The theory of the firm is a body of theory, which contains certain assumptions, theorems and conclusions. Theory of the firm states that firms (corporations) exist and make decisions in order to maximize profits. These theorems deal with the way in which businessmen make decisions about pricing, and production under prescribed market conditions. It is concerned with the study of the optimization process.
For optimality to exist profit must be maximized and this can occur only when marginal cost equals marginal revenue. Thus, the optimum position of the firm is that which maximizes net revenue. Managerial economics, on the other hand, aims at developing a managerial theory of the firm and for the purpose it takes the help of economic theory of the firm. However, there are certain difficulties in using economic theory as an aid to the study of decision-making at the level of the firm. This is because for the purposes of business decision-making it fails to provide sufficient analytical tools that are useful to managers. Some of the reasons are as follows:
- Underlying all economic theory is the assumption that the decision-maker is omniscient and rational or simply that he is an economic man. Thus being omniscient means that he knows the alternatives that are available to him as well as the outcome of any action he chooses. The model of “economic man” however as an omniscient person who is confronted with a compete set of known or probabilistic outcomes is a distorted representation of reality. The typical business decision-maker usually has limited information at his disposal, limited computing ability and a limited number of feasible alternatives involving varying degrees of risk. Further, the net revenue function, which he is expected to maximize, and the marginal cost and marginal revenue functions, which he is expected to equate, require excessive knowledge of information, which is not known and cannot be obtained even by the most careful analysis. Hence, it is absurd to expect a manager to maximize and equalize certain critical functional relationships, which he does not know and cannot find out.
- In micro-economic theory, the most profitable output is where marginal cost (MC) and marginal revenue (MR) are equal. This is the point at which the slope of the profit function or marginal profit is zero. In economic theory, the decision-maker has to identify this unique output level, which maximize profit. In real world, however, a complexity often arises, viz., certain resource limitations exist. As a result, it is not possible to attain the maximum output level. In practical terms the maximum output possible as a result of resource limitations. Now the problem before the decision-maker is to find out whether the output, which maximize profit or some other level of output. It is obvious that economic theory is of no help for maximum output level of output because it is not relevant in view of the resource limitations. A managerial economist here has to take the aid of linear programming, which enables the manager to optimize or search for the best values within the limits set by inequality conditions.
- Another central assumption in the economic theory of the firm is that the entrepreneur strives to maximize his residual share, or profit. Several criticisms of this assumption have been made:
- The theory is ambiguous, as it doesn’t clarify. Whether it is short or long run profit that is to be maximized. For example, in the short run, profits could be maximized by firing all research and development personnel and thereby eliminating considerable immediate expenses. This decision would, however, have a substantial impact on long-run profitability.
- Certain questions create some confusion around the concept of profit maximization. Should the firm seek to maximize the amount of profit or the rate of profit? What is the rate of profit? Is it profit in relation to total capital or profit in relation to shareholders’ equity?
- There is no allowance for the existence of “psychic income” (Income other than monetary, power, prestige, or fame), which the entrepreneur might obtain from the firm, quite apart from his monetary income.
- The theory does not recognize that under modern conditions, owners and managers are separate and distinct groups of people and the latter may not be motivated to maximize profits.
- Under imperfect competition, maximization is an ambiguous goal, because actions that are optimal for one will depend on the actions of the other firms.
- The entrepreneur may not care to receive maximum profits but may simply want to earn “satisfactory profits”. This last point is particularly relevant from the behavioral science standpoint because it introduces a concept of satiation. The notion of satiation plays no role in classical economic theory. To explain business behavior in terms of this theory, it is necessary to assume that the firm’s goals are not concerned with maximizing profit, but with attaining a certain level or rate of profit, holding a certain share of the market or a certain level of sales. Firms would try to satisfy rather than maximize. But according to Simon the satisfying model damages all the conclusions that can be derived concerning resource allocation under perfect competition. It focuses on the fact that the classical theory of the firm is empirically incorrect as a description of the decision-making process. Based on this notion of satiation, it appears that one of the main strengths of classical economic theory has been seriously weakened.
- Most corporate undertakings involve the investment of funds, which are expect to produce revenues over a number of years. The profit maximization criterion provides no basis for comparing alternatives that can promise varying flows of revenue and expenditure over time.
- The practical application of profit maximization concept also has another limitation. It provides no explicit way of considering the risk associated with alternative decisions. Two projects generating similar expected revenues in the future and requiring similar outlays might differ vastly as regarding the degree of uncertainty with which the benefits to be generated. The greater the uncertainty associated with the benefits, the greater the risk associated with the project.
- Baumol on the other hand is of the view that firms do not devote all their energies to maximizing profit. Rather a company will seek to maximize its sales revenue as long as a satisfactory level of profit is maintained. Thus Baumol has substituted “Total sales revenue” for profits. Also, two decision criteria or objectives have been advanced viz., a satisfactory level of profit and the highest sales possible. In other words, the firm is no longer viewed as working towards one objective alone. Instead, it is portrayed as aiming at balancing two competing and non-consistent goals. Baumol’s model is based on the view that managers’ salaries, their status and other rewards often appear as closely related to the companies’ size in which they work and is measured by sales revenue rather than their profitability. As such, managers may be more concerned to increased size than profits. And the firm’s objective thus becomes sales maximization rather than profits maximization.
- Empirical studies of pricing behavior also give results that differ from those of the economic theory of firm as can be seen from the following examples:
- Several studies of the pricing practices of business firms have indicated that managers tend to set prices by applying some sort of a standard mark-up on costs. They do not attempt to estimate marginal costs, marginal revenues or demand elasticities, even if these could be accurately measured.
- For many firms, prices are more often set to attain, a particular target return on investment, say, 10 per cent, than to maximize short or long-run profits.
- There is some evidence that firms experiencing declining market shares in their industry strive more vigorously to increase their sales than do competing firms, which are experiencing steady or increasing market shares.
- An alternative model to profit maximization is the concept of wealth maximization, which assumes that firms seek to maximize the present value of expected net revenues over all periods within the forecasted future.
- As pointed out by Haynes and Henry, a study of the behavior of actual firms shows that their decisions are not completely determined by the market. These firms have some freedom to develop decisions, strategies or rules, which become part of the decision-making system within the firm. This gap in economic theory has led to what has come to be known as ‘Behavioral Theory of the Firm’. This theory, however, does not replace the former but rather powerfully supplements it. The behavioral theory represents the firm as an adoptive institution. It learns from experience and has a memory. Organizational behavior, is embodies into decision rules and standard operating procedures. These may be altered over long run as the firm reacts to “feedback” from experience. However, in the short run, decisions of the organization are dominated by its rules of thumb and standard methods.