THEORY OF THE FIRM

INTRODUCTION

In the theory of the firm, the behavior of any company is said to be driven by the desire for profit
maximization. The theory (of the firm) governs decision-making in a variety of areas including
resource allocation, production techniques, pricing adjustments, and the volume of production.
The theory of the firm is the microeconomic concept founded in neoclassical economics that
states that a firm exists and makes decisions to maximize profits. The theory holds that the
overall nature of companies is to maximize profits meaning to create as much of a gap between
revenue and costs. The firm's goal is to determine pricing and demand within the market and
allocate resources to maximize net profits.

Basic Assumptions of the Neoclassical Theory of Firm

The basic assumptions of the neoclassical theory may be outlined as follows:

i. The entrepreneur is also the owner of the firm

ii. The firm has a single goal, that of profit-maximisation
iii. The goal is obtained by the application of the Managinalist principle, MC = MR
iv. In the world of certainty, full knowledge is assumed about the past performance, the present
conditions, and the future development of the firm. The firm knows with certainty its own
demand cost conditions.
There are objections to the traditional theory of the firm which led to alternative theory of the
firm.

The Firm and its Objectives

The fundamental question to ask under the theory of a firm and its objectives is that why
do firms exist.

A firm is a business organization such as a corporation, limited liability company, or

partnership and Sole Proprietorship that sells goods and services to make a profit.

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A firm can also be defined as an organization that employs productive resources to obtain
products or services offered in the market to make a profit.

We start by looking at the firm as the center of finance and that the firm obtains funds
from its surplus investors and re-invests them in projects.

One must remember that a business's objective has traditionally changed from money
money-motivated organization to a social organization.

It should be noted that a firm is a purposive organization whose behaviour is directed

towards identifying who earns purpose or objectives.

OBJECTIVES OF A FIRM

The Traditional Objective Firm

The objective of the firm is to maximize the return of the ordinary shareholders, who are
regarded as equity holders, that is, those who are the owners of the business towards
achieving the objectives of the firm.

There are several criteria for achieving these objectives. These criteria are not sufficient
enough to be the organization's objective on their own but they assist in achieving
organizational goals.

Below are the objectives of the firm:

i. Sales Maximization.
ii. Output Maximization.
iii. Management of Optimum Control maximization
iv. Maximization of Market Share.
v. Profit Maximization.

1. SALES MAXIMIZATION

It should be noted that not all organization undertakes sales since they do not all produce
goods and that the owners of the business may not be interested in sales maximization.

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 One of the models of the firm is based on the theory of sales maximization. This comes into play
when managers think that their own compensation and/or their professional prestige depends
more on sales volume than on profits with the constraint that there is a minimum rate of return on
investment
of return on investment)
Annual Profit rate (rate

10%

O
Q1 Q2 Q3
Total sales per unit time period

From the diagram above, profit expressed as a rate of return on investment, is represented on the
vertical axis, and limit sales per unit time period is shown on the horizontal axis. The curve gives
the relationship between the profit rate and unit sales. The profit rate reaches a maximum at a
rate of sales in Q1. However, assume that the point of maximum revenues occurs at a quantity of
sales in Q3. Even if management wishes to maximize sales revenues, it will not be able to
produce at the quantity Q3 because a constraint of a minimum profit rate of 10% (drawn
arbitrarily) per year has been imposed. Thus, the managers will set sales at Q 2 rather than at the
profit-maximizing rate of Q1.

2. OUTPUT MAXIMIZATION

The argument of the above is attached to this.

3. MANAGEMENT OPTIMUM CONTROL MAXIMIZATION

This is regarded as the planning coordination, and execution of activity within a form or
organization usually ownership is separated from management control. Those who
manage the activities of the firm is called the manager. They coordinate all the firm's
activities, but that does not mean that whatever they say is binding on the equity holder.
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4. MAXIMIZATION OF MARKET SHARE

A firm that seeks to maximize market shares has its purpose for doing so. It is either to
maximize profit or to maximize wealth. The maximization of market share cannot be the
main objective of establishing the business.

