CHAPTER TWO

THE THEORY OF THE FIRM

 2.1. The Neoclassical Theory of the firm

• It is also called Microeconomic theory of the firm

• The theory suggest
 firms generate goods to a point where MC=MR
• central to determine the behavior of the firm to profit
maximization is the objective in neoclassical view of the firm
• neoclassical firm arrived at MR = MC, then profit is said to be
maximized.
 The neoclassical theory of the firm is criticized based on the following points:

1. the right price determine based on recovering full cost (including a

conventional allowance for profit), rather than MR=MC
2. Imperfect information, and uncertainty, is not taken as a relevant
factor
3. The organizational complexity of firms may impede the application
of the profit maximization principle

2.2. The Modern Theory of the Firm

 which can be further classified as: Managerial theory, Principal-Agent
Theory and Transactions Cost Theory.
 2.2.1. Managerial theory
 the objective of firms is sales/revenue maximization
 on the complex nature of the modern corporate firm. The
theory is based on two major principles/premises:
1. There is separation of ownership and control:
 firm, ownership (by shareholders) is distinct from control
(exercised by managers)
 there is a possibility of setting growth or revenue
maximization objectives as priority instead of profit
maximization.
2. firms are considered as active entities that make a difference
in their economic performance
 Models in managerial theory
A. Baumol’s Model. hired managers may be more preoccupied by
sales or revenue maximization instead of profit maximization
The justification of the theory is that
 Sales performance is equated with the performance in market
share and market power.
 market share is the ratio of firm‘s sales to total sales of a given
market.
 performance report of a firm is usually in terms of sales not profit.
 Sales data are easily accessible
 The financial market and retail distributors are more responsive to
a firm with rising sales
 Baumal assumes that the firm maximizes sales revenue subject to a
minimum profit constraint.
the difference between the maximum possible level of profit and minimum
constrained profit ‘sacrificeable’.
 B. Marris’s Model

• Used the principle of segregation of managers from owners

 owners (shareholders) aim at profits and market share
 managers aim at better salary, job security and growth. focus
at max their utilities
 A manager faces two constraints to maximize balanced
growth rate
1. managerial constraint and
2. financial constraint.
 Marris assume that these two set of goals can be achieved by
maximizing balanced growth of the firm (G), rather than sales
 2.1.2. The Principal-Agent Theory

• known as the Agency Theory examines situation

• two main actors in principal-agent theory
1. a principal who is usually the owner of an asset, and
2. the agent who makes decisions, which affect the value of
that asset, on behalf of the principal.
It assume principal-agent problems are that the principal knows
less than the agent about something important, and their
interest conflict in some way.
The factors which brings principal-agent problems:

1. Moral Hazard: it come from Conflict of interest and the

existence of information asymmetry
 shirking, hidden action problem and post contract
opportunism are used interchangeably with the concept of
Moral Hazard.
 shirking, that is, a reduction in effort by an agent who is part
of a team that causes a declining in total output
 Shirking is the moral hazard arising from the employment
contract.
contacts between principals and agents should be think in two parts:

I. Risk-sharing: To convince the agent to sign a contract,

II. Incentives: If under a given contract payments are larger for
higher outcomes, there will be higher effort.
III. Managers could each be paid a Salary plus a bonus based on
the performance of the company.
IV. Development of efficient ways of monitoring the
performance of individual managers (or management teams).
V. Bonding (where the agent makes a promise to pay the
principal a sum of money if inappropriate behavior by the
agent is detected) and
VI. Mandatory retirement payments.
 2.1.3. Transaction Cost Theory
• in the real world institutional structure affects both transaction
costs and individual incentives and hence economic behavior.
What are the causes of transaction cost?
• Bounded rationality: the imperfect ability to solve complex
problems.
• Opportunism relates to how people will respond to conflicts,
given the existence of bounded rationality
• Asset specificity: either to physical or human elements in the
transaction.
• In general transaction costs are costs of running the economic
system. These costs arise from the establishment, use,
maintenance, and change of:
– Institutions in the sense of law;
– Institutions in the sense of rights;
– Transaction costs arising from informal activities
connected with the operation of the basic formal
institutions.
 Three types of transaction costs

1. Market Transaction Costs

2. Managerial Transaction costs
3. Political Transaction costs

• Each of the three may have two cost elements, fixed

transaction costs (the specific investments made in setting up
institutional arrangements) and the variable transaction costs
that depend on the number of volume of transactions.
 2.3. The Growth of the Firm

• There are two alternative Motives for Growth

1. Natural Process firm will born, grow to maturity and die.
2. External Pressure There are certain external forces which
compel a firm to grow over time. This are:-
 Development of Needs
 Dynamism of Competition: Competition is dynamic. Survival
and growth are not one-time achievements.
 The Drive for Market Power: firm decision-making in the
market in areas such as: prices output and other related
ones.
 The Determinants of the Growth of the Firm

• There are four theories that attempt to explain the

determinants of the growth of the firm
1. Life – Cycle Theory
A firm is created, grows, matures and finally dies out like any
biological species.
It captured by the product-life cycle or the Sigmoid Curve / S-
Curve/.
 firm’s growth rate accelerates the objective of
management and shareholders coincides profit raises
Managerial diseconomies of older firms arise Growth
slows.
Criticism of the Life – Cycle Theory

