Theories of Firm

Introduction:
The term theories of the firm deal with the collation of theories that attempt to
explain how business firms behave under various market structures.

There are different market structures in which a business firm has to conduct its
undertakings and which directly affect the firm's objectives. Every business firm
has a goal or an objective.

The firm has to fulfill different objectives like profit maximization, value
maximization, sales / revenue maximization, cost minimization and so on within
a given market structure and business environment.

Thus theories of firms explain the behavior or working pattern of business firms
to get their objectives being fulfilled within the existing structures and
mechanism of the market.

Basically, there are three types of major market structures in which a firm has to
run its business activities. They are perfect competition, oligopoly and
monopoly.

The theory of firm answers the major issues like why the firms do emerge in the
market, what kind of transactions they do perform and they have to perform,
why they have to fit themselves into a particular structure of the organization
and market, what should be the relation of the firms with other firms and
stakeholders and what drive them to do better and better performances.

A firm is an organization that converts raw materials into output. The primary
activity of the firm is to proceed with raw materials into finished goods with the
help of various factors of production within a given market structure. The firm
hires the factors of production and transforms materials into saleable output in
the market.

So, the firms are there to link raw materials and finished goods in a systematic
and well-structured group formed by risk-bearing and skillful personnel.
Therefore, the firm is a collection of resources that is transformed into products
demanded by consumers. Basically, firms do produce different goods and
services for profit. Profit is the difference between revenue by the firm and the
costs incurred.
Introduction:

Theories of the firm encompass various models that explain how business firms
operate under different market structures, aiming to achieve their objectives.
These theories help understand the decision-making process within firms and
how external conditions, like market competition and internal organizational
structures, shape their behavior.

Market Structures:
Firms operate in different market environments, which directly influence their
objectives and behavior. The three major types of market structures in which
firms conduct their business activities are:

 Perfect Competition: A market structure characterized by a large number

of small firms, homogeneous products, and ease of entry and exit. Firms in
this structure are price takers and aim primarily at cost minimization and
efficiency to survive.

 Oligopoly: In an oligopoly, a few large firms dominate the market. These

firms are interdependent, meaning their decisions regarding pricing or
production influence the behavior of competitors. Objectives like
sales/revenue maximization often become critical.

 Monopoly: A market with a single producer that dominates supply, giving

the firm significant power to set prices. In this case, the firm's primary goal
might be profit maximization since there is little to no competition.

Firm Objectives:

Regardless of the market structure, every firm has certain goals. Theories of the
firm explain how businesses balance various objectives, including:

 Profit Maximization: The traditional goal of any firm is to maximize its

profit, which is the difference between total revenue and total cost.

 Value Maximization: Firms may focus on maximizing the value for

shareholders or stakeholders, which often involves long-term strategies
beyond short-term profits.

 Sales/Revenue Maximization: Some firms prioritize increasing their

sales or market share, especially in competitive industries where growth
and market presence are key to survival.
  Cost Minimization: In a highly competitive market, firms may focus on
minimizing costs to maintain profitability despite competitive pricing
pressures.

Role of the Firm:

A firm is essentially an organization that transforms raw materials into goods or

services. This transformation occurs through the coordination of various factors
of production such as labor, capital, and technology within the constraints of the
market structure. The firm hires resources, combines them, and produces output
that meets consumer demand.

Firms serve as intermediaries between raw material inputs and the final
products sold in the market. They play a crucial role in the economy by
ensuring the efficient allocation of resources and by taking on risk through
investment and innovation.
 Meaning of a firm.
In simple terms, firms are companies. They are legally recognised bodies that
provide goods and/or services to their consumers, government bodies, and other
businesses.

Firms can be divided on the basis of their legality, nature of work, number of
owners, size, and need for its resources.

Firms can be broadly classified into three main categories. These categories are
then divided into subcategories:

1. Private Sector:

o Operated by private individuals or groups.

o Subcategories:

 Proprietary Firms: Owned and managed by a single individual.

 Partnerships: Owned by two or more individuals who share

responsibilities.

 Companies: Larger legal entities where ownership can be shared among

shareholders.