5. STAFF MAXIMISATION
Whenever there is a separation of ownership of a business from its control, the possibility arises
that the managers will not act in the interests of the owners. Since monitoring is itself a costly
activity, owners would not be motivated to completely eliminate managerial activities that
benefit the managers at the expense of owners. Given the separation of ownership and control,
managers may, for example, be willing to trade off some owners’ profit for increased staff size,
particularly if it is difficult for managers to get caught when not acting 100 percent in the
owners’ interest. A utility-maximizing theory of managerial behaviour requires the existence of
expensive information among the owners and stockholders. It also requires that the firm have
some degree of market power. However, if the firm were in a completely competitive market, it
would have to maximize profit in order to survive, except if the owners decided to spend some of
their income on staff or if all firms exhibited the same behaviour.

6. GROWTH MAXIMISATION
A similar model of the firm is growth maximization. This indicates a manager’s efforts to
maximize the rate of growth of sales revenues. Presumably, this would explain why managers are
also so amenable to mergers with other firms. If it is observed that their salaries are related to the
rate of growth of their firm and to having larger organizations under their influence, they will
engage in activities to enlarge the firm. However, they are still constrained by some profitability
requirements. In principle, this profitability exists because if profitability becomes too low, some
group of stockholders might be able to take over the firm (and fire some or all of the current
managers).

7. SATISFICING BEHAVIOUR
According to the satisficing behaviour theory of firm behaviour, the firm sets for itself a
minimum standard of performance. It aims at a satisfactory rate of profit; presumably, once this

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rate of profit is obtained, the firm will slack off. An implication of this is that, within the firm no
consistent attempt is made to maximize costs for any given level of output, provided, of course,
that a satisfactory rate of return is being earned.

CRITICISM OF NON-PROFIT-MAXIMISING ASSUMPTIONS

Criticisms have been leveled against the alternative models. One criticism is that there is indeed
a market for managers. Every management team of every firm faces the possibility that some
other management team may convince the stockholders that they will increase the profitability of
the firm if allowed to take control. Given the existence of a market for corporate management,
managerial behaviour that deviates dramatically from profit maximization presumably will not
be allowed to continue indefinitely. The more impediments there are to controlling corporate
management, the more likely is the firm to operate in a non-profit maximizing dimension.
Again critics of non-profit maximizing models of the firm point out that not only existing
stockholders but also potential stockholders must be considered. The price of an asset is taken to
be the discounted stream of its anticipated future net income. If such an asset in question is the
common stock of a firm, then its value or price in the marketplace will be the present value of the
expected stream of future net profits. Thus, to the extent that current management decisions fail
to maximize long-run profits, the current market price of the firm’s stock will be less than it
otherwise would be. With this, a group of investors could attempt to take over the corporation by
buying a large block of its stock at its current low price, firing the current managers, and
installing new managers, thereby increasing anticipated future profitability. The market value of
the stock would then rise. Those who took over would receive an increase in their net worth
because the stock they owned in the company could now be sold for more than they paid for it.
Thus, to the extent that a market exists for corporate takeovers, non-profit-maximizing behaviour
has some limit set on it.

The extent to which the managers depart from profit-maximizing behaviour depends heavily on
the transaction costs of new managers taking over the firm.

5. PROFIT MAXIMIZATION

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To the layman, the objective of establishing any business is the maximization of profit but
this is not. Profit which is the difference between Total revenue (TR) and Total cost (TC)
is usually related to the level of investment made to bring it about.

In this modern business context, profit maximization cannot be regarded as an

appropriate criterion for achieving the objective of a firm for these reasons.

i. It is vague.
ii. It ignores the timing of returns.
iii. It ignores risk and uncertainty.

Based on these reasons, it is sufficient to conclude that the criteria cannot serve as an
appropriate guide for efficient financial decisions.

6. WEALTH MAXIMIZATION

The wealth of the firm is defined as the NET PRESENT VALUE (WORTH) of its stream
of expected future benefit under wealth maximization, for a set of mutually exclusive
alternatives, you select the project with the highest net present value.

Wealth maximization takes into consideration time and risk factors, this is reflected in the
discounting rate by adjusting or manipulating upward when the risk is high and
manipulating downward when the risk is low.

The data needed for the calculation of the benefits are the inflows and outflows of cash.

The Non-cash expenses are excluded while the assets are valued at current market prices.

From the above, the superiority of wealth maximization to profit maximization is

obvious. Most organizations are still guided by profit maximization in their decision-
making.

The reasons for this known adoption of wealth maximization are the difficulties in
obtaining data for future cash flows and the determination of the appropriate rate of
discount.

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After all is said and done, the objective of a firm is the maximization of owners wealth.

