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Theories of the 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

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.

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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

Company

Cooperative

Public Sector

Private Sector

Individual

Collective

Proprietorship

Partnership

Forms of Ownership

Company

Corporation

Department

Joint Sector

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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

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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

Limited liability

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Private Sector

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 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

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Public Sector

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)

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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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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).

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Summary

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.

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Summary

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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ARISE ! AWAKE!

AND STOP NOT

TILL THE GOAL IS REACHED…….