Notes on the Theory of the Firm

Topics: Economics, Profit maximization, Management Pages: 16 (4558 words) Published: August 9, 2013
THE THEORY OF THE FIRM

Notes by:Ramon Somar

THE THEORY OF THE FIRM Even though managerial economics is not concerned solely with the management of business firms, this is its principal field of application. To apply managerial economics to business management, we need a theory of the firm, a theory indicating how firms behave and what their goals are.

The concept of the firm plays a central role in the theory and practice of managerial economics. An understanding of the reason for the existence of firms, their specific role in the economy, and their objective provides a background for that theory.

Reasons for the Existence of Firms and Their Functions A firm is an organization that combines and organizes resources for the purpose of producing goods and/or services for sale.

Firm exist because it would be very inefficient and costly for entrepreneurs to enter into and enforce contracts with workers and owners of capital, land, and other resources for each separate step of the production and distribution process.

Firms often hire labor for long periods of time under agreements that specify only that a wage rate per hour or day will be paid for the workers doing what they are asked. The two parties do not have to negotiate a new contract every time the worker is given a new assignment.

The saving of the transactions costs associated with such negotiations is advantageous to both parties. Reasons for the Existence of Firms and Their Functions A second explanation for the existence of firms is that some government interference in the market-place applies to transactions among firms rather than within firms.

For example, sales taxes usually apply only to transactions between one firm and another. By internalizing some transactions within the firm that would otherwise be subject to those interferences, production costs are reduced.

Notes by:Ramon Somar

Because this is a secondary factor, firms would exist in the absence of such interference, but it probably contributes to the existence of more and larger firms. Given that production costs are reduced by organizing production factors into firms, why won’t this process continue until there is one large firm? The Objective of the Firm To be able to discuss efficient or optimal decision making requires that a goal or objective be established. That is, a management decision can only be evaluated against the goal that the firm is attempting to achieve.

Originally, the theory of the firm was based on the assumption that the goal of the firm was to maximize current or short-run profits. Firms, however, are often observed to sacrifice short-term profits for the sake of increasing future or long-term profits.

Since both short-term as well as long-term profits are clearly important, the theory of the firm now suggests that the primary goal of the firm is to maximize the wealth or value of the firm. The Objective of the Firm Put briefly, a firm’s value will be defined here as the present value of its expected future cash follows. For present purpose, we can regard a firm’s cash flow as being the same as its profit. Thus, expressed as an equation, the value of the firm equals :

Present value of = expected profits

+ ... + ……… (1)

=
Where
t

is the expected profit in the year t, i is the appropriate discount rate used to find the

present value of future profits, and t goes from 1 (next year) to n (the last year in the planning horizon). Because profit equals total revenue (TR) minus total cost (TC), this equation can also be expressed as :

Present value of expected profits

=
Notes by:Ramon Somar

……… (2)

Where

is the firm’s total revenue in year t, and is its total cost in year t.

Again, managerial economists generally assume that firms want to maximize their value, as defined in equations (1) and (2). However, this does not mean that a firm has complete control over its value, and that it can set it at any level it...
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