ALTERNATIVE THEORY OF BUSINESS FIRM

MANAGERIAL THEORY OR BEHAVIOURAL THEORY OF THE FIRM
While mentioning the objectives of the business firms, the conventional theory of firm
does not distinguish between owners' and managers' interests.

The recent theories of firms called managerial and behavioural theories of firm consider
owners and managers as separate entities in large corporations. This distinction allows the
managers to use their discretion in setting the goals for the firms they manage.

Such objectives are:

i. Baumol’s hypothesis of sales-revenue maximization.

ii. Marris Hypothesis of maximization of firm’s growth rate.
iii. Cyert and March's hypothesis of satisfying behavior.

1. BAUMOL’S HYPOTHESIS OF SALES-REVENUE MAXIMIZATION.

Baumol has postulated the maximization of sales revenue as an alternative to profit

maximization. The reason behind this objective is the distinction between ownership and
management. This distinction gives the management an opportunity to set their goal other
than profit maximization which most owners of businesses pursue. Given the opportunity,
most managers always choose to maximize their own utility function.

According to Baumol, most managers always choose to maximize their utility function
which is sales-revenue maximization.

The factors that explain the goal by the manager are based on the following, namely

i. That the salary and other earnings of managers are more closely related to sales
revenue than profit.

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 ii. The banks and their financial institutions look at sales revenue while financing
the institutions.
iii. The trend in sales revenue is readily available and acts as an indicator of the
performance of the firm which also helps in handling the personnel problem.
iv. That increase in sales revenue enhances the prestige of managers while profits
go to the owners.
v. That the managers find profit maximization as a difficult objective to fulfill
consistently over time and at the same level, because profit may fluctuate with
changing conditions and lastly
vi. That growing sales strengthen the competitive spirit of the firm in the market.

Following the above empirical validity of the sales maximization objective, certain pieces
of evidence are inconclusive such as;

i. Most empirical works are, in fact, based on inadequate data as adequate data
are mostly not available.
ii. In the long run, sales maximization and profit maximization objectives
converge into one because, in the long run, sales maximization tends to yield
only a normal level of profit which turns out to be the maximum under
competitive conditions. Hence, profit maximization is not incompatible with
sales revenue maximization.

2. MARRIS HYPOTHESIS MAXIMASATION OF FIRMS’S GROWTH RATE.

Marris suggested another alternative known as the maximization of the balanced growth
rate of the firm. Marris recognizes the distinction between owners' and managers'
interests.

Accordingly, Marris assumes that owners and managers have to maximize. The
manager’s utility function (Um) and Owners utility function (Uo) may be specified as
follows;

Um=f(salary, power, job security, prestige, status) and

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Uo = f(output, capital, market share, profit, public esteem).

The owner's utility function (Uo) implies the growth of demands for firms' products and
the supply of capital. Therefore, maximization of owners utility function means
maximization of demands of firm’s product” “or growth of capital supply”. By
maximizing these variables, the managers maximize both their own utility function and
that of the owners. The managers can do so because most of the variables (e.g. salary
status, Job security, power, etc.) appearing in their own utility function and those
appearing in the utility function of the owners (e.g. profit, capital-market-share, etc.) are
positive and strongly correlated with a single variable, that is, size of the firm.
Maximizing these variables depends on the maximization of the growth rate of the firm.
Therefore, the managers seek to maximize a steady growth rate.

Marris's theory is more rigorous and sophisticated than Baumol’s Sales-Revenue

maximization, it has its own weaknesses, which include the following:-

i. It fails to deal satisfactorily with Oligopolistic interdependence.

ii. It ignores price determination which is the main concern of the profit
maximization hypothesis.
iii. Marris's model does not seriously challenge the profit maximization
Hypothesis.

3. WILLAMSON’S HYPOTHESIS OF MAXIMIZATION OF MANAGERIAL

UTILITY FUNCTION.

Like Baumol and Marris, Willamson argues that managers have the discretion to pursue
objectives other than profit maximization. The managers seek to maximize their own
utility function (Um) is expressed as:

Um = f( s,m,ID)

Where

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 S = additional expenditure on staff,

M = Management emoluments,

ID = Discretionary Investment

According to this hypothesis, managers maximize utility function subject to a satisfactory

profit. Thus, a minimum profit is necessary to satisfy the shareholders, or else managers'
Job security is endangered.

