The theories of firm

Meaning of firm:

A firm is an organization that combines and organizes resources for the purpose of producing goods and services for sale. In economics, the term firm refers to a unit. The form is a producing unit. It is a business unit which undertakes production activity. The firm buys and co-ordinates the services of productive factors such as land, labor and capital along with its organization for producing a commodity and sells it in the market to the households or other firm.

A firm as to take decisions regarding:

The products to be produced The nature of the product Quantity and quality of the product Methods of production Whom to sell and at what price?

The motive behind all these decisions is maximizing the projects of the firm. The firm hires factors of production and pays them remuneration for the productive services they render. In short, the firm organizes the business and bears the risks. Thus a firm earns profits as the reward.

Firm owns and organizes a plant. It may be a factory or plant as a productive unit containing building, machineries, equipment’s etc. A plant is a place or arrangement for a production process whereas a firm is a decision making unit.

FIRM AND INDUSTRY:

Firm refers to an enterprise engaged in the production of a commodity. Firm means a particular production unit. An industry is a set of firms

producing homogeneous goods. There are firms which are engaged in the same type of production. All these firm together constitute the industry. A firm’s production plant is located in a specific city or area but an industry is spread over a wide region.

In short, firm is an individual productive unit and industry is a set of all such firms, big or small engaged in the identical productive activity.

In economic theory the entrepreneur is the owner and controller of the individual firm. Thus behavior of the firm studies as the behavior of the entrepreneur. The entrepreneur is supposed to act rationally. The assumption of rationality here implies that the businessman or a firm strives to seek maximum money profit. For over a century in economic theory the maximization of profit is regarded as the sole objective of a rational firm.

On practical observations, this assumption has been questioned in recent years. In reality, it is found that the entrepreneurs generally do not care to maximize profits but simply to earn a satisfactory return.

According to Simon, “instead of profit maximization, a firm must adopt the goal of satisfactory profit”. A rational firm which is more meaningful as it makes allowance for all kinds of psychic income derived by the entrepreneur from the business activity. For instance, earning a reputation as a good businessman by maximizing sales rather than profit, an entrepreneur may have a psychologically pleasant gain. Sometimes an appreciation from the public as a quality producer also gives an immense psychological satisfaction to the entrepreneur. This is commonly found in case of art film producers. Such businessmen quite often balance reduction of profit against an increase in psychic income.

OBJECTIVES OF FIRM:

Profit or profit maximization

Profit is accorded a high priority by a business firm. But in practice firms rarely wish to maximize profits. This is due to a number of reasons such as

I. Fear of attracting rivals in the businessII. Fear of provoking governments anger on egalitarian grounds

III. To avoid attraction of nationalization move from the political arena

IV. To maintain good public relations. Sales maximization:

Prof Baumol argues that managers are more concerned with the maximization of sales or sales revenue rather than profits. This is because:

I. Manager’s salaries are tied to sales and not profit. II. Larger sales revenue that is bigger size of sales causes to

expand business. When the size of the firm increases, it provides better opportunities in the managerial cadre for promotion and higher status.

III. Increasing sales enables the firm to capture more market and earn business reputation.

Boumol further states that a firm gives priority to earn a minimum level of profit and once this is realized it would seek to maximize its sales.

Boumol’s model of sales maximization is explained in the following diagram.

In this diagram OA is the curve between the size of sales and annual profit rate. X axis measures the size of sales and Y axis measures the profit, OQ1 is the optimum sales that causes maximum profit rate NQ1. At this point, the indifference curve for the manager IC1 intersects the OA curve. The manager’s utility function is highest when it is tangent to the profit curve. IC2 curve tangent to point E. It gives minimum profit OM. The firm thus produces output OQ2 giving the maximum sales.

Growth maximization

Prof Penrose and Morris consider growth maximization to be the primary goal of manager’s. This is because the firm increases the employment of managerial staff at a rate which maximizes growth. With the growth of the, the complexities of organization increases, so the firm requires greater managerial services.

