Chapter 2

Theory of Firm

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 Lecture Plan
• Objectives
• Forms of ownership
• Private sector
• Public sector in India
• Objectives of firm
– Profit maximization theory
– Baumol’s theory of sales maximization
– Marris’ hypothesis of maximization of growth rate
– Williamson’s model of management utility function
– Behavioural theories
• Principal Agent Problem
• Summary
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 Chapter Objectives
• To identify the various types of organizations on the
basis of ownership pattern and highlight the
advantages and limitations of each type.
• To appreciate the role of public sector in economy.
• To understand various objectives of a firm and develop
a critical appraisal of the various theories of objectives
of a firm.
• To understand the nuances of concepts like principal
agent problem and asymmetric information in an
organizational context.

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 Introduction
• A firm is an entity that draws various types of factors of
production in different amounts from the economy, and
converts them into desirable output(s), through a process
with the help of suitable technology.
• Economists have identified five factors of production,
namely land, labour, capital, enterprise and organization.
• The process of identifying the potential sources of the
factors such as land, labour and capital, collecting them in
required quantities and assigning them specific tasks as
per their skills is the subject matter of organization.
• An entrepreneur is a person (or group of persons) who
decide(s) to undertake the responsibility of the inherent
risks in starting a business.
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 Forms of Ownership
• Ownership is always measured from the point of view of
investors (entrepreneurs).
• Businesses may be organized in various forms,
depending on their size, nature and need for resources.
• Three broad categories of business organizations are:
 Private sector (wholly owned by people, individually,
or as a group),
 Public sector (owned, managed and controlled by
government) and
 Joint sector (owned and managed jointly by
individuals and government)

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 Forms of Ownership
Forms of
Ownership

Private Joint Public

Sector Sector Sector

Individu Collectiv
al e Compan Corporati Depart
y on ment
Proprietors
hip
Partners Compan Cooperati
hip y ve 6
 Private Sector

• Ownership is in the hands of individuals, whether

independently, or as a small group, or in a large number,
without any investment from the government
• Sole Proprietorship: An individual invests own (or
borrowed) capital, uses own skills in management, and
is solely responsible for the results of operations.
• Simple and easy to start or exit
• Undivided profits
• No separate entity of firm
• Unlimited liability

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 Private Sector
• Partnership: Two or more individuals (individually
partners and collectively a firm) decide to start a
common business
• May be for a certain specified period or for an uncertain period
and a specific purpose, or for any purpose
• An heir of a partner does not automatically become a partner,
unless other members agree to induct the heir(s) as partners.
• Partnership deed: Partnership is created as an agreement. It is
not necessary to prepare this agreement in writing, though it is
strongly desired that the agreement is prepared in writing, in
order to avoid any dispute arising in future.

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 Private Sector
• Joint Stock Company: The owners’ capital invested in the form of shares;
hence the owners are regarded as shareholders
– Legal person with right to own/sell/buy/bestow/inherit property
– Perpetual existence
– Limited liability
Private Limited Company
 Number of shareholders limited to fifty
 Shares of the company transferable only among members
 Free from the necessity of submitting certain returns to the Registrar
 It can neither issue a prospectus, nor can it raise capital by selling
its shares to outside public other than members
Public Limited Company
 Minimum number of members seven
 No limit on maximum number
 Has to submit certain statements and balance sheet to the Registrar
annually
 Can invite the public to buy shares by issuing a prospectus 9
 Private Sector
• Cooperative: A nonprofit, nonpolitical,
nonreligious, voluntary organization based on
mutual help and self reliance
– Producers’ Cooperative
– Consumers’ Cooperative

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 Public Sector
• Government is the investor and the owner of a business
– Balanced economic growth
– Employment generation
– Profits for public welfare
– Evils of bureaucracy
• Established in India as per the First Industrial Policy
enunciated in 1948 and restated in 1956
• Three broad categories of State Enterprises in India:
– Public Sector Enterprises (e.g. SAIL, BHEL, ONGC and IOC)
– Corporations and Boards (e.g. Coir Board, Railway Board and
Food Corporation of India)
– Departments (e.g. Telephone and Telegraph, Education, and
Health)
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 Objectives of the Firm
• Why do people do business?
• What motivates the owners /investors / promoters to take
so much of risk and conduct their own businesses, rather
than going for a secured employment?
• Is it only maximization of profits that drives businesses?
• Or is it something beyond?
• Every business has some objective, which provides the
framework for all the functions, strategies and
managerial decisions of that business.
• It determines the short term and long term perspective of
the firm.
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 Profit Maximization Theory

• Objective of business is generation of the largest amount

of Profit = (Total Revenue-Total Cost)
• Traditionally, efficiency of a firm measured in terms of its
profit generating capacity
• Criticism
 Confusion on measure of profit
 Confusion on period of time
 Validity questioned in competitive markets

