The Theory of the Firm

Réka Polák-Weldon
Topic 1/B
Objectives

To introduce and To discuss business To compare the To introduce the To consider areas of
define the concept transactions and advantages and concept of the profit- economic theory
of the firm and its transaction costs. disadvantages of maximizing model that are involved in
and its criticisms
nature. using the market the
based on the various
rather than assumptions which examination of the
internalizing frequently underlie nature of the firm
transactions within the profitmaximizing
the firm. model and explain the agency problem
why they are made. in terms of how it
affects firms’
objectives

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 Economic organizations

• Composed of individuals and are created by Global

individuals in order to serve particular purposes, UN, WTO, IMF
which ultimately compromise some of the
individual purposes.
• They are also managed by individuals and their
performance can be evaluated in terms of International
certain criteria, which at this level can be Within trading blocs
difficult and controversial to determine, since
they tend to involve value judgements made by
large numbers of individuals.
National

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Why do economic
organizations exist?

Increase specialisation

Use large-scale technology

Manage the external environment

Economize on transaction costs

Exert power and control

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The main objectives of the firm

• To achieve the organizational goals

• To maximize the output
• To maximize the sales
• To maximize the profit of the organization
• To maximize the customer and stakeholders
satisfaction
• To maximize shareholder’s return on investment
(ROI)
• To maximize the growth of the organization
Neoclassical theory and behavioural aspects

Any behaviour has economic

Neoclassical theory makes no
aspects if it involves the
attempt to deal with
allocation of resources.
• Why firms exist?
• How the individuals who
constitute firms are
motivated and interact?

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The basic profit-
maximizing model

• profit above all

• driven by self-interest
• marginal analysis
• a firm will produce the output
where marginal cost equals
marginal revenue

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 Basic asumptions
1. The firm has a single decision-maker.
2. The firm produces a single product.
3. The firm produces for a single market.
4. The firm produces and sells in a single location.
5. All current and future costs and revenues are known with certainty.
6. Price is the most important variable in the marketing mix.
7. Short-run and long-run strategy implications are the same.

MC:
each additional unit costs more than the
previous one to produce
MR:
the firm has to reduce its price to sell more units

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1. The firm has a single decision-maker

not a realistic assumption

in any firm above a small size the owner, or anyone else, is not going to
have time to be able to make all decisions

decision-making process involves delegation which leads to the agency

problem

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 2. The firm produces a single product/market/location

very rarely☺

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 3. All current and future
costs and revenues are
known with certainty

• a well-managed firm has

accurate, detailed and
up-to-date records of its
current costs and
revenues to determine a
firm’s costs and revenues
and their relationship to
the output
• in practice it can be
difficult to estimate these
in a constantly changing
environment e.g. next
year, next quarter → risk
and uncertainty!!

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4. Price is the most important variable in the
marketing mix

• ‘the set of marketing tools that the firm

uses to pursue its marketing objectives
in the ‚target market’.
• business managers do generally agree
that price is not the most important of
these, rather the aspects of product

Why the price?

it is the price system that is responsible for allocating resources
Product shortage → price will rise → decreasing consumption
a far easier variable to measure than product aspects

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5. Short-run and long-run strategy implications are the same

• any strategy aimed at maximizing profit

in the short run will automatically
maximize profit in the long run and
vice versa
• this is not a realistic assumption

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 Transaction costs theory

Six main areas of Information theory

economic theory
Motivation theory
that are involved in
the Agency theory
examination of the
nature of the firm Property rights theory

Game theory

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 Transaction cost theory

Examines the costs of undertaking transactions (exchanging

‚things’) in different ways; providing for some good or service
through the market rather than having it provided from within
the firm.

Transaction costs are related to the problems of co-ordination and motivation.

Costs will occur whichever method (short-term, long-term, internal) of transaction is used
• co-ordination costs
• motivation costs

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Transaction cost theory: Co-ordination costs

Search costs
• buyers and sellers search for the relevant information before completing transactions (prices,
quality, delivery and transportation)
• markets search externally
• within firms search is internal

Bargaining costs
• when markets are involved, where negotiations for major transactions can be put off, but even
within the firm, salary and wage negotiations can also be costly in terms of the time and effort of
the parties involved

Contracting costs
• there are costs associated with drawing up contracts; these take managerial time and can involve
considerable legal expense

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Transaction cost theory: Motivation costs (Agency costs)

Hidden Assymetric information, relevant information is not shared

information • secondhand car market, the HUGE advantage of sellers

Monitoring and supervision by contracted partners to ensure that the terms of the
Hidden contract are being upheld →‚moral hazard’
action Legal actions are the most costly

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 The characteristics of
transactions – some
attributes affecting
transactions

Asset specificity
• how easy it is for parties in a
transaction to switch partners
without incurring sunk costs
• protected by a long-term
contract which also costs
less in case of those
transactions which are
repeated all the time (e.g.
cleaning services)

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Implications of transaction cost theory

There is an optimal size of the firm from the point of view of minimizing
transaction costs.

more transactions
increase in size
internally

costs of coordination (admin and bureaucracy) increase

costs of using the market decrease

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Information theory

Examines the concept of bounded rationality (limited rationality),

and the associated aspects of incomplete contracting, asymmetric
and imperfect information.