Managerial utility maximization: Williamson argued that corporate control or governance is largely in the hands of manager who seek to maximize managerial utility for the obvious reasons of deriving intrinsic satisfaction from their individual business and social status. He identified the following model of managerial behavior U= f(S, DI, M) Where U= Managerial utility S= Expenditure on staff DI= Discretionary investment M= managerial slack

The variable S includes all payment to managerial and administrative staff on account of salary. It increases with expansion and promotion of the supporting staff for the top manager’s. It reflects the power,

prestige, status and professional success of the manager’s. Variable M includes manager’s gross emoluments which comprises salary and slack earnings in the form of luxurious residence, office, car, travel grants and entertainment. Variable DI refers to the investment that manager’s

Increasing market share: One of the objectives of the firm would be to increase its market share. The firm tries to achieve this objective through various promotional activities.

Staff maximization:In modern business, when large corporations are basically run by the professional managers, there is a separation of the ownership from the control.According to Berle and Means, when the managers control the business, instead of satisfying the profitability interest of the owners, they may seek to satisfy or justify their own utility or worth for the concern by having a more than necessary larger staff to be employed in the organization. The manager assumes its utility on the basis of a larger staff utility size.

Building a good business reputation: A firm strives hard to build a good business reputation. It is one of the long term objectives of the firm. It is important for a firm to win the confidence of the consumers in order to remain in the business.

Financial stability and liquidity:Another long term objective of the firm is financial stability and liquidity. Financial stability is imperative for the firm to achieve all other objectives. Financial liquidity is equally important for a firm.

Theories of the growth of the firm:There are few important theoretical contributions for the growth of the firm. Major contributions in the theory of the growth of the firm came from Downie, Penrose and Marris. The concept of the firm used in the theories of these authors is significantly different from the one that has been adopted in the traditional theory of the firm. Such theory defines the firm as the smallest technical unit engaged in the production of commodity. The function of a firm is to transform a set of inputs into some output of a commodity as specified by its production function. The term producer and entrepreneur are interchangeable for the firm. The firm operates in a single homogeneous market with static profit maximization objective. Generally, it is an accepted fact that there will be an upper limit to the rate of the growth of the firm because growth is subject to various dynamic restraints of which financial, demand and managerial restraints will be crucial and there will be social restraints for the growth of the firm. The restraints operate from the cost side of the growth, so it is the equilibrium between gains from the growth and the cost of the growth that sets the upper limit to the rate of growth of the firm, given its objective. Downie, Penrose and Marris developed the theories of the growth of the firm by considering these restraints. The interpretation and combination of the restraints, differing in their theories. DOWNIE’S THEORY:Downie was mainly concerned with analyzing the way in which alternative firms of market structure and conventions governing business behavior which he calls as “rules of game”, affect he

dispersion of efficiency between firms and the rate of technical progress. His theory of the growth of the firm is a by-product of this analysis. According to him, in an industry, which he defines as a group of firms having similarity of technical process, there will be a dispersion of efficiency across the firms that is some firms having greater efficiency than the industry average and some lower than this. The source of variation in efficiency across the firms is attributed to their technical processes by Downie. Those firms having access to technological superior processes or products are taken to be more efficient than the firms which do not have such facility. The technological superiority of the firm is established as a result of its past innovations which are patented or kept secret by it, and the accumulated skill or experience gained by the firm in its activities. Given the competitive environment and assuming the firms pursue the growth maximization objective, the process of growth of the firms in Downie’s model starts with the postulation of the steady encroachment on the market share of the less efficient firms by the more efficient firms. Downie used the concept of the “transfer mechanism” to explain this. The efficient firms having advantageous access to the means of growth will be able to encroachment on the market shares of the less efficient firms more or less rapidly. The means of the growth that Downie takes into account are capacity of production and customer’s to expand capacity, finance is needed which may raise either internally or externally. In both situation, the access to finance depends on the rate of profit. The efficient firm are assumed to have high rate of profit. They will be able to raise finance for capacity expansion has a positive relationship with the rate of profit. On customer side an efficient firm having better technique or efficient production, may be also to sustain a price reduction for its product and

