The Cyert and March Theory of Firm | Firm depends on the demand of the members of the coalition

The behavioral theory of firm was developed by Cyert and March, focuses on the decision making process of the large multi product firm under uncertainty in an imperfect market. They deal with the large corporate managerial business in which ownership is separated. Their theory was originated from the concern about the organizational problem with the internal structure of such firms that
creates the need to investigate the effect on the decision making process in these large organizations. The internal organizational actors may well explain the difference in the reactions of firms to the same external stimuli, that to the same changes in their economic environment.

The assumptions underlying the behavioral theories about the complex nature of the firm introduces an element of realism into the theory of the firm. The firm is not treated as a single-goal, single decision unit, as in the traditional theory, but as a multi goal, multi decision organization coalition. The firm is as a coalition of different groups which are connected with its activity; in various ways, managers, workers, shareholders, customers, suppliers, bankers, tax inspectors and so on. Each group has its own set of goals or demands.

The behavioral theory recognizes explicitly that there exists a basic dichotomy in the firm, there are individual members of the coalition firm and there is the organization coalition known as ‘the firm’. The consequence of the dichotomy is a conflict of goals; individuals may have different goals to those of the organization firm.

Cyert and March argue that the goals of the firm depends on the demand of the members of the coalition, while the demand of these members are determined by various factors such as aspiration of the members, their success in the past in occupying their demands, the expectations, the achievements of other groups in the same or other firms, the information available to them. The demands of the various groups of the coalition firm change continuously over time. Given the resources of the firm in any one period, not all demands, which confront the top management can be satisfied. Hence, there is a regular bargaining process between the various members of the coalition firm and inevitable conflict.

The top management has several tasks; to get the goals of the firm which are often in conflict with the demands of the various groups, to resolve the conflict between the various groups, to reconcile as far as possible the conflict in goals of the firm and of its individual groups.

The goals of the firm are set by the top management, which the main five goals of the firm are:
  1. Production Goal: The production goal originates from the production department. The main goal of the production manager is the smooth running of the production process. Production should be distributed evenly over time, irrespective of possible seasonal fluctuations of demand, so as to avoid excess capacity and lay off of workers at some periods and over working the plant and resorting to rush recruitment of workers at other times with the consequence of higher, costs due to excess capacity and dismissal payments or too frequent breakdowns of machinery and waste of raw materials in period of rush production.
  2. Inventory Goal: The inventory goal originates mainly from the inventory department if such a department exists, or from the sales and production department. The sales department wants an adequate stock of output for the customers, while the production department needs adequate stocks of raw materials and other items necessary for a smooth flow of the output process.
  3. Sales Goal: The sales goal and the share of the market goal originate from the sales department. The same department will also normally set the ‘sales strategy’ that is decided on the advertising campaigns, the market research programs, and so on.
  4. Profit Goal: The profit goals is set by the management so as to satisfy the demand of share holders and the expectations of bankers and other finance institutions; and also to create funds with which they can accomplish their own goals and projects, or satisfy the other goals of the firm.
  5. Share of the market goal: While making decisions, the firms are guided by these goals. All goals must be satisfied but there is an implicit order of priority among them. The conflict among different goals may crop up.

The number of goals of the firm may be increased, but the decision making process becomes increasing complex. The efficiency of decision making decreases as the number of goals increases. The law of diminishing returns holds for managerial work as for all other types of labor.

The goals of the firm are ultimately decided by the top management through continuous bargaining between the groups of the coalition. In the process of goal formation, the top management attempts to satisfy as many as possible of the demands with which the various members of the coalitions confront it. The goals of the firm such as the goals of the individual members or particular groups of the coalition take the form of aspiration levels rather than strict maximizing constraints.

The firm in the behavioral theories seeks to satisfy, i.e., to attain a ‘satisfactory’ overall performance as defined by the set aspiration goals, rather than maximize profits, sales or other magnitudes. The firm is as satisfying organization rather than a maximizing entrepreneur. The top management, responsible for the coordination of the activities of the various members of the firm, wishes to attain a ‘satisfactory’ level of production, to attain a share of the market, to earn a ‘satisfactory’ level of profit, to divert a ‘satisfactory’ percentage of their total receipts to research and development or to advertising, to acquire a ‘satisfactory’ public image and so on. But it is not clear in the behavioral theories what is a satisfactory and what an unsatisfactory attainment is.

They argue that satisfying behavior is rational given the limitations, internal and external with in which the operation of the firm is confined. They take by the form of aspiration levels, and whether attained, the performance of the firm is considered as satisfactory. The goals do not normally take the form of maximization of the relevant magnitudes. The firm is not a maximizing but rather a satisfying organization.

