Prof.

Rajendra Prasad Shrestha

Theory of firm:
• Profit maximization theory,
• Baumol's theory of sales revenue
maximization,
• Marris's hypothesis of maximization of growth
rate,
• Williamson's model of managerial utility
function,
• Behavioral theories.
 Prof. Rajendra Prasad Shrestha

Profit Maximization (P/M) as Business Objective

*Basis for price and
production theories
*The strength of this
*The conventional
assumption lies in the fact
economic theory
that this assumption has
assumes profit
never been
maximization as the
unambiguously disproved.
only objective of
 P/M assumption has a
business firm.
great predictive power.
*P/M as the
* It helps in predicting the
objective of
behaviour of business
business firms has a
firms under different
long history in
market conditions.
economic literature.
*No alternative
*P/M is regarded as
hypothesis explains and
most reasonable
predicates the behaviour
and analytically
of firms better than P/M
most productive
assumption.
business objective.
 Prof. Rajendra Prasad Shrestha

Assumptions
• Owner-cum-manager
• Rational behaviour (profit earning motive) of
owner-cum-manager
• Only one commodity
• Price of factor of production is given
• Unit of each factor of production is equally
efficient
 Prof. Rajendra Prasad Shrestha

Appropriateness of Profit Maximization

Objectives
• Business activity rationally aims profits.
• Profit is essential for the existence and operations of
the firm.
• Can maximizes social economic welfare.
• Profit is required to raise fund from capital market.
• Possibility of providing high benefit packages for
employees.
• It may offer more dividend.
 Prof. Rajendra Prasad Shrestha

Profit Maximizing Conditions

Conditions for the profit to be maximum.
• (i) Necessary condition, and
• (ii) Secondary of Supplementary condition.
 Prof. Rajendra Prasad Shrestha

• The Necessary Condition requires that marginal

revenue (MR) must be equal to marginal cost (MC).
In simple words, marginal revenue is the changes in
total revenue obtained from the production and sale
of one additional unit of output. Marginal cost is the
cost arising due to the production of one additional
unit of output. A condition is said to be necessary if
its fulfilment results non-occurrence of an event.
• ( /Q) = (TR/Q) - (TC/Q) = 0
• or, (TR/Q) = (TC/Q)
 Prof. Rajendra Prasad Shrestha

• The Secondary Condition requires that necessary condition

must be satisfied under the condition of decreasing MR and
rising MC.
• (2 /Q2 ) = (2 TR/Q2 ) - (2 TC/Q2 ) < 0
• The second order condition requires that
• (2 TR/Q2 ) - (2 TC/Q2 ) < 0
• or, (2 TR/Q2 ) < (2 TC/Q2 )
• The fulfilment of the two conditions makes the sufficient
condition. The necessary and secondary conditions are also
known as first order and the second order conditions,
respectively.
 Prof. Rajendra Prasad Shrestha

Limitation
1. It is vague (profit before or after
tax).
2. It ignores the timing of return.
3. It ignores risk (cash flow under
certainty and uncertainty).
4. It ignores quality and goodwill of
the firm.
5. There are legal, moral and social
constraints to earn maximum
profits.
6. Maximizing profit is basically
short run concept.
7. Profit maximization assumes full
and perfect knowledge of
market conditions (operation in
certainty). Most price and
output decisions are based on
probabilities.
 Prof. Rajendra Prasad Shrestha

Controversy over Marginal Analysis

• Full and perfect knowledge about current market condition
• Fully aware of demand and cost function in both short and
long runs.
• Operation in the world of uncertainty.
• Most price and output decisions are based on probabilities.
• Limited use of the marginal principle in practice.
• Marginal rule of pricing does not stand the test of empirical
verification.
• Hall and Hitch found average cost principle so as to cover AC
= AVC + AFC and a normal margin of profit, i.e. Cost plus
pricing in short run and profit maximization in long run.
 Prof. Rajendra Prasad Shrestha
Conclusion
• Marginal analysis is the most as popular rule in economic
analysis.
• It is a time honoured rule.
• The empirical evidence against this rule is not conclusive.
• The alternative rules are not strong enough to replace the
rule for profit maximising.
• Greater predictive and explanatory power than other
alternatives.
• Marginal rule of profit maximising still forms the basis of the
firm’s behaviour.
• The validity of this rule can not be judged by priory logic or by
asking the business executive.
• The ultimate test is its ability to predict business behaviour
and trend. It is reliable measures of firm efficiency of a firm.
 Prof. Rajendra Prasad Shrestha