attract new customers affects the market for less efficient firms adversely. The attraction of new customers is possible through non-price competition such as sales promotion or advertisement, but Downie has not considered these aspects. The attraction of customers or expansion of market by an efficient firm through its price reduction strategy will be feasible only up to certain limit e.g. as long as it is operating on the elastic zone of its demand curve, beyond which further reduction in price for expanding the marketing may lead to a reduction in the rate of profit for the firm. This implies an inverse relationship between the rates of profit for the firm. There are two opposite trends in the growth process of the firm. The capacity side of the growth varies positively with the rate of profit. These two opposite trends will set the upper limit on the rate of growth of the firm. At that limiting point, the rate of profit and the product price of the firm are such as to enable capacity and market of the firm to grow at the same rate. In this diagram such optimum situation for the rate of growth of the firm would be at the point “G” where the capacity and the market growth curves intersect. An efficient firm will be able to sustain a higher rate of growth than an inefficient firm because of its higher rate of profit initially, rapidly growing market or customer expansion curve, and ability to expand its capacity. The financial and market demand sustain restrains play the crucial role in the processes of the growth of the firm in Downie’s frame work.

In the process of the rapid growth of the relatively efficient firms, the other firms will be recognizing their inefficiency and declining market shares in the industry. How will they react to the new situation? Since it is a matter of survival for them, they will actives’ themselves to make improvement in their efficiency. According to Downie, the “innovation mechanism” in which the less efficient firms are compelled to initiate innovations in there process and products for reversing the efficiency differences. If they succeed, a new technological break- through is made by them, then relative efficiencies of the firms in the industry are likely to be reversed making the firms which were less efficient initially now more efficient and hence faster growing than the firms which were efficient initially but now relatively inefficient and hence less growing. This process continues in the industry. If this does not happen, then the implication of the Downie’s growth model is the ever growing concentration in the industry. Downie’s model provided very useful basis for the subsequent works particularly the two-way relationship between growth of the firm and its profitability from capacity and market demand side was well recognized. Further, the applicability of the model in competitive environments including oligopolistic interdependency was well taken into account. LIMITATIONS OF THE THEORY:

It has not considered diversification as a way to remove the market restraint on growth of the firm.

It has not taken into account the managerial restraint which plays very important role in the limiting the size of the firm.

The focus on innovation as a competitive strategy for the growth of the firm was also inadequate.

One need not believe that innovations are initiated only by the relatively inefficient firms as Downie postulated.

PENROSE THEORY: Penrose has not given any formal equilibrium growth model for the firm. But her description of the way in which the firms grows and the limiting factors for that is very much like a growth theory for the firm. To achieve this objective, the firm continues to make investment as long as it gets positive return from that. It takes the advantages of the productive opportunity for expansion which it thinks profitable. Penrose considers the firm as a pool of productive resources organized within an administrative frame work. The set of activities which the firm is aware of and able to undertake at a profit, defies its “productive opportunity”. The firm will continue to grow if allowed by it productive opportunity but there will be some restraints which will limit the productive opportunity and hence growth of the firm. Penrose has given major emphasis on explanation of the restraints on the productive opportunity of the firm in her theory. A brief sketch of how the growth of the firm is restricted in the Penrosian frame work is given below. The concept of the productive opportunity is conceived of as the basic element in the theory of the growth of firm by Penrose. Every individual firm is supposed to have a unique itself. Penrose defined productive resources as a bundle of potential services rather than nearly the physical quantities. The physical amount of a resource may be same but its use or service may be different in different firms. Service implies a function or an activity. Various inputs provide unique services or functions to a firm which may be quite different from the services of those inputs elsewhere. Some resources may of course have identical functions in all firms but considering all resources together including the past experience of the firm’s managerial team and its future perception for profitable activities, the productive opportunity of the firm will be unique.

