Industrial Economics Chapter-2-By Milkeysa

Chapter-2-
AGENT, OWNERSHIP,
CONTROL AND GOALS OF
FIRMS
Continued….
The traditional theory was generally

developed on the basis of:
 Profit maximization assumption
 Tools of marginalizim
The theory of the firm traces back to Adam
Smith “competitive equilibrium paradigm.”
The neo classical theory based on:
 Marginal analysis
 Mathematics for such analysis
Continued….
Generally we have two theories of the firm:
Traditional(Neo classical)
theories of the firm
Modern theories of the firm
Traditional theories of the firm
Assumes:
firm is the smallest technical unit
firm transforms a set of inputs .
firm operates in an “exogenously given

environment” which lies beyond its control
firm pursues a “passive behavior”

Continued….
We have five basic assumptions here:

 There is a single owner-entrepreneur
 The firm has a single Goal
 The world is one of certainty
 “Entry considerations” differ depending on the type of

market structure
 The firm acts with a certain time horizon (identical &

independent time period.)
There is a single owner-entrepreneur:
no information, time or capacity (ability)

constraints.
unlimited information
unlimited ability to compare all the possible
alternative actions
1. The firm has a single Goal:
Profit maximization
Firms attain this goal by applying the
marginalist principle (MR=MC)
However, In reality Firms have a multitude of
goals. This alternative goals include:
 Managerialism
 Behaviorism
 Long run survival and market share
goals
 Entry prevention and risk avoidance
Continued……………………………
 Managerialism(managerial theorist):
 separation of ownership and management which allows some
discretion to managers in goal setting.

 Elements of managerial utility function are:
 Salaries
 Prestige
 Market share
 Job security
 quite life, etc.
 Baumol managerial utility is maximized when sales
revenue is maximized.
e.g. coca cola
 Marris managerial utility is maximized when the balanced
increase of both the firm ( sales and capital, Demand and
supply ) is maximized
Continued…
Behaviorism: satisfying behavior :

 due to Uncertainty and lack of accurate
information firms instead they exhibit a
satisfying profits.
 Firms act with bounded rationality,

rather than global rationality
Continued…
Long run survival and market share goals:

Entry prevention and risk avoidance:
The traditional behavioral rule:
 decisions are temporally independent.
 So short run profit maximization implies also long run
profit maximization
Continued…
The most radical reaction came from HALL

and HITCH(1939)
 marginal principles
 Interdependent decisions
 They state firms set their price on the average
cost(AC) principle( full cost pricing) i.e.
 P=AVC + AFC + Profit margin (usually 10%)
 P= AC+ Profit margin
Continued…
 They stated two reasons why firms set the above price( behavior)
 Firms do not know their demand and cost curves (I.e.
marginal costs).
 Firms believe that “full cost pricing”
 Traditional theory predicted change in price and quantity as a
response to change in demand and cost.
 However, Prices are tends to be sticky because of the expectation
of firms about their competitors reaction.
The world is one of certainty:
perfect information
Full knowledge is assumed about the past,
present and future,
hence, uncertainty can not influence firms’
decisions.
The theory, however, does not explain the
way this information (knowledge) was
acquired
“Entry consideration” differ depending on
the type of market structure
Entry is free both in the models of pure

competition and monopolistic competition,
yet it can only occur in the long run
In monopoly entry is blocked by definition
The firm acts with a certain time horizon
(identical & independent time period.)
Decisions in one period do not affect decision

in other period.
 LR profit is maximized when SR profits are
maximized.
Modern theories of the firm

In this firms will have:-
 Multi-products
 Multi-techniques
 Multi-plant
 Multi-division
In contrast
 to the passive behavior, the modern firm adopts an
active behavior.
 Firm is not necessarily limited to any particular
activity
 Measures that can be taken so as to reduce or remove constraints
include:
 Advertising
 Research and development
 product diversification
 merger and takeover
Continued…
The modern theory of the firm divided in to 3:

