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1. Theories of the firm
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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
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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.
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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.
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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)
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6. Forms of Ownership
Forms of
Ownership
Private Joint Public
Sector Sector Sector
Individual Collectiv
Company Corporatio Departme
e
n nt
Proprietorsh
ip
Partnersh Company Cooperativ
ip e
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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
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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.
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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
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10. Private Sector
Private 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 members
Public 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
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11. Private Sector
 Cooperative: A nonprofit, nonpolitical,
nonreligious, voluntary organization
based on mutual help and self reliance
 Producers’ Cooperative
 Consumers’ Cooperative
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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
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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)
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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.
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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
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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
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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
firm
G = 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)
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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)
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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
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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
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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).
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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.
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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.
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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.
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25. ARISE ! AWAKE!
AND STOP NOT
TILL THE GOAL IS REACHED…….
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