Chapter 2

Theory of Firm

Lecture Plan
Objectives Forms of ownership Private sector Public sector in India Objectives of firm
Profit maximization theory Baumols theory of sales maximization Marris hypothesis of maximization of growth rate Williamsons model of management utility function Behavioural theories Reasonable profit objective

Principal Agent Problem Summary

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.

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 Sector

Joint Sector

Public Sector

Individual

Collective Company Corporation Department

Proprietorship Partnership Company Cooperative

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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

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.

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
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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 Includes services like the police, military, public roads, infrastructure, education and healthcare for the poor Objectives
Provide services that benefit the poor Provide services that encourage equal opportunity

Main propounders are Karl Marx and Keynes

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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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Baumols 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 Managers salary and other benefits linked with sales volumes, rather than profits Managers attach their personal prestige to the companys revenue or sales Managers maximize firms 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), which depends on Growth rate of demand for the firms products (GD) and Growth rate of capital supply to the firm (GC) G = GD = GC GD = f(d, k) GC = f(r, )
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Marris Hypothesis of Maximization of Growth Rate

Constraints in the objective maximization of balanced growth: of

 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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Williamsons 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 = D ( D is discretionary profit) = Actual profit Minimum profit Tax Therefore : Um = f (S, D)
D

An increase in S is only possible by decrease in

and vice versa.

D
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Managers try to find an optimum combination of S and

Behavioural Theories
Simons 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 organizations performance; pass on some ownership to managers
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Reasonable Profit Objective

Profit is necessary in the long run
It is an indicator of the financial health of the company and growth

Shareholders, creditors and other investors are satisfied that the firm is growing and their capital is well-invested The possibility of profit maximization may attract competition, while reasonable profit may make the market less attractive Workers and unions refrain from demanding higher wages as profits are not huge Thus a minimum reasonable profit is a must for any firm
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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 22 maximizing revenue, through maximization of sales.

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. Williamsons 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. Simons 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. According to reasonable profit objective, a minimum reasonable profit is a must for any firm.
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