Unit-2 : Objectives of the Firm:

Managerial theories of firm

Behavioral theories of firm
Optimization techniques
Optimization with calculus
New Management tools of Optimization
 Introduction
 A business is an economic and production unit
converting inputs to outputs
 Each firm lays down its own objectives which are multi
dimensional, competitive and sometimes
supplementary in nature
 These objectives are determined by various factors
based on external and internal environment
 These objectives have to satisfy the needs of
shareholders, management, employees, suppliers and
consumers.
 The following Models will help us to understand
different objectives of the Firm.
 Introduction
Top 3 Theories of Firm (With Diagram)
1. Profit-Maximizing Theories  2. Other Optimizing Theories 3. Non-
Optimizing Theories.
 1. Profit Maximization Model
Main Propositions
 It’s single most important objective of the firm
 A firm is a producing unit converts inputs into outputs of higher
value under a given technique of production
 A firm operates under a given market condition
 A firm will select that alternative course of action which helps to
maximize consistent profits
 A firm makes an attempt to change its prices, input and output
quantity to maximize profit.
The Model
 It implies earning highest possible amount of profits during a
given period of time by building optimum productive capacity
both in short/long term.
 1. Profit Maximization Model
The Model
 In the short term the firm can make minor adjustments in
production process and business conditions.
 the plant capacity is fixed and the firm increases its production
by overtime and maximum utilization of machinery and plant.
 In the short run managerial and technical constrains are faced by
the firm
 In the long run because of plenty of time the firm can expand its
capacity by building new plants, add labor to meet the growing
demands of the market
 All kinds of adjustments are possible in the long run in
production processes and managerial strategies.
 1. Profit Maximization Model
Assumptions of the Model
1. Profit Maximization is the main goal of the firm
2. Rational behavior to achieve its goal of profit maximization
3. The firm is managed by owner-manager
Determination of profit- maximizing price and output
a. Total Revenue (TR) and Total Cost (TC) approach
b. Marginal Revenue (MR) and Marginal Cost (MC) approach
Total Revenue (TR) and Total Cost (TC) approach
 1. Profit Maximization Model
Marginal Revenue (MR) and Marginal Cost (MC) approach
 MR : Marginal revenue is the revenue obtained from the last unit sold.
 MR = Change in TR / Change in Q (TR= total revenue; Q= quantity)
 MC : Marginal cost is the additional cost incurred in the production of one
more unit of a good or service.
 Two conditions are necessary for profit maximization.
1. A profit maximizing firm will produce up to the point where marginal cost
(MC) equals marginal revenue (MR). MR=MC
2. MC curve cut MR curve from below.
 1. Profit Maximization Model
Justification for Profit Maximization
1. Firm is owned and managed by the entrepreneur and profit
maximization is the natural principle of the firm.
2. A firm is not a charitable institution
3. To predict most realistic price-output behavior
4. Necessary for survival and to achieve its objectives.
Criticisms
5. Ambiguous term
6. Always not possible
7. Separation of ownership from management
8. Difficulty in getting relevant data
9. Conflicts among departmental goals
10. Emphasis on non profit goals
 2. Baumol’s Theory of Sales Maximization
 Managers attempt to maximize the firm’s total revenue instead of
profits.
 Sales volume not profit volume determines market leadership
 In large organizations Managers are different from owners and
managers benefits are often linked with sale volume and not
profits
 The goal of the firm is maximization of sales revenue subject to a
minimum profit constraint
 Increase in sales results in increase of revenue and market share
 Increases competitive ability of the firm and its influence in the
market
 Enhances prestige and reputation of the firm and distribute more
dividends to shareholders
 Managers undertake projects with steady and satisfactory level of
profits than risky, high profit projects
 2. Baumol’s Theory of Sales Maximization
 Prof. Baumol developed 2.models . 1. Static model 2. Dynamic model
The Static Model
 It assumes that the firm operates in a single period
 The objective is to maximize sales revenue rather than sales
 There is profit constraint ; minimum profit expected by shareholders
 The demand curve of the firm slope downwards from left to right.
 The average cost curve of the firm is U-shaped one.
The Dynamic Model
 It is applicable in multi periods
 The objective of the firm is to maximize the rate of growth of sales
revenue over its life cycle
 profit is the main means of financing growth of sales
 Higher advertisement expenditure would certainly increase sales of a firm
 Market price remains constant
 Demand and cost curves of the firm are conventional in nature.
 3.Williamson’s Managerial Discretionary Theory
 When a firm achieves certain amount of growth and profit to
pay satisfactory dividends to the shareholders, the top managers
focus on their own interests.
Assumptions of the model:
 Market is imperfect (not perfectly competitive)
 ownership and management is separated
 A minimum level of profit to be achieved to satisfy shareholders
Framework of the model
 Managers have their own utility functions. They aim at
maximizing their utility functions than maximizing the profits
 Managers utility function is expressed as U=f(S, M,Id)
 S= Additional expenditure on staff
 M= Managerial emoluments
 Id= Discretionary investment
 3.Williamson’s Managerial Discretionary Theory
 S= Wages and salaries for additional staff
 M= expenses on entertainment, allowances and AC and other
Luxuries
 Id= expenditure on furniture, latest gadgets, decoration materials
 All these expenses are part of the total cost of operations and keep
the Managers happy and motivated
 If reasonable level of dividends are not paid to the shareholders
they demand for change in management and results in change of
management
 Hence the managers maximize their utility function when they
ensure reasonable profits for the company
 There is no direct relationship between managers utility function
and better performance .
 A firm can not spend more money on only improving the conditions
of the managers as it has to look into the interests of other groups
also.
 4. Marris Model of Managerial Enterprise
 Its growth maximization model as the growth is better yardstick
of performance
 Growth depends on volume of investment.
