The Theory of Firm

 

 

The Theory of Firm

OR

Objectives of Business Firms

The sole and only objective in the traditional theory of the firm has been profit maximization. This objective occupied the centre stage of economic theories until 1933 when R. L. Hall and C. J Hitch with the help of their empirical studies, challenged both the profit maximization and marginalistic behavioral rules.

 

The Firm and its Objectives

A firm is a technical unit in which commodities are produced for sale to economic units like individuals, households, firms and government bodies.

 

     1.   Maximization of Profit

The traditional economic theory assumed profit maximization as the sole objective of the firm. Under perfect competition, the price of a commodity is determined by the forces of demand and supply. Since the firm is one among the many firms, its action has no perceptible influence on price and supply. The firm is a “price taker” and a “Quantity adjuster”. That is, by accepting the market price, the firm can sell any amount of the product it likes. The difference between the total revenue (TR) and total cost (TC) is the economic measure of profit (Profit = TR-TC). It is the residue that is left after payments to all factors of production have been made.

 

2.     Sales Maximization

Baumol’s theory of sales maximization is an alternative theory of a firm’s behavior. The hypothesis rests on the separation of ownership and management found in firms. Being a consultant to number of firms in America, he points out that most managers seek to maximize their sales revenue rater than profits. He argues that the mangers in oligopolistic markets must earn a minimum level of profits to keep the share holders satisfied and only after that, they may pursue other goals.

 

In simple terms Baumol’s sales maximization hypothesis suggests that the maximization of sales revenue subject to a profit constraint may be a more likely goal of large business firms than the mere assumption of profit maximization.

 

1.     Security of Profit

According to Prof.Rothchild, the main aim of a firm is not profit maximization, but a steady flow of profits for a long time. In other words, it is interested in getting secure profits for a long period of time rather than profit maximization. 

            Rothchild argues that the objective of profit maximization is valid only under conditions of perfect competition or monopolistic competition, where there are a large number of firms. This is true under pure monopoly also. In these forms of market, the problem of security does not arise. For the pure monopolist, security against competition is ensured by virtue of his monopoly power. And for a small competitor the security question is a very urgent one; the market conditions have such an over whelming force that he alone cannot do anything to safeguard his position. Maximization or (short term) profits is therefore a legitimate generalization about the behavior of an entrepreneur in such cases.

            But Rothchild points out that in the field of duopoly and oligopoly this assumption is no longer valid. Under oligopoly, a firm is not motivated by profit maximization. It is engaged in a constant struggle to achieve and maintain a secure position in the market, like a military strategist.

 

2.     Maximization of Satisfaction

Prof. Scitovsky favors satisfaction maximization in the place of profit maximization. According to Scitovsky, the satisfaction of an entrepreneur does not depend only upon the material goods in the form of comforts and necessaries obtained by him out of the profits due to his entrepreneurial activity. It includes the leisure of what Hicks calls “a quiet life” also as an essential ingredient of individual welfare.

           

 

Scitovsky argues that an entrepreneur would maximize profits only if his choice between more income and more leisure is independent of his income. If and entrepreneur works more, less time will be available to him for leisure. Therefore the entrepreneur wants to maximize satisfaction and keep his efforts and output below the level of obtaining maximum profits. 

 

3.     Utility Maximization

Oliver E. Williamson has developed the managerial utility hypothesis in the place of profit maximization. According to this hypothesis, managers seed to maximize their own utility function, subject to minimum level of profit. A minimum level of profit is necessary to satisfy the share holders or to keep the manger’s position unchanged. The utility of the self-seeking managers depends upon three factors (i) number of persons working as subordinates, known as staff (ii) perquisites enjoyed by managers, and (iii) discretionary powers to sanction investment projects. Thus the hypothesis states that as long as a firm earns profits which meet the minimum requirements of the owners, mangers seek to maximize their own utility functions.

 

4.     Satisficing

Prof. Herbert Simon has developed a theory which emphasizes that the objective of a firm is not profit maximization but satisficing. According to Simon, the firms may prefer the “quiet life” and may be satisfied in achieving a certain minimum level of profits, a certain share of market or a certain level of sales.

 

5.     Growth Maximization

According to Marris, the main goal of a firm is the balanced rate of growth of the firm. It means the maximization of the rate of growth of demand for the products of the firm and of the rate of growth of its capital supply. By maximizing these variables, mangers maximize their own utility functions (salaries, job security, prestige, etc) and also the owner’s utility functions (profit, capital, market share etc).

 

 

6.     Other Possible Objectives

·         Papandreou says organizational objectives grow out of an interaction among the various participants in the organization. This interaction produces preference function.

·         Cooper argues that business (mainly banks) attempt to maintain liquidity sufficient to assure the firm’s financial position and retention of its control.