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Chapter 2

Theory of Firm

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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.

• To understand the nuances of concepts like principal agent problem and asymmetric information in an organizational context.

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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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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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Forms of Ownership

Company Cooperative

Public SectorPrivate Sector

Individual Collective

Proprietorship

Partnership

Forms of Ownership

Company Corporation Department

Joint Sector

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A. 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

• Types of business organizations under private sector: • Sole Proprietorship • Partnership• Joint Stock Company• Cooperative

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A.1: Sole Proprietorship

• The most ancient form of ownership • An individual invests own (or borrowed) capital, uses

own skills in management, and is solely responsible for the results of operations.

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Advantages and Limitations• Advantages

Simple and easy to start or exit Undivided profits earned accrues to the owner Secrets of the trade are not leaked out Prompt decision making Personal touch to business

• Limitations No entity of firm separate from the owner Unlimited liability Limited availability of funds Uncertain life of business: The life of single ownership

business depends upon the will and life of the owner

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A.2: Partnership

• Two or more individuals (individually partners and collectively a firm) decide to start a common business

• Persons who have entered into partnership are individually regarded as ‘partners’ and collectively as a ‘firm’

• Examples: ‘& Sons’, ‘& Brothers’ or two names comprising the name of a firm

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Characteristics

• Association of two or more persons • Agreement to voluntarily form partnership • Business carried out by all or any one acting for all • Created as an agreement, preferably prepared in writing,

in order to avoid any dispute arising in future

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Advantages and Limitations• Advantages

Easy formation Strong credit position dependent on the

creditworthiness of owners Risk divided among all the partners Shared wisdom and resources

• Limitations Uncertain life of firm Liability extended even to the personal assets of the

partners Dissents and distrust between partners Availability of funds directly related to the

creditworthiness of partners

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A.3: Joint Stock Company

• Established under Companies Act 1956 • Commonly called “company” • Details of functions and scope of the company are

governed by Memorandum of Association signed among members.

• Memorandum contains the name of the company, the location of the head office, its aims and objectives, the amount of share capital, the kind(s) and value(s) of shares and a declaration that the liability is limited.

• Articles of Association contain the rules and regulation of the company

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Characteristics• The owners’ capital in a joint stock company is invested

in the form of shares; hence the owners are regarded as shareholders.

• Profit earned is divided in the form of dividends on the basis of shares.

• Besides raising capital by shares, the company may also raise funds by bonds and debentures.

• Owners of bonds and debentures are the creditors of the company.

• A company is a legal entity and has perpetual existence.• The liability of each shareholder is limited to the

proportion of shares held by him/her• A joint stock company is also known as a limited

company.

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Characteristics• In the event of inability of a company to repay loan or

interest amount the creditors can raise their claim on assets of the company and not on the personal belongings of shareholders.

• A joint stock company is a legal entity and its existence is independent of its members.

• It has a name, a seal and an authorized signatory; it has the right to own, buy, sell and transfer property; it can sue and can be sued in its own name.

• A company is like a person, but it exists only in contemplation of law, and is strictly governed by the clauses laid in the Memorandum of Association.

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Types of Company• Private Limited Company

Maximum number of shareholders limited to fifty Shares of the company are 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 is seven, without any limit on the maximum number

It has to submit certain statements and its balance sheet to the Registrar of joint stock companies on an annual basis

It can invite the public to buy shares by issuing a prospectus Business cannot be started unless the minimum capital laid

down as per law has been subscribed

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Advantages and Limitations

• Advantages Limited liability Perpetual existence Ownership separated from control Financial resources much larger than ownership firm

or partnership Economies of large scale

• Limitations No loyalty of common shareholders to any particular

company Complexity in formation

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A.4: Cooperative • A nonprofit, nonpolitical, nonreligious, voluntary organization• Main principles of cooperation:

i. Based on mutual help and self reliance "each for all and all for each"ii. Dealings confined to members onlyiii. Objective of encouraging mutuality and cooperation

• Producers’ Cooperative Business owned by workers Surpluses (profits) divided among all the members

• Consumers' Cooperative Formed by persons living in a particular place, or working in an

establishment Examples: multi purpose stores, credit societies and housing

societies.

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Advantages and Limitations

• Advantages Combination of the benefits of capitalism with

socialism Perpetual existence

• Limitations Fraudulent activities Uncertainty of life due to differences among members

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B. Public Sector

• Government is the investor and the owner of a business• Established in India as per the First Industrial Policy

enunciated in 1948 and restated in 1956 • Three broad categories of State Enterprises in India:

i. Public Sector Units (e.g. SAIL, BHEL, ONGC and IOC)

ii. Corporations and Boards (e.g. Coir Board, Railway Board and Food Corporation of India)

iii. Departments (e.g. Telephone and Telegraph, Education, and Health)

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Advantages and Limitations

• Advantages– Balanced economic growth – Employment opportunities by developing large

industries – Profits earned go to the government

• Utilized for the benefit of the society at large

• Limitations Presence of ills of bureaucracy Absence of profit incentive Little check on extravagance and inefficiency

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Firms under Public Sector• Corporate (or Company)

Government invests in production activities and enters the market

Such firms are called as (PSUs) or Public Sector Enterprise (PSEs)

• Corporation or Board Normally controls some of the economic activities Where government intervention is necessary for equal

distribution of economic resources • Department

Run for a specific purpose related to social utility, such as education, health, civil administration, etc.