Conflicting Goals

The aspiration levels of the individuals within the firm which determine these goals change over time as a result of organizational learning. Thus, these goals are regarded as the product of a bargaining learning process in the organization coalition. But it is not essential that the different goals may be resolved amicably. There may be conflicts among these goals.

The conflicting interest can be reconciled by the distribution of side payments’ to members of the coalition. Side payments may be in cash or kind, the latter being mostly in the form of policy side payments. But the actual total side payments is not fixed for the coalition but depends upon the demand of members and on the form of the coalition. Demands of coalition members equal actual side payments only in the long-run. But the behavioral theory focuses on the short-run relation between side payments and demands and on the imperfections in factor markets.

In the short-run, new demands are being constantly made and the goals of the organization are continually adapted, to a greater or lesser extent, to take account of these demands. The demands of the members of the organizational coalition need not be mutually consistent. But all demands are not made simultaneously and the organization can remain viable by attending the demands in sequence. A problem will arise when the organization is not able to accommodate the demands of its members even sequentially, because it lacks the resources to do so.

Besides, side payments, the conflicting goals of the organization are resolved by subjecting them to a constant review. This is because, aspiration levels’ of coalition members change with experience. In fact, the aspiration levels change with the process of satisfying. Each person in the organization has a satisfying level for each of his goals.

Criticisms of the Cyert and March Theory

The Cyert and March theory of firm has been severely criticized on the following grounds:
  1. The behavioral theory relates to a duopoly firm and fails as the theory of market structures. It does not explain the interdependence and interaction of firms, nor the way in which the interrelationship of firms leads to equilibrium of output and price at the industry level. Thus, the conditions for the attainment of a stable equilibrium in the industry are not determined.
  2. The theory does not consider either the conditions of entry, effects on the behavior of existing firms of and the threat of potential entry by firms.
  3. The behavioral theory explains the short-run behavior of firms and ignores their long-run behavior. It cannot explain the dynamic aspects of inventions and innovations which are related to the long-run.
  4. The behavior theory is based on the simulations approach which is a predictive technique. It is simply the products of behavior of the firm but does not explain it.


Williamson’s Model of Managerial Discretion | Behavioral Relations Involved in Williamson's Model

The managerial theory of firm developed by Oliver E. Williamson states that managers apply discretion in making and implementing policies to maximize their own utility rather than trying for the maximization of profit which ultimately maximize own utility subject to minimum profit. Profit works as a limit to the top managers’ behavior in the sense that the financial market and the shareholders require a minimum profit to
be paid out in the form of dividends, otherwise the job security of managers is put in danger. Hence, managers look at their self-interest while making decision on price and selling quantity of output. Manager’s decision on price and output differs from the decisions of profit maximizing firm.

Utility maximization of managers guided by their own self-interest is possible, like in Baumol’s sales maximization model, only in a corporate type of business organization with the separation of ownership and management functions. Such organizational structure permits the managers of a firm to pursue their own self-interest, subject only to their ability to keep effective control over the firm. In particular managers are fairly certain of keeping hold of their power (i) if profits at any time are at an acceptable level, (ii) if the firm shows a reasonable rate of growth over time, and (iii) if sufficient dividends are paid to keep the stockholders happy.

Williamson’s model suggests that manager’s self-interest focuses on the achievement of goals in four particular areas, namely:
  1. High salaries
  2. Staff under their control
  3. Discretionary investment expenditures
  4. Fringe benefits (i.e., additional employee benefit: an additional benefit provided to an employee, for example, a company car or health insurance)

This model depends on some assumptions which are:
  1. Weakly competitive environment.
  2. A divorce of ownership from control of firm (manager is free to perform any action)
  3. A capital market imposes minimum profit constraint (manager’s work for minimum profit imposed by a capital market).

According to Williamson, managers want ‘utility’ which is the same things as happiness or satisfaction. Top managers and chief executive officers reveal expenditure preference that is they derive utility expenditure on staff (S), managerial emoluments (M), and discretionary profits. The discretionary profit is defined as the profit level higher than the level necessary for long-term survival.

The managerial utility function includes such variables as salaries, security, power, status, prestige and professional excellence. Of these variables, only the first variable ‘salaries’ is measurable. The others are non pecuniary. Therefore, in order to make them operational, they must be expressed in terms of other variables with which they are related and which are measurable. This is captured by the concept of expense preference, which is defined as the satisfaction which managers again form certain types of expenditures. In particular, staff expenditures on well being (slack payments) and funds available for discretionary investment gives a positive satisfaction to the managers because these expenditures are a source of security and reflect the power, status, prestige and professional achievement of managers.

