The Theory of the Firm

1
The Theory of the Firm

• City University 2007

2
Theories of the Firm

• Neoclassical theory profit maximization
• Assumptions
• Single-minded purpose
• Rationality
• Operational rules MC MR

3
Transaction Costs

• Transaction costs the costs of providing for
  some good or service through the market rather
  than having it provided from within the firm
  Ronald Coase
• Search and information costs
• Bargaining and decision costs
• Policing and enforcement costs

4
Transaction costs

• Three dimensions along which transactions may
  vary
• asset specificity
• uncertainty
• frequency

5
The three main characteristics of the firm

• Collectivity of people in an organization
• Action by superior-subordinate direction
• Continuity over time

6
Firms vs. Markets

• The firms benefits
• specialization in teams
• transaction-cost savings
• corporate capital formation
• morale

• The firms costs
• shirking
• agent misdirection
• rent seeking

7
The Problem of X-inefficiency

• X-inefficiency - the difference between efficient
  behaviour of firms assumed or implied by economic
  theory and their observed behaviour in practice.
• - the cost that is higher than it needs to be
  because the firm is operating inefficiently

8
Factors causing X-inefficiency

• Internal Factors
• Poor contracts between principals and agents
• Large firms may be difficult to control

• External Factors
• Diffuse share ownership
• Limited threat of takeover
• Degree of competition
• Barriers to entry

9
The Principal Agent Problem

• the principal-agent problem - the difficulties
  that arise under conditions of incomplete and
  asymmetric information when a principal hires an
  agent
• the agents actions affect the principal's
  payoff, but they are not directly observable by
  the principal, or they are not verifiable to
  outsiders.
• The central dilemma - how to get the employee or
  contractor (agent) to act in the best interests
  of the principal (the employer) when the employee
  or contractor has an informational advantage over
  the principal and has different interests from
  the principal.

10
Theories of the Firm

• Theory of Managerial Utility Oliver Williamson
• Sales Revenue Maximization Model William Baumol
• Maximizing Present Value of the Firms Future
  Stream of Sales Revenues William Baumol

11
Theories of the Firm

• Maximizing Growth Robin Marris
• - the managerial utility depends on the firms
  rate of growth
• Supply led growth vs. Demand led growth, or
• profitability vs. diversification
• The principal-agent problem

12
The Theory of the Firm

• The Integrative Model Oliver Williamson
• Integrates the growth maximization model and the
  profit/sales maximization models and the
  maximization of the present value of future sales
• Max growth max sales

13
Theories of the Firm

• Behavioral theories - Herbert Simon, Richard
  Cyert and James March
• Firms multi-goal, multi-decision,
  organizational coalitions
• Imperfect knowledge and bounded rationality
• Managers cannot meet the aspiration levels of all
  stakeholders
• Managers cannot maximize, instead they have to
  satisfice

14
Stakeholders in the Firm

• Owners/investors
• Employees
• Customers
• Suppliers
• Distributors
• Creditors/banks
• The government
• Public at large