Theory of the Firm Introduction. In developing the supply and demand approach to economics, economists first worked out the basis of the demand curve

Theory of the FirmIntroduction

Introduction

In developing the supply and demand approach to economics, economists

first worked out the basis of the demand curve.

IntroductionAs a first step, we need to think

about the decision-makers in supplying goods and services, and

what a "rational decision"

to supply goods and services would mean. In economics, this is often called the "Theory of the Firm."

FirmsProprietorships PartnershipsCorporations

ProprietorshipsA proprietorship (or proprietary

business) is a business owned by an individual, the "proprietor."

Many "Mom and Pop stores" - and other "Mom and Pop"

businesses, as Americans call them - are proprietorships.

PartnershipsA partnership is a business jointly owned by two or more persons. In most partnerships, each partner is legally liable for debts and agreements made by any partner.

Corporations

Limited liabilityAnonymous ownership

A corporation has two characteristics that distinguish it from most proprietorships and partnerships:

Traditional Theory of the Firm

This assumes that firms aim simply to maximise profits.


The classical theory of the firm relied heavily on the notion that firms are small, owner-managed organisations, such as proprietorships, operating in highly competitive markets whose demand functions are given and where only normal profits can be earned.


If the firm did not therefore maximise

profits it would fail to survive under these

conditions.


1. The model of a profit-maximising firm is an owner-managed firm producing only one good, which knows all future cost and revenue streams with certainty.

There are two main objections to this notion:


Such a firm could indeed choose the levels of output and price that would maximise its profits.

But, in fact, firms are faced with much more complex decisions, to be taken in a dynamic and uncertain environment, and in this case it is far less clear how a profit-maximising firm will behave.


2. Firms may be aiming to do something completely different; for example to maximise sales or growth.

Such an objection may well apply to modern joint-stock companies or to any other company that is not managed by its owners.

What does a supplier maximise?

The operations of the firm will, of course, depend on its objectives.

One objective that all three kinds of firms share is profits, and it seems that profits are the primary objective in most cases.


1. First, despite the growing importance of nonprofit organizations and the frequent calls for corporate social responsibility, profits still seem to be the most important single objective of producers in our market economy.

There are two reasons for this assumption.


2. Second, a good deal of the controversy in the reasonable dialog of economics has centered on the implications of profit motivation.

ProfitProfit is defined as revenue minus cost, that is, the price of output times the quantity sold (revenue) minus the cost of producing that quantity of output.

However, we need to be a little careful in interpreting that.

ProfitRemember, economists understand cost as

opportunity cost –

the value of the opportunity given up. Thus, when we say that businesses maximize profit, it is important to include all costs -- whether they are expressed in money terms or not.

ProfitBecause accountants traditionally considered only money costs, the net of money revenue minus money cost is called "accounting profit."

(Actually, modern accountants are well aware of opportunity cost and use the concept for specific purposes).

ProfitThe economist's concept is sometimes called

"economic profit."

The John Bates Clark Model

Like any other unit, a firm is limited by the technology available. Thus, it can increase its outputs only by increasing its inputs. As usual, this will be expressed by a production function.


The output the firm can produce will depend on

the land, labour and capital the firm puts to

work.


In formulating the Neoclassical theory of the firm, John Bates Clark took over the classical

categories of land, labour and capital and simplified them in

two ways.


1. First, he assumed that all labour is homogenous -- one labour hour is a perfect substitute for any other labour hour.


2. Second, he ignored the distinction between land and capital, grouping together both kinds of nonhuman inputs under the general term "capital." And he assumed that this broadened "capital" is homogenous.


Some inputs can be varied flexibly in a relatively short period of time.

We conventionally think of labour and raw materials as "variable inputs" in this sense.


Other inputs require a commitment over a longer period of time. Capital goods are thought of as "fixed inputs" in this sense.

More Simplifying Assumptions

The John Bates Clark model of the firm is already pretty simple.

We are thinking of a business that just uses two inputs, homogenous labour and homogenous capital, and produces a single homogenous kind of output.


The output could be a product or service, but in any case it is measured in physical (not money) units such as bushels of wheat, tons of steel or minutes of local telephone calls.


The price of output is a given constant.

The wage (the price of labour per labour hour) is a given constant.