Staff expenditures, emoluments and discretionary investment expenses are measurable in money terms and will be used as proxy-variables to replace the non-operational concepts (e.g. power, status, prestige, professional excellence) appearing in the managerial utility function. With this background, the utility function of the managers may be written in the form,

U = f  (  S,   M,   ID)

Where S = staff expenditure, including managerial salaries; M = managerial emoluments; and ID = discretionary investment; f(S, M, ID) is the utility function.

Managers have “expense preferences”, maximization of utility derived from;
(i) amount spent on staff (S)
(ii) additions to manager’s salaries and benefits in the form of “perks” (M)
(iii) discretionary profit (D) which exceed the minimum required to satisfy the shareholder’ available as a source of finance for “pet project”.

Different definitional and behavioral relations are involved in Williamson’s model. They are introduced below:
i) Demand of the firm

It is assumed that the firm has a known downward sloping demand curve defined by the function.
Q  = f1(P, S, Ɛ)

P = f2(Q, S, Ɛ)

Where, Q = output,
P = price,
S = staff expenditure,
Ɛ = (Greek letter epsilon) = the condition of the environment or a demand-shift parameter reflecting autonomous changes in demand;
f1(P, S, Ɛ) and f2(Q, S, Ɛ) are the market demand equation for the firm’s product.

An increase in staff expenditure (S) is supposed to cause an upward shift to the demand curve and thus allow the charging of a higher price. The same holds for any other change in the environment, which shifts upwards the demand curve of the firm.

ii) Production cost

The total cost of production (C) is assumed to be an increasing function of output (Q).

C = f3 (Q)

δC / δQ > 0 (i.e., total cost increases with the increase in the level of output, and vice versa)

iii) Actual Profit (π)

The actual profit is defined as revenue from sales (R), minus the production costs (C), and minus the staff expenditure (S) or actual profits are the difference between total revenue earned less the production costs (C) and expenditure on staff (S). This is symbolically expressed as:

π = R – C – S

iv) Reported Profit πR
This is the profit reported to the tax authorities. Reported profit (πR) is the difference between actual profits and supplementary or nonessential managerial expenditure as represented by management slack. It is the actual minus the managerial emoluments (M) which are tax deductible. So,

πR = π – M = R – C - S – M

v) Minimum Profit (π0)
Minimum profit (π0) is the amount of profits (after tax) which is required to be paid as acceptable dividend to satisfy the owner-shareholders of the firm. If the shareholders do not get reasonable dividends they may sell their shares and thereby expose the firm to the risk of being taken over by others, or alternatively they will vote for the dismissal of the top management. Both of these actions by the shareholders will reduce the job security of the top managerial team. Hence, managers must earn some minimum profits for the shareholders in the form of dividends to keep the shareholders satisfied so as to ensure manager’s job security. To meet this objective, the reported profits must be large enough to be equal to minimum profit (π0) plus the tax (T) that must be paid to the government. This is mathematically expressed as:

πR  ≥  π0 + T

The tax function is of the form T = Ť + t. πR

Where, t = marginal tax rate or unit profit tax; Ť = a lump sum tax

vi) Discretionary investment (ID)
Discretionary investment is the amount left from the reported, after subtracting the minimum profit (π0) and the tax (T). The mathematical expression for this definitional relationship is:

ID = πR - π0 – T

vii) Discretionary profit (πD)
This is the amount of profit left after subtracting from the actual profit (π), the minimum profit requirement (π0) and the tax (T). The mathematical expression for this definitional relationship is:

πD = ππ0 – T

Thus, there are three types of profit concepts discussed in Williamson’s managerial utility maximization model of the firm;
- actual profits (π)
- reported profit (πR)
- minimum profits (π0).

Discretionary profits should be carefully distinguished from discretionary investment. As explained earlier, discretionary profits are the amount left after minimum profit (π0) and tax (T) and are deducted from actual profits (πD = ππ0T) but discretionary investment equals reported profits minus minimum profits and tax. Thus, we have discretionary investment

ID = πRπ0 – T

Since difference between reported profits (πR) and actual profits (π) arise / occur due to management slack, discretionary profits can be stated as under;

πD = ID + expenditure due to management slack. Thus, if management slack is zero

πR = π and πD = ID


H. A. Simon opines that firms aim at satisfying rather than maximizing profit | Simon's Satisficing Theory

H. A. Simon opines that firms aim at satisfying rather than maximizing profit.

H.A. Simon has propounded this model in 1955, he argued that the real business world is full of uncertainty. Accurate and adequate data are not readily available where data are available, managers have little time and ability to process data and managers work under a number of constraints. Under such conditions, it is not possible for the firms to act in terms of rationality postulated under profit maximization hypothesis.

