Theories of the firm


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Theories of the firm

  1. 1. Theories of the firm 1
  2. 2. 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 2
  3. 3. 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. 3
  4. 4. 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. 4
  5. 5. 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) 5
  6. 6. Forms of Ownership Forms of Ownership Private Joint Public Sector Sector SectorIndividual Collectiv Company Corporatio Departme e n ntProprietorsh ip Partnersh Company Cooperativ ip e 6
  7. 7. 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 7
  8. 8. 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. 8
  9. 9. 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 9
  10. 10. Private SectorPrivate 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 membersPublic 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 10
  11. 11. Private Sector Cooperative: A nonprofit, nonpolitical, nonreligious, voluntary organization based on mutual help and self reliance  Producers’ Cooperative  Consumers’ Cooperative 11
  12. 12. 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 12
  13. 13. 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) 13
  14. 14. 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. 14
  15. 15. 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 15
  16. 16. 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 16
  17. 17. 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 firmG = 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) 17
  18. 18. 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) 18
  19. 19. 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 19
  20. 20. 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 20
  21. 21. 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). 21
  22. 22. 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. 22
  23. 23. 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. 23
  24. 24. 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. 24