THE THEORY OF THE FIRM

Although managerial economics is not concerned solely with the management of business firms, this is its principal field of application. To apply managerial economics to business management, we need a theory of the firm, a theory indicating how firms behave and what their goals are.

The concept of the firm plays a central role in the theory and practice of managerial economics. An understanding of the reason for the existence of firms, their specific role in the economy, and their objective provides a background for that theory.

THE THEORY OF THE FIRM

Reasons for the Existence of Firms and Their Functions
A firm is an organization that combines and organizes resources for the purpose of producing goods and/or services for sale. Firm exist because it would be very inefficient and costly for entrepreneurs to enter into and enforce contracts with workers and owners of capital, land, and other resources for each separate step of the production and distribution process.

Firms often hire labour for long periods of time under agreements that specify only that a wage rate per hour or day will be paid for the workers doing what they are asked. The two parties do not have to negotiate a new contract every time the worker is given a new assignment. The saving of the transactions costs associated with such negotiations is advantageous to both parties. 2

THE THEORY OF THE FIRM

Reasons for the Existence of Firms and Their Functions
A second explanation for the existence of firms is that some government interference in the market-place applies to transactions among firms rather than within firms. For example, sales taxes usually apply only to transactions between one firm and another.

By internalizing some transactions within the firm that would otherwise be subject to those interferences, production costs are reduced.
Because this is a secondary factor, firms would exist in the absence of such interference, but it probably contributes to the existence of more and larger firms. Given that production costs are reduced by organizing production factors into firms, why wont this process continue until there is one large firm?
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THE THEORY OF THE FIRM

Reasons for the Existence of Firms and Their Functions
There are at least two reasons: why wont the process continue until there is one large firm? First, the cost of organizing transactions within the firms tends to rise as the firm gets larger. At some point, these internal transactions costs will equal the cost of transacting in the market. At that point, the firm will cease to grow. A second factor constraining firm size is the limitation of an managements ability to effectively control and direct the operation of the firm as it becomes larger and larger. Both of these reasons for a limit on the size of the firm fall under the heading of what economists have termed diminishing returns to management. Stated another way, production costs per unit of output will tend to rise as firms grow larger, because of limited managerial ability.
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THE THEORY OF THE FIRM

The Objective of the Firm
To be able to discuss efficient or optimal decision making requires that a goal or objective be established. That is, a management decision can only be evaluated against the goal that the firm is attempting to achieve. Originally, the theory of the firm was based on the assumption that the goal of the firm was to maximize current or short-run profits. Firms, however, are often observed to sacrifice short-term profits for the sake of increasing future or long-term profits. Since both short-term as well as long-term profits are clearly important, the theory of the firm now suggests that the primary goal of the firm is to maximize the wealth or value of the firm.
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THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
Put briefly, a firms value will be defined here as the present value of its expected future cash follows. For present purpose, we can regard a firms cash flow as being the same as its profit. Thus, expressed as an equation, the value of the firm equals

Present value of = expected profits

+ ... + (1)

Where is the expected profit in the year t, i is the appropriate discount rate used to find the present value of future profits, and t goes from 1 (next year) to n (the last year in the planning horizon).
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THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
Because profit equals total revenue (TR) minus total cost (TC), this equation can also be expressed as

Present value of = expected profits

Where

(2)

is the firms total revenue in year t, and is its total cost in year t.

To repeat, managerial economists generally assume that firms want to maximize their value, as defined in equations (1) and (2). However, this does not mean that a firm has complete control over its value, and that it can set it at any level it chooses. On the contrary, firms must cope with the fact that there are many constraints on what they can achieve. 7

THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
The constraints that limit the extent to which a firms value can be increased are of various kinds as given below:

i. Input Constraints: - The amount of certain types of inputs may be limited. In the relevant period of time, the firm may be unable to obtain more than a particular amount of specialized equipment, skilled labour, essential materials, or other inputs.
ii. Legal Constraints: - Another important type of constraint that limits what firms can do is legal in nature. A wide variety of laws (ranging from environmental laws to antitrust laws to tax laws) limit what firms can do, and the contracts and other legal agreement made by firms further constrain their actions. As indicated in figure given below, these constraints limit how much profit a firm can make, as well as the value of the firm itself.

