Managerial Economics

1. Unit 9
Theory of a firm
Objectives:
After going through this unit, you will be able to explain:
The concept and significance of the structure of the market
Types of market structures
Difference between competitive and non-competitive markets
Behavior of firms in various market structures
Equilibrium conditions in various market forms
Structure:
1.1 Introduction
1.2 Meaning of Business Firm
1.3 Forms of Business Firms
1.4
1.5
1.6
Goal of Business Firm
Profit – Normal and Economic profit
Profit maximization
1.1 Introduction
The productive efforts in the economy are summarized in a commercial unit called the
firm. The rationality behind doing business as firms, lies in the benefits of an organized
effort through multi-skilled, multi-functional teams, which work jointly towards
achievement of pre-defined goals, while utilizing scarce resources most efficiently. In
this sense firms can be viewed as systems comprising of subsystems and parts which are
integrated, coordinated, and interdependent. The following sections evaluate the concept

2. of a firm, its forms, and processes that help it achieve business goals efficiently and
effectively.
1.2 Meaning of Business Firm
A firm is a unit that does business on its own account. Firm is from the Italian word,
“firma” which means a signature, and the idea is that a firm can commit itself to a
contract. The firm is the decision-maker in supplying goods and services. It is an entity
that employs scarce resources to produce goods and services which are demanded by
consumers. The firm is an alternative system of allocation to the market, which exists
because in many case it is more efficient to organize production in a non-price
environment. As stated by Ronald Coase (1937), “Within a firm … market transactions
are eliminated and in place of the complicated market structure with exchange
transactions is substituted the entrepreneur-co-coordinator, who directs production.”
1.3 Forms of Business Firms
There are four main kinds of firms in modern market economies:
Proprietorship
A proprietorship (or proprietary business) is a business owned by an individual, who is
called the “proprietor”. A proprietorship Some proprietorship are too small even to
employ one person full time. Craftsmen, such as plumbers and painters, may have “day
jobs” and work as self-employed proprietors part time after hours. Computer
programmers and others may also do that. At the other extreme, some proprietary
businesses employ many hundreds of workers in a wide range of specializations. In a
proprietorship, the proprietor is almost always the decision-maker for the business.
Partnerships
A partnership is a business jointly owned by two or more persons. In most partnerships,
each partner is legal liable for debts and agreements made by any partner. Of course, this
requires a great deal of trust, and thus partners generally know one another well enough

3. to have that sort of trust. Family partnerships are very common for that very reason.
There are now a few “limited partnerships” in which some partners are protected from
legal liability for the agreements made by others, beyond some limits. In many cases, one
partner is designated as the managing partner and is the main decision-maker for the
business.
Corporations
A corporation has two characteristics that distinguish it from most proprietorships and
partnerships:
Limited liability
Anonymous ownership
Limited liability means that the owner of shares in a corporation cannot lose more than a
certain amount if the company fails. Usually the amount is the money paid to buy the
shares. Anonymous ownership means that the owner of the shares can sell them without
getting the permission of anyone other than the buyer. By contrast, in most partnerships,
no one partner can sell out without getting the agreement of the other partners. In such a
case the continuing partners will, of course, want to know about the new partner -- he will
not be an “anonymous owner”. In a typical corporation, the shareholders formally elect a
board of directors, who in turn select the officers of the company. One of these officers,
often called the “president”, will be the principle decision-maker for the firm, but he will
be expected to make decisions in the interest of the shareholders.
Co-operative
A co-operative is a corporation organized by people with similar needs to provide
themselves with goods or services or to make joint use of their available resources to
improve their income. Their business structure ensures:
all members have an equal say (one vote per member, regardless of the number of shares
held);
open and voluntary membership;
limited interest on share capital;

4. surplus is returned to members according to amount of patronage.
There is no requirement to incorporate as a co-operative in order to run a business
collectively and cooperatively.
While there is millions of proprietorship, typically very small, the biggest businesses are
corporate and corporations are particularly important because of their size. The following
table brings out the advantages and disadvantages of various business forms:
Sole Proprietorship
Advantages Disadvantages
ease of formation unlimited liability
low start-up costs difficulty raising capital
less administrative paperwork than somelack of continuity in business organization in
other organizational structures (such asthe absence of the owner
incorporation)
owner in direct control of decision making
minimal working capital required
tax advantages to owner
all profits to owner
Partnership
Advantages Disadvantages
ease of formation unlimited liability (for general partners)
low start-up costs lack of continuity
additional sources of investment capital divided authority
broader management base hard to find suitable partners
possible development of conflict between
partners
Corporation
Advantages Disadvantages
limited liability closely regulated
specialized management most expensive form to organize
ownership is transferable charter restrictions
continuous existence extensive record keeping necessary
separate legal entity double taxation of dividends
possible tax advantage (if you qualify for
small business tax rate)
easier to raise capital