1. Managerial theories of the firm
2. The principal-agent theory
3. The transaction cost theory
1. Managerial theories of the firm
Divorce of ownership from management
Managers maximize their own utility subject to a
minimum profit constraint necessary for their job
security.
A minimum level of profit is necessary:
 For a dividend policy
 for a satisfactory operation
 For keeping a good reputation with banks
 For avoiding risk of take over
Managerial theories of the firm
Managerial theories of the firm divided in two:

1. Baumol’s theory of sales revenue
maximization
2. Marris theory of balanced growth of the
firm.
Baumol’s theory of sales revenue
maximization
 managers seeks to maximize sales or revenue than profit: WHY?
 Salaries and other earnings of managers are correlated
more closely with sales than profits
 Financial markets and retail distributions are more sensitive to

firms with rising sales
 If sales fail to rise, it reduces market shares and increase

vulnerability for competitors to takeover.
 Large sales give prestige to the managers while large profits go

into the pockets of share holders.
 Managers prefer to a steady performance with satisfactory

profits to spectacular profit maximization.
Marris theory of balanced growth
of the firm:
 Like Baumol’s model, Marrs’s model assume that managers will
act to maximize their utilities.
 But in contrast to Baumol’s, it assumes that this will be achieved
through “growth” rather than “sales”
 If managers preferred low rate of retention (growth) they would
follow the steeper supply growth curve for the purpose of job
security.
 The financial market acts as a factor (important constraint) in
the retention (growth) rate actually chosen.
Marris theory
 If the managers borrow too much or if the firm bankrupt:

 company will become subject to takeover
 Managers are likely to lose their job

 the following 3 factors act to prevent managers from
enriching themselves at the expense of owners:
 The market for corporate control
 The market for managerial labor
 The market for company’s product
Marris theory
Where is a market for corporate control:

 Underperformance is due to poor management-
Managers will be replaced

 In competitive world, self enrichment Raise
Company’s cost. To offset this managers have to

charge higher price or reduce product quality.
2. The principal-agent theory
In this we have two agents:

Principal(owner)
Agent (manager) which makes decision on
the behalf of the principal
This theory:
States contractual relationship between
owners and agents
Assumes information asymmetry between
principal and his agent but there is
unbounded rationality
Continued…
 Unbounded rationality refers to the ability of
those that design of contracts to take all possible,
relevant, future events in to consideration.
 problem of moral Hazard arises which results
“Shrinking performance”
To avoid the problem of Moral Hazard :
 Manager’s salary be equal to his/her MP
 Formulation of contract to offset shrinking
and other types of managerial misbehavior
 Providing incentive contracts which
reward agents only on the basis of results

3.The Transaction Cost theory
Firms:
 Many firms purchase the services of computer specialists,
lawyers, accountants, etc. in the market place.
 E.g. The movie “ EWINET HASET”.
Transaction cost refers to those incurred:
 To in force this rights
 To locate trade partners
 To carry out this transaction
 Transaction theorists hold that firms exist because of the
existence of transaction costs.
 Eg. Me cooking my own food instead of going out for market
will lower my cost.
 internalize transactions they will be at lower cost than if
they were market transaction.
Continued…
 COASE gave two justifications for the coordination of

production within the firm rather than the market:
1. Price mechanism for allocating resources is costly both to
establish and to use.
2. Many transactions necessitate commitments along way into an
uncertain future
Continued…
 Williamson believe that the factors that favor organization within

the firm rather than the market are:
 Bounded rationality
 Opportunism
 Asset specificity
Growth of the firm
We have 3 theories of the growth of the firm

Penrose’s theory
Marris’s theory
Downie’s theory
Penrose’s theory
To Penrose’s the growth of the firm limited by:

management can expand its numbers
Managerial capacity
These unused resources exist for 3 sorts of
reasons:
the firm is very large
Increasing specialization
New skills, information results the old to be
unused.
Continued…
Initially THE FIRM COULD GROW WITH