Nor do the firms seek to maximize sales, growth or anything else. Instead they seek to achieve a ‘satisfactory profit’, a ‘satisfactory growth’, and so on.

This behavior of firms is termed as satisfactory behavior of firms in which a firm is a coalition of different groups connected with the various activities of the firm e.g. shareholders, managers, workers, input supplier, customers, bankers, tax authorities and so on. All, if these groups have some kinds of expectations often conflicting from the firm, and the firm seeks to satisfy all in one way or another.

Simon said that a firm has normally an aspiration level. An aspiration level is the level of achievement, which the firm hopes for in a particular field. For example, if a firm hopes to increase sales in the present year by 10%, it is his aspiration level about sales. The aspiration level of profit will depend on past experience and in fixing in future uncertainties will be taken into account. If it is easily attained, the aspiration level will be raised. If it proves difficult to attain, it will be revised downwards. When the actual performance of a firm falls short of an aspiration level, ‘search activity’ will be started so that remedial action can be taken to achieve the aspiration level by better performance. Search activity is the search for new alternatives of action.

But there is limit to search activities because of the cost to be incurred in obtaining information. Hence, all alternatives will not be explored. A satisfactory alternative course of action will be selected. Since the firm limits search activity due to involvement of costs, it does not maximize profit. Hence, the firms aim at ‘satisfying’, rather than ‘maximizing’. If the aspiration level is nearer to profit, the result that can be obtained under the assumption of satisfying is similar to the result under the assumption of profit maximization.

The aspiration level of the firm means the demarcation between the satisfactory and unsatisfactory results.
Criticisms of Simon’s Satisficing Theory

This theory has the following weaknesses which are as follows:
  1. The main weakness of the satisficing theory of Simon is that he has not specified the ‘target’ level of profits which a firm aspires to reach. Unless that is known, it is not possible to point output the precise areas of conflict between the objectives of profit maximizing and satisficing.
  2. As commended by Boumol and Quant, it is constrained maximization with only constraints and no maximization.
  3. Simon does not clarify a satisfactory level of performance based on a certain level of rate of profits. According to Simon, there may be many satisfactory levels depending upon the groups that cooperate in the firm. It is difficult for the firm to choose such a profit rate that satisfies all groups function within the firm. Thus, the operational value of Simon’s model is limited.


Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints | Boumol's Theory of Sales Maximization

Modern Oligopolistic firms typically seek to maximize their sales subject to minimum profit constraints.

Boumol’s theory of sales maximization is an alternative theory of firm’s behavior. The basic premise of this theory is that sales maximization, rather than profit maximization, is the plausible goal of the firm. As pointed by him, there is no reason to believe that all firms seek to maximize their profits.

Business firms pursue a number of incompatible objectives and it is not easy to single out one as the most common objective pursued by the firms. His observation shows that more managers seek to maximize sales revenue rather than profits. He argues that in modern business management is separated from ownership, and managers enjoy the discretion to pursue goals other than profit maximization. According to Boumol, business managers pursue the goal of sales maximization for the following reasons:
  1. Financial institutions consider sales as an index of performance of the firm and willing to finance to the firm with growing sales.
  2. Profit figures are available only annually, sales figures can be obtained easily and more frequently to assess the performance of the management. Maximization of sales is more satisfying for the managers than the maximization of profits which go to the pockets of the shareholders.
  3. Salaries and slack earnings of the top managers linked more closely to sales than to profit.
  4. The routine personal problems are more easily handled with growing sales. Higher payments may be offered to employees. Sales figure indicate better performance. Profits are generally known after a year.
  5. If profit maximization is the goal and it rises in one period to an unusually high level, this becomes the standard profit target for the shareholders which managers find very difficult to maintain in the long-run.
  6. Sales growing more than proportionately to market expansion indicate growing market share and a greater competitive strength and bargaining power of a firm in a collective oligopoly.

Under sales maximizing objective, output is greater and price is lower under the objective of profit maximization. Hence, Boumol has described two types of equilibrium under sales maximization objective which are;
  1. Without profit constraint to sales maximization, & 
  2. There is profit constraint to sales maximization

In the figure, total profit curve (TP) measures the vertical distance between the total revenue and that cost at various levels of output. At first, total profit rises and after a profit falls downwards.

If the firm is a profit maximizer, it would produce the level of output OA. However, in Boumol’s model, the firm is sales maximizer, but it must also earn a minimum level of profit. The acceptable level of profit is OM. The firm will produce the level of output OB which maximizes its sales revenue. The firm earns profit BE, which is less than the maximum attainable profit AH. At this point, output OB total revenue is BR1. The figure shows that sales or total revenue maximizing output OB is larger than profit maximizing output OA.