 Investments depends on capital availability either internal or
external capital.
 External capital is more costly than internal capital hence firm
needs to generate more profit
 Both owners and managers have distinct goals. Their utility
functions are as follows:
 Uo = f(size of output, market share, volume of profit, capital, public
esteem)
 Um = f ( salaries, power, status, prestige, job security)
 If the firm is big in size both the utilities can be satisfied
 If the rate of growth is high then promotional opportunities for
managers and higher dividends for shareholders.
 4. Marris Model of Managerial Enterprise
 Marris identifies 2. constraints in the rate of growth of firm
 1. There is a limit up to which output of a firm can be increased
more economically, limit to manage the firm more efficiently,
limit to employ talented and more experienced managers, limit
to R&D and Innovation
 2. Ambition of job security limits the growth rate. If growth
reaches maximum then no expansion further hence managers
may loose jobs. Managers would like to seek their job security.
 High risk vs. Risk averse managers
 Marris model emphasizes on achieving balanced growth rate for
the firm.
 Maximum growth rate (g) depends on 2.factors. 1. The rate of
demand for the products 2. Growth rate of capital ( rate of
diversification and average profit margin)
 5. Cyert and March Model
 Behavioral Theory Model as per their book- “ A Behavioral
Theory of the Firm”. The model can be studies in the
following sequence.
 The Firm as a Coalition of groups with conflicting goals
 A Large Multi-product firm under uncertainty in an imperfect market
 A Multi goal, multi-decision organizational coalition of different
groups- Mangers, workers, shareholders, customers, bankers
etc….with conflicting goals.
 Each group has its own set of goals.
 The Process of Goal formation-the aspiration level
 The demands of one coalition group often conflicting with another
group and with overall goal of the firm
 Demands change continuously with past achievement, environment,
time.
 Not all demands can be satisfied by top management hence there is
bargaining process and the conflict
 5. Cyert and March Model
 Goals of the Firm
 The Goals are set by top management and there are 5.main goals.
Production, Inventory, Sales, market share and profit. Goal formation is
done by continuous bargaining between coalition groups and tries to
satisfy as many demands as possible
 Satisficing behavior is rational and the firm is not maximizing but
satisficing
 Means for Resolution of conflict
 conflicts are managed by various means.
 Budget-share
 Goals are set based on past experience, goals, and decisions
 Delegation of functions which limits discretion
 Money payments to satisfy the demands
 Additional payments and Slack payments like higher wages, perks,
dividends
 Decentralization of decision making
 Sequential attention and meeting the demands on priority basis
 5. Cyert and March Model
 Decision-making process
 2.levels of decision making- 1. at top level 2. at lower level
 Top management makes decisions based on quick screening and
based on search for information and selects the best alternatives
 Lower level administration learns by experience and execution of
budgets provides valuable experience
 Uncertainty and Environment of the Firm
 2.types of uncertainty 1. market uncertainty 2. uncertainty of
competitors’ reactions.
 Market uncertainty refers to changes in consumer tastes,
techniques of production which can be reduced by information
gathering and the firm considers only short term and not long run
consequences
 Uncertainty due to competitors actions is brushed aside by
assuming that existing firms have arrived at collusive action. Little
attention to environment and examines only internal allocation.
 Optimization techniques and Calculus
• Optimization techniques helps in Maximizing or Minimizing an
Objective function.
• It is to examine ways to express economic relationships between total,
average and marginal concepts and measures such as Revenue, Cost,
Product or Profit.
• The economic relationships can be expressed by equations, tables or
graphs .
• Optimization analysis is to examine the process by which a firm
determines the output level at which it maximizes total profits.
• It can be done either by Total Revenue and Total cost approach or by
Marginal Analysis (Marginal cost and Marginal Revenue).
• Optimization analysis can be conducted much more efficiently and
precisely with differential calculus.
• Multivariate analysis is the process of determining maximum and
minimum point of a function of more than 2.variables.
 Optimization techniques
• Calculus Technique : It will help us how cost changes with
respect to volume output. It can also be used to determine the
maximum or minimum vale of the dependent variable
• Constrained Optimization Technique : The objective function has
to be minimized or maximized subject to certain constraints. For
Eg: a producer maximizing sales revenue subject to resource
constraint or cost constraint or profit constraint.
• Linear Programming : In LP the statement of
optimization( maximization or minimization) problem is in linear
form; that is we have a system of linear equations or linear
inequalities.
• Game Theory : It is used to explain the behavior of players in a
given market environment. Optimal decision may be arrived at by
using Game theory. When two sellers face each other for a given
market share it is used to arrive at a stable equilibrium condition.
 New Management tools of optimization
1. Benchmarking :
 Benchmarking is comparing one’s business processes and
performance metrics to industry bests and best practices from
other companies.
 It requires picking a specific process to improve and identify few
firms that do better
 It can result in dramatic cost reductions, Manpower planning
2. Total Quality Management:
 constantly improving the quality of products and the firm’s
processes so as to consistently deliver value to the customers.
 How it can be done cheaper, faster or better?
 requires CEO support, creates value for the customer, clear
strategic goals, get the belief of people, tailored specifically to the
firm,
 New Management tools of optimization
3.Reengineering :
 Radical redesign of all the processes to achieve major gains in
speed, quality, service and profitability.
 Two major reasons to reengineer either by Threat from
competition or greed to obliterate competition.
 Expertise required to reengineer to gain major benefits for the
organization.
4. Learning Organization:
 values continuous learning both individual and collective and
this creates competitive advantage for the firm.
 Peter senge – it is based on 5. basic ingredients.1. new mental
model 2. personal mastery 3. system thinking 4. shared vision or
strategy 5. team learning