10. Alternative theories of the firm.

1) Traditional profit maximizing Theory

It explains the behaviour of a producer who is assumed to be an entrepreneur, an owner and a manager himself. Producer’s major goal is profit maximization. Profit maximization is achieved at the output for which marginal revenue equals marginal costs, or the difference between total revenue and total cost is the greatest.

Modern economics formulates the following critical arguments:

1) Today a producer is not necessarily an entrepreneur and owner and manager. As stock capital developed and corporations (public limited liability companies, joint-stock companies) became dominant, the situation changed radically. Ownership and control have become separated. Ownership is in the hands of voting shareholders while day-to-day control is in the hands of management. Owners and managers can have different goals.

2) The principle of MR=MC is good in theory but firms do not use marginal revenue and marginal cost concepts.

3) If a firm would like to use the MR=MC principle, that won’t be so easy to fulfill. Information that firms dispose is not complete, so they do not know even approximately their demand curves and hence their marginal revenue curves.

4) It is also difficult to predict actions and reactions of the rivals and estimate their effects.

2) Managerial Theory

Argues that a firm is likely to pursue sales revenue maximization rather than profit maximization. The managers’ salaries are more determined by sales revenue than profits. It is a general practice that the more a manager of any level sells the more he is remunerated. Also, increased staff levels give the manager greater social status and seniority.

Thus, there is a conflict between the aims of shareholders who are interested in profit and managers who seek sales revenue maximization.

So, the profit –maximizing firm produces less and sells at a higher price than the firm that maximizes its sales revenue.

3) Growth Theory

-is dynamic in comparison with the static managerial theory: it considers the firm behaviour in time period, not at a specific moment. Growth takes place in two major forms: as growth by internal expansion or growth by merger.

- Growth by internal expansion: The firm growth has to be supported by financial sources (external–from a bank, gov-nt, public (a new issue of bonds), abroad; internal–the firms profit).

-The ratio of retained in the firm to distributed profits is called the retention rations.

-Low retention ratio: If managers distribute most of the profits and pay good dividends, shareholders will be content and the share price will be sufficiently high to deter takeover. But low investment opportunities will be faced by the firm.

-High retention ratio: If managers distribute less profit, then retained profit can be used for investment, stimulating the growth of the firm and its innovation. Still in this case shareholders may be less content, the market share price will fall, thereby increasing the risk of a takeover bid.

-Growth by merger

-A merger is an act of joining together of two or more companies or organizations to form one larger firm. It takes place with the mutual agreement of the management of both companies, usually through an exchange of shares of the merging firms with the shares of new legal entity.

-A takeover is actually an acquisition of a company be a larger and stronger one. A takeover is the act of getting control of a company by buying most of its shares.

-Horizontal integration occurs when firms combine at the same stage of production, involving similar products or services. Most mergers are of the horizontal type.

-Vertical integration occurs when firms combine at different stages of production of a common good or service. Only about 5% are of this type. Firms might benefit by the better control over quality and delivery of supplies.

-Conglomerate integration refers to the adding of different products to each firm’s operations: e.g. Unilever has interest in food, chemicals, paper, animal feeds, etc.

-Why do companies merge?

1. The market power (an increased size helps to reduce risk and to raise market power)