Managerial Economics

PGDM : 2015 17
Term 1 (June September, 2015)
(Lecture 03)

Categories of Organization
Organization
Business
Organization

Not for Profit

Organization

Government
Agency

Sole Proprietorship
Partnerships
Corporation

Business Organization

Position of a Business Organization in an Economy

TAX
Government
Organizing
Resources: Land,
Labor, Capital
etc.

Business
Organization

????????????

Income: Rent,
Wage, and
Interest

Resource Owner

Public Services such

as Defense,
Education, Health

Purchase of Goods and

Service produced and
distributed by the firm
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Different Theories to Understand the Nature

of the Firm/ Business Organization

Different Theories to Understand the Nature

of the Firm / Business Organization

Transaction Cost Theory

Transaction Cost Theory

Why does a firm exist: Transaction Cost

Theory
Note that, a production or a distribution process consists of multiple steps.
It is inefficient and costly for an entrepreneur to enter and enforce contracts with the
owners of the required resources for each separate step of production and
distribution.
It is less costly and advantageous to both parties - entrepreneur and resource owners
- if there is a longer term, broader contract between them, i.e., a General Contract.
A General Contract internalizes many transactions through performing many
functions within the organization i.e. the Firm.
Moreover, operating a firm, an entrepreneur can save sales tax and can avoid those
Government Regulations which are only applicable to transaction between firms.
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What is Optimal Level of Expansion?

So, if internalization reduces transaction cost then, should a firm
expand indefinitely?
Answer is NO. But Why?
It is very important to decide on the optimal size of firm since expansion
beyond the optimal point leads to Diseconomies of Scale i.e., increase
in average cost with the increase in output.
Up to a certain point this diseconomies of scale can be avoided by
establishing a number of semi-autonomous divisions i.e., through
decentralization.
After a certain point on the expansion path of the firm, the distance
between top management from each division starts increasing.
This in turn limits the managements ability to effectively control and
direct the operations of the firm and impose sufficient diseconomies of
scale to limit the growth of the firm.
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Divorce between Ownership and Control:

Management Utility Maximization Problem
Modern corporations allow firm managers to have no participation (or only
limited ownership participation) in the profitability of the firm.

Shareholders are Principals, managers are Agents

Two common problems:

Often hard to observe managerial effort and

Random disturbances in team performance (luck versus effort?)

Consequence: The Principal-Agent Problem
Shareholders (principals) want profit/value to be maximized
Managers (agents) want individual utility/benefit to be maximized through
receiving more leisure & financial security
It is very likely that there will be conflict between the interest of these two
groups
This conflict of interest leads to the Principal-Agent Problem
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Agency Theory/ Agency Problem

Read Section 2.4.1
for Details

Read Section 2.4.2 for Details

Read Section 2.4.2 for Details
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Control Measures

Read this Case Study from the Material Sent with this PPT.

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Motivation Theory

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Property Rights Theory

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