The firm aims at sales maximization subject to a profit constraint as Boumol contended. If OM is the minimum total profit, which firm wants, then ML is the minimum profit line. This minimum profit line ML cuts TP curve at point E. There, the firm produces and sells OB output.

At output OB, the firm will have total revenue equal to BR1, which has less maximum possible total revenue of CR2. It should be noted that the firm can earn minimum profit ON even by producing ON output. But total revenue at output OH is much less than at output OB. In summary, two types of equilibrium appear to be possible. One in which the constraint provides no effective barrier to sales maximization. The firm is assumed to be able to pursue an independent price policy that is to set its price so as to achieve its goal of sales maximization (given the profit constraint) without being concerned about the reactions of competitors.

A profit maximizer produces the output OB defined by the equilibrium

Given that the marginal cost is always positive, it is obvious that at the level OB, the marginal revenue is also positive. That is TR is still increasing at OB, since its slope is still positive. In other words, the maximum of TR curve occurs to the right of the level of output at which profit is maximized.

The sales maximize sells at a price lower than profit maximize. The price at any level of output is the slope of the line through the origin to the relevant point of the total revenue curve (corresponding to the particular level of output).

Criticisms of Boumol's Theory of Sales Maximization

This model is not also free from certain weaknesses as below:
  1. As pointed by Boumol, sales maximize will in general produce and advertise more than a profit maximize, which is invalid. Hawkins comments that a sales-maximizer may choose a higher, lower or identical output and a higher, lower or advertising budget. It depends on the responsiveness of demand to advertising rather than price cuts.
  2. In case of multi-products, Baumol has argued that revenue and profit maximization yield the same results. But Williamson has shown that sales maximization yields different results from profit maximization.
  3. This model fails to explain observed market situations in which price are kept for considerable time periods in the range of inelastic demand.
  4. This model ignores the interdependence of the price of oligopolistic firms.
  5. It ignores not only actual competition, but also the threat of potential competition from rival oligopolistic firms.
  6. This model does not show how equilibrium in an industry in which all firms are sales maximizers, will be attained. Baumol does not establish the relationship between the firms and industry.


Value of Maximization Theory of Firm | Superiority of Maximization Theory

In managerial economics, the primary objective of management is assumed to be maximization of the firm’s value. The value can be defined as the present value of the firm’s expected future cash flows. Cash flows may be for now, be equated to profits, therefore the value of the firm today, its present value, is the value of its expected future profits, discounted back to the present at an appropriate interest rate.

The essence of the model with which are concerned expressed as follows:
Value of the firm = PV of expected future profits

PV is the abbreviation for the present value, and so forth represent the expected profits in each year ‘t’, ‘i’ is the appropriate interest rate.
Since profits are equal to total revenue (TR) minus total cost (TC), equation (i) may be written as

Maximizing equation (ii) involves the determinants of revenues, costs and the discount rates in each future year of some unspecified time. Revenues, costs and the discount rates are interrelated, complicating the problem even more.

A firm’s total revenues are directly determined by the quantity of its products sold and the process received, for managerial decision making, the important considerations relate to factors that affect prices and quantities, and to the interrelationships between them. These factors include the choice of products of the firm designs, manufactures and sells the advertising-strategies, it employs, the pricing it established, the general state of the economy it encounters and the nature of the competition it faces in the market place. In short, revenue relationship encompasses both demand and supply considerations.

The cost relationships involved in producing a firm’s products are similarly complex. Costs require examination of alternative production systems, technological options, input possibilities, and so on. The prices of the factors of production play an important role in cost determination, and thus factors supply considerations are important.

Finally, there is the relationship between the discount rate and the company’s production mix, physical assets and financial structure. These factors affect the cost of availability of financial resources for the firm and ultimately determine the discount rate used by investors to establish a value of the firm.

To determine the optional course of action requires that marketing, production and financial decisions as well as decisions related to personnel, product distribution and so on be combined into a single integrated system, one which shows how any action affects all parts of the firm. The economic model of the firm provides a basis for this integration and the principles of economic analysis enable to analyze the important interrelations.

