Objectives of the firm

• Problem of scarcity and choice

• expected resource to be balanced against its opportunity cost and the most profitable alternative chosen

• Firm’s objective is profit maximization, sales maximization, cost minimization

• Economy’s objectives are welfare oriented

Theories

• Profit maximizing theories—Theory of firm

• Managerial theories of firm—Baumol’s sales revenue maximization model

--Williomson model

• Growth maximization model—Marris theory

Profit maximizing theories—Theory of firm

• Objective of a firm is profit maximization, subject to technical and market constraints

• Firm is a unit transforming valued inputs into outputs of a higher value

• Market conditions like competition or monopoly is given

• Firm prefers the alternative which helps it to consistently achieve profit maximization

• Primary concern is to analyze changes in price and quantities of inputs and outputs

Assumptions of the model

• Firm has a single goal—maximize profits• Firm acts rationally to pursue its goal—

perfect knowledge of all relevant variables at the time of decision making

• Market conditions like competition, monopoly are given

• Primary concern is analyze changes in the prices and quantities of inputs and outputs

• Firm is a single ownership one

The model

• Profit maximization in relation to the time period

• Short run—adjustments to changed conditions is only partial

• Long run—adjustments to changed conditions is complete

• Long run consists of several short run periods

• Does this mean that if the firm increases its profit in the short run its profits in the long run also increases?

• Short run maximizing principles defeat the long run profit maximization

• Higher profits in the short run may induce workers to demand higher wages

• Maximization of profits in short run gives an impression of being exploitative thus inviting legal or govt intervention affecting long run profits considerably

• Firm trying to build up its reputation by charging low prices can make long run profits—not maximize short run profits

Determination of profit-maximizing output and price

• Profit=TR-TC

• For profits to attaint the maximum, firm shall produce that level of output, MR should be equal to MC

Criticism of profit-maximizing theory

• Assumption that the firm is owner-managed• Maximizing profits mean maximizing the income

of the owner—owner likes to have adequate return for his activity as an entrepreneur

• Survival of the firm dependent on entrepreneur’s ability to maximize profits in long run

• Other goals

• In the context of biz situation, assumption of profit-maximization is doubtful

• Aim at other goals like sales maximization, market share, etc

• Owner driven firm not valid—modern biz • Not always true that firms not maximizing profits will be

driven out of biz—demand for a product is high• Managers are generally risk-averse—lack of predictive

power• Firms are prevented to maximize profit because they

generally suffer from lack of proper intra-firm coommunication

Baumol’s sales revenue maximization model

• Oligopolistic firms aim at maximizing their sales revenue because

--fin institutions judge the health of a firm largely in terms of growth rate of its sales

--increasing sales revenue overtime provides prestige to top mgt, profits of SH increase

-- increasing sales helps in keeping a health personnel policy

--managers prefer a “steady performance with steady profits” than big profits

--large and growing sales by maintaining or increasing market share increases the competitive power of firm

Assumptions

• Goal is sales maximization subject to minimum profit constraint

• Advt is a major factor• Production costs are independent of

advertizing• Advt will always create favourable

conditions of product—shift of demand curve to the right

• Price of the product is assumed to be constant

Single period model

• After the profit constraint is satisfied, profits become subordinate to sales in the firm’s hierarchy of goals.

Implications of the model

• In both profit maximizer and sales maximizer case—company will charge a lower price to sell the extra output Q2-Q1

• Sales maximizing firm—spend more on advt than a profit-maximizing firm.

• Baumol assumes that advt does not affect the product’s price but it does lead to increased output sold

Williamson’s model of ‘Managerial Discretion’

• Managers are free to pursue their own self-interest once they have achieved a level of profit that will satisfactory dividends to SH and growth is ensured

Assumptions

• Markets is non-perfectly competitive

• Ownership of firm and management is divorced

• A minimum profit constraint is imposed on the managers by the capital market, ie the SH which cannot be ignored by the mgt

Framework

• Managers have their own ‘Utility functions’ ie a set of factors which give rise to managerial satisfaction

• Managers have the discretion to pursue policies which maximize their own utility rather than aiming to maximize profit

• Profits act as a constraint to managerial behaviour

• Managerial satisfaction arises from certain aspects of mgt task like responsibility, status, prestige, professional excellence, etc

• A new concept introduced—expense preference—satisfaction which managers derive from certain types of expenditures

• U-f{S, M, Id}

• U-Utility

• S-Managerial emoluments

• Id-Discretionary investment

• Staff variable covers the benefits of increases in quality and no. of staff reporting to manager—mainly in the form of salary

