Chapter 8: Alternative Theories
of the Firm
8.1 Problems with traditional theory
The traditional profit-maximising theories of the firm have been criticised for being
unrealistic. The criticisms are mainly of two sorts: (a) that firms wish to maximise profits but
for some reason are unable to do so; or (b) that firms have aims other than profit
maximisation.
Difficulties in maximising profit
Lack of information
The main difficulty in trying to maximise profits is a lack of information.
The biggest problem in estimating the firm’s demand curve is in estimating the actions and
reactions of other firms and their effects.
Time period
Finally there is the problem of deciding the time period over which the firm should be
seeking to maximise profits. Firms operate in a changing environment.
Alternative aims
An even more fundamental attack on the traditional theory of the firm is that firms do not
even aim to maximise profits.
Public limited company A company owned by its shareholders. Shareholders’ liability is
limited to the value of their shares. Shares may be bought and sold publicly – on the stock
market.
In large companies, there is likely to be a separation between ownership and control. The
shareholders (the owners) may want maximum profits, but it is the managers who make the
decisions, and managers are likely to aim to maximise their own utility rather than that of
the shareholders. This leads to profit ‘satisficing’.
Profit satisficing Where decision makers in a firm aim for a target level of profit rather than
the absolute maximum level.
8.2 Behavioural theories
Are firms rational?
One reason is that individual managers may be pursuing their own interests rather than
those of their employer. In addition, firms operate in complex environments, dealing with
the imperfect information and uncertainty about both the present and the future. As a
consequence managers may resort to using rules of thumb or other shortcuts when making
decisions.
Revenge is sweet
Asymmetric information and the principal-agent problem
Principal–agent problem Where people (principals), as a result of lack of knowledge, cannot
ensure that their best interests are served by their agents. Agents may take advantage of this
situation to the disadvantage of the principals.
One of the features of a complex modern economy is that people (principals) have to
employ others (agents) to carry out their wishes.
, Junior managers are the agents of senior management. Senior managers are the agents of
the directors, who are them- selves agents of the shareholders. Thus in large firms there is
often a complex chain of principal–agent relationships.
Asymmetric information Where one party in an economic relationship (e.g. an agent) has
more information than another (e.g. the principal).
The agent knows more about the situation than the principal – of course, this is part of the
reason why the principal employs the agent in the first place. The danger is that the agent
may well not act in the principal’s best interests, and may be able to get away with it
because of the principal’s imperfect knowledge. The estate agent may try to convince the
vendor that it is necessary to accept a lower price, while the real reason is to save the agent
time, e ort and expense.
In firms, too, agents may not act in the best interests of their principals.
So how can principals tackle the problem? There are two elements in the solution:
The principals must have some way of monitoring the performance of their agents.
Second, there must be incentives for agents to behave in the principals’ interests.
The adverse impact of asymmetric information
Survival and attitudes towards risk
Aiming for profits, sales, salaries, power, etc., will be useless if the firm does not survive.
Trying to maximise any of the various objectives may be risky.
Not all firms, however, make survival the top priority. Some are adventurous and are
prepared to take risks.
Indeed, a willingness to take risks is a noticeable characteristic of successful entrepreneurs.
If a firm is too cautious, however, it may not survive. It may find that it loses markets to more
aggressive competitors.
Can firms make use of behavioural economics?
Behavioural economics is a relatively new area of study for economists.
8.3 Alternative maximising theories
Long-run profit maximisation
The traditional theory of the firm is based on the assumption of short-run profit
maximisation. Many actions of firms may be seen to conflict with this aim and yet could be
consistent with the aim of long-run profit maximisation.
Long-run profit maximisation An alternative theory which assumes that managers aim to
shift cost and revenue curves so as to maximise profits over some longer time period.
Even if long-run profit maximisation is the prime aim, the means of achieving it are
extremely complex. The firm will need a plan of action for prices, output, investment, etc.,
stretching from now into the future.
Managerial utility maximisation
Managers are free to pursue their own interests.
Williamson identified a number of factors that affect a manager’s utility. The four main ones
were salary, job security, dominance (including status, power and prestige) and professional
excellence.
Of these only salary is directly measurable.