Superiority of Maximization Theory

Shareholder wealth maximization is the basic goal of any business firm because of the following reasons:
  1. Efficient allocation of resources: It provides guideline for making decision of firm and also promotes an efficient allocation of resources. Resources are generally allocated by taking into consideration the expected return and risk associated to course of action. The market value of stock itself reflects the risk return trade off associated to any investor in the capital market. 
  2. Separation between ownership and management: The goal of shareholder wealth maximization is also justifiable from the view point of separation of ownership and management in a business firm. Stockholders provides funds to operate a business firm and they appoint a team of management to run the firm. 
  3. Residual owners: Shareholders are the last to share in earnings and assists of the company. Therefore, shareholders wealth is maximized, and then all other with prior claim that shareholder could be satisfied. 
  4. Emphasis on cash flow: Wealth maximization goal uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flow is clearer because it uniformly means profit after tax plus non-cash outlays to all. 
  5. Recognizes time value of money: It also recognizes the time value of money. All the cash flow generated over the life of the business firms are discounted back to present value using required rate of return and decision is based on the present value of future returns.
  6. Consideration risk: Wealth maximization objective also considers the risks associated to the streams of future cash flows. Depending on the degree of risk, a proper required rate of return is determined to discount back the future streams of cash flows. Greater the risk larger will be the required rate of return and vice-versa.

The complexities involved in the fully integrated decision making analysis limit its use to major planning decisions. The decision process involved in both fully integrated and partial optimization problems takes place in two steps, one must apply various techniques to determine the optimal decision.


Profit Maximization Objective of a Firm | Total Revenue (TR) - Total Cost (TC) Approach | Marginal Revenue (MR) - Marginal Cost (MC) Approach

Profit maximization is the most accurate description of managerial goal. The profit maximization is one of the very important assumptions of economic theory, which always assumes that a firm aims to maximize profit. The attempt of an entrepreneur to maximize profit is regarded as a rational behavior. Hence, profit maximization continues to be a central concept in managerial economics.

There are two approaches to explain the equilibrium of a firm on the context of profit maximization. Among them one is old method of total cost and total revenue approach and another is the marginal revenue and marginal cost approach.

Total Revenue (TR) – Total Cost (TC) Approach

Total revenue (TR) and total cost (TC) approach is the simplest method to determine the equilibrium of a firm. To calculate the profit of a firm, we find out the difference between the total revenue and total cost at difference levels of output. A firm is said to be in equilibrium when the difference between total revenue (TR) and total cost (TC) is maximum. Every rational producer will try to maximize his profit. We can find equilibrium of a firm with the help of this approach both under perfect and imperfect (monopoly) market competition.

i) Equilibrium of the firm under perfect competition

The firm is in equilibrium when it has no incentive to change its level of output. In perfect competition, a firm is said to be in equilibrium when it maximizes its profits (π), which is defined as the difference between total revenue and total cost.
π = TR – TC

π = profit,
TR = Total Revenue and
TC = Total Cost

Given that the normal profit rate is included in the cost items of the firm, π is the profit above the normal rate of return on capital and the remuneration for the risk bearing function of the entrepreneur. The firm is in equilibrium when it produces the output that maximized the differences between total receipts (Revenue) and total costs. The equilibrium of the firm can be explained with the help of the following figure:

As shown in the figure, TR and TC are total revenue and total cost curves of a firm in a perfectly competitive market. TR curve in a straight line through the origin, showing that the price is constant at all levels of output. The firm is a price taker and can sell any amount of output at the going market price, with its TR increasing proportionately with its sales. The slope of TR curve is the MR. It is constant and equal to the prevailing market price. Since all units are sold at the same price.

The slope of TC curves reflects ‘U’ shape of the AC curve i.e. law of variable proportions. The firm maximizes its profit at the output ‘OX’, where the distance between TR and TC is the greatest. At the lower (OX1) and higher levels (OX2) than OX, the firm has losses. The TR-TC approach awkward to use when firms are combined together in the study of the industry.

ii) Equilibrium of the Firm under Imperfect Competition (Monopoly)

Under imperfect competition, AR and MR of a firm are two different things. This is because under imperfect competition, a firm is a price-maker. It can sell more by lowering the price of its output. In the figure, AR and MR curves of a firm fall downward from left to right. According to this approach, for a firm to be equilibrium or maximization of profit, marginal revenue should be equal to marginal cost and the marginal cost curve should cut the marginal revenue curve from below.

It is shown in the figure, at the beginning, total cost is higher than total revenue. There is no profit. At points P and Q, total revenue is equal to total cost. So, there is neither profit nor loss and is called the break-even point. After OA output, total revenue is higher than total cost, so profit begins to show. At OB output, the difference between total revenue and total cost is maximum. The firm is in equilibrium and earns maximum profit, TR - TC (EB - NB) = EN is profit. Point Q is again the break-even point. Beyond OC output, total cost exceeds total revenue and the firm incurs losses. In case of perfect competition, the TR become the straight line.

