as a result of lack of

knowledge, cannot ensure that their best interest are served by their
agents.

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9.5 Multiple Aims

Satisficing and the setting of targets:

In many firms, targets are set for production, sales, profit, stockholding,
etc. If, in practice, target levels are not achieved, a ‘search’ procedure will
be started to find out what went wrong and how to rectify it. If the
problem cannot be rectified, managers will probably adjust the target
down-wards.

If, targets are easily achieved, managers may adjust them upwards.

- Managers aspire depend to large extent on the success in achieving

previous targets.
- Targets are also influenced by expectations of demand and costs.

Organisational slack: Where managers allow spare capacity to exist,

thereby enabling them to respond more easily to changed circumstances.

Just-in-time methods: Where a firm purchases supplies and produces

both components and finished products as they are required. This
minimizes stockholding and its associated costs. It does, however, put
pressure on the supply chain and increases the probability that on
occasion firms may not be able to meet demand for example in times of
bad weather.

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