Constant managerial work-force is assumed.
Nonetheless, the firm will able to grow, for
two reasons:
1. more routine and less demanding of
managerial services
2. As managers become more experienced
Continued…
growth require the requirement of new

managers.
diminishing returns due to the additional
managerial services by new managers
require
 training and
 greater degree of integration.
Example: the 45 days training by CBE
Marris’s theory
 divorce of ownership from management

 allows managers certain degree of discretion in goal setting.
 The utility of managers includes
 salaries,
 status,
 Power
 job security
 The utility of owners includes

 profit,
 size of outputs,
 size of capital
 share of markets
Continued…
 The variables appearing in both functions are strongly correlated

with a single variable.
E.g. profit related to revenue
 The goal of the firm is maximization of the balanced rate of
growth of the firm.
Continued…
The rate of growth of demand:

 Diversification rate, d
 Percentage of successful new products of the firm, k
Percentage of successful new products of

the firm, k, depends on:
 Advertizing(A)
 Research and development expenditures
(R & D)
Continued…
If too many new products are introduced too

fast, the proportion of fails increases.
The rate of growth of supply:
can be financed from:
 Internally from profit
 Externally from the issues of bonds or bank loans.
In perusing the maximum balanced growth
rate firm face two types of constraints:
 managerial constraint
 financial constraint
Continued…
Limitation of Marris theory:

diversification is questionable.
The model heavily relies on the assumption
that firm has their own R & D department.
Downie’s theory
Efficiency variation is assumed to be the

determinant of the growth of the firm.
Firms with technologically superior processes
or product are assumed to be more efficient
The sources of growth are:
 Capacity expansion(ss side growth)
price discount ( demand side
growth)
Continued…
Lower price, however, means lower profit for

the firm.
Hence for Downie there are two opposite
forces:
 Capacity side directly related to
profit
 Market side indirectly related to
profit
Continued…
Limitation of Downie’s theory
Effcincey may leads to monopoly.
Efficiency may change overtime

growing concentration
 ignores non own price competition
does not take into account the

managerial restraints
THE END
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Chapter-2-

The traditional theory was generally

Generally we have two theories of the firm:

firm transforms a set of inputs .

firm operates in an “exogenously given

firm pursues a “passive behavior”

We have five basic assumptions here:

 The firm has a single Goal

 The world is one of certainty

 “Entry considerations” differ depending on the type of

 The firm acts with a certain time horizon (identical &

no information, time or capacity (ability)

discretion to managers in goal setting.

Behaviorism: satisfying behavior :

 Firms act with bounded rationality,

Long run survival and market share goals:

The most radical reaction came from HALL

Entry is free both in the models of pure

Decisions in one period do not affect decision

Modern theories of the firm

The modern theory of the firm divided in to 3:

Managerial theories of the firm divided in two:

 Financial markets and retail distributions are more sensitive to

 If sales fail to rise, it reduces market shares and increase

 Large sales give prestige to the managers while large profits go

 Managers prefer to a steady performance with satisfactory

 If the managers borrow too much or if the firm bankrupt:

 Managers are likely to lose their job

Where is a market for corporate control:

Managers will be replaced

Company’s cost. To offset this managers have to

In this we have two agents:

reward agents only on the basis of results

 COASE gave two justifications for the coordination of

 Williamson believe that the factors that favor organization within

We have 3 theories of the growth of the firm

To Penrose’s the growth of the firm limited by:

Initially THE FIRM COULD GROW WITH

growth require the requirement of new

 divorce of ownership from management

 The utility of owners includes

 The variables appearing in both functions are strongly correlated

The rate of growth of demand:

Percentage of successful new products of

If too many new products are introduced too

Limitation of Marris theory:

Efficiency variation is assumed to be the

Lower price, however, means lower profit for

Limitation of Downie’s theory

Effcincey may leads to monopoly.

Efficiency may change overtime

 ignores non own price competition

does not take into account the

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