Marginal Revenue (MR) - Marginal Cost (MC) Approach

Marginal revenue and marginal cost approach is another method to know the equilibrium of a firm. The modern economist Mrs. John Robinson propounded this approach. According to this approach, for a firm to be equilibrium or maximization of profit, marginal revenue (MR) should be equal to marginal cost (MC) and the marginal cost curve should - cut the marginal revenue curve from below. It will be profitable for a firm to increase its production when MR exceeds MC.

i) Equilibrium of the firm under perfect competition

The equilibrium of a firm in the perfect competition can also be shown through the help of marginal revenue (MR) and marginal cost (MC) approach. For fulfilling the condition of maximum profit, marginal cost (MC) must be less than marginal revenue (MR). A firm is said to be in equilibrium when marginal cost (MC) must be equal to the marginal revenue (MR) or MC curve must intersect MR curve from below. It is shown in the figure:

In the figure, AR and MR are the same and AR = MR is a straight line. It is assumed that MC falls at first and then starts rising. MC curve cuts MR curve at E point from below and it is equal to MR. The profit maximizing output is OQ where firm fulfills two basic conditions of equilibrium.

ii) Equilibrium of a firm under imperfect competition (Monopoly)

Under imperfect competition, AR and MR of a firm are two different things. This is because under imperfect competition, a firm is a price-maker. It can sell more by lowering the price of its output. In the figure, AR and MR curves of a firm fall downward from left to right. According to this approach, for a firm to be equilibrium or maximization of profit, marginal revenue should be equal to marginal cost and marginal cost curve should cut the marginal revenue curve from below.

In this figure, at point E both the conditions of equilibrium have been fulfilled. Hence, E is the point of equilibrium. The firm gets equilibrium at OM output where marginal revenue is equal to marginal cost. The OM quality of output is sold at price OP price. Before OM output, the increase in output add more to revenue than to cost but after OM output, the increase in output adds more to cost than revenue. Profit is the total revenue OMQP minus total cost OMNR. Hence, the firm earns the abnormal profit equal to RNQP.

Criticisms/ Demerits of Profit Maximization Theory

The objective has been criticized by some economists saying there may have other objectives in a firm such as sales maximization, welfare or satisfactions etc. This objective is criticized on the following grounds.
  1. Profit maximization criterion is vague and ambiguous. Profit may be long-term, after tax or before tax. It is not clear.
  2. In this objective, total profit earned during the life of assets and timing of their realization is ignored. Hence, equal value for earning realized on different periods is not realistic. It ignores the time value of money.
  3. This objective is concerned only with the size of profit and gives no weight to the degree of uncertainty of future profits. Two businesses with varying degree of risk and producing same size of profit is considered similar under profit maximization criterion. Thus, the risk element is ignored, which is one of the most important dimensions of financial management.
  4. This objective is incomplete because it ignores the appreciation in the value of securities or firm. Investors and owners of the businessmen are benefited not only by the earning of profit, but also due to the appreciation in the stock price.


Uses / Significance of Managerial Economics in Business Decision Making

Management is concerned with decision-making. Decision-making needs a balance between simplification of analysis to be manageable and complications for handling a variety of factors and objectives. Managerial economics accomplished several objectives. Moreover, it also needs common sense and good judgment. Managerial economics helps the decision-making process in the following ways:
  1. Managerial economics presents those aspects of traditional economics, which are relevant for business decision-making in real life. It culls from economic theory the concepts, principles and techniques of analysis, which have a bearing on the decision-making process. These are, if necessary, adopted or modified with a view to enable the manager take better decisions. Thus, managerial economics accomplished the objective of building a suitable took kit from traditional economics.
  2. Managerial economics also incorporates useful ideas from other disciplines such as psychology, sociology, etc; if they are found relevant for decision-making. In fact, managerial economics takes the aid of other academic disciplines having a bearing upon the business decisions of a manager in view of the various explicit and implicit constraints subject to which resource allocation is to be optimized.
  3. Managerial economics helps in reaching a variety of business decisions in a complicated environment such as what products and services should be produced? What inputs and production techniques should be used? How much output should be produced and at what prices it should be sold? What are the best sizes and locations of new plants? When should equipment be replaced? And how should the available capital be allocated?
  4. Managerial economics makes a manager a more competent model builder. Thus, he can capture the essential relationship, which characterizes a situation while leaving out the cluttering details and peripheral relationships.
  5. At the level of the firm, where for various functional areas, functional specialists or functional departments exist, such as finance, marketing, personal, production, etc. Managerial economics serves as an integrating agent by coordinating the different areas and bringing to bear on the decisions of each department or specialist the implications pertaining to other functional areas. It thus, enables business decision-making not in watertight compartments but in an integrated perspective, the significance of which lies in the fact that the functional departments or specialists often enjoy considerable autonomy and achieve conflicting goals.
  6. Managerial economics takes cognizance of the interaction between the firm and society and accomplishes the key role of business as an agent in the attainment of social and economic welfare. It has come to be raised that business, apart from its obligations to shareholders, has certain social obligations. Managerial economics focuses attention on those social obligations as constraints subject to which business decisions are to be taken. It serves as an instrument in furthering the economic welfare of the society through socially oriented business decisions.
  7. Managerial economics is helpful in making decisions such as the following: What should be the product-mix? Which is the production technique and the input-mix that is least costly? What should be the level of output and price for the product? How to take investment decisions? How much should the firm advertise and how to allocate an advertisement fund between different media? It has to concede that good decisions require ability to analyze problems logically and clearly.