5. Co-operative
Advantages Disadvantages
owned and controlled by members longer decision making process
democratic control: one member, one vote requires members to participate for success
limited liability extensive record keeping necessary
profit distribution (surplus earnings) toless incentive to invest additional capital
members in proportion to use of service;
surplus may be allocated in shares or cash
possibility of development of conflict
between members
Goal of Business Firm - Profit and profit maximization
Profit is the main reason firms exist. In economic theory, profit is the reward for risk
taken by enterprise. Put simply, profit is a firm’s total revenue (TR) minus total cost
(TC), calculated through the following equation,
Profit = TR - TC
Economists distinguish between normal profit and economic profit
Normal profit is understood as the opportunity cost of using entrepreneurial abilities in
the production of a good, or the profit that could be received by entrepreneurship in
another business venture. Marshall has stated that normal profit is that rate of minimum
profit which a firm must earn in order to survive in the market. If profit is any lower than
that, then enterprise would be better off engaged in some alternative economic activity
On the other hand, a firm is said to be making an economic profit when its revenue
exceeds the total (opportunity) cost of its inputs. This can be used as another name for
“economic value added” (EVA). For example, a person invests Rs.100, 000 to start a
business, and in that year earns Rs.20, 000 in profits. The accounting profit would be
Rs.20, 000. However, the same year he could have earned an income of Rs.45, 000 had
he been employed. Therefore, he has an economic loss of Rs.25, 000 (120,000 - 100,000
- 45,000). A firm is said to be making an economic profit when its average total cost is
less than the price of the product at the profit-maximizing output. The economic profit is
equal to the quantity output multiplied by the difference between the average total cost
and the price

6. Profit maximization
In economics, profit maximization is the process by which a firm determines the price
and output level that returns the greatest profit. This can be obtained by two approaches,
viz.,
Point at which TR exceeds TC by the greatest margin
Point at which MR = MC
It is imperative to note the following points to understand the firm’s profit maximization
goal:
A firm is said to be making an economic profit when its average total cost is less than the
price of the product at the profit-maximizing output. The economic profit is equal to the
quantity output multiplied by the difference between the average total cost and the price.
A firm is said to be making a normal profit when its economic profit equals zero. This
occurs where average cost equals price at the profit-maximizing output.
A firm is said to be making a zero economic profit when its marginal revenue equals
marginal cost.
If the price is between average total cost and average variable cost at the profit-
maximizing output, then the firm is said to be in a loss-minimizing condition. The firm
should still continue to produce, however, since its loss would be larger if it was to stop
producing. By continuing production, the firm can offset its variable cost and at least part
of its fixed cost, but by stopping completely it would lose equivalent of its entire fixed
cost.
If the price is below average variable cost at the profit-maximizing output, the firm is said
to be in shutdown. Losses are minimized by not producing at all, since any production
would not generate returns significant enough to offset any fixed cost and part of the
variable cost. By not producing, the firm loses only its fixed cost.
To summarize on the profit maximization goal, consider the following figure,

7. Economic Objectives
Market share
Profit margin
Return on investment
Technological advancement
Customer satisfaction
Shareholder value
Goal of the firm Profit Maximization
Non-economic Objectives
Workplace environment
Product quality
Service to community
Goal of Business Firm - Maximizing stock prices
The goals of maximizing stock prices, in turn maximizing share holder’s wealth, is an
objective for firms that are publicly traded. However, firms that are private have another
crucial goal i.e. the maximization of the firm’s value. Since firm value is not directly
observable and has to be calculated, these kinds of firms can not enjoy a major benefit
that publicly held ones can – they are deficient in the feedback that other ones may get
due to a policy change, a new project take over or also while making chief decisions.
Goal of Business Firm – Maximizing Productivity
Productivity is the amount of output created (in terms of goods produced or services
rendered) per unit input used. For instance, labour productivity is typically measured as

8. output per worker or output per labour-hour. With respect to land, the “yield” is
equivalent to “land productivity”.
An increase in productivity not only maximizes output per unit of input for the firm, it
also can influence society more broadly, by improving living standards, and creating
income. They are central to the process generating economic growth and capital
accumulation. Companies can increase productivity in a variety of ways. The most
obvious methods involve automation and computerization which minimize the tasks that
must be performed by employees. Recently, less obvious techniques are being employed
that involve ergonomic design and worker comfort.
Goal of Business Firm – Satisficing
Satisficing is a behavior which attempts to achieve at least some minimum level of a
particular variable, but which does not necessarily maximize its value. The most common
application of the concept in economics is in the behavioral theory of the firm, which,
unlike traditional accounts, postulates that producers treat profit not as a goal to be
maximized, but as a constraint. Under these theories, a critical level of profit must be
achieved by firms; thereafter, priority is attached to the attainment of other goals.
The word satisfice was coined by Herbert Simon as a portmanteau of “satisfy” and
“suffice”. Simon pointed out that human beings lack the cognitive resources to maximize:
we usually do not know the relevant probabilities of outcomes, we can rarely evaluate all
outcomes with sufficient precision, and our memories are weak and unreliable.