We will add two more simplifying assumptions:

The Firm's DecisionIn the short run, then, there are only two things that are not given in the John Bates Clark model of the firm.

They are the output produced and the labour (variable) input.

The Firm's Decision

And that is not actually two decisions, but just one, since labour input and output are linked by the "production function."

The Firm's Decision

Eitherthe output is decided, and the labour input will have to be just enough to produce that output

or the labour input is decided, and the output is whatever that quantity of labour can produce.

The Firm's Decision

Thus, the firm's objective is to choose the labour input and

corresponding output that will maximize profit.

Labour Input and Profits

Problems with Profit Maximisation

Returning to the concept of

Profit Maximisation

we'll now take a closer look at the problems associated with it and, perhaps more importantly, its alternatives.

Problems with Profit Maximisation

Firstly the problems,the existence of

uncertainty andthe complexity of large

firms.

1. UncertaintyThe Profit maximising model is a static one in which the firm knows its revenue and cost curves with certainty and

maximises profits by equating marginal cost and marginal

revenue.

1. UncertaintyIn practice firms make decisions in a dynamic

context. Therefore, revenue and cost calculations must

take into account the dimension of time.

1. Uncertainty

Future cost and revenue streams must be discounted to yield the Net Present Value (NPV) associated with each

course of action.

1. Uncertainty

Profit maximisation means choosing the

course of action which yields the highest NPV.

Net Present Value

nn ii

NPV = NPV = i = 1i = 1(1 + r)(1 + r)ii

Where Where ii = R = Rii - C - Cii

r = discount rater = discount rate

n = time horizonn = time horizon

With uncertaintyWith uncertainty nn

(NPV) = (NPV) = EEii))

i = 1i = 1 (1 + (1 + r)r)ii

nn(NPV) = (NPV) = ii p(H p(Hii))

i = 1i = 1 (1 (1 + r)+ r)ii

Where p(HWhere p(Hii) = probability attached to ) = probability attached to

each value that profits may each value that profits may take in year itake in year i

Risk Minimisation v. Profit MaximisationPolicy APolicy A

Profit Profit ProbProb00 0.250.2540 40 0.500.50100 100 0.250.25

A = 0 x 0.25 + 40 x 0.5 + 100A = 0 x 0.25 + 40 x 0.5 + 100 x 0.25 = 45x 0.25 = 45

Policy BPolicy B

ProfitProfit ProbProb0 0 0.500.50100100 0.500.50

B = 0 x 0.50 + 100 B = 0 x 0.50 + 100 x 0.50 = 50x 0.50 = 50

ButBut 50% probability of zero profits with policy B. 50% probability of zero profits with policy B.

2. Organisational Complexity

The owners of the modern firm are a large number of share-holders, who have nothing to do with the running of the firm, while the main decisions are made by the board of directors of

the firm and implemented by managers and workers all through the

different levels and departments of the firm.


1. even if managers do wish to maximise profits, this objective will often be difficult to achieve in a modern firm;

This has two main implications for the profit maximisation assumption:


2. the managers who take the decisions may be interested not in maximising profits but in some other goal.

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Baumol’s Static Sales Revenue Maximising Baumol’s Static Sales Revenue Maximising Model without AdvertisingModel without Advertising

Alternatives to Profit Maximisation

Baumol's Theory of Sales Revenue

Maximisation

Baumol's Theory of Sales Revenue Maximisation

Two basic models:static single-period model;multi-period dynamic growth model.

Each model can include advertising activity or not.

1. Rationalisation of the Sales Maximisation Hypothesis

-There is evidence that salaries and other (Mach) 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.

1. Rationalisation of the Sales Maximisation

Hypothesis- 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.


Hypothesis- 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.

- Large, growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-à-vis its rivals.


Hypothesis

The implication of Baumol’s model is that risk avoidance has a statistical effect upon economic activities, eg. R&D in large firms.

2. Baumol’s Static Models

The basic assumptions of the static models:

- The time-horizon of a firm is a single period.- During this period the firm

attempts to maximise its total sales revenue (not physical volume of output) subject to a profit constraint.


- The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and other financial institutions. The firm must realise a minimum level of profits to keep shareholders happy and avoid a fall of the prices of shares on the stock exchange.


