Premium Essay

Theories of the Firm

In: Other Topics

Submitted By jojowu
Words 984
Pages 4
Theories of the Firm
To understand firm heterogeneity within industries and its relations to competitive advantage, reviewing some of the most influential theories of the firm is important.

Starting with Coase (1937), academic research in economics and management has nurtured a long tradition of trying to unveil the “essence of the firm.” Some scholars believe that discovering the true nature of the firm permits understanding real- world firms.
Whether things or concepts have “essences” is questionable. From a practical standpoint, finding this essence is not essential, but having a practical definition of the firm may be needed. A good “theory of the firm” is one that helps managers identify and choose the best projects among all feasible ones. It must also provide a definition of “best.”
A brief review of three theories of the firm follows. The first theory views the firm as a nexus of contracts. Most valuation and project selection frameworks implicitly assume this view. The second one views the firm as an efficient solution to the problem of economizing on transaction costs. Such a view is particularly useful for understanding acquisitions and divestitures, especially in those cases involving vertical integration or outsourcing decisions. The third theory views the firm as the locus of crucial resources. This view is particularly helpful for understanding corporate strategy and value creation.
The Firm as a Nexus of Contracts
Some argue that the firm is nothing more than a nexus of contracts. Under this view, most stakeholders such as employees, bondholders, and suppliers are thought to be protected by bilateral contracts with the firms’ equity holders. Equity holders own the firm in the sense that they have residual cash flow rights: After all stakeholders are paid according to their contracts, equity holders are entitled to the residual profits

Similar Documents

Premium Essay

A Behavioral Theory of a Firm

...Prior to this book, neo-classical economists assumed that firms sought to maximize profits and operated with perfect knowledge. These two assumptions are the first questioned by the authors especially due to the fact that there are sociological and psychological certainties that are left out by the classical approach about the firm. Now going through the author’s major theory which has the basic models: The Organizational goal, Expectations and decisions of an organization and Relational concepts. The goal of an organization The authors’ state that individual person has goal, as an organization they do not. However, if the theory is to be well defined, there is need for a goal for the organization, or a corresponding equivalent to that of an individual. The authors adopt a series of independent constraints forced on the organization through negotiation among the bloc members and adjusted over time in response to strains within. For the goal analysis, the authors adopt two organizing devices. The first setoff exhaustive variables influencing the dimensions of the goal while the second set of relational concepts influences the aspiration on a particular goal. The second set is made of past performances, goals of the organization and of others. Though the author state conflicting goals exist in firms, they do not solve the problem given that for maximization problem we can use Lagrange Multiplier or constraints to the objective function directly. Expectations and decisions...

Words: 686 - Pages: 3

Premium Essay

Resource Based Theory of the Firms

...in strategic management is understanding the sources of sustained competitive advantage of a firm. To develop the strategy we need to analyze the firm’s internal strength and weaknesses (resource based model) as well as the external opportunities and the threat(environmental models). Environmental model is based on heterogeneity and mobility of the resources and assumes that all firms have the same strategy and the resources are heterogenic and mobile so the competitive advantage are not long lasting. Where as resource based model states that resources are immobile as well as heterogenic and can have long lasting competitive advantage. Firm resources are categorized into three types – physical capital resources, human capital resources and organizational capital resources. Some of the attributes of this resources can be used for developing strategies for increasing the effectiveness and efficiency of a firm. We need to specify conditions under which we can select resources which can be used as an competitive advantage. Competitive advantage means that a firm as a value added strategy over others and competitive advantage can only be sustainable if the other firms cannot duplicate that strategy. Once the strategy is being duplicate depending upon the strategy of the competitors or due to change in economic condition it is not longer sustainable. In an industry where firms have similar resources I,e resources are homogenous and mobile, it is not possible to have sustainable...

Words: 1452 - Pages: 6

Premium Essay

Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure

...Journal of Financial Economics 3 (1976) 305-360. Q North-Holland Publishing Company THEORY OF THE FIRM: MANAGERIAL BEHAVIOR, AGENCY COSTS AND OWNERSHIP STRUCTURE Michael C. JENSEN and William H. MECKLING* University of Rochester, Rochester, NY 14627, U.S.A. Received January 1976, revised version received July 1976 This paper integrates elements from the theory of agency. the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears these costs and why, and investigate the Pareto optirnality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing tht- creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem. The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frcqucntly watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give thcmsclvcs a dispensation from...

Words: 27266 - Pages: 110

Premium Essay

Discuss How the Theory of Contestable Markets Could Impact on the Price and Output of a Monopoly Firm.