• Increase in S is equivalent to manager’s promotion as it increases the range of activity and control over resources

• M includes facilities like expense a/c for entertainment, luxurious office, staff car, etc

• Variable reflects the utility derived by manager from being able to authorize expenditure of the firm to serve his own needs

• Such expenditures reflect the prestige, power and status of the manager

• Though these expenses may seem unnecessary from the firm’s productivity point of view, managers need this to create goodwill and the right atmosphere for business activities and long run profitability

• Id reflects the power and status of manager as it implies manager’s discretion to undertake investment beyond those required for normal operations

Conclusion-Williamson model

• Suggests that a firm led by utility-maximizing manager spends more on staff expenses

• Exhibits organizational slack than a profit-maximizing firm

• Not sufficient importance to non-salary components of compensation

Growth maximization model—Marris model

• Growth cornerstone of corporate strategy• Rate of growth and potential of growth yardsticks

to measure corporate success• Financing for growth—retained earnings or from

market borrowings or both• Debt inhibits growth and internal funds grow only

thru’ profit- maximization• Cost of funds—opportunity cost• Decision to maximize growth is necessarily a

decision to maximize profits

The model

• Stressed on maximization of growth subject to the security of mgt’s position

• Like Williamson Marris approach is based on the fact that ownership and control of firm is in the hands of 2 different sets of people

• Managers are concerned with utility functions—profits, salary, status, power, prestige, security

• Owners concerned with profits, market share, ouptut

• Um=f{salaries, power, job security}

• Uo={profits, market share, output, capital, public esteem}

• Um and Uo are strongly correlated with a single variable—the size of the firm

Other postulates

• Corporate capital—sum total of book value of assets, inventory and short term assets including cash revenue

• Managers aim to maximize the growth rate of size rather than the absolute size—managers wish to stay in the firm and grow than move from a smaller size to a bigger size

Constraints

• Drive for rate of growth is with constraints• Existence of a sure limit on the rate of

managerial expansion—high possibility that mgt will lose control over a rapidly growing firm, limit on output, ability of managers to find and successfully launch new products in place of old ones

• Voluntary slowing down process by the mgt itself—desire of mgt for job security—mgt holding high consideration for job security grows in such a way that it remains safe on the financial side

Cautious and prudent financial policy

• Non-involvement in risky investments

• Financing growth mainly from the profit levels being generated by the present set of products

• Prudence of financial policy judged byrisk attitude of top mgt.

• Risk loving mgt prefers high value of ‘a’—weighted avg of foll 3 security ratios

• Liquidity ratio (a1)=liquid assets/total assets low LR implies possibility of insolvency of firm, high increases security, but has an adverse impact on growth

• Leverage ratio (a2)=value of debts/total assets. Implies extent of borrowings for expansion, high ratio implies rate of failure and invites take-over bids. Low ratio retards growth

• Profit retention ratio (a3)=retained profits/total profits

• Value of financial constraint would increase if either a2 or a3 is increased or a1 is decreased

• LR and profit retention ratio positively correlated

• Low LR and high retention ratio

Concluding remarks

• Managers aim at balanced growth

• Growth in demand should match with growth in capital

• Max g=gd=gc

• Mgt walks on a knife-edge between a debt/asset ratio high enough to stimulate growth but not low enough to suggest financial imprudence

Behavioural theories

• Firm engaged in non-maximizing behaviour

• Firm’s ub-optimal behaviour arises from uncertainty and conflicting goals of various groups within the firm

• These theories analyze the orgn of firm, the way in which decisions are reached and inter-group conflicts of firm

Simon’s ‘satisficing model’

• Managers take decisions for future on the basis on incomplete info

• Mgt realizing the complexity of calculations and data imperfections cannot take optimal decisions but something less—satisficing decisions

• Mgt explore limited alternatives and a satisfactory alternative course is pursued

• Theory helps in explaining real world situations

Flaws

• Nature of info—not every info is complete like tax related or wage related is complete info

• Not easy to determine a ‘satisfactory level’—many factors influence decisions—keeping SH happy, demonstrate company’s health for raising capital

Cyert and March’s behavioural theory

• Focus on the way decisions are made in ‘large multi-product firm under uncertainty in an imperfect market’

• Theory based on internal structure of such firms and typical organizational problems are analyzed

• Cyert and March consider the firm as multi-goal, multi-decision organizational coalition

Goals of firm

• Production goal• Inventory goal• Sales goal• Market share goal• Profit goal

• Satisficing model and not a maximizing model