-Conventional cost and revenue functions are assumed - cost curves are ill-shaped and the demand curve of the firm is downward sloping.


Four models:- A single-product model, without

advertising.- A single-product model, with

advertising.- A multi-product model, without

advertising.- A multi-product model, with

advertising.

3. Baumol’s Dynamic Model

The most serious weakness of the static model is the short-time losses of the firm and the treatment of the profit constraint as an exogenously determined magnitude. In the dynamic model the time horizon is extended and the profit constraint is endogenously determined.

The assumptions of the dynamic model

- The firm attempts to maximise the ratio of growth of sales over its lifetime.

- Profit is the main means of financing growth of sales, and as such is an instrumental variable whose value is endogenously determined.


- Demand and of cost have the traditional shape - demand is downward-sloping and costs are U-shaped. Profit is not a constraint (as in the static model) but an instrumental variable, a means whereby the top management will achieve its goal of a maximum rate of growth of sales.

- Growth may be financed by internal and external sources. However, there are limits to the external sources of finance.Thus profits will be the main source for financing the rate of growth of sales revenue.


Growth may be financed by internal and external sources. However, there are limits to the external sources of finance. Thus profits will be the main source for financing the rate of growth of sales revenue.

Williamson's Model of Managerial DiscretionWilliamson argues that managers

have discretion in pursuing policies which maximise their

own utility rather than attempting the maximisation of profits which

maximises the utility of owner-shareholders.

Williamson's Model of Managerial Discretion

Profit acts as a constraint to this managerial behaviour, in that the financial markets and share-holders require a minimum profit to be paid out in the form of dividends, otherwise the job security of managers is endangered.


The managerial utility function includes such variables as salary, security, power, status, prestige, professional excellence. Expense

preference is defined as the satisfaction which managers derive from certain types of

expenditures.


Staff expenditures on emoluments, and funds available for discretionary investment give to managers a positive satisfaction (utility) because these expenditures are a source of security and reflect the power, status, prestige and professional achievement of managers.


Staff expenditures, salary and benefits, emoluments and

discretionary investment expenses are measurable in money terms and

can be used to replace the non-operational concepts of power,

status, prestige and professional excellence in a managerial utility

function.


The latter may be written:

U = f1 (S, M, ID)

where

S = staff expenditure, including

managerial salaries

M = managerial emoluments

ID = discretionary investment

Marris - Growth Maximisation

Model highlights two important factors as far as management is concerned: the attitude to risk and uncertainty and the desire for utility which may not be maximised by the pursuit of maximum profits.


Marris, like Williamson, suggests that managers have a utility

function in which salary, prestige, status, power, security, etc., are important. The owners

of the firm are, however, likely to be more concerned with profits,

market share, output, etc.


In contrast to Williamson, Marris argues that the owners and managers have one aspect of the firm in common; namely, its size.

He therefore postulates that 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.


s can be measured by a weighted average of three ratios: the liquidity ratio,

the leverage debt ratio and the profit-retention ratio.


S can be measured by weighted average of S can be measured by weighted average of liquidity ratio, debt ratio and profit retention ratioliquidity ratio, debt ratio and profit retention ratio

Liquidity ratio = Liquidity ratio = Liquid assetsLiquid assetsTotal assetsTotal assets

Debt ratioDebt ratio = = Value of debtValue of debtTotal assetsTotal assets

Retention ratio =Retention ratio = Retained profitsRetained profitsTotal profitsTotal profits


Too low liquidity ratio may lead to insolvency and bankruptcy and there is a threat of take-over in case it being too high.

Too low Retention ratio may upset shareholders and too high ratio may inhibit growth.

Cyert and March Behavioural Theory

1. The Firm as a Coalition of Groups with Conflicting

Goalsbased on a large multiproduct 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.


2. Goal Formation – The Concept of the Aspiration

LevelIndividuals may have (and

usually do have) different goals to those of the organisation-firm.


3. The Goals of the Firm: Satisficing Behaviour

Goals set by top management.


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.


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.


5. 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.


6. Uncertainty and the Environment of the Firm

Two types of uncertainty:

- market (cannot be avoided)

- competitor's reactions (overcome by tacid collution, eg. trade associations)

Documents

Theory of the Firm Introduction. In developing the supply and demand approach to economics, economists first worked out the basis of the demand curve