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Theory of firm


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Theory of firm

  1. 1. Alternatives theories of the firm
  2. 2. Managerial theories • Baumol (1962); Marris (1964) and Williamson (1963) suggest that managers may pursue a strategy of maximum growth of the firm • Separaton of Ownership from Control • Two implications: – Increasing organizational complexity meant that it was impossible for the large firms to be managed solely by the owner • Teams of managers • Functional divisions – Impractical for the enterpreneur to finance solely by personal resources • Presence of capital markets
  3. 3. Baumol’s Theory of Sales Revenue Maximization • Maximize sales revenue subject to minimum profit constraint • Why sales revenue and not profits?? – Sales are good general indicator of organizational performance – Executive power, influence, status tend to be linked to the sales performance – Lenders tend to rely on sales data
  4. 4. • Profit figures are available only annually • Maximization of sales is more satisfying for managers as profits go to the pocket of shareholders • Salaries and slack earnings of the top managers are linked more closely to sales than profit • Routine problems can be more easily handled by growing sales
  5. 5. Figure 3.1 Baumol’s sales revenue maximization model
  6. 6. • Thus there are two types of equilibrium: One in which profit constraint does not provide an effective barrier, And second in which profit constraint does provide an effective barrier
  7. 7. Criticism • It has been argued that in the long run, baumol’s sale maximisation hypotheses and the conventional hypothesis will yield identical results as required level of profit would concide with normal level of profit
  8. 8. Marris’s Theory of Growth Maximization • Strategy of max. Growth of firm :Max. Growth at the expense of firms’ future profit streams. • Marris define growth rate(Gr) as Gr=Gd=Gc • Managers strive for growth rather than profit max. • Growth of demand => advertising expenditures; further price reductions; extensive advertisements • Faced with two types of constraints: -Managerial constraint on growth –Financial constraint on growth
  9. 9. • Managerial constraints arise due to: -Limit to managers’ ability to manage and achieve optimum efficiency -managers’ own job security • Financial constraints arise due to: - Conflict between managers’ own utility function and owners utility function - Um=f(salary, power, job security, status) - Uo=f(profit, capital, output, market share, public reputation) - However he claims that the two utility functions converge into one variable that study growth in the size of firm.
  10. 10. Figure 3.2 Marris’s growth maximization model
  11. 11. • As the rate of growth of demand is increased, profitability is increased until a certain point. Then managerial constraints on growth tend to take place. • The maximum growth of capital function shows the relationship between the firm’s rate of profit and the maximum rate at which the firm is able to increase its capital • This model suggests several testable hypothesis one of which is: “owner controlled firms achieve lower growth and higher profits”.
  12. 12. Williamson’s Theory of Managerial Utility Maximization • Baumol’s model view that managers’ interests are tied to a single variable: sales revenue. • Williamson (1963) argue that several variables should be in the manager’s utility functrion • U=U(S,M,ProfitD) U= Utility function S= Expenditure on staff (which leads to a higher prestige on behalf of the manager) M= Expenditure on managerial banefits (company car, fringe benefits, ..) ProfitD= Net profit (after tax and expenditure over and above the minimum level of profit required
  13. 13. Assumptions • Demand function: Q=f(P,S,e) • Cost function :C=f(Q) • Profit measures Actual profit=R-C-S Reported profit= Actual Profit- Managerial emoluments Minimum profit = Actual Profit- tax Minimum profit + tax< or= reported profit Discretionary profit=Actual profit=minimum profit + tax
  14. 14. Figure 3.3 Williamson’s managerial utility maximization model
  15. 15. The Behavioral Theory of the Frm • Cyert and March (1964) • Defines the firm in terms of its organizational structure and decision making processes • Boundaries of the firm are loosely defined • Satisficing behavior • Due to observance of actual behavior within organizations
  16. 16. Figure 3.4 Unitary or U-form organizational structure
  17. 17. Figure 3.5 Multidivisional or M-form organizational structure
  18. 18. Steps • Aspiration levels and process of goal formulation Cyert & March argue that Managers have a crucial task in formulating a goal for the firm that reconciles the conflicting and competing interests of different groups. • Setting the Goals- The satisficing behavior. Five types of goals are set: Production goal, Inventory goal, Sales goal, Market share goal & Profit goal.
  19. 19. • Production goal: continuity in production irrespective of any seasonal variability • Inventory goal : aims at maintaining a balanced inventory of both raw material and finished goods • Sales and market share goals aims at promotion and enhancing the market share of the firm • Profit goal is so determined that it satisfies the shareholders, bankers etc. Note:does not analyse and reveal how a firm reaches its equilbrium level in satisficing behaviour.