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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 business
II. 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 IC 1 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 force
Technical 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