Theory of a Firm


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Theory of a Firm

  1. 1. Unit 9 Theory of a firm Objectives: After going through this unit, you will be able to explain: The concept and significance of the structure of the market Types of market structures Difference between competitive and non-competitive markets Behavior of firms in various market structures Equilibrium conditions in various market forms Structure: 1.1 Introduction 1.2 Meaning of Business Firm 1.3 Forms of Business Firms 1.4 1.5 1.6 Goal of Business Firm Profit – Normal and Economic profit Profit maximization1.1 IntroductionThe productive efforts in the economy are summarized in a commercial unit called thefirm. The rationality behind doing business as firms, lies in the benefits of an organizedeffort through multi-skilled, multi-functional teams, which work jointly towardsachievement of pre-defined goals, while utilizing scarce resources most efficiently. Inthis sense firms can be viewed as systems comprising of subsystems and parts which areintegrated, coordinated, and interdependent. The following sections evaluate the concept
  2. 2. of a firm, its forms, and processes that help it achieve business goals efficiently andeffectively.1.2 Meaning of Business FirmA firm is a unit that does business on its own account. Firm is from the Italian word,“firma” which means a signature, and the idea is that a firm can commit itself to acontract. The firm is the decision-maker in supplying goods and services. It is an entitythat employs scarce resources to produce goods and services which are demanded byconsumers. The firm is an alternative system of allocation to the market, which existsbecause in many case it is more efficient to organize production in a non-priceenvironment. As stated by Ronald Coase (1937), “Within a firm … market transactionsare eliminated and in place of the complicated market structure with exchangetransactions is substituted the entrepreneur-co-coordinator, who directs production.”1.3 Forms of Business FirmsThere are four main kinds of firms in modern market economies:ProprietorshipA proprietorship (or proprietary business) is a business owned by an individual, who iscalled the “proprietor”. A proprietorship Some proprietorship are too small even toemploy one person full time. Craftsmen, such as plumbers and painters, may have “dayjobs” and work as self-employed proprietors part time after hours. Computerprogrammers and others may also do that. At the other extreme, some proprietarybusinesses employ many hundreds of workers in a wide range of specializations. In aproprietorship, the proprietor is almost always the decision-maker for the business.PartnershipsA partnership is a business jointly owned by two or more persons. In most partnerships,each partner is legal liable for debts and agreements made by any partner. Of course, thisrequires a great deal of trust, and thus partners generally know one another well enough
  3. 3. to have that sort of trust. Family partnerships are very common for that very reason.There are now a few “limited partnerships” in which some partners are protected fromlegal liability for the agreements made by others, beyond some limits. In many cases, onepartner is designated as the managing partner and is the main decision-maker for thebusiness.CorporationsA corporation has two characteristics that distinguish it from most proprietorships andpartnerships:Limited liabilityAnonymous ownershipLimited liability means that the owner of shares in a corporation cannot lose more than acertain amount if the company fails. Usually the amount is the money paid to buy theshares. Anonymous ownership means that the owner of the shares can sell them withoutgetting the permission of anyone other than the buyer. By contrast, in most partnerships,no one partner can sell out without getting the agreement of the other partners. In such acase the continuing partners will, of course, want to know about the new partner -- he willnot be an “anonymous owner”. In a typical corporation, the shareholders formally elect aboard of directors, who in turn select the officers of the company. One of these officers,often called the “president”, will be the principle decision-maker for the firm, but he willbe expected to make decisions in the interest of the shareholders.Co-operativeA co-operative is a corporation organized by people with similar needs to providethemselves with goods or services or to make joint use of their available resources toimprove their income. Their business structure ensures:all members have an equal say (one vote per member, regardless of the number of sharesheld);open and voluntary membership;limited interest on share capital;
  4. 4. surplus is returned to members according to amount of patronage.There is no requirement to incorporate as a co-operative in order to run a businesscollectively and cooperatively.While there is millions of proprietorship, typically very small, the biggest businesses arecorporate and corporations are particularly important because of their size. The followingtable brings out the advantages and disadvantages of various business forms:Sole ProprietorshipAdvantages Disadvantagesease of formation unlimited liabilitylow start-up costs difficulty raising capitalless administrative paperwork than somelack of continuity in business organization inother organizational structures (such asthe absence of the ownerincorporation)owner in direct control of decision makingminimal working capital requiredtax advantages to ownerall profits to ownerPartnershipAdvantages Disadvantagesease of formation unlimited liability (for general partners)low start-up costs lack of continuityadditional sources of investment capital divided authoritybroader management base hard to find suitable partners possible development of conflict between partnersCorporationAdvantages Disadvantageslimited liability closely regulatedspecialized management most expensive form to organizeownership is transferable charter restrictionscontinuous existence extensive record keeping necessaryseparate legal entity double taxation of dividendspossible tax advantage (if you qualify forsmall business tax rate)easier to raise capital
