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Theories of the firm. Theory of the firm is an analysis of the behavior of companies that examine inputs, production methods, output and prices. The traditional.

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Presentation on theme: "Theories of the firm. Theory of the firm is an analysis of the behavior of companies that examine inputs, production methods, output and prices. The traditional."— Presentation transcript:

1 Theories of the firm

2 Theory of the firm is an analysis of the behavior of companies that examine inputs, production methods, output and prices. The traditional theory assumes that profit maximization is the goal of the firm. –More recent analyses suggest that sales maximization or market share, combined with satisfactory profits, may be the main purpose of large industrial corporations.

3 The Goal Of Profit Maximization What is the firm’s goal? A firm’s owners will want the firm to earn as much profit as possible Why? –Managers who deviate from profit- maximizing for too long are typically replaced either by Current owners or Other firms who acquire the underperforming firm and then replace management team with their own

4 Why Are There Profits? Economists view profit as a payment for Risk-taking –Someone—the owner—had to be willing to take the initiative to set up the business This individual assumed the risk that business might fail and the initial investment be lost –Innovation In almost any business you will find that some sort of innovation was needed to get things started

5 Profit Maximization: TC-TR approach Total Fixed Cost TC TR  TR from producing 2nd unit  TR from producing 1st unit Profit at 3 Units Profit at 5 Units 3,500 3,000 2,500 2,000 1,500 1,000 500 Output Amount 1210345678910 Profit at 7 Units

6 Profit Maximization: MC-MR Approach profit risesprofit falls MC MR 0 600 500 400 300 200 100 –100 –200 Output Amount 123456 7 8

7 Critique of the NC Model Insufficiently realistic Based on oudated view of competition 1.Organizational goals Max. of profits or ??? Rationality ?? Perfect information ?? Decision making ??

8 Separaton of Ownership from Management Two implications: –Increasing organizational compleqity meant that it was impossible for the large firms to be managed solely by the owner Teams of managers Functional divisions –Impractical for the enterpreneur to finance solely by personal resources Presence of capital markets OwnersBoard of DirectorsTop Management

9 Baumol: Sales Revenue Maximization Maximize sales revenue subject to minimum profit constraint Why sales revenue and not profits?? –Sales are good general indicatof of organizational performance –Executive power, influence, status tend to be linked to the sales performance –Lenders tend to rely on sales data

10 Rationalisation of sales revenue Hypothesis –Salaries and other earnings (slack) of the top managers are correlated more closely with sales than profit. –Banks and other financial institutions keep a close eye on sales –Personnel problems are handled more satisfactorily when sales are growing –Large sales gives prestige to the managers, while profit go into the pocket of share holders –Managers prefer steady performance with satisfactory profits –Growing sales strengthen the power to adopt competitive tactics. Baumol: Sales Revenue Maximization

11 Minimum acceptable profit

12 Short run profit maximization implies that sales revenue is lower than it could be (q1) ‏ By increasing output beyond its short run profit maximising level (q1), the firm achieves an increase in current sales revenue (q3) at the expense of reduction in profit

13 Marris’s Theory of Growth Maximization Goal of firm in Marris’s model is the maximisation of the balanced rate of growth of the firm, i.e., maximisation of the rate of growth of demand for the products and the growth of its capital supply. Max. g = g D = g c g = Balanced Growth rate g D = Growth of Demand for Products of the firm g c = Growth of Supply of Capital

14 Maximum balanced growth rate of the firm depends of two contraints –Constraint set by the managerial team –Financial constraint set by the desire of managers to achieve maximum job security Managers and Owners –Um = f (Salaries, power, status, job security) ‏ –Uo = f (profit, capital, output, market share, public esteem) ‏ Marris’s Theory of Growth Maximization

15 –U owners = f (g c ) ‏ –U Managers = f (g D, S) ‏ S = measure of job security Marris’s Theory of Growth Maximization Max. g = gD = gc

16 Williamson: Managerial Utility Maximization Baumol’s model view that managers’ interests are tied to a single variable: sales revenue. Williamson (1963) argue that several variables should be in the manager’s utility functrion –U = U (S,M,I D ) ‏ S= staff expenditure, including managerial salaries (administrative and selling expenditure) ‏ M= Managerial emoluments I D = Discretionary investment

17 Figure 3.3 Williamson’s managerial utility maximization model Williamson: Managerial Utility Maximization

18 Organizations are viewed as consisting of a number of coalitions and the role of management is to achieve a Quasi- Resolution of Conflict and Uncertainty Avoidance. Problemistic Search that is stimulated by a problem with (or lack of) an existing routine is assumed to be motivated, simple-minded, and biased (reflecting unresolved conflicts within the organization). The Behavioral Theory of the Firm

19 Cyert and March (1964) ‏ Defines the firm in terms of its organizational structure and decision making processes Boundaries of the firm are loosely defined Bounded rationality (Simon (1959)) ‏ Satisficing behavior Due to observance of actual behavior within organizations

20 Thank you

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