Baumol's Hypothesis of Sales Maximisation

Baumol has postulated maximization of
sales revenue as an alternative to
profit maximization objective. The
reason behind this objective is the
dichotomy between management and
ownership. This dichotomy gives
managers an opportunity to set their
goals other than profit maximization
which most owner-businessmen
pursue. Given opportunity, managers
choose to maximize their own utility
function
 Prof. Rajendra Prasad Shrestha
According to Baumol, the most plausible factor in managers'
utility functions is maximization of sales revenue.
• Salary and other earnings of managers are closely related to sales rather
than profit.
• Banks and financial institution are interested to see sales (index of
performance) for financing.
• Sales data are readily available at any time.
• Increasing sales revenue enhances the prestige of the managers.
• Profit maximization is a difficult task to fulfill consistently over a period of
time.
• Growing sales strengthen competitive sprit of the firm in the market.
• It is also argued that in the long run, profit maximization and sales
maximization objectives converge into one. In the long run, sales
maximization tends to yields only normal level of profit which turn out to
be maximum profit under competitive condition.
Prof. Rajendra Prasad Shrestha
 Prof. Rajendra Prasad Shrestha

Appropriateness of Sales Revenue Maximization

• Strengthen competitive sprit
• Protect interest of management
• Applicable in large scale firms where ownership
is divorced from management
• Considers to provide social welfare
• Makes easy to obtain loan
 Prof. Rajendra Prasad Shrestha

Limitations of Sales Revenue Maximization

• Theory collapse if total cost intersect total revenue before it reaches to
climax
• Sales maximization converges to profit maximization in long run (minimum
profit constraints = normal profit under perfect competitive market in long
run)
• Difficulty in testing validity of the theory due to lack of adequate and
relevant data availability.
• It does not clearly shows the implication of interdependence of the firm's
price and output decision. It ignores action reaction and counter action that
prevails in oligopoly market.
• It ignores actual and potential threats of competition in oligopoly market.
• It does not establish the relationship between firm and industry. It does not
distinguish between firm's equilibrium and industry equilibrium
• Baumol's claims of providing better solution, from social point of view, is not
necessarily valid.
 Prof. Rajendra Prasad Shrestha

Williamson's Hypothesis of Maximization of

Managerial Utility Function
• Like Baumol, O. E. Williamson argues that
managers have discretion to pursue objective
other than profit maximization. The managers
seeks to maximize their own utility function
subject to a minimum level of profit. Managers
utility function (U) is expressed as
• U = f(S, M, Id )
• Where, S = additional expenditure on staff,
• M = managerial emoluments,
• Id = discretionary investment
• According to Williamson Hypothesis, managers
maximize their utility function subject to a
satisfactory profit. A minimum profit is
necessary to satisfy the shareholders or else
manager's job security is endangered.
Prof. Rajendra Prasad Shrestha
 Prof. Rajendra Prasad Shrestha

• Like other alternative hypothesis, Williamson's

theory too suffers from certain weakness. His model
fails to deal with the problem of oligopolistic
interdependence. It is said to to hold only where
rivalry is not strong. In case of strong rivalry , profit
maximization is claimed to be a more appropriate
hypothesis. Thus, Williamson's managerial utility
function too does not offer a more satisfactory
hypothesis than profit maximization.
 Prof. Rajendra Prasad Shrestha

• The utility function which managers seek to

maximize include both quantifiable variables like
salary, and slack earning, 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 expense preferred defined as
"satisfaction derived out of certain types of
expenditure" (such as slack payments), and readily
available of funds for discretionary investment.
 Prof. Rajendra Prasad Shrestha
Marris Hypothesis of Maximization of Firm's Growth
Rate

Marris R. has suggested another alternative

objective, i. e. maximization of balanced
growth rate of the firm. Marris recognizes the
dichotomy between owner and managers
have their own interest. Accordingly, he
assumes that owners and managers have their
own utility function to maximize. The
managers' utility function (Um) and owners'
utility function (Uo) may be specified as
follows:

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

  Uo=f(Output, capital, market-share, profit, public steem)

Prof. Rajendra Prasad Shrestha
 Prof. Rajendra Prasad Shrestha

• According to Marris, by maximizing these variables,

managers maximize both their own utility function
and that of owners. The managers can do so because
most of the variables appearing in their own utility
function and those appearing in the utility function
of the owners are positevly and strongly correlated
with a single variable, i. e. size of the firm.
Maximization of these variavles depends on the
maximization of the growth rate of the firms. The
managers therefore seek to maximize a steady
growth rate.
 Prof. Rajendra Prasad Shrestha

• Marris theory, though more rigorous and

sophisticated than Baumol's sales
maximization, has its own weakness.
• It fails to deal satisfactorily with oligopolistic
interdependence.
• It ignores price determination which is the
main concern of profit maximization
hypothesis.
• Marris model too does not seriously challenge
the profit maximization hypothesis.
 Prof. Rajendra Prasad Shrestha

Simon's Satisfying Theory

Understanding Society
Innovative thinking about social
agency and structure in a global
world
 Prof. Rajendra Prasad Shrestha

• Prof. Simon submitted satisfying theory of behavioral

objective to explain the objectives of the firm.
• He assumes that manager takes decision with imperfect
knowledge. If full knowledge about business information is
available, decision making would be complex and
impracticable.
• He further argues that the real business is full of uncertainty
and accurate and adequate data are not readily available.
Even if data are available managers have little time & ability
to process them.
• Therefore, the firms can never know whether they are
maximizing profit or not. Instead they would try to "satisfy
rather than to maximize profits. They aim merely at
satisfactory profits.
 Prof. Rajendra Prasad Shrestha

• The theory explains that the business firms operate on the assumption that
minimal standards of achievement which provide satisfactory aspiration levels of
profits and guarantee the firm's long-run existence..
• The underlying principle of theory is that it shows firm's business behavior which
concentrates towards attaining certain level of profit, holding a certain share of the
market or a certain level of sales..
• The managers consider past experience and take account of future uncertainties
as a basis of determining the satisfactory aspiration level of profit.
• The profit gained at minimal standards of achievement is known as satisfactory
profit, or minimum profit or targeted profit.

Limitation
• It is difficult to make operational statement of what is to be regarded as
satisfactory. However, the theory lies in obtaining satisfactory level of profit, it is
less satisfactory than optimizing assumption..
• Fails to deal with interdependence and interaction of the firms.
 Prof. Rajendra Prasad Shrestha
Cyert-March Hypothesis of Satisfying Behaviour
• Cyert-March hypothesis is an extension of
Simon's hypothesis of firm's satisficing
behaviour
• Apart from dealing with an uncertain business
world, managers have to satisfy a variety of
group of people- managerial staff, labour, share
holders, customers, financers, suppliers, etc.
• All these groups have their own interest in the
firms, often conflicting.
• The managers' responsibility is to satisfy them
all. The underlying assumption of the satisficing
behavior of the firm is that a firm is a coalition of
different groups connected with various
activities of the firms.
• All these groups have some kind of expectations-
high and low- from the firm, and the firm seeks
to satisfy all of them in one way or another by
sacrificing some of its interest.
Richard Michael Cyert
Prof. Rajendra Prasad Shrestha
 Prof. Rajendra Prasad Shrestha

In order to reconcile between the conflicting interests and goals,

managers form an aspiration level of the firm combining the following
goals.
 Production goal,
 Sales and market share goal,
 Inventory goal, and
 Profit goal.
These goals and aspiration level are set on the basis of the managers' past
experience and their assessment of the future market conditions. The
aspiration levels are modified and revised on the basis of achievements
and changing business environment.
 Prof. Rajendra Prasad Shrestha

Criticism
• First, though the behavioural theory deals
realistically with the firm's activity, it can not explain
firm's behaviour under dynamic conditions in the
long-run.
• Secondly, it cannot be used to predict exactly the
future course of firm's activities.
• Thirdly, this theory does not deal with equilibrium of
the industry.
• Fourthly, like other alternative hypotheses, this
theory, too fails to deal with interdependence and
interaction of the firms.