Chapter 2

Theory of Firm

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 Chapter Objectives
• To identify the various types of organizations on the
basis of ownership pattern and highlight the
advantages and limitations of each type.
• To appreciate the role of public sector in economy.
• To understand various objectives of a firm and develop
a critical appraisal of the various theories of objectives
of a firm.
• To understand the nuances of concepts like principal
agent problem and asymmetric information in an
organizational context.

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 Introduction
• A firm is an entity that draws various types of factors of
production in different amounts from the economy, and
converts them into desirable output(s), through a
process with the help of suitable technology.
• Economists have identified five factors of production,
namely land, labour, capital, enterprise and
organization.
• The process of identifying the potential sources of the
factors such as land, labour and capital, collecting
them in required quantities and assigning them specific
tasks as per their skills is the subject matter of
organization.
• An entrepreneur is a person (or group of persons) who
decide(s) to undertake the responsibility of the inherent
risks in starting a business.
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 Forms of Ownership
• Ownership is always measured from the point of view of
investors (entrepreneurs).
• Businesses may be organized in various forms,
depending on their size, nature and need for resources.
• Three broad categories of business organizations are:
 Private sector (wholly owned by people, individually,
or as a group),
 Public sector (owned, managed and controlled by
government) and
 Joint sector (owned and managed jointly by
individuals and government)

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 Forms of Ownership
Forms of Ownership

Private Sector Joint Sector Public Sector

Individual Collective
Company Corporation Department

Proprietorship

Partnership Company Cooperative

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 A. Private Sector
• Ownership is in the hands of individuals, whether
independently, or as a small group, or in a large number,
without any investment from the government
• Types of business organizations under private sector:
• Sole Proprietorship
• Partnership
• Joint Stock Company
• Cooperative

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 A.1: Sole Proprietorship
• The most ancient form of ownership
• An individual invests own (or borrowed) capital, uses
own skills in management, and is solely responsible for
the results of operations.

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 Advantages and Limitations
• Advantages
 Simple and easy to start or exit
 Undivided profits earned accrues to the owner
 Secrets of the trade are not leaked out
 Prompt decision making
 Personal touch to business
• Limitations
 No entity of firm separate from the owner
 Unlimited liability
 Limited availability of funds
 Uncertain life of business: The life of single ownership
business depends upon the will and life of the owner

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 A.2: Partnership
• Two or more individuals (individually partners and
collectively a firm) decide to start a common business
• Persons who have entered into partnership are
individually regarded as ‘partners’ and collectively as a
‘firm’
• Examples: ‘& Sons’, ‘& Brothers’ or two names
comprising the name of a firm

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 Characteristics
• Association of two or more persons
• Agreement to voluntarily form partnership
• Business carried out by all or any one acting for all
• Created as an agreement, preferably prepared in writing,
in order to avoid any dispute arising in future

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 Advantages and Limitations
• Advantages
 Easy formation
 Strong credit position dependent on the
creditworthiness of owners
 Risk divided among all the partners
 Shared wisdom and resources
• Limitations
 Uncertain life of firm
 Liability extended even to the personal assets of the
partners
 Dissents and distrust between partners
 Availability of funds directly related to the
creditworthiness of partners

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 A.3: Joint Stock Company
• Established under Companies Act 1956
• Commonly called “company”
• Details of functions and scope of the company are
governed by Memorandum of Association signed among
members.
• Memorandum contains the name of the company, the
location of the head office, its aims and objectives, the
amount of share capital, the kind(s) and value(s) of
shares and a declaration that the liability is limited.
• Articles of Association contain the rules and regulation of
the company

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 Characteristics
• The owners’ capital in a joint stock company is invested
in the form of shares; hence the owners are regarded as
shareholders.
• Profit earned is divided in the form of dividends on the
basis of shares.
• Besides raising capital by shares, the company may also
raise funds by bonds and debentures.
• Owners of bonds and debentures are the creditors of the
company.
• A company is a legal entity and has perpetual existence.
• The liability of each shareholder is limited to the
proportion of shares held by him/her
• A joint stock company is also known as a limited
company.

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 Characteristics
• In the event of inability of a company to repay loan or
interest amount the creditors can raise their claim on
assets of the company and not on the personal
belongings of shareholders.
• A joint stock company is a legal entity and its existence
is independent of its members.
• It has a name, a seal and an authorized signatory; it has
the right to own, buy, sell and transfer property; it can
sue and can be sued in its own name.
• A company is like a person, but it exists only in
contemplation of law, and is strictly governed by the
clauses laid in the Memorandum of Association.