 Cooperatives: Firms owned and run by a group of individuals for their

mutual benefit.

2. Public Sector:

o Owned and operated by government bodies.

o Subcategories:

 Companies: Government-owned entities that operate commercially.

 Corporations: Larger entities that often provide essential services like

transportation or utilities.

 Departments: Specific government departments that may offer certain

services (e.g., postal services).

3. Joint Sector:

o Operated through a collaboration between the private sector and government.

Goals or Objectives of the Firm
Every business firm has its own goal or objective. After fixing the objective, it
guides the decision-making of the firm. In the past, profit maximization was
regarded as the sole objective of the firm. But, in modern society, a firm may
have multiple objectives though some may get more priority and take over
others.

In modern days, employees' welfare, an obligation towards consumers. and the

community are also said to be the objectives of a firm. Similarly, a firm may
have the goal of minimization of costs or maximization of sales. In all cases, the
decision will have to be made in an optimum manner so as to attain the
objective efficiently.

Normally it is almost impossible to achieve all of these goals at once. The firm
cannot keep all the goals at the level of the same priority. The firm must choose
one of these three objectives. The main objectives of a firm have been discussed
as below:

Profit Maximization
To examine the profit-maximization goal of the firm there is a model developed
by a classical economist named Profit Maximization Model.

Profit Maximization Theory of the Firm

Profit maximization is one of the most important assumptions of economic
theory.

In economics, it is always assumed that a firm's rationality is the maximization

of profit. It means, rational producer or entrepreneur always attempts profit
maximization.

Thus profit maximization constitutes a central and crucial concept in the theory
of the firm.

The profit maximization model as a goal of the firm or profit maximization

theory of the firm was developed by classical economists.

It means the classical and neo-classical economists regarded profit

maximization as the most important and primary objective of the firms.
According to them. profit is the core concern of the business firm and it is
necessary for the existence and survival of the firms.

The profit maximization model is considered as a traditional and classical

objective of the business firm.

The model defined profit as the gap between revenue and the total cost of the
firm.

Profit (P)=(TR-TC)
Where,

P= Total Profit (Economic Profit)

TR- Total Revenue (Price*Output)

TC=Total Cost (Explicit Cost + Implicit Cot)

As per the model, profit is the main reason behind the business undertaking of
the firm and it is necessary to the economic activities of the business firm.

It means profit works as the motivating factor for the entire business firm and its
operation.

This model is the most popular and profit maximization is a universally

accepted objective by business firms.

Assumptions
The profit maximization theory of the firm or profit maximization model is
based on the following assumptions:

1. The firm is an individual enterprise and produces a single commodity

2. The entrepreneurs act rationally or producer is rational (here rationality
refers to the behavior of the producer and which requires that the producers
attempt to earn/maximize the profit as much as possible)
3. The owner itself is the manager of the business firm
4. The factor price is given and constant
5. ' The market is imperfectly competitive.
6. The time period is static
7. Each unit of each factor of production is equally efficient.
 Approaches to studying the model
There are two approaches to examine the firm's profit maximization condition
of the firm.

Here the profit maximization condition of the firm is known as the firm's
equilibrium of producer's equilibrium and we have two different approaches to
define such a point of equilibrium of the firm.

One is the old and traditional method called the total revenue total cost
(Total) approach and another is the marginal revenue and the marginal
cost (Marginal) approach.

From a mathematical point of view, both of the methods are the same. Under
both approaches, how the firm could maximize its profit by converting raw
mates into finished goods.

I. Total Revenue-Total Cost/Total Approach

This is a traditional approach to measure the equilibrium point of the
entrepreneur or profit maximization point of a particular business firm.

According to the approach, profit is maximized when there is a maximum gap

between the total revenue of the firm and the total cost of the firm.

Profit (π)= Total Revenue (TR) - Total Cost (TC)

Three cases can be seen as;

•When TR> TC, π>0 (There is excess profit)

•When TR=TC, π=0 (There is only normal profit)

•When TR<TC, π<0 (There is loss)

The firm always wants to hold the first condition and wants to make the
possible maximum gap between total revenue and total cost.