Normally function under the directives of relevant ministries, either at the appropriate level

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Objectives of Firm

• Objective of business: Provides the framework for all the functions,

strategies and managerial decisions Determines the short and long term perspective of the

firm • Theories on objectives of firm:

Profit Maximization Theory Baumol’s Theory of Sales Revenue Maximization Marris’ Hypothesis of Maximization of Growth Rate Williamson’s Model of Managerial Utility Function Behavioural Theories

o Simon’s satisficing model o Model by Cyert and March

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Profit Maximization Theory

• Objective of business is generation of the largest amount of profit

• 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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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 They attempt to maximize the firm’s total revenue,

instead of profits • Criticism

Insufficient empirical evidence

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Marris’ Hypothesis of Maximization of Growth Rate

• Two sets of goals: Owners (shareholders) aim at profits and market share Managers aim at better salary, job security and growth

• Both achieved by maximizing balanced growth of the firm (G), dependent on: Growth rate of demand for the firm’s products (GD) and Growth rate of capital supply to the firm (GC)

• Constraints in the objective of maximization of balanced growth: Managerial Constraint Financial Constraint

• Criticism Ignores the role of other constraints to growth pattern of the

firm

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Williamson’s Model of Managerial Utility Function

• Managers apply their discretionary power to maximize their own utility function– Constraint of maintaining minimum profit to satisfy

shareholders

• Utility function of managers (Um) depends on:– managers’ salary (measurable)– Job security– Power– Status– Professional satisfaction– Power to influence firm’s objectives

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Behavioural Theories • Simon’s Satisficing Model

Firms have to incur costs in acquiring information in the present

Objective of maximizing either profit, or sales, or growth act as constraints to rational decision making

“Bounded rationality" Satisfactory level of profit, sales and growth

• Model by Cyert and March Stakeholdershave different and oft conflicting goals ‘Satisficing behaviour’ aiming at satisfying all

stakeholders. Aspiration level on basis of past experience, past

performance of the firm, performance of other similar firms, and future expectations

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Principal Agent Problem • conflict of interests between the owners and the managers of a firm. As per

Williamson’s model, managers are more interested in maximization of their own benefits, instead of maximizing corporate profits.

• In an organizational set up the owners are the principal, while managers are the agents.

• In an organizational set up the owners (principals) hire managers (agents) who work on a well defined task, as the latter have better knowledge of the market and are expected to steer the business. Now this difference in information between two parties in any transaction (typically in principal agent problems cited here) is termed as information asymmetry, or a state of asymmetric information[1]. Because of such asymmetry, the principal cannot directly observe the activities of the agent; the agent may also know some aspect of the situation, which may be unknown to the principal [1] George Akerlof, Michael Spence and Joseph Stiglitz had jointly received the Nobel Prize in Economics for 2001 for their contribution on asymmetric information.

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consequences of asymmetric information

• Adverse selection: This refers to immoral behaviour that takes advantage of asymmetric information before a transaction.

• Moral hazard: This refers to immoral behaviour that takes advantage of asymmetric information after a transaction.

•

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Summary• We may divide business organizations 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).

• A sole proprietorship firm is one in which an individual invests own (or borrowed) capital and is solely responsible for the results of operations.

• A partnership is that form of ownership in which two or more individuals decide to start a common business. Persons who have entered into partnership are individually regarded as ‘partners’ and collectively as a ‘firm’.

• A joint stock company (or “company”) is a legal entity, limited liability and has perpetual existence.

• A joint stock company may be a ‘private limited’ or ‘public limited’. A private limited company cannot transfer shares to non members whereas public limited company can offer equity shares to any one.

• A cooperative is a nonprofit, nonpolitical, nonreligious, voluntary organization, formed with an economic objective.

• Public Sector in India has played important role in the development of economy of the country. However disadvantages subsequently overweighed the advantages, resulting in mounting deficits, inefficiency and sluggish growth.

• Every business has some objective, which provides the framework for all the functions, strategies and managerial decisions of that business.

•

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Summary• 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. According to him, sales volumes, and not profit volumes, determine market leadership in competition.

• 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.

• Oliver Williamson’s model is a combination of the objectives of profit maximization and growth maximization, which proposes that managers would apply their discretionary power in such a way, as to maximize their own utility function, with the constraint of maintaining minimum profit to satisfy shareholders.

• Herbert 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.

• In the organizational framework of asymmetric information, owners can make managers work in the interest of the organization by minimizing the information gap in between; or by tying the managers’ rewards to organization’s performance.