Theory of the Firm Introduction

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

Introduction As 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."

Firms Proprietorships Partnerships Corporations

Proprietorships A 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.

Partnerships A 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 liability Anonymous 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.

Traditional Theory of the Firm 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.

Traditional Theory of the Firm If the firm did not therefore maximise profits it would fail to survive under these conditions.

Traditional Theory of the Firm 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:

Traditional Theory of the Firm 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.

Traditional Theory of the Firm 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.

What does a supplier maximise? 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.

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

Profit Profit 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.

Profit Remember, 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.

Profit Because 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).

Profit The 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 John Bates Clark Model The output the firm can produce will depend on the land, labour and capital the firm puts to work.

The John Bates Clark Model 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.

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

The John Bates Clark Model 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.

The John Bates Clark Model 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.

The John Bates Clark Model 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.

More Simplifying Assumptions 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.

More Simplifying Assumptions 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 Decision In 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 Either the 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 and the complexity of large firms.

1. Uncertainty The 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. Uncertainty In 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 n  i n  i NPV =   i = 1(1 + r) i Where  i = R i - C i r = discount rate r = discount rate n = time horizon n = time horizon

With uncertainty n n (NPV) =  E   i )  i = 1(1 + r) i n (NPV) =   i p(H i )  i = 1 (1 + r) i Where p(H i ) = probability attached to each value that profits may take in year i take in year i

Risk Minimisation v. Profit Maximisation Policy A Profit Prob A = 0 x x x 0.25 = 45 x 0.25 = 45 Policy B ProfitProb B = 0 x x 0.50 = 50 x 0.50 = 50 But 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.

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

TRTC(£) 0 TC TR  max   constraint  s  rev.max Q   max Q  constraint Q s  revenue max Q  Dr J. R Anchor, HUBS Baumol’s Static Sales Revenue Maximising Model without Advertising

Alternatives to Profit 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.

1. Rationalisation of the Sales Maximisation 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.

1. Rationalisation of the Sales Maximisation 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.

2. Baumol’s Static Models -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.

2. Baumol’s Static Models -Conventional cost and revenue functions are assumed - cost curves are ill-shaped and the demand curve of the firm is downward sloping.

2. Baumol’s Static Models 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.

The assumptions of the dynamic model -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.

The assumptions of the dynamic model 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 Discretion Williamson 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.

Williamson's Model of Managerial Discretion 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.

Williamson's Model of Managerial Discretion 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.

Williamson's Model of Managerial Discretion 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.

Williamson's Model of Managerial Discretion The latter may be written: U = f 1 (S, M, I D ) where S = staff expenditure, including managerial salaries M = managerial emoluments I D = 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 - Growth Maximisation 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.

Marris - Growth Maximisation 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.

Marris - Growth Maximisation 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.

Marris - Growth Maximisation Managerial utility function may be written as follows: U m = f (g D,s) where g D = rate of growth of demand for the products of the firm; s = a measure of job security.

Marris - Growth Maximisation Owners utility function may be written as U 0 = f *(g c ) where g c = rate of growth of capital.

Marris - Growth Maximisation s can be measured by a weighted average of three ratios: the liquidity ratio, the leverage debt ratio and the profit-retention ratio.

Marris - Growth Maximisation S can be measured by weighted average of liquidity ratio, debt ratio and profit retention ratio Liquidity ratio = Liquid assets Total assets Debt ratio =Value of debt Total assets Retention ratio =Retained profits Total profits

Marris - Growth Maximisation 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 Goals based 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.

Cyert and March Behavioural Theory 2. Goal Formation – The Concept of the Aspiration Level Individuals may have (and usually do have) different goals to those of the organisation-firm.

Cyert and March Behavioural Theory 3. The Goals of the Firm: Satisficing Behaviour Goals set by top management.

Cyert and March Behavioural Theory 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.

Cyert and March Behavioural Theory 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.

Cyert and March Behavioural Theory 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.

Cyert and March Behavioural Theory 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)