ENTREPRISING FIRM

The firm is an organisation that produces a good or service for sale and it plays a central role in theory and practice of Managerial Economics. In contrast to non profit institutions like the ‘Ford Foundation’, most firms attempt to make a profit. There are thousands of firms in India producing large amount of goods and services; the rest are produced by the government and non-profit institutions. It is obvious that a lot of activities of the Indian economy revolve around firms.

One of the crucial determinants of a firm’s behaviour is the state of technology. Technology imposes a limit on how much a firm can produce. It is the sum total of society’s pool of knowledge concerning the industrial and agricultural arts. Production is any activity that transforms inputs into output and is applicable not only to the production of goods like steel and automobiles, but also to production of services like banking and insurance.

The firm changes hired inputs into saleable output. An input is defined as anything that the firm uses in its production process. Most firms require a wide array of inputs. For example, some of the inputs used by major steel firms like SAIL or TISCO are iron ore, coal, oxygen, skilled labour of various types, the services of blast furnaces, electric furnaces, and rolling mills as well as the services of the people managing the companies. The inputs or the factors of production are divisible into two broad categories – human resources and capital resources. Labour resource and entrepreneurial resource are the two human resource inputs while land, man-made capital forests, rivers, etc. Are the two capital resources. Thus the four major factors of production (FOP) are land, manmade capital, labour, and entrepreneur (organisation) while the remuneration they get is rent, interest (capital rental), wage, and profit, respectively.

The function of the firm, thus, is to purchase resources or inputs of labour services, capital and raw materials in order to convert them into goods and services for sale. There is a circular flow of economic activity between individuals and firms as they are highly interdependent. Labour has no value in the market unless there is a firm willing to pay for it. In the same way, firms cannot rationalise production unless some consumer is willing to buy their products. However, there is some incentive for each. Firms earn profits in turn satisfying the consumption demand of individuals and resource owners get wage, rent and interest payment. In the process of supplying the goods and services that consumers demand, firms provide employment to workers and also pay taxes that government uses to provide service (education, defense) that firms could not provide at all or as efficiently.

Essentially a firm exists because the total cost of production of output is lower than if the firm did not exist. There are several reasons for lower costs. Firstly, long term contract with labour saves the transaction costs because no new contract has to be negotiated every time a labour is to be hired or given new assignment. Secondly, there are government regulations like price-control and sales taxes also saved by having the transaction within the firm. Recall that sales tax is levied for transaction between firms and not within firms. When transactions take place within a firm they may be cheaper and hence such savings decrease the total cost of production of an output. In other words, the existence of firms could be explained by the fact that it saves transaction costs.

However, the size of the firm has to be limited because as the firms grow larger, a point is reached where the cost of internal transaction becomes equal to or greater than the cost of transaction between firms. When such a stage is reached, it puts a limit to the size of the firm. Further, the cost of supplying additional services like legal, medical etc. within the firm exceeds the cost of purchasing these services from other firms; as such services may be required occasionally.

INTRDEPENDENCE OF CONSUMER AND FIRMS

Let us consider the size of different kinds of firms around us and try to understand the reasons for such differences. Why are service firms generally smaller than capital-intensive firms like SAIL, Maruti Udyog, and ONGC etc? What is the reason that a number of firms are choosing the BPO route? A part of the explanation must lie in the fact that it is cheaper to outsource than to absorb that activity within the firm. Consider a firm that needs to occasionally use legal service. Under what conditions will it choose to hire a full time lawyer and take her on its rolls and under what conditions will the firm outsource the legal activity or hire legal services on a case-by-case basis. Naturally, the answer depends upon the frequency of use for legal services. The transaction cost framework demonstrates that the firm will contract out if the cost of such an arrangement is lower and will prefer in-house legal staff when the opposite is true.

Firms are classified into different categories as follows:

a) Private sector firms.

b) Public sector firms.

c) Joint sector firms.

d) Non-profit firms.

Firms can also be classified on the basis of number of owners as:

a) Proprietorship.

b) Partnership.

c) Corporations.

