Theories of Firm

- Introduction
Dr.P. Ganesan
VIT Business School
 What is a FIRM?
A firm is an organisation that combines
and organizes resources for the purpose of
producing goods and / or services for sale.

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MANAGERIAL ECONOMICS
Managerial Economics refers to the application
of Economic theory and the tools of decision
science to examine how an organization
achieve its aims or objectives most effectively.

Managerial Economics consists of the use of

economic modes of thought to analyse business
situations – McNair & Meriam

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 Spencer & Siegelman

• Managerial Economics as, “the

integration of economic theory with
business practice for the purpose of
facilitating decision making and forward
planning by management ”.

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 Scope of Managerial Economics
Managers decides to venture into business
Tries to Find out

What is the nature and the amount of demand for the

Product, both at present and future(Demand analysis
and forecasting)

Manager’s Problem

Choice of best Input-Mix and Technology

Maximum output at Minimum possible cost
@
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 @ Product is ready for Sale at what Price?

Pricing:
Correct Pricing Policy
Market Management
Product Competition
Advertising
Product Design

PROFIT MANAGEMENT Depends

Long Range Decision on Investment,

Capital Budgeting
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Fundamental Concepts

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 Marginal Analysis
• Resource-allocation decisions typically are expressed
in terms of the marginal conditions that must be
satisfied to attain an optimal solution
– Marginal Revenue = MC ~~ Profit Maximizing
output
– Marginal Return = MC ~~ long term investment
• Resource allocation decisions are made by comparing
the marginal (or incremental) benefit of a change in
the level of activity with the marginal (or
incremental) cost of the change

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 1. INCREMENTAL REASONING
Two basic concepts :
Incremental cost : the change in total cost as a result of
change in the level of output, investment etc.
Incremental Revenue : a change in total revenue
resulting from a change in the level of output, prices, etc.
INCREMENTAL REVENUE > INCREMENTAL COST
= ?????????????

Two Main Theorems :

Theorem I : A course of action should be pursued upto the point where its
incremental benefits equal its incremental costs.

Theorem II : Different courses of action should be pursued upto the point

where all the courses provide equal marginal benefit per unit of cost.

- EQUI-MARGINAL PRINCIPLE
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 Equal-marginal Principle
• an input should be so allocated that the value
added by the last units is the same in all cases
Or
• the value of the marginal product is equal in
all the four activities
VMPLA = VMPLB = VMPLC = VMPLD

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 2. OPPORTUNITY COST
….benefits or revenue foregone by pursuing
one course of action rather than another.
• the opportunity cost of the funds employed in
one’s own business is the interest that could be
earned on those funds had they been employed in
other ventures

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 3. CONTRIBUTION
Unit contribution is the per unit difference of
incremental revenue from incremental cost.
4. TIME PERSPECTIVE
Short-run – period within which some of the inputs
can be altered / changed, not all
Long-run
5. DISCOUNTING PRINCIPLE
• The future must be discounted both the elements of delay
and risk of future
• A rupee now is worth more than a rupee earned year after
• ν ═ (100/(1 + i)) ~ e.g., 10% of rate of interest
• ν ═ (100/(1 + 10)) ~ 90.90

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 RISK
A situation where there is more than
one possible outcome to a decision and the
probability of each specific outcome is
known or can be estimated.

E.g. :- In a tossing coin, we can get either a head

or a tail, and each has an equal (i.e.; 50-50) chance
of occurring.

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UNCERTAINITY
It is the case when there is more than one possible
outcome to a decision and where the probability of each
specific outcome occurring is not known or even
meaningful.

PROBABILITY
The probability of an event is the chance or odds
that the event will occur. By listing all the possible
outcomes of an event and the probability attached to
each, we get a PROBABILITY DISTRIBUTION.

The PROBABILITY DISTRIBUTION is ESSENTIAL in

evaluating and comparing investment projects under risk &
uncertainty.
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 THEORIES OF FIRM
1. Profit Maximisation
2. Firm’s value Maximisation
3. Sales Maximisation – William J. Baumol
4. Size Maximisation – Edith Penrose
5. Long-run Survival – K.W.Rothschild
6. Management Utility Maximisation – O.E.Williamson
7. Satisfying – Herbert Simon, Cyert & March.
8. Other (non-profit) Objectives
- maximisation of quantity & quality of output.
- administrators’ utility maximisation
- maximisation of factor productivity
- maximisation of cash flows
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• Our deep roots in local cultures and
markets around the world give us
our strong relationship with
consumers and are the foundation
for our future growth. We will
bring our wealth of knowledge and
international expertise to the
service of local consumers – a truly
multi-local multinational.
• Our long-term success requires a
total commitment to exceptional
standards of performance and
productivity, to working together
effectively, and to a willingness to
embrace new ideas and learn
continuously.
 The Company values all
stakeholders and believes that
all of them deserve the best
deal from us. We shall aim not
just to satisfy them but deliver
more than their expectations to
delight them. (Stakeholders
include both internal and
external consumers,
customers, employees,
vendors, financial institutions,
government agencies and
share holders.)
 THEORIES OF FIRM

