Traditional economic theories of the firm

The traditional theory (short run profit maximisation), utilises the concept of marginal cost and marginal revenue. Marginal cost is the cost of producing one more unit of output and marginal revenue is the extra revenue gained by selling one more unit per time period. Some criticisms of the traditional theory are that firms don’t always use marginal revenue and marginal cost concepts.

In order to make even an informed guess about marginal revenue, they must have some idea of how responsive demand will be to a change in price (price elasticity) having time to do market research may help decide if a price change is the right thing to do, which isn’t always cost effective. An even more fundamental attack on the traditional theory of the firm is that firms do not even aim to maximize profits even if they could.

Game theory which is the study of alternative strategies that oligoplists may choose to adopt might help a firm to decide its price and output strategy; it may choose to sacrifice the chance of getting the absolute maximum profit (the high risk, maximax option ), and instead go for the safe strategy of getting probably at least reasonable profits (maximin). Long run profit maximisation is an alternative theory which assumes that managers aim to shift cost and revenue curves so as to maximize profits over a longer time period.

If a firm decides that long run profit maximisation is their prime aim, the means of achieving it are extremely complex. The firm will need a plan of action for prices, output, investment, stretching from now into the future. The down fall of this theory is that we will not know if it’s worked because of its long term. Managerial utility maximisation is a theory that assumes that managers are motivated by self- interest. They will adopt whatever policies are perceived to maximize their own utility.

Much of the pioneering work was done by O. E Williamson. He identified a number of factors that would determine a manager’s utility, salary, security dominance which includes status, power prestige and professional excellence. Of these variables only salary was directly measured, as the rest are measured indirectly. One important conclusion that Williamson came to was that average costs would be higher when managers have the discretion to pursue their own utility.

Perks and unnecessarily high staffing levels increases cost but on the other the additional slack allows managers to rein in these costs in times of low demand by reducing staffing levels. Behavioral theories of the firm are theories that attempt to predict the actions of firms by studying the behaviors of various groups of people within the firm departments and their aims and objectives which could conflict those of other departments. These aims will be constrained by the interest of shareholders, workers, customers and creditors who will need to be kept sufficiently happy.

Behavioral theories do not dictate how to achieve these aims; they just try to resolve them. Firms also may have more than one goal (satisficers). They may try to increase sales revenue and increase profits; the problem with this is that if two aims conflict it will not be possible to maximise both of them. Where firms have two or more aims, a compromise may be reached so that targets for individual aims are set low enough to achieve simultaneously, and at the same time are sufficient to satisfy the relevant stakeholders.