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 Types of Company
• Private Limited Company
 Maximum number of shareholders limited to fifty
 Shares of the company are transferable only among
members
 Free from the necessity of submitting certain returns
to the Registrar
 It can neither issue a prospectus, nor can it raise
capital by selling its shares to outside public other
than members
• Public Limited Company
 Minimum number of members is seven, without any
limit on the maximum number
 It has to submit certain statements and its balance
sheet to the Registrar of joint stock companies on an
annual basis
 It can invite the public to buy shares by issuing a
prospectus
 Business cannot be started unless the minimum
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capital laid down as per law has been subscribed
 Advantages and Limitations
• Advantages
 Limited liability
 Perpetual existence
 Ownership separated from control
 Financial resources much larger than ownership firm
or partnership
 Economies of large scale
• Limitations
 No loyalty of common shareholders to any particular
company
 Complexity in formation

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 A.4: Cooperative
• A nonprofit, nonpolitical, nonreligious, voluntary
organization
• Main principles of cooperation:
i. Based on mutual help and self reliance
 "each for all and all for each"
ii. Dealings confined to members only
iii. Objective of encouraging mutuality and cooperation
• Producers’ Cooperative
 Business owned by workers
 Surpluses (profits) divided among all the members
• Consumers' Cooperative
 Formed by persons living in a particular place, or
working in an establishment
 Examples: multi purpose stores, credit societies and
housing societies.
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 Advantages and Limitations
• Advantages
 Combination of the benefits of capitalism with
socialism
 Perpetual existence
• Limitations
 Fraudulent activities
 Uncertainty of life due to differences among members

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 B. Public Sector
• Government is the investor and the owner of a business
• Established in India as per the First Industrial Policy
enunciated in 1948 and restated in 1956
• Three broad categories of State Enterprises in India:
i. Public Sector Units (e.g. SAIL, BHEL, ONGC and IOC)
ii. Corporations and Boards (e.g. Coir Board, Railway
Board and Food Corporation of India)
iii. Departments (e.g. Telephone and Telegraph,
Education, and Health)

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 Advantages and Limitations
• Advantages
– Balanced economic growth
– Employment opportunities by developing large
industries
– Profits earned go to the government
• Utilized for the benefit of the society at large
• Limitations
 Presence of ills of bureaucracy
 Absence of profit incentive
 Little check on extravagance and inefficiency

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 Firms under Public Sector
• Corporate (or Company)
 Government invests in production activities and
enters the market
 Such firms are called as (PSUs) or Public Sector
Enterprise (PSEs)
• Corporation or Board
 Normally controls some of the economic activities
 Where government intervention is necessary for equal
distribution of economic resources
• Department
 Run for a specific purpose related to social utility,
such as education, health, civil administration, etc.
 Normally function under the directives of relevant
ministries, either at the appropriate level
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 Objectives of Firm
• Objective of business:
 Provides the framework for all the functions,
strategies and managerial decisions
 Determines the short and long term perspective of the
firm
• Theories on objectives of firm:
 Profit Maximization Theory
 Baumol’s Theory of Sales Revenue Maximization
 Marris’ Hypothesis of Maximization of Growth Rate
 Williamson’s Model of Managerial Utility Function
 Behavioural Theories
o Simon’s satisficing model
o Model by Cyert and March
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 Profit Maximization Theory
• Objective of business is generation of the largest amount
of profit
• Profit = Total Revenue-Total Cost
• Traditionally efficiency of a firm measured in terms of its
profit generating capacity
• Criticism
 Confusion on measure of profit
 Confusion on period of time
 Validity questioned in competitive markets

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 Baumol’s Theory of Sales Revenue
Maximization
• In competitive markets firms aim at maximizing revenue
through maximization of sales
• Sales volumes determine market leadership in
competition
• Dichotomy of managers’ goals and owners’ goals
• Manager’s salary and other benefits linked with sales
volumes, rather than profits
• Managers attach their personal prestige to the
company’s revenue or sales
 They attempt to maximize the firm’s total revenue,
instead of profits
• Criticism
 Insufficient empirical evidence

