Theories of the Firm

Among teachers of management theory the dissatisfaction in the 1930s with the simple conception of a firm as a mechanism which transforms atomistic inputs into marketable outputs resulted in alternative perspectives.  A legaleconomic view of the firm emerged, aimed at revealing key aspects of the internal structure of the corporate firm.  One development of this view formed the basis of the managerial theory of the firm (Section 2.1).  Other developments, based on the work of Coase, Williamson and others, are discussed in Sections 2.2 to 2.5.

2.1  The Managerial Theory

Throwing some light into the neoclassical black box, the managerial theory emphasised the complex nature of the modern corporate firm.  In their pioneering work, Berle and Means (1932) described the diminishing influence of shareholders in the decision making process of large corporations in the USA from the turn of the century.  This left much of the decision making to the manager, whose objectives, it was suggested, could be different from those of the owners of the firm.  If, in terms of its influence on managers' salaries, size of firm, for example, was more important than firms' profitability, then growth could be a more important objective of firms than profit.

Other reasons why hired managers may be more preoccupied by sales or revenue maximisation than by profit maximisation include, according to Baumol (1967), the following:

        i) If sales fail to rise, this is often equated with reduced market share and market power, and consequently, with increased vulnerability to the actions of competitors.

        ii) When asked about the way his company performs, an executive would typically reply in terms of what the firm's levels of sales are.

        iii) The financial market and retail distributors are more responsive to a firm with rising sales.

The model developed by Baumol attempts to reconcile the behavioural conflict between profit maximisation and the maximisation of the firm's sales (i.e. its total revenue).  It assumes that the firm maximises sales revenue subject to a minimum profit constraint.  Figure 3.1 depicts the firm's total sales revenue (TR), total costs (TC) and total profits (π).  The quantity qp represents the output produced by a profit-maximising firm, and qr the output produced by a revenue maximising firm.

        

       

qp = profit-maximising output

qr = revenue-maximising output

qc = revenue-maximising output, subject to a minimum profit constraint πc.

The revenue-maximising level of output is the level at which the marginal revenue is zero (and the elasticity of demand is unity).  The output qc is that which is produced by the revenue-maximising firm when constrained by a minimum profit πc.  The difference between the maximum possible level of profit and minimum constrained profit (i.e. between πp and πc) is called "sacrificeable" by Baumol.  In his view, these profits will be voluntarily given up by the firm in order to increase sales revenues.  If the sacrificed profits are too apparent, they would tend to attract other firms acting in the same market, and would tend to create the ultimate threat of takeovers. This is why the sacrifice "will be done quietly and only in ways which don't look like sacrificing" (Shepherd, 1990, p.251). In any event, the profit-maximising output will generally be less than the revenue-maximising output.  The profit-constrained revenue-maximising output may be greater than or less than the revenue-maximising output.  If qc < qr, then the firm will produce qc.  If qc > qr, then the firm will produce qr.  Baumol argues that the unconstrained equilibrium position never occurs in practice.

The managerial theory of the firm was further developed by a number of writers, and in particular by Marris (1963 and 1966), whose 1966 formulation has become "the standard one for analysis of [the growth of] the managerially controlled firm" (Hay and Morris, 1991, p.328).  In this model, Marris formalised the hypothesis that managerial control would lead to growth as an objective, showing that shareholders were a less important constraint on such firms than financial markets.  Marris' model is dynamic in the sense that it incorporates growth.  Like Baumol's model, it assumes that managers will act to maximise their utilities rather than profits, but in contrast to Baumol, it assumes that this will be achieved through growth rather than sales.

        

At its simplest, the model has two curves, one of supply-growth (SG1), and one of demand-growth (DG1).  The axes are profit rate and growth rate, with growth arising through diversification into new products, rather than expansion of output.  The supply-growth is the maximum growth of supply that can be generated from each profit rate, given management's attitudes to growth and job security.  Supply-growth is directly and constantly related to profit, because a higher profit facilitates both more investment from retained earnings, and more funds to be raised in the capital market.  Unlike in relation to demand-growth, the positive relationship between supply-growth and profit is possible at both low and high levels of profit (and growth).

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The demand-growth curve shows the maximum profit rate consistent with each growth of demand.  With demand-growth, growth is seen as determining profits, rather than - as in supply-growth - profit determining growth.  Growth, which is diversification into new products, leads to an increase in the profit rate at low levels of growth because the first new products that the firm introduces will be the most profitable.  As more and more new products are introduced (i.e. as the growth rate increases) so more has to be spent on R&D for the next lot of products and on advertising for the ...

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