I. MODEL OF PROFIT MAXIMISATION

Basic Propositions:
1. Input Output @ given the state of technology
2. Goal – Profit maximisation
3. Market conditions – Given
4. While choosing alternatives consistently achieve profit
maximisation.
5. Primary concern Firm to analyse

Prices
in
Quantity of I/O

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Assumptions :
1. Single goal Profit maximisation
2. Perfectly knowledge of all relevant variable
3. Firm – single ownership

MODEL :
* Time period
- Short-run
- Long-run
* Relationship between short-run & Long-run
Profit
Maximisation. PG/ME
 The firm compares the cost &
revenue implications of different
output levels, and pick up the output
level that maximise the absolute
difference between the two.

∏=TR-TC

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 K1
TC

TR

K2

Q1 Q2 Q3

Profit Maximization
Output

Q1 Q2 PG/ME Q3
The shareholder Wealth-Maximization Model
of the Firm
• Profit maximization does not incorporate the time
dimension and does not consider risk
• Shareholder wealth – maximization model overcomes
the above limitations
• The goal states that the objective of a firm’s management
should be
– To maximize the present value of the expected future cash flows to the
equity owners (shareholders)

– Shares outstanding =__π___ + __π___ + __π___ + …. + __π___

(1+Ke)1 (1+Ke)2 (1+Ke)3 (1+Ke)n

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• Greater the risk associated with receiving a
future benefit (profit), the lower the value
placed by investors on that benefit
• The achievement of the shareholder wealth-
maximization goal
• Πt = TRt – TCt
• TRt = Pt . Qt
• TCt = Vt . Qt + Ft

x
P . Q t + V t . Qt + F t
Vo (Share Outstanding)= ∑ t
t=1 (1 + ke)t

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 x P .Q +V .Q + F
t t t t t
Vo (Share Outstanding)= ∑
t=1 (1 + ke)t

The discount rate, ke depends on

1. Perceived risk of the firm

2. Capital market conditions

Future stream of profits (economic profits) depends on

3. Revenue generated and forecasting

1. Demand theory and forecasting
2. Pricing
3. International considerations
4. Costs
1. Production methods used
2. Nature of cost function

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Separation of Ownership
and Control
The Problem of Agency

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Principal-agent theory OHT 10.5

The principal-agent relationship: private v public sector

 Divergent Objectives
• Separation of ownership and control has permitted managers
to “satisfice”, or seek acceptable levels of performance while
maximizing their own welfare
• Maximizing their own welfare lead to minimize the amount of
risk incurred by the firm
• Desire for job security – as one reason often opposes takeover
or merger offers by other companies
• “Golden Parachute” – a contracts to compensate if the senior
management lose their positions as the result of a merger
(STOCK OPTION PLAN)

• The existence of divergent objectives lead to Agency

Problems
– Agency relationship – one or more individuals (the principals) delegate
decision making authority to another
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 BAMOL’S SALES REVENUE MAXIMISING
• TheMODEL
oligopolistic firms aim at maximising their sales revenue
• WHY SALES MAXIMISATION?
- There is evidence that salaries and other (Mace.) earnings of top
managers are correlated more closely with sales than with profits.

- Banks and other institutions, which keep a close eye on the sales of
firms, are more willing to finance firms with large and growing sales.

- Personnel problems are handled more satisfactorily when sales are

growing. Employees of all levels can be given higher earnings and
better terms of work in general. Declining sales make the converse and
lay-offs more likely.

- Large sales, growing overtime, give prestige to managers; large profits

go into the pockets of shareholders.

- Managers prefer a steady performance with satisfactory profits to

spectacular profit maximisation projects. If they realise high profits in
one period, they might find themselves in trouble in other periods when
profits are less than maximum.
 BAMOL’S SALES REVENUE MAXIMISING MODEL

The oligopolistic firms aim at maximising their sales

revenue.

ASSUMPTIONS :

1. Goal Sales maximisation subject to minimum profit constraint.

2. Advertisement instrument of the firm as non-price competition.
3. Production costs are independent of advertising.
4. Advertising create favourable conditions for the product.
5. Price of the product as constant.