THE THEORY OF THE FIRM

The Objective of the Firm (contd.)
Value of Firm
Input, legal and other constraints

The value of i depends on: 1 Riskiness of firm 2 Conditions in capital market

The value of depends on: The value of depends on: 1 Production Techniques 1 Demand and forecasting 2 Cost of Production 2 Pricing 3 Process Development 3 New product development

THE THEORY OF THE FIRM

Limitations of the Theory of the Firm The theory of the firm, which postulates that the goal or objective of the firm is to maximize wealth or the value of the firm, has been criticized as being much narrow and unrealistic.

In its place, broader theories of the firm have been proposed. The most prominent among these are models that postulate that the primary objective of the firm is the maximization of sales, the maximization of management utility, and satisficing behaviour.

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THE THEORY OF THE FIRM

Sales Maximization Model
According to the sales-maximization model introduced by William Baumol and others, managers of modern corporations seek to maximize sales after an adequate rate of profit has been earned to satisfy stockholders. Baumol argued that a larger firm may feel more secure, may be able to get better deals in the purchase of inputs and lower rates in borrowing money, and may have a better image with consumers, employees, and suppliers. Indeed, some early empirical studies found a strong correlation between executives salaries and sales, but not between salaries and profits. More recent studies, however, found the opposite.

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THE THEORY OF THE FIRM

Williamsons Model of Managerial Discretion
The managerial theory of firm developed by Oliver E. Williamson states that managers apply discretion in making and implementing policies to maximize their own utility rather than trying for the maximization of profit which ultimately maximizes the utility of owner shareholders. This is known as the management utility maximization. It postulates that with the advent of the modern corporation and the resulting separation of management from ownership, managers are more interested in maximizing their utility, measured in terms their compensation (salaries, fringe benefits, stock options, etc.), the size of their staff, the extent of control over the corporation, lavish offices, etc., than in maximizing corporate profits. This is referred to as the principal-agent problem. That is, the agent (manager) may be more interested in maximizing his or her benefits than maximizing the principals (the owners) interest. 12

THE THEORY OF THE FIRM

Theory of Satisficing
The advocates of satisficing theory say that firms goal should be satisficing rather than optimizing. Satisficing means acceptance of less than the best. They argue that the behavior of real-world managers is not always consistent with the profit-maximization goal. Because of the great complexity of running the large modern corporation a task often complicated by uncertainty and a lack of adequate data managers are not able to maximize profits but can only strive for some satisfactory goal in terms of sales, profits, growth, market share, and so on.

Simon called this satisficing behaviour. That is, the large corporation is a satisficing, rather than a maximizing organization.

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THE THEORY OF THE FIRM

Cyert and Marchs Behavioral Theory
Cyert and March opined that a large-scale corporate type of firm exists these days. Hence, entrepreneur cannot alone be a decision maker. The decisionmaking involves a complex group or organization. It consists of various individuals whose interest may conflict with each other.

The group is called organizational coalition and includes managers, stockholders, workers, consumers and so on. All of these individuals participate in setting the goals of an organization.
Unlike conventional theory of single goal, behavioral theory states that an organization has multiple goals. The real world firm generally possesses the following five goals:

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THE THEORY OF THE FIRM

Cyert and Marchs Behavioral Theory (contd.)
1. Production Goal: According to this goal, production should not fluctuate too much nor fall below an acceptable level. Because this ensures stable employment, maintenance of adequate cost performance and growth, the workers and those in production department have this goal.
2. Inventory Goal: This goal originates mainly from the inventory department, or from the sales and production departments. The sales department needs enough stock of output for the customers, while the production department requires adequate stocks of raw materials and other items necessary for a uniform flow of the output. 3. Sales Goal: The sales goal is simply an aspirations with respect to the level of sales. Particularly, this goal arises from salesmen, since their success depends on their ability to maintain or expand the sales.
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THE THEORY OF THE FIRM

Cyert and Marchs Behavioral Theory (contd.)
4. Market-share Goal: This goal is an alternative to the sales goal and arises from the sales department. This department decides on the advertising campaigns, the market research programmes, and so on.
5. Profit Goal: This goal is set by the top management in order to satisfy the demands of shareholders and the expectations of bankers; and also to generate funds with which they can achieve their own goals and projects, or satisfy the other goals of the firm.