The greater the level of expenditure (staff, perks and discretionary investment) by managers
on these items, the greater is likely to be their status, power, prestige, professional
excellence and job security, and hence utility.
of the Firm
8.1 Problems with traditional theory
The traditional profit-maximising theories of the firm have been criticised for being
unrealistic. The criticisms are mainly of two sorts: (a) that firms wish to maximise profits but
for some reason are unable to do so; or (b) that firms have aims other than profit
maximisation.
Difficulties in maximising profit
Lack of information
The main difficulty in trying to maximise profits is a lack of information.
The biggest problem in estimating the firm’s demand curve is in estimating the actions and
reactions of other firms and their effects.
Time period
Finally there is the problem of deciding the time period over which the firm should be
seeking to maximise profits. Firms operate in a changing environment.
Alternative aims
An even more fundamental attack on the traditional theory of the firm is that firms do not
even aim to maximise profits.
Public limited company A company owned by its shareholders. Shareholders’ liability is
limited to the value of their shares. Shares may be bought and sold publicly – on the stock
market.
In large companies, there is likely to be a separation between ownership and control. The
shareholders (the owners) may want maximum profits, but it is the managers who make the
decisions, and managers are likely to aim to maximise their own utility rather than that of
the shareholders. This leads to profit ‘satisficing’.
Profit satisficing Where decision makers in a firm aim for a target level of profit rather than
the absolute maximum level.
8.2 Behavioural theories
Are firms rational?
One reason is that individual managers may be pursuing their own interests rather than
those of their employer. In addition, firms operate in complex environments, dealing with
the imperfect information and uncertainty about both the present and the future. As a
consequence managers may resort to using rules of thumb or other shortcuts when making
decisions.
Revenge is sweet
Asymmetric information and the principal-agent problem
Principal–agent problem Where people (principals), as a result of lack of knowledge, cannot
ensure that their best interests are served by their agents. Agents may take advantage of this
situation to the disadvantage of the principals.
One of the features of a complex modern economy is that people (principals) have to
employ others (agents) to carry out their wishes.
, Junior managers are the agents of senior management. Senior managers are the agents of
the directors, who are them- selves agents of the shareholders. Thus in large firms there is
often a complex chain of principal–agent relationships.
Asymmetric information Where one party in an economic relationship (e.g. an agent) has
more information than another (e.g. the principal).
The agent knows more about the situation than the principal – of course, this is part of the
reason why the principal employs the agent in the first place. The danger is that the agent
may well not act in the principal’s best interests, and may be able to get away with it
because of the principal’s imperfect knowledge. The estate agent may try to convince the
vendor that it is necessary to accept a lower price, while the real reason is to save the agent
time, e ort and expense.
In firms, too, agents may not act in the best interests of their principals.
So how can principals tackle the problem? There are two elements in the solution:
The principals must have some way of monitoring the performance of their agents.
Second, there must be incentives for agents to behave in the principals’ interests.
The adverse impact of asymmetric information
Survival and attitudes towards risk
Aiming for profits, sales, salaries, power, etc., will be useless if the firm does not survive.
Trying to maximise any of the various objectives may be risky.
Not all firms, however, make survival the top priority. Some are adventurous and are
prepared to take risks.
Indeed, a willingness to take risks is a noticeable characteristic of successful entrepreneurs.
If a firm is too cautious, however, it may not survive. It may find that it loses markets to more
aggressive competitors.
Can firms make use of behavioural economics?
Behavioural economics is a relatively new area of study for economists.
8.3 Alternative maximising theories
Long-run profit maximisation
The traditional theory of the firm is based on the assumption of short-run profit
maximisation. Many actions of firms may be seen to conflict with this aim and yet could be
consistent with the aim of long-run profit maximisation.
Long-run profit maximisation An alternative theory which assumes that managers aim to
shift cost and revenue curves so as to maximise profits over some longer time period.
Even if long-run profit maximisation is the prime aim, the means of achieving it are
extremely complex. The firm will need a plan of action for prices, output, investment, etc.,
stretching from now into the future.
Managerial utility maximisation
Managers are free to pursue their own interests.
Williamson identified a number of factors that affect a manager’s utility. The four main ones
were salary, job security, dominance (including status, power and prestige) and professional
excellence.
Of these only salary is directly measurable.
The greater the level of expenditure (staff, perks and discretionary investment) by managers
on these items, the greater is likely to be their status, power, prestige, professional
excellence and job security, and hence utility.