The detailed procedure can be explained with the help of the following graph;
The above figure shows the profit maximization model under the total approach.
The X-axis shows the levels of output and the Y-axis shows total costs and total
revenues.

TC represents the Total Cost Curve and TR represents the Total Revenue Curve.

In an imperfect competition market, the entrepreneur can generate more revenue

when there is less price and earn more profit.

It means there is a negative relationship between price and quantity of output

and as a result Total Revenue Curve initially increases at a decreasing rate,
reaches its maximum point and it finally starts falling and it upward to right
from the point of its origin.

The Total Cost Curve is S-shaped, i.e. total cost curve increases at a decreasing
rate and after a certain level of output, it increases at an increasing rate due to
the operation of the law of variable proportions.

Total revenue and total cost curve intersect with each other at points A and B
and these points are known as break-even points.

Break-even point shows the situation where there is, neither profit nor loss. At a
point, A and B total revenue is exactly equal to total cost and there is no profit
or zero profit.
 Left to the part of Q1 or point A and right to the part of Q3 or point B, there is a
loss for the firm as the total cost is greater than the total revenue for the firm.
So, the firm has to bear the loss if it produces less than OQ₁ and more than OQ 3.

Thus in between Q₁and Q3 levels of output, the firm can generate profit as there
is total revenue is greater than the total cost.

The vertical difference between total revenue and total cost represents the profit.
In between points A and B, there are different levels of profit but the firm can
generate maximum profit at the point or at the level of output where there is a
maximum gap between TR and TC.

In the above diagram at the output level of Q₂ the firm can generate maximum
profit as the vertical distance between TR and TC is maximum represented by
MN or EQ2. Thus, the firm is in equilibrium or generates maximum profit by
producing the OQ₂ level of output.

II. Marginal Revenue Marginal Cost (MR-MC) Approach

Neo-classical economists developed the MR-MC approach. Under this
approach, MR and MC are considered to find the maximüm profit earning level
of output.

This approach states that for a firm to be in equilibrium two conditions should
be fulfilled simultaneously.

They are First Order Condition (FOC), Marginal Revenue equals Marginal Cost
(MR-MC)

Second-Order Cost (SOC): Marginal Cost cuts Marginal Revenue from below
(Slope of MC is higher than Slope of MR)

The MR-MC approach to profit maximization model can be explained with the
help of the following diagram,
The above figure shows the marginal revenue-marginal cost approach to the
profit maximization model.

AR curve which is also a demand curve is drawn on the assumption of

imperfect competition. MR curve is also downward sloping.

MC curve is U-shaped due to the inverse S-shaped total cost curve.

MR and MC intersect or cut or equal to each other at point 'a' and 'e' and the
first- order condition is fulfilled at both of the points.

The firm enjoys equilibrium or maximum profit at point’ e’ because at such

point both of the conditions are fulfilled.

At point 'e', MC cuts MR or MR is equal to MC, and MC cuts MR from below,

and thus the firm can ensure maximum profit with a given level of output.

At point 'a' the first-order condition of profit maximization is fulfilled

(MR=MC) but MC cuts MR from above and is the violation of the second-
order condition.
Hence, the firm generates maximum profit with the Qe level of output and the
generated profit is represented by the shaded area in the given figure.

Criticisms of the model

Profit maximization is a universally accepted and important objective or goal of
the firm. Many economists consider the profit-maximization goal as the realistic
and simple goal of the firm. They believe, firms are basically organized to earn
a profit, and profit is the measure of success of a firm.So all the activities of the
business firm are guided to earn profit as much as possible.

However, the profit maximization theory of the firm is being criticized by

several critics.

Major criticisms are expressed as below:

1) In the modern times business firms operates at a larger scale and in such
case the owner himself/herself cannot manage his business and thus the
assumption of the owner itself manager is not applied.
2) The goal of the firm to maximize the profit as much as possible may not
be the ultimate objective all the time.
3) Risk association factors are not considered in the model.
4) The model talked about a particular firm but did not explain the relation
of the firm with other firms and stakeholders in society.
5) This model did not include a time element.