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THE THEORY OF THE FIRM

Cyert and Marchs Behavioral Theory (contd.)
While making decisions, firms are guided by these five goals. The conflict among different goals may come up. For example, sales goal may require a lower price whereas the profit goal a higher price. Sales and production goal may require high inventories whereas profit goal may require low inventories. Such conflicts among coalition members are resolved within the firm as a result of persuasion and accommodation of each others viewpoint. The firm in the behavioral theories seeks to satisfice overall performance, rather than maximize profits, sales or other magnitudes. The firm is a satisficing organization rather than a maximizing entrepreneur. The top management, accountable for the coordination of the activities of the various members of the firm, want:
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THE THEORY OF THE FIRM

Cyert and Marchs Behavioral Theory (contd.)
to attain a satisfactory level of production,

to attain a satisfactory share of the market,

to earn a satisfactory level of profit to divert a satisfactory percentage of their total receipts to research and development or to advertising, to acquire a satisfactory public image, and so on. But, it is not clear in the behavioral theories what is a satisfactory and what an unsatisfactory attainment is.

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THE THEORY OF THE FIRM

Cyert and Marchs Behavioral Theory (contd.)
Means for the Resolution of Conflicts: The top management uses different methods to resolve the conflicts within the firm. The means for the resolution of conflicts are: delegation of authority, budget determination, monetary payments like wages, salary and dividend, side payment given to the scientist of research department in addition to regular salary, slack payments it is defined as payments to the various groups of the coalition above than the payments required for efficient working of the firm. fulfilling demand according priority, decentralization of decision-making.
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THE CONCEPT OF ECONOMIC PROFIT

Practically all published profit figures are based on the accountants definition of profits. This notion of profit is relatively straightforward: Profit is defined as total revenue minus explicit costs. This is known as accounting profit.

When economists speak of profit, they mean profit after taking account foregone incomes - interest, salary and rent of the resources owned and used by entrepreneur of which there is no direct payment. They are included in implicit cost. The implicit cost means opportunity cost. The profit arrived at by deducting imputed costs from accounting profit can be called as economic profit.
Economic profit = Accounting profit Imputed cost (Implicit cost). Following example makes clear the underlying difference between these two concepts accounting and economic profit.
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THE CONCEPT OF ECONOMIC PROFIT

Robin Singh, a SMC graduate, has planned to invest Rs 2, 00, 000, which he has kept in a bank at 5% interest rate, in a poultry firm in Gitanagar in own land. The accountant prepares such income statement for one year:
Sales Less: Cost of goods sold Gross profit Less: Advertising Depreciation Utilities Miscellaneous expenses Net accounting profit Rs. 50,000 Rs. 20,000 Rs. 30,000 Rs. Rs. Rs. Rs. 1,000 1,000 1,000 2,000

Rs. 5,000 Rs. 25,000

The use of this concept may lead to wrong decision. The firm making profit from accounting viewpoint may have been incurring loss from economic viewpoint. Hence, only the concept of economic profit is relevant in decision-making. The implicit cost considered by the economist is related to the opportunities foregone. Hence such costs should be included for rational decision-making. Three important implicit costs in above example are:

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THE CONCEPT OF ECONOMIC PROFIT

a. The investment of Rs. 2, 00,000 investment would return Rs. 10,000 annually @ 5% interest rate. Thus, Rs. 10, 000 should be considered as the implicit or opportunity cost of having the Rs. 2, 00,000 invested in the poultry firm.
b. Second implicit cost is the management's time and talent. If the annual wage return of Robin is Rs 90, 000. This is the implicit cost of managing this business rather than working for someone else. c. Forgone annual rent is Rs. 24, 000 of the house owned and used by Robin.

Hence, the above income statement should be amended in the following way in order to determine economic profit:

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THE CONCEPT OF ECONOMIC PROFIT

Sales Less: Cost of goods sold Gross profit Less: Advertising Depreciation Utilities Miscellaneous expenses Net accounting profit Less: Implicit costs: Return on invested capital Foregone wages Foregone rent Net economic profit Rs. 50,000 Rs. 20,000 Rs. 30,000 Rs. Rs. Rs. Rs. 1,000 1,000 1,000 2,000

Rs. 5,000 Rs. 25,000

Rs. 10, 000 Rs. 90, 000 Rs. 24, 000

Rs. 1, 24,000 Rs. (-) 99, 000

From this broader prospective, the business is projected to lose Rs. 99, 000 in the first year. The Rs. 25, 000 accounting profit disappears when all relevant costs are included.
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