The process of growth is not automatic in the Penrosian framework. It’s deliberate and conscious choice of the management. The process starts with the planning stage. Plans for expansion of the firm are prepared first and then executed. The existing managerial team will be preforming these acts. The team will work as a well co - ordinated administrative structure in organizing the growth of the firm. The collective experience of the managerial team will determine the character and extent of the productive services available for expansion given the firm’s productive resources. The nature and availability of the managerial services both entrepreneurial and administrative will shape the rate and direction of the firm’s expansion. If the managerial services are adequate, the firm can sustain higher rate of expansion. It is possible to expand the managerial services by recruitment of the new managerial services by recruitment of the new managerial resources. But such resources will take time to gain the managerial team at full efficiency. The existing managerial resources of the firm would not be increased significantly by such recruitment immediately. Its rate of expansion is very much limited which will put a restraint on the expansion of the firm also. In the words of Penrose, “if a firm deliberately or inadvertently expands its organization more rapidly than the individuals in the expanding organization can obtain the experience with each other and with the firm that is necessary for the effective operation of the group, the efficiency of the firm will suffer even if optimum adjustments are made in the administrative structure. The importance of the effective management for a firm is clearly shown by this connection. It, not only affects the efficiency of the firm, but regulates its future growth. The managerial restraint limits the productive opportunity of the firm at any given time which in turn puts an upper limit to its growth.

There are some other restraints on the growth of the firm as seen in practice, such as the growth rate of the firm. She emphasized solely on the managerial restraints.Penrose analyzed the possible external and internal inducement and obstacles for expansion of the firm. The external inducements mentioned by her include changes in demand, technological innovations and other changes in market conditions which help the firm to improve its competitive position, external obstacles including competition from rivals, patent or other barriers to entry, and market scarcity of external and internal inducements and obstacles which determine the direction and method of expansion of the firm. Penrose place much emphasis on the internal factors The internal inducements such as unused capacities including managerial services are quite dominating in her growth theory. The firm, having used managerial skills, will utilize them in new areas of productivity which gives new experience and new skills to its managerial team. On the basis of such new experience, the firm can venture into other new areas of productivity. The process of continuously goes on till some internal managerial restraints limit it. A natural process of growth in Penrose model is the diversification. Through the process of product diversification the firm will be able to utilize the productive opportunity fully and grow further till it is restrained by the availability of certain managerial services. Diversification is an effective strategy to neutralize the effect of the demand restraint on the growth of the firm. Merger or acquisition is also a mechanism for growth of the firm. According to Penrose, when a firm has achieved the maximum rate of profitable growth by means of internal expansion and constrained by the managerial restraint, it may still grow further through external expansion in the form or merger or acquisition. There will be certain

situations under which such strategy for the growth of the firm will be fruitful. Penrose’s work is an important contribution in the theory of growth of the firm. Her analysis is very much complex but not rigorous and formal. The effect of the managerial restraint on growth of the firm as postulated by Penrose is well known as the “Penrose effect”. She emphasized much on the variables for growth of the firm which are non-economic and often difficult to quantify. But, her ideas on the process of the growth of the firm are logically consistent. Subsequent works on the theory of growth of the firm used them without any challenge.There is a serious draw back in her work. She has neglected financial and other external constraints on growth of the firm. This is not justified. In practice, we do find firms unable to grow due to lack of finance and other market restraints. Because of the practical approach she followed for an explanation of the growth process of the firm, her work can be called as an organizational theory of the firm rather than an economic theory of growth of the firm as argued by Marris

