Theory of Firm
The following are the various theories of the firm.
1. Profit Maximization Theory
Profit maximization is one of the most common and widely accepted objectives of a firm. According to the profit maximization theory, the main aim of the firm is to produce a large amount of profits. Profit is considered as the internal source of funds and the market value of the firm also relies mainly on the profits earned by the firm. In order to survive in the market, it is very essential for the firms to earn profits. Profits are obtained by deducting total revenue from the total cost i.e.,
Profit = Total revenue – total cost
2. Baumol's Theory of Sales Revenue Maximization
Profit maximization is one of the most common and widely accepted objectives of a firm. According to the profit maximization theory, the main aim of the firm is to produce a large amount of profits. Profit is considered as the internal source of funds and the market value of the firm also relies mainly on the profits earned by the firm. In order to survive in the market, it is very essential for the firms to earn profits. Profits are obtained by deducting total revenue from the total cost i.e.,
Profit = Total revenue – total cost
According to Baumol, maximization of sales revenue is the main objective of the firms in the competitive markets. It’s based on the theory that, once a company has reached an acceptable level of profit for a good or service, the aim should shift away from increasing profit to focus on increasing revenue from sales. According to the theory, companies should do so by producing more, keeping prices low, and investing in advertising to increase product demand. The idea is that applying this sales revenue maximization model will improve the overall reputation of the company and, in turn, lead to higher long-term profits.
He found that sales volumes help in finding out the market leadership in competition. According to him, in large organizations, the salary and other benefits of the managers are connected with the sales volumes instead of profits. Banks give loans to firms with more sales. So, managers try to maximize the total revenue of the firms. The volume of sales represents the position of the firm in the market. The managers’ performance is measured on the basis of the attainment of sales and maintaining minimum profit. Thus, the main aim of the firm is to maximize sales revenue and maintain minimum profits for satisfying shareholders.
3. Marris Theory of Growth Maximization
According to Marris, owners/shareholders strive for attaining profits and market share, and managers strive for better salary, job security, and growth. These two objectives can be attained by maximizing the balanced growth of the firm. The balanced growth of the firm relies mainly on the growth rate of demand for the firm’s products and the growth rate of capital supplied to the firm. If the demand for the firm’s product and the capital supplied to the firm grow at the same rate, then the growth rate of the firm will be considered balanced.
Marris found that the firms face two difficulties while attaining the objectives of maximization of balanced growth which are managerial difficulties and financial difficulties. For maximizing the growth of the firm, the managers should have skills, expertise, efficiency, and sincerity in them. The prudent financial policy of the firm depends on at least three financial ratios which restrict the growth of the firm:
1. Debt-Equity Ratio
2. Liquidity Ratio
3. Retention Ratio
4. Williamson's Model of Managerial Utility Functions
Williamson’s model combined profits maximization and growth maximization objectives. According to the model of managerial utility functions, managers make use of their discretionary powers for maximizing their own utility function and maintain minimum profits for satisfying shareholders.
• Minimum profits for minimum investment and growth of the firm.
• Managers want to maximize their own utility (satisfaction).
• Satisfaction or utility of managers depends on three variables:
1. Staff salaries, S: Includes management salaries, administration expenses, selling expenditure. More the staff expenditure, more the sales. Power and prestige of managers increase with S.
2. Management emoluments, M: i.e., luxury offices, fancy cars, perks.
3. Discretionary investments, D: Amount spent at his own discretion, e.g., on the latest equipment, furniture, decoration material, etc., to satisfy ego and give them a sense of pride. These give a boost to the manager’s esteem and status in the organization.
Managers use that combination of the above variables that maximizes their own satisfaction. The Williamson’s model is written as, UM = f(S,M,D)
Where, UM = Utility of Manager, S = Salaries, M = Managerial emoluments, D = Discretionary power for investments.
The utility function of the managers relies on the salary of the managers, job security, power, status, professional satisfaction, and power to affect the objectives of the firm.
5. Behavioral Theories
According to the behavioral theories, the firm tries to attain satisfactory behavior instead of maximization. There are two important behavioral models:
1. Simon’s satisficing model and 2. Model developed by Cyert and March.
The Simon’s satisficing model states that firms carry out their operations under ‘bounded rationality’ and can only attain a satisfactory level of profit, sales, and growth. Simon carried out research and found that modern business does not have adequate information and is uncertain about the future due to which it is very difficult to attain profit, sales, and growth objectives.
The model developed by Cyert and March states that firms should be oriented towards multi-goal and multi-decisions making. Instead of dealing with uncertainty and inadequate information, the firms should fulfill the conflicting goals of various stakeholders (such as shareholders, employees, customers, financiers, government, and other social interest groups).