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 Marris’ Hypothesis of Maximization of
•
Growth Rate
Two sets of goals:
 Owners (shareholders) aim at profits and market
share
 Managers aim at better salary, job security and
growth
• Both achieved by maximizing balanced growth of the
firm (G), dependent on:
 Growth rate of demand for the firm’s products (GD)
and
 Growth rate of capital supply to the firm (G C)
• Constraints in the objective of maximization of balanced
growth:
 Managerial Constraint
 Financial Constraint
• Criticism
 Ignores the role of other constraints to growth
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of the firm
 Williamson’s Model of Managerial
Utility Function
• Managers apply their discretionary power to
maximize their own utility function
– Constraint of maintaining minimum profit to satisfy
shareholders
• Utility function of managers (Um) depends on:
– managers’ salary (measurable)
– Job security
– Power
– Status
– Professional satisfaction
– Power to influence firm’s objectives
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 Behavioural Theories
• Simon’s Satisficing Model
 Firms have to incur costs in acquiring information in
the present
 Objective of maximizing either profit, or sales, or
growth act as constraints to rational decision making
 “Bounded rationality"
 Satisfactory level of profit, sales and growth
• Model by Cyert and March
 Stakeholdershave different and oft conflicting goals
 ‘Satisficing behaviour’ aiming at satisfying all
stakeholders.
 Aspiration level on basis of past experience, past
performance of the firm, performance of other similar
firms, and future expectations

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 Principal Agent Problem
• conflict of interests between the owners and the managers of a firm. As per
Williamson’s model, managers are more interested in maximization of their
own benefits, instead of maximizing corporate profits.
• In an organizational set up the owners are the principal, while managers are
the agents.
• In an organizational set up the owners (principals) hire managers (agents)
who work on a well defined task, as the latter have better knowledge of the
market and are expected to steer the business. Now this difference in
information between two parties in any transaction (typically in principal
agent problems cited here) is termed as information asymmetry, or a state
of asymmetric information[1]. Because of such asymmetry, the principal
cannot directly observe the activities of the agent; the agent may also know
some aspect of the situation, which may be unknown to the principal
[1] George Akerlof, Michael Spence and Joseph Stiglitz had jointly received
the Nobel Prize in Economics for 2001 for their contribution on asymmetric
information.

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 consequences of asymmetric
information
• Adverse selection: This refers to immoral
behaviour that takes advantage of
asymmetric information before a
transaction.
• Moral hazard: This refers to immoral
behaviour that takes advantage of
asymmetric information after a
transaction.
•

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 Summary
• We may divide business organizations into three broad categories: private sector
(wholly owned by individuals, independently, or as a group), public sector (owned,
managed and controlled by government) and joint sector (owned and managed jointly
by individuals and government).
• A sole proprietorship firm is one in which an individual invests own (or borrowed)
capital and is solely responsible for the results of operations.
• A partnership is that form of ownership in which two or more individuals decide to
start a common business. Persons who have entered into partnership are individually
regarded as ‘partners’ and collectively as a ‘firm’.
• A joint stock company (or “company”) is a legal entity, limited liability and has
perpetual existence.
• A joint stock company may be a ‘private limited’ or ‘public limited’. A private limited
company cannot transfer shares to non members whereas public limited company
can offer equity shares to any one.
• A cooperative is a nonprofit, nonpolitical, nonreligious, voluntary organization, formed
with an economic objective.
• Public Sector in India has played important role in the development of economy of
the country. However disadvantages subsequently overweighed the advantages,
resulting in mounting deficits, inefficiency and sluggish growth.
• Every business has some objective, which provides the framework for all the
functions, strategies and managerial decisions of that business.
•

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 Summary
• Many economists including Milton Friedman support profit maximization as the
objective of firm.
• Baumol stressed that in competitive markets, firms would aim at maximizing
revenue, through maximization of sales. According to him, sales volumes, and not
profit volumes, determine market leadership in competition.
• According to Marris, owners (shareholders) aim at profits and market share, whereas
managers aim at better salary, job security and growth. These two sets of goals can
be achieved by maximizing balanced growth of the firm.
• Oliver Williamson’s model is a combination of the objectives of profit maximization
and growth maximization, which proposes that managers would apply their
discretionary power in such a way, as to maximize their own utility function, with the
constraint of maintaining minimum profit to satisfy shareholders.
• Herbert Simon’s Satisficing Model says that a firm has to operate under "bounded
rationality" and can only aim at achieving a satisfactory level of profit, sales and
growth.
• Cyert and March propose that businesses have to satisfy a variety of stakeholders,
who have different and oft conflicting goals; hence a firm has to aim at a multi
dimensional goal and exhibit a ‘satisficing behaviour’.
• The conflict of interests between the owners (principal) and the managers (agent) of a
firm is known as principal agent problem.
• Difference in information between two parties in any transaction is termed as
information asymmetry, or a state of asymmetric information.
• In the organizational framework of asymmetric information, owners can make
managers work in the interest of the organization by minimizing the information gap in
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between; or by tying the managers’ rewards to organization’s performance.