Alternative Theory of the Firm

 Overview of the Traditional Theory of the Firm

The traditional theory of the firm is also known as the Profit Maximization theory of the firm. 

• Analysis of Production Function in the short run:

In times of rising sales (demand) firms can increase labor and capital but only up to a certain level. Example: land is the fixed factor which cannot be altered in the short run. If demand slows down, the firm can reduce its variable factors. Example: it reduces its labour and capital but again, land is the factor which stays fixed.

The traditional profit-maximizing theories of the firm have been criticized for being unrealistic

. • The criticisms are mainly of two sorts: 

      1) that firms wish to maximize profits but for some reason are unable to do so. 

       2) that firms have aims other than profit maximization. 

Example 

 • Managers want to maximize their own utility

 • Managers ensure that sufficient profits are made to keep shareholders happy

Managerial theories indicate managers would seek or pursue to maximize their own aims within an organization. 

▪ Alternative theories tend to assume that large firms are Profit Satisficers:

    – Where decision makers in a firm aim for a target level of profit rather than the absolute maximum level

 ▪ These alternative theories formulated due to decisions taken by the managers of the organizations who may be assumed to maximize their own utilities and due difficulties in applying profit maximization in present organization, due to:

 – lack of information to determine the marginal revenue line

 – market conditions organizations

In the long run, the firm can change all its factors of production thus increasing its total capacity. In this example it has doubled its capacity.

• One of the most influential of the alternative theories of the firm has been that developed by O. E. Williamson in the 1960s. 

• Williamson argued that, provided satisfactory levels of profit are achieved, managers often have the discretion to choose what policies to pursue. In other words, they are free to pursue their own interests. 

      WHAT ARE THE MANAGERS INTEREST?

• Williamson identified several factors that affect a manager’s utility:

      • salary, job security, dominance (including status, power and prestige) and professional excellence.

• The most famous alternative theories of the firm, developed by William Baumol in the late 1950s
• The theory stated that after a minimum amount of profits have been reached firms that operate in an oligopolistic market will aim for sales revenue maximization and not profit maximization.
•  It also assumes that managers aim to maximize the firm’s short-run total revenue

Growth Maximization

• Growth maximization refers to an alternative theory that assumes that managers seek to maximize the growth in sales revenue (or the capital value of the firm) over time 

• Managers may take a longer-term perspective and aim for growth maximization in the size of the firm. ➢They may directly gain utility from being part of a rapidly growing ‘dynamic’ organization; 

➢ Promotion prospects are greater in an expanding organization since new posts tend to be created; ➢larger firms may pay higher salaries; 

➢managers may obtain greater power in a larger firm

• Growth maximization refers to an alternative theory which assumes that managers seek to maximize the growth in sales revenue (or the capital value of the firm) over time 

• Growth may be achieved either by:

 1. Internal Expansion 2. Merger 3. Strategic Alliances

• Growth may be achieved either by: 

1. Internal Expansion

 ▪ In order to increase its sales, the firm is likely to engage in extensive product promotion and to try to launch new products.

 ▪ In order to increase productive capacity, the firm will require new investment. Both product promotion and investment will require finance.

 ▪ Types of growth: i. Growth through vertical integration ii. Growth by internal expansion

2. Merger 

A merger may be the result of the mutual agreement of two firms to come together. 

▪ The term ‘merger’ is generally used to include both mutual agreements and acquisitions. 

▪ There are three types of mergers: 

i. A horizontal merger 

ii. A vertical merger iii. 

A conglomerate merger

There are three types of merger:  

i. A horizontal merger is where firms in the same industry and at the same stage of production merge 

ii. A vertical merger is where firms in the same industry but at different stages in the production of a good merge. 

iii. A conglomerate merger is where firms in different industries merge

3, Strategic Alliances

• Where two firms work together, formally or informally, to achieve a mutually desirable goal
•  There are many types of strategic alliance between businesses, covering a wide range of alternative collaborative arrangements.

 i. Joint ventures  ii. Consortium iii. Franchise iv. Subcontracting

Joint ventures → A joint venture is where two or more firms decide to create, and jointly own, a new independent organization. 

ii. Consortium → Where two or more firms work together on a specific project and create a separate company to run the project. 

iii. Franchise → A formal agreement whereby a company uses another company to produce or sell some or all of its product. 

iv. Subcontracting → Where a firm employs another firm to produce part of its output or some of its input(s)

Principal-Agent Problem

– Where people (principals), as a result of lack of knowledge, cannot ensure that their best interests are served by their agents.

Whenever an individual (the principal) entrust another person (the agent) to perform a service on her behalf and cannot fully observe the agent’s actions, a principal-agent problem’ arises.

 ➢The underlying assumption is that the interests of the agent and the principle may deviate from each other. In economics, the classical example is the potential conflict of interest between shareholders of the firm and management team of the firm. 

➢A typical application of principal-agent problem has been made to the case of an insurer who cannot observe the level of the care taken by the person being insured

Reason Of Principal-Agent Problem

– A conflict of interest is a situation in which some person (whether an individual or corporate body) stands in a certain relationship to one or more decisions

. – In the economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other

Pricing Strategy 

• Average Cost or Mark-up Pricing

 ➢Producers work out the price by simply adding a certain percentage (mark-up) for profit on top of average costs (average fixed costs plus average variable costs). 

P = AFC + AVC + profit mark-up 

➢Choosing the mark-up

 ✓The level of profit mark-up on top of average cost will depend on the firm’s aims: whether it is aiming for high or even maximum profits, or merely a target based on previous profit. 

✓It will also depend on the likely actions of rivals and their responses to changes in this firm’s price and how these responses will affect demand.