 Growth at any point in time

may be exogenously given
– not determined from
within by age of the firm.
 Needs never die they
rather develop over time
 Management‘s deliberate
move, vision and success in
Research and Development
can change the growth
pattern.
 2. The Theory of Profit Constraint

 This theory is also called Downie‘s theory

 market structures and the rules of the game lead to the
divergences in efficiency and the rate of technical progress
among firms.
 Downie‘s model starts with steady encroachment on the
market share of less efficient firms by more efficient firms.
 It can be examined from the supply and demand sides of
growth of a firm.
1. Supply side :focused investment in new technology:
 The rate of capacity expansion is positively related to the rate
of profit and/or efficiency.
2. Demand Side: an efficient firm must offer price discounts to
attract new customers.
there are two opposite forces in the growth process of the firm

 the supply side (the capacity) of growth, which varies positively

with the rate of profit and the demand side,
 the demand side is inversely with the rate of profit after some
level of profit.
 The two opposite trends set the upper limit on the rate of growth
of the firm.
 At upper limit the rate of profit and the product price of the firm
should enable capacity and market of the firm to grow at the
same rate is called Downie’s Equilibrium Point.
 financial constraints, (specifically profitability, which is the source
of own finance) play the crucial role in the process of the growth
of the firm in Downie’s framework.
 Criticism of the Theory

• It ignores the possibility that inefficient firms might react

positively and aggressively to declining market share.
• The new customers are attracted through price-reduction
ignores non-price competition strategy like: advertisement,
new product development and so on.
• The model can not take account the managerial restraint,
which plays very important in limiting the growth of the firm.
• The model undermines the role of other sources of financing:
Issuing of new shares, borrowing from banks, issuing bonds
and related others.
 3. The Theory of Management Constraint
• It is known as Penrose‘s Theory
• It suggested growth of a firm continues unless some factors
constraint opportunities for expansion. It can be of two types:
1. Internal Constraints:
 Managerial capacities
 Financial restraints
2. External obstacles; refer to both demand- and supply-side
factors.
 Competition from rivals leading to narrow market;
 Patent or other restrictions on the adoption of new
technologies;
 Lack or shortage of inputs, escalation of costs of major inputs,
etc.
Cont…d
• Penrose concluded that the most important constraint to
growth is shortage of competent and dependable managers
Criticism of the Theory
• The theory gave marginal attention to financial and external
constraints.
• Management is not a perfect substitute to the other inputs.
4. The Integrated Theory of Growth
 It is known as Marris‘s Model
 It referred to as an integrated theory of growth and at the
same time managerial theory of the firm because:
• It integrates Downie‘s & Penrose‘s theories. All the three
constraints, namely, financial, market demand & managerial
restraints are integrated and made operative in the Marris‘s
theory;
• It is a Managerial Theory of the firm as it is based on the
presumption of separation of ownership and control, which
results in divergence of objectives of the owners and
managers.
Marries model is dynamic one.
 Like Baumol‘s theory, it assumes that managers will act to
maximize their utilities rather than profits,
 but in contrast to Baumol, it assumes that this will be achieved
through growth rather than sales.
cont…d

 The goal of the firm is defined as the maximization of the

balanced rate of growth of the firm, that is, the maximization
of the:
 Rate of growth of demand for the products of the firm; and
 Rate of growth of its capital supply. In other words, g = gd = gc
is the Equilibrium Condition for Growth.
• according to Marris a firm maximizes the growth of total
productive assets subject to a managerial constraint. Like
Buamol‘s model, here the objectives of the owners and the
managers are reconcilable.
 Utility Functions of Owners and Managers

• The utility function of mangers

Um = f (salaries, power, status, job security)
Utility =f (gd)
• Utility function of owners; the objective of the owners is to
maximize return
Uo = f (profits, capital, output, market share, public esteem)
U owners = f(gc)
The manager’s utility Managers’ Utility =f (gd, s)
S’ is a measure of job security
• Balanced growth is necessary to avoid excess capacity or excess
demand
• Marris argues that this divergence of goals is not so wide as it is
claimed so by other scholars
• some of the variables appearing in both utility functions are
strongly correlated with a single variable:
• Marris argues that managers prefer promotion within the same
but growing firm enjoying higher salaries, power and prestige to
moving from a smaller firm to another larger firm,
• mobility of managers is very low. Hence managers aim at the
maximization of the rate of growth of the firm (rather than the
absolute size of the firm).
 Sources of Growth

Demand Side: the growth of demand (gd) depends on:

• The diversification rate, ‘d’ ; that is, gd = f (d), where, gd is
growth of demand and ‘d’ is rate of successful diversification;
• Number of successful new products introduced
• If demand for a product reaches its saturation point, Marris
advocated diversification and/or new product development
(innovation) as the most effective way to grow further-
continuous growth+
 Supply Side:

 (gC) is based on the increase in the asset-base of the firm.

The growth rate of assets gC= I/K,
where: ‘I’ new investment, and
‘K’ capital (capital employed)
 New investment depends on available finance.
A firm can raise finance for expansion from three sources:
a) retained earnings;
b) borrowing
c) issuing new equity shares
 Growth Constraints

In pursuing balanced growth rate, the firm faces two constraints:

• Management Constraint : it is a constraint set by the
competence of a management team and its behavior;
• Financial Constraint: A financial constraint set by the limit to
the amount of capital a firm can mobilize at certain time.