The utility functions that managers seek to maximize include both quantifiable variables
like salary and slack earnings, and Non- Quantifiable variables such as prestige, power,
status, Job security, professional excellence, etc.

The non-quantifiable variables are expressed in order to make them operational, in terms
of expenses as “Satisfaction derived out of a certain type of expenditure” such as slack
payment and ready availability of funds for discretionary investment.

Like other alternative Hypotheses, Williamson’s theory suffers from certain weaknesses.
This model fails to deal with the problem of oligopolistic interdependence, which is said
to hold only where rivalry is not strong.

Thus, in the case of strong rivalry, profit maximization is claimed to be a more

appropriate hypothesis. Therefore, Williamson’s managerial utility function does not offer
a more satisfactory hypothesis than profit maximization.

4. CYERT AND MARCH HYPOTHESIS OF SATISFYING BEHAVIOUR.

This hypothesis is an extension of Simon’s hypothesis of firms satisfying behaviour.

Simon argued that the real business world is full of uncertainty, such as a lack of accurate
and adequate data, where data are available the managers have little time and ability to
process them, and the managers work under a number of constraints. Under such
conditions, it is not possible for the firms to act in terms of rationality as postulated under
the profit maximization hypothesis. Nor do the firms seek to maximize sales, growth, or

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anything else. Instead, the managers seek to achieve a satisfactory profit, satisfactory
growth, and so on. This behaviour of the firm is termed as Satisfactory Behaviour.

Cyert and March added that part of dealing with uncertainty in the business world, the
managers have to satisfy various groups of people such as managerial staff, labour,
shareholder, customers, financiers, input suppliers, accountants, lawyers, authorities, etc.
it should be noted that all these groups have their interest in the firms, which are
conflicting. The manager's responsibility is to satisfy all of these. Thus, according to the
behavioural theory of the firm, a firm’s behaviour is satisfying behaviour.

The assumption of satisfying behavior of the firms is that a firm is a coalition of different
groups connected with various activities of the firm e.g., shareholders, managers,
workers, input suppliers, customers, bankers, tax authorities, and so on.

Note that all these groups have some kind of expectations either high or low from the
firm and the firm seeks to satisfy all of them in one way or another by sacrificing some of
its interest.

In order to reconcile the conflicting interests and goals, the managers form an “aspiration
level of the firm by combining the following goals.

a. Production goals,
b. Sales and market share goals,
c. Inventory goal, and
d. Profit goal.

These goals and “aspiration levels” are set on the basis of the manager's past experience
and their assessment of future market conditions. The aspiration level is modified and
revised on the basis of achievements and the changing business environment.

This theory is criticized on the following grounds.

i. That it cannot explain the firm’s behaviour under dynamic conditions in the
long run.

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 ii. It cannot be used to predict the future course of a firm’s activities.
iii. This theory does not deal with the equilibrium of the industry.
iv. This theory fails to deal with the interdependence and interaction of the firms.

5. ROTHSCHID’S HYPOTHESIS OF LONG-RUN SURVIVAL AND MARKET

SHARE GOALS.

Another alternative objective of a firm as an alternative to profit maximization was

suggested by Rothschild. According to him, the primary goal of the firm is long-run
survival some others have suggested that attainment and retention of a constant market
share is the objective of the firms.

The managers therefore seek to secure their market share and long-run survival. While
the firm seeks to maximize its profit in the long run, which is not certain.

6. ENRY PREVENTION AND RISK AVOIDANCE.

Another alternative object of the firms suggested by some economists is to prevent the
entry of new firms into the industry. The motive behind entry prevention may be

i. Profit maximization in the long run.

ii. Securing a constant market share.
iii. Avoidance of risk caused by the unpredictable behaviour of the new firms.

The evidence of whether firms maximize profit in the long run is not conclusive.

Some argue that where management is divorced/separated from the ownership. The
possibility of profit maximization is reduced. Some also argue that only profit-
maximizing firms can survive in the long run. The firms can achieve all other subsidiary
objective goals easily if they can maximize their profit. It is further argued that
prevention of entry may be the major objective in the pricing policy of the firm because
the motive behind the prevention of entry is to secure a constant share in the market
which is compatible with the profit maximization object.

Practice questions
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i. Discuss extensively the Cyert-March hypothesis of Satisfying managerial
behavior with examples.
ii. Examine critically profit maximization as the objective of a business firm.
What are the alternative objectives of a business firm?

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