THEORY OF FIRM

A firm is an organization that combines and

organizes
resources for the purpose of producing goods
and/or
services for sale.
There are millions of firms in the United States.
These
include:
 Proprietorships.
 Partnerships.
 Corporations.
Firms produce more than 80 percent of all goods
and
services consumed in the United States.
The remainder is produced by the government
Firms exist because it would be very inefficient and
costly
for entrepreneurs to enter into and enforce
contracts with
workers and owners of capital, land and the other
resources for each separate step of production and
distribution process.
Instead, entrepreneurs usually enter into longer
term and broader contracts with labor to perform a
number
of tasks for a specific wages and fringe benefit.
There are a great variety of arrangements in producing
goods. In agriculture often most of the labor force works
on a day-to-day basis. In other industries the labor force
may be permanent, tied to the firm with long-term
contracts.
Repair services in some firms may be supplied by an
internal organization; in others it is provided by
specialized firms from outside. A firm is a system of long-
term contracts that emerge when short-term contracts
are unsatisfactory.
The unsuitability of short term contracts arise from the
costs collecting information and the costs of negotiating
contracts.
This leads to long term contracts in which the
remuneration is specified for the contractee in return for
obeying, within limits, the direction of the entrepreneur.
For example, all automobile producers in the
world buy tyres from companies specialized in
production of rubber products.
Ford and General Motors must have considered
building plants to produce their own tyres.
But the cost of developing the new management
skills must have been costly and complicated than
purchase from such companies.
Similarly, attorneys are not an integral part of the
production process but required periodically. Full
time attorneys are costly and, therefore, legal
services are contracted on need basis. Large firms
that have regular need for legal services have an
in-house legal staff.
Such a general contract is much less costly than
numerous specific contracts and is highly
advantageous both to entrepreneurs and to the
workers and the other resource owners. The firm
exists in order to save on such transaction costs.
*transaction costs:
In economics and related disciplines, a transaction cost is
a cost incurred in making an economic exchange (restated: the cost of
participating in a market).
*The cost associated with exchange of goods or services . Transaction
costs cover a wide range: communication charges, legal fees,
informational cost of finding the price, quality, and durability, etc., and
may also include transportation costs. Transaction costs are a
critical factor in deciding whether to make a product or buy it.
By performing many functions within the firm, the
firm
also saves on sales taxes and avoids price controls
and
other government regulations that apply only to
transactions among firms. This is called
internalizing
transactions. Primary goal is to maximize the
wealth or
value of the firm.
Firms, however, do not continue to grow larger
and larger indefinitely because of limitations on
mgt ability to effectively control and direct the
operation of the firm as it becomes larger and
larger.
 THE OBJECTIVE AND THE VALUE OF THE
FIRM
The present value of all expected future profits.

1 2 n n
t
PV  1
 2
  n
 t
(1  r ) (1  r ) (1  r ) t 1 (1  r )

t n
TRt  TCt n
Value of Firm  t
 t
t 1 (1  r ) t 1 (1  r )
 TR depends on sales or the demand for the firm’s output and the
firm’s pricing decisions. (Responsibilities of Marketing department).
 TC depends on the technology of production and resource pricings.
(Responsibly of production and personnel or HR departments).
 The discount rate depends on the perceived risk of the firm and on
the cost of borrowing funds. (Responsibility of finance department).
 The above equation also used to organize the discussion of how the
various departments within the firm interact with one another.
 For example, the marketing dept can reduce the cost associated with
the given level of output by promoting off season sales.
 The production or HR dept can stimulate sales by quality
improvements and the development of new products.
 The accounting dept can provide more timely information on sales
and costs.
 All these activities increase the efficiency of the firm and reduce the
risk.
Constraints on the Operation of the firm
In order to maximize profit, a firm faces many
constraints.
Some of these constraints arise from limitations
on the availability of essential inputs.
Skilled workers (especially in the short run)
Raw material
It might also face limitations on factory and
warehouse space.
Quantity of capital funds available for a given
project.
 Legal constraints.
 Minimum wage laws.
 Health and safety standards.
 Pollution emission standards.
 Laws and regulations that prevent firms from
employing unfair business practices.
Within these constraints, however, the firm seeks to
maximize wealth or its value.
While government agencies and not-for-profit
organizations may have goals other than wealth or
value maximization, they also face constraints in
achieving their goals or objectives.
Limitations of the Theory of the Firm
 The theory of the firm has been criticized as being unrealistic.
 In its place, broader theories of the firm have been proposed.