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 Baumol’s Theory of Sales Revenue
Maximization
• In competitive markets firms aim at maximizing revenue
through maximization of sales
• Sales volumes determine market leadership in competition
• Dichotomy of managers’ goals and owners’ goals
• Manager’s salary and other benefits linked with sales
volumes, rather than profits
• Managers attach their personal prestige to the company’s
revenue or sales
• Managers maximize firm’s total revenue, instead of profits
• Criticism
 Insufficient empirical evidence

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 Marris’ Hypothesis of Maximization of
Growth Rate
• Two sets of goals:
 Owners (shareholders) aim at profits and market share
(Uo )
 Managers aim at better salary, job security and growth
(Um)
• Both achieved by maximizing balanced growth of
the firm
G = GD = GC ………(1), GD = f(d, k)………(2), GC = f(r, π)
………(3)
 Growth rate of demand for the firm’s products (GD) and
 Growth rate of capital supply to the firm (GC)
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 Marris’ Hypothesis of Maximization of
Growth Rate
• Constraints in the objective of maximization
of balanced growth:
 Managerial Constraint : Non availability of
managerial skill sets in required size creates
constraints for growth
 Financial Constraint : debt equity ratio (r1),
liquidity ratio (r2) and retained profit ratio (r3)
• Managers will normally prefer a moderate r1
moderate r2 and r3
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 Williamson’s Model of Managerial
Utility Function
• Managers apply their discretionary power to maximize their own utility
function
 Constraint of maintaining minimum profit to satisfy shareholders
• Utility function of managers (Um) depends on: salary, Job security,
power of discretionary investment (ID)
Um = f (S, M, ID)
ID = πD (πD is discretionary profit)
π D = Actual profit – Minimum profit – Tax
Therefore :
Um = f (S, πD)
• An increase in S is only possible by decrease in πD and vice versa.
• Managers’ try to find an optimum combination of S and πD

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 Behavioural Theories

• Simon’s Satisficing Model

 Biggest challenge before modern businesses
is lack of full information and uncertainty about
future
 the objective of maximizing either profit, or
sales, or growth is not possible.
 they act as constraints to rational decision making
 the firm has to operate under "bounded rationality"
 can only aim at achieving a satisfactory level of
profit, sales and growth
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 Behavioural Theories
• Model by Cyert and March
 apart from dealing with inadequate information and
uncertainty, businesses also have to satisfy a variety of
stakeholders, who have different and oft conflicting
goals
 ‘Satisficing behaviour’ aims at satisfying all
stakeholders.
 Managers form an Aspiration level on basis of past
experience, past performance of the firm, performance
of other similar firms, and future expectations

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 Principal Agent Problem
• In an organizational set up the owners (principals) hire
managers (agents) who work on a well defined task
– Agents have better knowledge of the market and are expected to
steer the business.
– Asymmetric Information: Difference in information between two
parties in any transaction (typically in principal agent problems)
• Consequences:
 Adverse selection: Immoral behaviour that takes advantage of
asymmetric information before a transaction
 Moral hazard: Immoral behaviour that takes advantage of
asymmetric information after a transaction
• Solutions:
– Minimize the information gap between the principal and the
agent.
– tie the managers’ rewards to organization’s performance;
– pass on some ownership to managers
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 Summary
• Business organizations may be divided into three broad categories:
private sector (wholly owned by individuals, independently, or as a group),
public sector (owned, managed and controlled by government) and joint
sector (owned and managed jointly by individuals and government).
• In a sole proprietorship firm, an individual invests own (or borrowed)
capital and is solely responsible for the results of operations; whereas in
partnership, two or more individuals decide to start a common business.
• A joint stock company (or “company”) is a legal entity, limited liability and
has perpetual existence. It may be a ‘private limited’ (it cannot transfer
shares to non members) or ‘public limited’ (can offer equity shares to any
one).
• A cooperative is a nonprofit, nonpolitical, nonreligious, voluntary
organization, formed with an economic objective.
• Every business has some objective, which provides the framework for all
the functions, strategies and managerial decisions of that business. Many
economists including Milton Friedman support profit maximization as the
objective of firm.
• Baumol stressed that in competitive markets, firms would aim at
maximizing revenue, through maximization of sales.
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 Summary
• According to Marris, owners (shareholders) aim at profits and
market share, whereas managers aim at better salary, job security
and growth. These two sets of goals can be achieved by maximizing
balanced growth of the firm.
• Williamson’s proposes that managers would apply their
discretionary power as to maximize their own utility function, with
the constraint of maintaining minimum profit to satisfy shareholders.
• Simon’s satisficing model says that a firm has to operate under
"bounded rationality" and can only aim at achieving a satisfactory
level of profit, sales and growth. Cyert and March propose that
businesses have to satisfy a variety of stakeholders, who have
different and oft conflicting goals; hence a firm has to aim at a multi
dimensional goal and exhibit a ‘satisficing behaviour’.
• The conflict of interests between the owners (principal) and the
managers (agent) of a firm is known as principal agent problem.
Difference in information between two parties in any transaction is
termed as information asymmetry, or a state of asymmetric
information.
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