Some firms mentioned below are different from above. They may provide service to a group of clients for example, patients or to a group of its members only.

a) Universities.

b) Public Libraries.

c) Hospitals.

d) Museums.

e) Churches.

f) Voluntary Organisations.

g) Cooperatives.

h) Unions.

i) Professional Societies, etc.

The concept of a firm plays a central role in the theory and practice of managerial economics. It is, therefore, valuable to discuss the objectives of a firm.

OBJECTIVE OF THE FIRM

The traditional objective of the firm has been profit maximisation. It is still regarded as the most common and theoretically the most plausible objective of business firms. We define profits as revenues less costs. But the definition of cost is quite different for the economist than for an accountant. Consider an independent businessperson who has an MBA degree and is considering investing Rs.1 lakh in a retail store that she would manage. There are no other employees. The projected income statement for the year as prepared by an accountant is as shown below:

income statement

This accounting or business profit is what is reported in publications and in the quarterly and annual financial reports of businesses.

The economist recognises other costs, defined as implicit costs. These costs are not reflected in cash outlays by the firm, but are the costs associated with foregone opportunities. Such implicit costs are not included in the accounting statements but must be included in any rational decision making framework. There are two major implicit costs in this example. First, the owner has Rs.1 lakh invested in the business. Suppose the best alternative use for the money is a bank account paying a 10 per cent interest rate. This risk less investment would return Rs.10,000 annually. Thus, Rs.10,000 should be considered as the implicit or opportunity cost of having Rs.1 lakh invested in the retail store.

Let us consider the second implicit cost, which includes the manager’s time and talent. The annual wage return on an MBA degree may be taken as Rs.35,000 per year. This is the implicit cost of managing this business rather than working for someone else. Thus, the income statement should be amended in the following way in order to determine the economic profit:

Economic Profit

Looking at this broader perspective, the business is projected to lose Rs.25,000 in the first year. Rs. 20,000 accounting profit disappears when all relevant costs are included. Another way of looking at the problem is to assume that Rs.1 lakh had to be borrowed at, say, 10 per cent interest and an MBA graduate hired at Rs.35,000 per year to run the store. In this case, the implicit costs become explicit and the accounting made explicit. Obviously, with the financial information reported in this way, an entirely different decision might be made on whether to start this business or not.

Thus, we can say that economic profit equals the revenue of the firm minus its explicit costs and implicit costs. To arrive at the cost incurred by a firm, a value must be put to all the inputs used by the firm. Money outlays are only a part of the costs. As stated above, economists also define opportunity cost. Since the resources are limited, and have alternative uses, you must sacrifice the production of a good or service in order to commit the resource to its present use. For example, if by being the owner manager of your firm, you sacrifice a job that offers you Rs. 2,00,000 per annum, then two lakhs is your opportunity cost of managing the firm.

The assignment of monetary values to physical inputs is easy in some cases and difficult in others. All economic costing is governed by the principle of opportunity cost. If the firm maximises profits, it must evaluate its costs according to the opportunity cost principle. Assigning costs is straightforward when the firm buys an input on a competitive market. Suppose the firm spends Rs. 20,000 on buying electricity. For its factory, it has sacrificed claims to whatever else Rs 20,000 can buy and thus the purchase price is a reasonable measure of the opportunity cost of using that electricity. The situation is the same for hired factors of production. However, a cost must be assigned to factors of production that the firm neither purchases, nor hires because it already owns them. The cost of using these inputs is implicit costs and has to be imputed. Implicit costs arise because the alternative (opportunity) cost doctrine must be applied to be firm. The profit calculated after including implicit as well as explicit costs in total cost is called economic profit. 

Profit plays two primary roles in the free-market system. First, it acts as a signal to producers to increase or decrease the rate of output, or to enter or leave an industry. Second, profit is a reward for entrepreneurial activity, including risk taking and innovation. In a competitive industry, economic profits tend to be transitory. The achievement of high profits by a firm usually results in other firms increasing their output of that product, thus reducing price and profit. Firms that have monopoly power may be able to earn above-normal profits over a longer period; such profit does not play a socially useful role in the economy. Although, profit maximisation is a dominant objective of the firm, other important objectives of the firm, other than profit maximisation that we will discuss are:

  1. Maximisation of sales revenue.
  2. Maximisation of firm’s growth rate
  3. Maximisation of manager’s own utility or satisfaction
  4. Making a satisfactory rate of profit.
  5. Long-run survival of the firm
  6. Entry-prevention and risk avoidance. 
VALUE MAXIMISATION

Most firms have side lined short-term profit as their objective. Firms are often found to sacrifice their short-term profit for increasing the future long-term profit. Thus, the theory states that the objective of a firm is to maximise wealth or value of the firm. For example, firms undertake research and development expenditure, expenditure on new capital equipment or major marketing programmes which require expenditure initially but are meant to generate future profits. The objective of the firm is thus to maximise the present or discounted value of all future profits and can be stated as:

Value Maximisation1

Thus maximising the discounted value of all future profits is equivalent to maximising the value of the firm.

A careful inspection of the equation suggests how a firm’s managers and workers can influence its value. For example, in a company, the marketing managers and sales representatives work hard to increase its total revenues, while its production managers and manufacturing engineers strive to reduce its total costs. At the same time, its financial managers play a major role in obtaining capital, and hence   influence the equation, while its research and development personnel invent and reduce its total costs. All of these diverse groups affect the company’s value, defined here as the present value of all expected future profits of the firm. 

ALTERNATIVE OBJECTIVES OF FIRMS

Economists have also examined other objectives of firms. We shall discuss some of them here. According to Baumol, most managers will try to maximise sales revenue. There are many reasons for this. For example, the salary and other earnings of managers are more closely related to sales revenue than to profits. Banks and financers look at sales revenue while financing the corporation. The sales revenue trend is a readily available indicator of performance of the firm. Growth in sales increases the competitive strength of the firm. However, in the long run, sales maximisation and profit maximisation may converge into one objective.

Another economist Robin Marris assumes that owners and managers have different utility functions to maximise. The manager’s utility function (Um) and Owner’ utility functions (Uo) are:

Um = f (Salary, job, power, prestige, status)

Uo = f (Output, capital, profit, share)

By maximising the variables, managers maximise both their own utility function and that of the owners. Most of the variables of both managers and owners are correlated with a single variable, namely, the size of the firm. Maximisation of these variables depends on the growth rate of the firm. Thus, Marris argues that managers will attempt to maximise growth rate of firms. However, this objective does not completely discard the profit maximisation objective.

According to Oliver Williamson, managers seek to maximise their own utility function subject to a minimum level of profit. The utility function which manager seek to maximise include both quantifiable variables like salary and slack earnings and non-quantifiable variables like power, status, security of job, etc. The model developed by Cyert-March focuses on satisfying behaviour of managers. The firm has to deal with an uncertain business world and managers have to satisfy a variety of groups-staff, shareholders, customers, suppliers, authorities, etc. All these groups have often-conflicting interests in the firm. In order to reconcile between the conflicting interests and goals, managers form an aspiration level of the firm combining the following objectives – production, sales and market share, inventory and profit. The aspiration levels are modified and revised on the basis of achievements and changing business environment.

As is true with most economic models, the application will depend upon the situation and one cannot say that a particular model is better than the other. In general, one can assert that the profit maximising assumption seems to be a reasonable approximation of the real world, although in certain cases there might be a deviation from this objective.

FIRM’S CONSTRAINTS

Decision-making by firms takes place under several restrictions or constraints, such as:

Resource Constraints: Many inputs may be available in a limited or fixed quantity e.g., skilled workers, imported raw material, etc.

Legal Constraints: Both individuals and firms have to obey the laws of the State as well as local laws. Environmental laws, employment laws, disposal of wastes are some examples.

Moral Constraints: These imply to actions that are not illegal but are sufficiently consistent with generally accepted standards of behaviour.

Contractual Constraints: These bind the firm because of some prior agreement such as a long-term lease on a building or a contract with a labour union that represents the firm’s employees. Decision-making under these constraints with optimal results is a fundamental part of managerial economics.

BASIC FACTORS OF DECISION-MAKING:
  1. THE INCREMENTAL CONCEPT
  2. THE EQUI-MARGINAL PRINCIPLE
  3. THE DISCOUNTING PRINCIPLE
  4. THE OPPORTUNITY COST PRINCIPLE

 

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