In summary, the usefulness of managerial economics lies in borrowing and adopting the took-kit from economic theory, incorporating relevant ideas from other disciplines to achieve better business decisions, serving a catalytic agent in the course of decision-making by different functional departments at the firm’s level and finally accomplishing a social purpose through orienting business decisions towards social obligations.

Related Topics on Managerial Economics:

Factors Influencing Managerial Decisions | Managerial Business Decision Making

Managerial decision-making is the process of selecting a particular course of action from among a number of alternatives. Since the factors of production are limited and can be put to alternative uses. The objective of a firm is to achieve optimal result from use of available resources. If there were no alternatives, there would be no scarcity, and no choice as well as no decisions, so that the problem of choice arises.

The choice is the most important role of management. Hence, best choice should be made whether the knowledge of future prospect, decision could be made and plans could be formulated without errors. However in many cases, there may not complete knowledge. New decisions have to be made and old plans may have to be repeated as new courses of action are adopted in order to obtain desired objectives. The following factors influence the managerial decision-making.

1. Objectives of a firm

Efficient or optimal decision-making requires a goal or objective to be established. That is, a management decision can only be evaluated against the goal that the firm is attempting to achieve. Traditionally, economists have assumed the objective of the firm is to maximize profit. That is, it is assumed that managers consistently make decisions in order to maximize profit. That should be clear either in current year or in next year.

2. Economic factors

According to traditional concept, a firm tries to maximize its profit. Many economists have challenged this concept; the firm may have other objectives such as sales maximization. Although it cannot be cleared that the preference for profitability is high. So that manager should consider if the set course of action is profitable or not, can be done with least cost or not. Demand forecasting, pricing condition, cost estimation will have to make for the purpose. It must consider the size of and direction of future changes in prices, demand, general level of economic activity, possible strikes, changes in fission, which affects the demand on the one side and on the supply side. Cost of machine, cost of borrowing, cost of renting space to store would be studied.

3. Technological Factors

There is significant role of technology in decision making in the economic theory. Technology also influences the business decisions. The manager must consider the factor such as assessment and emerging new technological alternatives, the technological moves of competitors and emerging new technological process in their planning and available resource allocation. The technological alternatives suitable to the situation should be taken as good for short run marketing or production decision. But the consideration of technological factor cannot be a basis for business decision with reaching at final decision, economic factor should also be considered well.

4. Human and behavioral factors

The economic consideration is important in decision-making. Although managers may not always give top most priority to economic consideration. It should be taken into account the factors such as the impact of decision on employee’s morale (determination) as in case of cutting of extra benefits of motivation. The small entrepreneurs may not be agreed to expand or diversify despite green signals ahead because they feel that expansion may strain their quiet life or may threaten their control over management. Manager must always consider constrain imposed upon him by forces at work within his own firm such as individual and collective interests and pressures within the firm. Hence, the manager should base his final decision on both economic, logic as well as human and personal thinking.

5. Environmental factors

The firm’s managers should be fully aware of the economic, social and political conditions curtailing the country while making business decisions. The environment existing in and out of the firm should be considered. The political and social consequences as to decision can’t be overlooked. The importance of environmental factors is growing each day due to the following causes.
  1. Public awareness: The awareness of the impact of firm’s decision on society is growing. Many pressure groups like political parties, consumer’s forum, trade unions and other exist these days. The pressure groups watch secondly the nature and consequences of a decision whether decisions are harmful to their interest and they will protest the decision.
  2. Social costs: The decision of firm has social through their productive activities like pollution, congestion, development of slums and others. Hence, the manager may have to take into account the environmental factors while making decisions. It should be considered carefully while making decisions of all the factors. But economic factors still play a dominant role in decision making because the firms are commercial in nature.

The managers cannot ignore the environment within which they operate. They must understand and adjust to the external factors, such as government intervention in business, taxation, business cycle fluctuation etc. Modern business has to keep itself well informed of changes in its environment and adjust its decisions accordingly from time to time.