The theory of the firm refers to a microeconomic concept founded by the neoclassical economists which states that firms exist and make decisions with a primary objective of maximizing profits. Therefore, the firms interact with the market in order to establish pricing and demand. Thereafter, the firms allocate resources to the appropriate models that look to maximize profits. Managerial theory of the firm refers to the concept whereby the ownership of the firm is separated from the management and the responsibility of facilitating maximization of sales revenue, growth and utility function is left to the managers (Lafontaine & Margaret, 2007). Therefore, the managerial theory of the firm focuses on the role of managers rather than the entrepreneurs in the running of a firm. It is a departure from the profit maximization goal of the economic theory.
The Economic Theory of the Firm
The theory of the firm is based on the objective of profit maximization by predicting the optimal price and output decisions which will facilitate profit maximization. Basically, the economic theory of the firm assumes that the entrepreneur is also the owner of the firm, the firm has a single goal of profit maximization, the goal is only attained through application of the marginalist principle and the world is one of certainty (John & Adrian, 2003). In this theory, there is no separation of between ownership and management. Therefore, the owner entrepreneur takes all the decisions. Moreover, all the organization problems are assumed to be solved by payments made to the factors of production employed by the firm. The entrepreneur is assumed to have unlimited information, time and ability necessary to effectively compare all the potential alternative decisions and chose the one that will maximize profit hence the entrepreneur acts with global rationality. Therefore, the firm acts within a certain time-frame which is influenced by various factors such as the capital intensity of the methods of production, rate of technological progress and the nature and gestation period of the product in question. The firm seeks to maximize profits within such a time limit. Therefore, the long-run profit maximization goal is attained by maximizing profits in each particular time-frame because the time frames are independent in terms of the particular decisions taken as the decisions made in a particular time frame do not affect the behavior of the firm in the subsequent time period.
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According to this model, a particular firm strives to maximize its discounted present value. Therefore, the future profits are reduced by a discount factor or weight to make future profits comparable to the present profits. As such, the discounted present value of the firm can be determined. However, this can be difficult because the choice of a discount factor greatly depends on the firm’s rate of time preference. Therefore, profits are independent in different time periods. However, such a situation does not prevail in the real world hence rendering the economic theory of the firm unrealistic. Therefore, critics have argued that the profit maximization goal is not the only objective of a firm because modern business firms and managers pursue various other goals other than profit maximization.
Managerial Theory of the Firm
The managerial theory of the firm postulates that the separation of ownership and management allows considerable discretion to the managers in terms of goal setting. The managers will be able to select the goals that will maximize their own utility function. Salaries, market, prestige, job security among other factors determine the managerial utility function (Lafontaine & Margaret, 2007). There are various dimensions of maximization of the utility of managers proposed by various economists. Baumol proposed that the managerial utility can be maximized by maximizing growth of sales revenue, Marris proposed that managerial utility can be maximized by maximizing the growth of the firm and Williamson suggested that the managerial utility can be maximized by maximizing the utility function of the managers.
Baumol proposed that firms that operate in oligopoly seek to maximize sales revenue subject to a profit constraint. The model suggests that profits can be sacrificed for revenue as the sales-maximizing level of output can exceed the profit maximizing level. Therefore, the selling price can be lower under imperfectly competitive market conditions. The motivation to maximize sales revenue is justifiable because the managers of large firms stand to gain more from sales revenue maximization as opposed to profit maximization. Sales revenue maximization facilitates expansion of the firm’s size as well as enhancing the status of managers and their promotion prospects.
Marris’ model of managerial enterprise is an alternative managerial theory of the firm that stems from the dichotomy between ownership and management. He proposes that the only possible goal that is interconnected with sales and profits is the firm’s growth. Therefore, the managers will have varying goals apart from profit maximization. The members of the management team are primarily concerned with maximization of the rate of firm’s growth in terms of corporate capital. Managers have great passion for growth of the firm because it enhances the status and promotion prospects of the firm managers. However, for purposes of job security, managers do not pursue growth objective beyond certain limits that can make the firms to suffer from financial stringency as it will affect them (Paul, 2016).
Williamson model of maximization of management utility proposes that managers of large firms conduct the affairs of the firm to serve their own interests. As such, the managers are only concerned with the goodwill of the firm to the extent that it works to their own personal interests and ambitions. Desires for salary, security, dominance and professional excellence are the most important motives of businessmen as they yield additional utility to them. Therefore, the maximization of the utility function of the management team has significant influence in the growth of the firm.
Conclusion
In conclusion, it is clear that the managerial theory of the firm is superior to the economic theory of the firm. The economic theory of the firm fails to consider the uncertainty in the market hence exposing the firm to precarious risks. On the other hand, the managerial theory of the firm considers the several environmental factors that affect the market of the firm. This is because managers will be able to select the goals that will maximize their own utility function in terms of facilitating firm progress.
References
Paul, W. (2016). The theory of the firm . London: Routledge.
Lafontaine, F., Margaret, S. (2007). “Vertical integration and firm boundaries: the evidence”, Journal of Economic Literature, 45(3); 629-685
John, M., Adrian, W. (2003). The company: a short history of a revolutionary idea . New York: The Modern Library.