Sales Maximization Model

• According to this model, managers of modern
corporations seek to maximize sales after an adequate
rate of profit has been earned to satisfy stockholders.
• Indeed, some early empirical studies found a strong
correlation between executives’ salaries and sales, but
not between salaries and profits. More recent studies,
however, found the opposite.
Management Utility Maximization
Oliver Williamson and others have introduced
a model of management utility maximization,
which postulates that with introduction of the
modern corporation and the resulting
separation of management from ownership,
managers are more interested in maximizing
their utility, measured in terms of their
compensation (salaries, fringe benefits, etc.),
the size of their staff, lavish offices, etc., than
in maximizing corporate profits. This is
referred to as the principal-agent problem.
That is, the agent (manager) may be more
interested in maximizing his or her benefits than
maximizing the principal’s (owner’s) interest.
This principal-agent problem can be resolved by
tying the manager’s reward to the firm’s
performance in relation to other firms in the same
industry.
Managers who maximize their own interests rather
than the corporation’s profit or value are also more
likely to be replaced either by the stockholders of
the corporation or as a result of the corporation’s
being taken over by (merged with) another firm that
sees the unexploited profit potential of the first.
Satisficing Behavior
Finally, Richard Cyert and James March,
building on the work of Herbert Simon,
pointed out that because of the great
complexity of running the large modern
corporation- a task often complicated by
uncertainty and a lack of adequate data--
managers are not able to maximize profits but
can only struggle for some satisfactory goal in
terms of sales, profits, growth, market share,
and so on.
Simon called this satisficing behavior.
That is, the large corporation is a satisficing,
rather than a maximizing organization.
This, however, is not necessarily inconsistent
with profit or value maximization; most likely,
with more and better data and search
procedures, the modern corporation could
possibly approach profit or value
maximization.
The Nature and Function of Profits
Explicit Costs are the actual out of pocket
expenditures of the firm to purchase or hire
the inputs it requires in production.
It includes:
 Wages
 Interest
 Rent
 Expenditures on raw materials
Implicit costs refer to the value of the inputs
owned and used by the firm in its own
production processes.
Economic Profit = Revenue –(Explicit &
Implicit Costs)
Business Profit = Revenue – Explicit Cost.
Example: Case 1
Total Revenue = 120,000
Explicit Cost = 100, 000
Foregone wage = 10,000
Forgone interest rate = 10%
Accounting Profit Economic Profit
Profit = TR – Explicit Cost Profit = TR – [EC + IC ]
= 120, 000 – 100, 000 = 120,000 – [100, 000 +
20,000]
= 20, 000 =0
In this example, doing business and its
alternative option are equal….means
Economic Profit is zero
Example: Case 2
 Total Revenue = 120,000
 Explicit Cost = 100, 000
 Foregone wage = 10,000
 Forgone interest rate = 5%

Accounting Profit Economic Profit

Profit = TR – Explicit Cost Profit = TR – [EC + IC ]
= 120, 000 – 100, 000 = 120,000 – [100, 000 + 15,000]
= 20, 000 = 5000

 In this example, doing business will give you 20,000 while

its alternative option is 15,000, means this business will
give you 5000 more….
 Economic Profit = 5000
Example: Case 3
Total Revenue = 120,000
Explicit Cost = 100, 000
Foregone wage = 10,000
Forgone interest rate = 15%

Accounting Profit Economic Profit

Profit = TR – Explicit Cost Profit = TR – [EC + IC ]
= 120, 000 – 100, 000 = 120,000 – [100, 000 +
25,000]
= 20, 000 = -5000
This is not absolute loss.
It means alternative option will give you 5000
more.
Theories of Profit
 Risk Bearing Theories of Profit: (Hawley)
 More risk…………More return
According to risk bearing theories, above normal returns (i.e.,
economic profits) are required by firms to enter and remain in such
fields.
 Relationship between risk and profit
 According to Hawley, entrepreneur may have to bear 4 kinds of risks.
i. Replacement (it refers to depreciation)
ii. Risk proper (e.g., gap between production and sale)
iii. Uncertainty. (future is uncertain)
iv. Obsolesce (machines obsolete)
 Frictional Theory of Profit:
The theory stresses that profits arise as a result of friction or
disturbances from long run equilibrium.
That is, in long run, perfectly competitive equilibrium, firms tend to
earn only a normal return or zero economic profit on their investment.
When profits are made in an industry in the
short run, more firms are attracted to the
industry in the long run, and this tends to
drive profits down to zero (i.e., it leads to
firms earning only a normal return on
investment).
On the other hand, when losses are incurred,
some firms leave the industry. This leads to
higher prices and the elimination of the
losses.
Monopoly Theory of Profit:
 Some firms with monopoly power can
restrict output and charge higher prices.
 Because of restricted entry into the
industry, these firms can continue to earn
profits even in the long run.
 Monopoly power may arise from the firm’s
owning and controlling the entire supply of a
raw material, from economies of large scale
productions, from ownership of patents, or
from government restrictions that prohibit
competition.
Innovation Theory of Profit:
The innovation theory of profit postulates that
(economic) profit is the reward for the introduction of
a successful innovation.
For example, Steven Jobs, the founder of the Apple
Computer Company, became a millionaire in the
course of a few years by introducing the Apple
Computer in 1977. Indeed, the U.S patent system is
designed to protect the profits of a successful
innovator in order to encourage the flow of
innovations.
Without doubt, as other firms copy the innovation,
the profit of the innovator is reduced and eventually
eliminated.
(Innovation is temporary)
Examples:
 Introduction of new methods of production to
reduce cost
 New machines / Better technology
 Adopting a new policy to increase the
demand of a product
 New attractive design of a product
 Profit is due to innovation.
Managerial Efficiency Theory of Profit:
This theory rests on the observation that if
the average firm tends to earn only a normal
return on its investment in the long run, firms
that are efficient than the average would earn
above normal returns and economic profits.