  5. 5. Co-operativeAdvantages Disadvantagesowned and controlled by members longer decision making processdemocratic control: one member, one vote requires members to participate for successlimited liability extensive record keeping necessaryprofit distribution (surplus earnings) toless incentive to invest additional capitalmembers in proportion to use of service;surplus may be allocated in shares or cashpossibility of development of conflictbetween membersGoal of Business Firm - Profit and profit maximizationProfit is the main reason firms exist. In economic theory, profit is the reward for risktaken by enterprise. Put simply, profit is a firm’s total revenue (TR) minus total cost(TC), calculated through the following equation,Profit = TR - TCEconomists distinguish between normal profit and economic profitNormal profit is understood as the opportunity cost of using entrepreneurial abilities inthe production of a good, or the profit that could be received by entrepreneurship inanother business venture. Marshall has stated that normal profit is that rate of minimumprofit which a firm must earn in order to survive in the market. If profit is any lower thanthat, then enterprise would be better off engaged in some alternative economic activityOn the other hand, a firm is said to be making an economic profit when its revenueexceeds the total (opportunity) cost of its inputs. This can be used as another name for“economic value added” (EVA). For example, a person invests Rs.100, 000 to start abusiness, and in that year earns Rs.20, 000 in profits. The accounting profit would beRs.20, 000. However, the same year he could have earned an income of Rs.45, 000 hadhe been employed. Therefore, he has an economic loss of Rs.25, 000 (120,000 - 100,000- 45,000). A firm is said to be making an economic profit when its average total cost isless than the price of the product at the profit-maximizing output. The economic profit isequal to the quantity output multiplied by the difference between the average total costand the price
  6. 6. Profit maximizationIn economics, profit maximization is the process by which a firm determines the priceand output level that returns the greatest profit. This can be obtained by two approaches,viz.,Point at which TR exceeds TC by the greatest marginPoint at which MR = MCIt is imperative to note the following points to understand the firm’s profit maximizationgoal:A firm is said to be making an economic profit when its average total cost is less than theprice of the product at the profit-maximizing output. The economic profit is equal to thequantity output multiplied by the difference between the average total cost and the price.A firm is said to be making a normal profit when its economic profit equals zero. Thisoccurs where average cost equals price at the profit-maximizing output.A firm is said to be making a zero economic profit when its marginal revenue equalsmarginal cost.If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firmshould still continue to produce, however, since its loss would be larger if it was to stopproducing. By continuing production, the firm can offset its variable cost and at least partof its fixed cost, but by stopping completely it would lose equivalent of its entire fixedcost.If the price is below average variable cost at the profit-maximizing output, the firm is saidto be in shutdown. Losses are minimized by not producing at all, since any productionwould not generate returns significant enough to offset any fixed cost and part of thevariable cost. By not producing, the firm loses only its fixed cost.To summarize on the profit maximization goal, consider the following figure,
  7. 7. Economic Objectives Market share Profit margin Return on investment Technological advancement Customer satisfaction Shareholder value Goal of the firm Profit Maximization Non-economic Objectives Workplace environment Product quality Service to communityGoal of Business Firm - Maximizing stock pricesThe goals of maximizing stock prices, in turn maximizing share holder’s wealth, is anobjective for firms that are publicly traded. However, firms that are private have anothercrucial goal i.e. the maximization of the firm’s value. Since firm value is not directlyobservable and has to be calculated, these kinds of firms can not enjoy a major benefitthat publicly held ones can – they are deficient in the feedback that other ones may getdue to a policy change, a new project take over or also while making chief decisions.Goal of Business Firm – Maximizing ProductivityProductivity is the amount of output created (in terms of goods produced or servicesrendered) per unit input used. For instance, labour productivity is typically measured as
  8. 8. output per worker or output per labour-hour. With respect to land, the “yield” isequivalent to “land productivity”.An increase in productivity not only maximizes output per unit of input for the firm, italso can influence society more broadly, by improving living standards, and creatingincome. They are central to the process generating economic growth and capitalaccumulation. Companies can increase productivity in a variety of ways. The mostobvious methods involve automation and computerization which minimize the tasks thatmust be performed by employees. Recently, less obvious techniques are being employedthat involve ergonomic design and worker comfort.Goal of Business Firm – SatisficingSatisficing is a behavior which attempts to achieve at least some minimum level of aparticular variable, but which does not necessarily maximize its value. The most commonapplication of the concept in economics is in the behavioral theory of the firm, which,unlike traditional accounts, postulates that producers treat profit not as a goal to bemaximized, but as a constraint. Under these theories, a critical level of profit must beachieved by firms; thereafter, priority is attached to the attainment of other goals.The word satisfice was coined by Herbert Simon as a portmanteau of “satisfy” and“suffice”. Simon pointed out that human beings lack the cognitive resources to maximize:we usually do not know the relevant probabilities of outcomes, we can rarely evaluate alloutcomes with sufficient precision, and our memories are weak and unreliable.