These give rise to opportunistic behaviour, which in turn affects the

behaviour of other parties and can lead to inefficiencies.

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Motivation theory

▪ According to the assumption of

economists in regard to individual actions:
• maximize their individual utilities
(subjective measures of value)
• self-interest
▪ Examines the underlying factors that
cause people to behave in certain ways.
▪ It is searching for general principles which
can be used to explain and predict
behaviour.

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Agency theory

Examines the situation where one

party, an agent, is involved in carrying
out the wishes of another called a
principal.
• Democracy: people elect a
government to govern on their
behalf

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Agency theory

The resulting problem is

• that principal and agent usually have goals that do not exactly coincide, and
that
• the principal can only partially observe the behaviour of the agent

principals have to engage in monitoring activities and design

incentives in ways that optimize their own welfare

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Property rights theory

• Residual control – residual (remaining) rights of

control
• the owner’s decisions regarding the asset’s use
are circumscribed by law and by any other
contract involving the rights of other parties to
use of the asset
• e.g. contracts
• Residual returns
• the owner is entitled to receive income from a
property (e.g. rental incomes)
• maintenance costs, legal obligation to pay
taxes
• the returns received by the owner can be
viewed as residual

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 Control over assets gives the owner bargaining power when
unforeseen or uncovered contingencies force parties to
negotiate how their relationship should be continued.
Bargaining power should be in the hands of those people
The central idea of whose efforts are most significant in increasing the value of
the business relationship.
property rights • capitalist system → private ownership: incentives to create, maintain
and improve assets vs state ownership
• What does it mean to own an asset?
• What does it mean to have a car? What is the situation with
sharing economy?
• it is even more difficult to answer for firms!!

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 Stronger
More bargaining
More rewards incentive to make
power
more investment

▪ In a classical firm, the ‚boss’ has residual control

and receives residual returns;
▪ since control and returns are both vested in
the same person, the boss has maximum incentive to manage the firm in a profitable
manner
▪ the owner of a simple asset like a car has an incentive to use the car efficiently

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 1. Shareholders
• own the company, but in practice their rights are quite
limited
• voting rights on issues such as changing the corporate
charter, electing and replacing directors, mergers etc.
The ownership of a complex asset like • have no say in major strategic issues
a firm is a difficult concept since four • no residual rights, but residual returns
parties have different types of claims
regarding control and returns: • rights are specified by law
shareholders
directors
managers and 2. Directors
other employees • the board of directors have residual control, making many
of the major strategic decisions of the firm, including
hiring the managers and setting their pay levels
• they do not have a claim to the residual returns; these
essentially belong to the shareholders

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 3. Managers
Senior managers usually have control over many of the
The ownership of a complex asset major strategic decisions of the firm because they control
like a firm is a difficult concept the flow of information within the firm and set the agenda
since four for many board decisions because shareholders rely on
parties have different types of information from managers in electing the board, the
claims regarding control and managers may effectively determine board nominations.
returns: Thus, there is a problem of asymmetric information in terms
shareholders of managers having more information regarding the firm’s
directors operations than either board members or shareholders.
managers and There is also a problem of moral hazard in that it is difficult
other employees for either directors or shareholders effectively to monitor the
activities of managers.

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The ownership of a complex asset like 4. Other employees - non-managerial workers
a firm is a difficult concept since four • managers rely on them to provide information, and
parties have different types of claims also to carry out managerial decisions
regarding control and returns: • no residual claims on the firm, they do exercise
shareholders some control
directors • have more information than managers, and the
managers and managers are not able to observe their behaviour
other employees easily (hidden information and hidden action)

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Game theory

Examines the strategic interactions/decisions

of different agents/players • Payoff: the players’ valuation of the outcome
of the game
• a game is an interaction between players
(individuals/firms) in which players use • Rules of the game: determines timing of
players’ moves and the actions players can
strategies make
• the behaviour of one party affects the • Action: a move a player makes at a specific
behaviour of other parties, and the first stage of the game
party must consider this in determining their • Strategy: a battle plan that specifies the action
own strategy that a player will make based on the
• the first party must also consider that the information available at each move and for any
possible contingencies
other party or parties will also consider the
first party’s considerations in determining • Strategic interdependence: when a player’s
their own strategy optimal strategy depends on the actions of the
other

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 The basic profit-maximizing model (BPM) is useful because it enables
managers to determine strategy regarding price and output decisions; it
thus enables the economist to predict firms’ behaviour.

In order to understand the nature of the firm we need to consider five

main areas of economic theory: transaction costs, motivation, agency,
information costs and game theory.
Summary Transaction costs consist of co-ordination costs and motivation costs.
According to transaction cost theory there is an optimal size for the firm,
since as the firm becomes larger the costs of transacting in the market
decrease while the costs of co-ordinating transactions within the firm
increase.

The conventional economic model of motivation is that individuals try to

maximize their utilities; this assumes that people act rationally in their self-
interest.

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 Agency problems arise because of conflicts of interest
between various stakeholder groups and it is aggravated by
the existence of asymmetric information, leading to adverse
selection and moral hazard.

Summary
The property rights theory reveals the importance of
ownership and how it affects all transactions.

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