THEORY OF THE FIRM -Originally, its goal was to maximize

current or short-term profits

2.1 INTRODUCTION -The value of the firm is given by the
Firm present value of all expected future
 an entity or an organization established profits of the firm
to use the four factors of production to To find the wealth or value of the firm, the theory
create and innovate desirable outputs derived a formula:
(goods/ services) available for sale. X1 X2 Xn
Four Factors of Production PV = (1+𝑟)^1 + (1+𝑟)^2 + … + (1+𝑟)^𝑛
1. Land
2. Labor
Where:
3. Capital
PV = present value of all expected future
4. Entrepreneurship
profits of the firm
Forms of Firms
X1, X2, .., Xn = expected profits in each
1. Sole Proprietorship
of the n years considered
2. Partnership
R = appropriate discount rate used to find
3. Corporation
the PV of the future profits
2.2 NATURE OF THE FIRM
Economic Organization THE BASIC PROFIT MAXIMIZING MODEL
-The way in which the means of The Profit Maximization Rule
production and distribution of goods -states that if a firm chooses to maximize
are organized, such as capitalism or its profits, it must choose that level of
socialism. output where Marginal Cost (MC) is
Capitalism equal to Marginal Revenue (MR) and the
o way of organizing an economy so Marginal Cost curve is rising. In other
that the things that are used to words, it must produce at a level where
make and transport products are MC = MR.
owned by individual people and
companies rather that by the 2.4. CONSTRAINTS ON THE
government.
Socialism OPERATION OF THE FIRM
o A way of organizing a society in 1. Resource Constraints
which major industries are owned -Limitations on the availability of
and controlled by the essential inputs.
government rather than by 2. Legal Constraints
ndividual companies. -Laws and regulations that prevent firms
from unfair business practices.
Transaction Cost Theory
-examines the conditions under which Constrained Optimization
organizations chose to internalize some -minimize costs and other objectives
functions (hierarchy) or to purchase subject to the constraints.
them on the market.
Motivation Theory 2.5 LIMITATIONS OF THE THEORY OF
-concerned with the processes that THE FIRM
explain why and how human behavior is -The theory of the firm, which postulates
activated. that the goal or objective of the firm is to
Property Rights Theory maximize wealth or value of the firm,
-Property Rights acknowledge that a HAS BEEN CRITICIZED as being much
person or entity can exclusively control too narrow and unrealistic.
an asset and the benefits that it -Because of this, (3) prominent Theories
generates have been proposed.

2.3 OBJECTIVE AND VALUE OF THE 1. SALES MAXIMIZATION MODEL

FIRM  American Economist WILLIAM JACK
THEORY OF THE FIRM BAUMOL
-postulates that the primary goal or  States that
objective of the firm is to maximize the  Maximizes sales after an adequate
wealth or value of the firm rate of profit has been earned to
-Managerial Economics postulated the satisfy stockholders.
theory for it to become an instrument to  Sales maximization is regarded as
be used to analyze managerial the short-run and long-run goal of the
decision making management.
Arguments to support his theory of Sales
Maximization
1. a firm attaches great importance to the
magnitude on sales and is much concerned
about declining.
2. if the sales of a firm are declining, bank,
creditors, and the capital market are not
prepared to provide finance to it.
3. salaries of workers and management also
depend to a large extent on more sales and
the firm gives the bonus and other facilities
4. if that sales is declining, reduction of
payments and perhaps the lay-off of some
employees might happen
5. but if firm sales are large, there are
economies of scale and the firm expands
and earns large profit

2. MANAGEMENT UTILITY MODEL

 OLIVER WILLIANSON et. al.
 States that
o maximizing utility is more
important that maximizing
corporate profits.
o can be in form of:
 compensation
 size of staff
 extent of control over the
corporation
 lavish office

3. SATISFICING BEHAVIOR
 RICHARD CYERT and JAMES MARCH
 States that
o Strive for some satisfactory goal

2.6 AGENCY PROBLEM

• a conflict of interest inherent in any
relationship where one party is expected
to act in the best interest of another.