MARRIS THEORY: A coherent and integrated theory of the growth of the firm has been developed by Marris. His theory is applicable to corporate firm owned by shareholders but controlled by managers. Shareholder’s being owners of the firm, are assumed to have the objective of maximizing the return on their investment in the firm. Managers of the firm, on the other hand aspire to maximize their own interests which are taken care of by higher pay, perks, power, prestige etc. All such things are postulated to be positively correlated with the growth of the firm in Marris model. It implies that managers of the firm are assumed to have the rate of growth of the firm as their objective. The return on

shareholder’s investment is realized in the form of dividend and capital gains throughout the life of the firm. The present value of the future stream of such earnings of current share capital determines the value of the firm in stock market. Higher the expectation of the earnings by shareholders from a firm, greater will be its value in stock market and vice-verse. In view of this relationship, one may take the growth in market value of equity shares of a firm as a proxy variable to specify the profit maximization goal of its shareholders. Marris used this approach in his model. He specified maximization of the rate of growth as the overall goal of the firm subject to stock market constraints. The constraints takes care of the objective of the shareholders. They have to be assured a minimum level of earnings on their investment, otherwise the job security of the managers will be in danger. If profitability or market value of the firm shares declines there will be a danger of its being taken over by other firms. In this situation also, the jobs or importance of the managers of the firm will be adversely affected. The mechanism of the growth of the firm in Marris frame work can best be explained with the help of a few relationships which Marris himself specified. They are as follows:

The steady growth condition: To simplify the analysis of the growth of the firm Marris made the assumption of steady state growth under which all characteristics of the firm such as assets, employment, sales, profits etc. grow at the same rate over time. There will be several ratios of any two of these characteristics which will of course be constant under the steady state of growth of the firm. E.g. the profit margin, the rate of return on capital, the capital-output ratio etc. which Marris called as the “state variable”. The implication of the steady state growth rate is that both supply and demand sides of the firm grow over time at the same rate. If

this is not so, there will be either ever growing spare capacity when supply grows at a faster rate than demand or ever growing excess demand when demand grows at faster rate than supply. Both these situation would be empirically unsound and so the management of the firm will be maintaining a balance between them over time.

The growth in demand function: The growth of demand is one side of the growth of a firm. If demand prospective for the existing and potential products of the firm are bright then it will grow, otherwise not. Market restraint will force it to be stagnant or declining over time. Every product as a life cycle. Its demand will be low first, then rises rapidly, after that it will be stagnant and then it will decline. The forces that govern the life cycle of a product are technological changes, competition from rival products etc. If the demand for the product of a firm will be stagnant. To avoid this situation, Marris advocates diversification as the most effective way. Diversification is not only a competitive strategy in the market but an effective way to grow further as Penrose advocated in her book. Marris followed her and specified the growth of demand function for a firm as gd= f1(d)Where gd is growth of demand and d is the rate of successful diversification. f1 shows the functional relationship between g and d.

The growth of supply function:

The growth of supply means an increase in the assets of the firm. The growth rate of assets will be simply the ratio of new investment to capital employed. The new investment depends on the finance available. A firm can raise finance primarily through three sources:

Retained earnings

Barrowings including bonds and debenture The issue of new equity shares

The specification of the growth of supply function becomes difficult in view of such diverse sources of funds.

OPTMUM FIRM:

Optimum firm means a firm operating at that scale at which in existing conditions of techniques and organizing capacity it has the lowest average cost of production per unit. When all those costs which must be covered in the long run are included.

The optimality is being seen here in terms of technical efficiency. This situation may be different from the point of view of optimum profitability or sales since that depends on market conditions along with the technical conditions. For the present we will not deal with this aspect and simply concentrate on looking at the efficiency of the firm in terms of cost reduction possibility.

Optimum firm presumes output levels as size variable. In the context of cost output relations this is appropriate measurement. The firm is to be conceived here as a technical unit producing a homogeneous product.

E A G Robinson divided the forces which determine the optimum size of all industrial unis into four main categories.

Technical force or factor Managerial force or factor Financial force or factor Marketing force or factor

o Technical forceTechnical force which determine optimum scale along with other three types of factors in many industries, favor a large operating unit. The technical optimum is the result of