MODEL :

sales maximiser will keep on selling, the marginal revenue remains positive

level of output is OQ1 where ∂(TR)/∂Q=0

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 ∂TR
Sales Revenue Maximization =0
TC
∂Q

TR

K1
╥0
K2

K3
╥1

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• Sales maximizer output OQ1 --- MR is Zero
• When minimum profit constraint (∏0)
– above the level of profits where MR=0 @ point K1,
the sales maximizer output is OQ3
• No profit constraint (∏1), output is OQ1
Berle-Means-Galbraith Model of ‘Corporate Power
Structure’
Owners/shareholders
• Separation of ownership and
management Top-level Management
• Interests (Board of Directors)
– Owners --- maximising profits
– Managers – own desires,
needs and motivations Middle-level Management
• Managers – greater power (line managers, etc)
on corporate policy
• Traditional Corporate Power Low-level Management
Structure - Vertical (Supervisory staff)

Workers
• Galbraith
– Modern corporations power structure - Concentric

Management
Technician &
Scientist
White-collar
workers
Blue-Collar
workers
Shareholders
 O. WILLIAMSON’S MODEL OF
‘MANAGERIAL DISCRETION’
Managers’ self – interest level of profit DIVIDEND to share
holder

ASSUMPTIONS :

a. Market is not perfectly competitive

b. Separation of ownership & management
c. A minimum profit constraint is imposed on the managers by the capital market.

MODEL : Managers’ UTILITY FUNCTION

U=f (S, M, ID)

S – Additional expenditure on staff (the benefits of increase the quality and number of
staff reporting to the manager)
M - Managerial Emolument (expenses account for entertainment, luxurious car etc)
ID – Discretionary investment (power and status of the manager)

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 Marris hypothesis of maximization
of firms growth rate
• Marris argues that the owners and managers have one
aspect of the firm in common; namely, its size.
• Managers will be primarily concerned with maximisation
of the rate of the growth of size rather than absolute firm
size.
• The attraction of the growth rate of size is thought
to stem from the positive effect growth has upon
promotion prospects. Stress is put on an alleged
preference of managers for internal promotion
and this is made easier if the firm is seen to be
expanding rapidly
• Managerial utility function may be written as follows:
Um = f (gD, s)

where
gD = rate of growth of demand for the products of the firm;
s = a measure of job security.

• Owners utility function may be written as

U0 = f *(gc)
• where gc = rate of growth of capital.
 PENROSE’S THEORY OF FIRM
-- the managerial constraint on growth of the
firm.
Assumption :
- FIRM both profit & a growth maximiser
- Growth = f (Managerial services)

MODEL :
* Managerial Roles
i. to conduct current operations & activities according to plan.
ii. to plan & carryout activities related to expansion.

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--How firm’s growth with managerial services

(i) Fixed amount of managerial services Expan-

sion Create flow of expansionary projects

(ii) With time, running new projects ~ less demand for

managerial services ~ creating underutilized
‘managerial services’ for undertaking additional
projects.

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 Cyert and March Behavioural Theory

The Firm as a Coalition of Groups

with Conflicting Goals
based on a large multi-product group operating under
uncertain conditions in an imperfect market - difference
between ownership and control - firm treated as a multi-
goal, multi-decision organisational coalition of managers,
workers, share-holders, customers, suppliers, bankers.
 Cyert and March Behavioural
Theory
Goal Formation – The Concept of the
Aspiration Level

Individuals may have (and usually do have) different

goals to those of the organisation-firm.

The Goals of the Firm: Satisficing Behaviour

Goals set by top management.

 Cyert and March Behavioural Theory

The main goals:

• Production goal - smooth running.

• Inventory goal - adequate stock of suitable raw
material.
• Sales goal - from sales department.
• Share of the market goal – also from sales
department.
• Profit goal – shareholders, finances.
Cyert and March Behavioural Theory

4 Means for the Resolution of Conflict

Conflict is inevitable. Nevertheless the

groups and the firm as a whole may
remain in a stable position - limited
time to bargain, etc. Behaviour, goals
and decisions are largely based on
past history.
 Cyert and March Behavioural Theory

The Theory of Decision Making

- At Top Management Level
Resource allocation - implemented by
the budget - share of budget taken by
each department. Largely determined by
bargaining power which is itself
determined by past performance.
Cyert and March Behavioural Theory

Uncertainty and the Environment of

the Firm
Two types of uncertainty:
- market (cannot be avoided)
- competitor's reactions (overcome by
tacit collution, eg. trade associations)
 Goals in the Public Sector and the Not-
For-Profit Enterprises
• The value-maximization objective – not an
appropriate objective in the public sector or in not-
for-profit (NFP) organizations
• The nature of goods and / or services and the manner
in which they are funded are different
• Three characteristics of NFP enterprises
– No one possesses a right to receive profit or surplus
– NFP enterprises are exempt from taxes on corporate
income
– Many NFP enterprises benefit from the fact that donations
to them are tax deductible
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• Public Sector agencies
– Provide services with a significant public good in
character
– Public Goods – consumed by more than one
person at the same time and entail high transaction
costs of excluding those who do not pay
• Not-for-Profit Objectives
– Efficiently managing its resources
– Increasing its capacity to supply high-quality
goods or services
– Providing a rewarding work environment for its
administrators
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