...determined on the basis of the number of firms in the market, the type of product, whether homogenous or differentiated and whether barriers to entry exist or not. Due to various specifications of all structures a “casual chain” is seen running from the market structure to the performance of that industry (Sloman, J. Hinde, K. pp 222) A monopoly involves one firm producing a good without close substitutes; that coincides with the firm. Barriers to entry exist thus making it difficult for new entrants to penetrate the industry and be a threat. The concept of the monopoly is relative since it crucially depends on how broadly or narrowly the product and the market are defined as. A monopoly firm can set the price as it is a price setter thus it has a certain degree of monopoly power that is determined by the difference between price charged and marginal cost expressed as a proportion of price. Monopolists can choose either the price or the level of output, but not both as it still faces a negatively sloped demand curve. Thus the monopoly firm does not have a supply curve. (Sloman, J. Hinde, K. 2007) For the monopoly firm to make supernormal profits it has to be a profit-maximizing firm. Therefore the firm shall not choose a rate of output Q that corresponds to the price inelastic segment of the demand curve. It will locate below the elastic segment because for profit maximization MR must equal MC. The diagram below shows a monopoly firm making supernormal profits. ...

Words: 673 - Pages: 3

Premium Essay

There Are Several Theories That Seek to Explain Why Fdi Takes Place. These Theories Try to Explain Why Firms Go to the Trouble of Acquiring or Establishing Operations Abroad. Such Theories Include Dunning’s Eclectic

...The Fundamentals of International Business | | Assignment question: There are several theories that seek to explain why FDI takes place. These theories try to explain why firms go to the trouble of acquiring or establishing operations abroad. Such theory includes Dunning’s Eclectic Paradigm, Vernon’s Life Cycle and Knickerbocker’s Model to name a few. Your academic paper should illustrate the use of such theories to evaluate the rationale for foreign direct investment for a leading player in your chosen industry. | | | | Student: Matteo Noris ID: 10224550 Course: (BA) International Business Assignment Due Date: 25th January 2012 Unit Tutor: Agnieszka Chidlow Matteo Noris ID: 10224550 Fundamentals of the International Business Submission Date: Wednesday 25th January 2012 Weighting: 30% of the total mark for the Unit * Chosen Assignment Question : 2 Foreign Direct Investment There are several theories that seek to explain why FDI takes place. These theories try to explain why firms go to the trouble of acquiring or establishing operations abroad. Such theories include Dunning’s Eclectic Paradigm, Vernon’s Life Cycle and Knickerbocker’s Model to name a few. Your academic paper should illustrate the use of such theories to evaluate the rationale for foreign direct investment for a leading player in your chosen industry. Contents Page Contents Page 2 Abstract 3 Introduction 3 Main Body 4 Conclusions 8 References...

Words: 2604 - Pages: 11

Free Essay

Dividend Policy

...Theories for Dividend Policy and Factors Affecting Dividend Payout A Review of the Literature Prepared for, 11038 Corporate Finance 307 School of Economics and Finance Curtin Business School Curtin University Miri Sarawak Campus Abstract The main objective of this literature review is to highlight the major theories for dividend policy that have been discussed and argued by many researchers over the years. It is aim to helping firms’ management to set their dividend policy and provide additional knowledge to investors. The theoretical aspect is agency theory which has negative relationship between percentages of insiders and ratio of dividend payout. The signaling theory is applicable in the real world but there is no evidence to support changes in dividend payout signaling the current and future performance of the firm. Bird-in-the-hand theory which risk adverse investors prefer receive dividend now instead of sell their shares in future for capital gain and this theory was not agreed by MM. Next is tax preference theory to study whether the level of firm leverage ratio will affect the dividend payout but it is not applicable for Indian firms. Lastly will discuss about how firm size and financial leverage can affect the firms’ dividend payout. In conclusion, since firms are free to choose whether to distribute dividend or retained their earnings, so there are not right or wrong theories and factors for dividend policy. Government regulations on firms and corporate...

Words: 4626 - Pages: 19

Premium Essay

Positive Theory of Accounting

...Synopsis Positive accounting theory is perceived as a hypothetical study in accounting which helps in clarifying and foreseeing tangible accounting procedures. These theories have a tendency to rationalize why a number of accounting practices are accepted than others. Positive accounting theory was introduced to better apprehend exactly how practices in accounting must be effectively managed. Introduction Modern positive accounting research began flourishing in the 1960’s and other introduce empirical finance method to financial accounting. The subsequent literature adopted the assumption that accounting number supply information for security market investment decision and used the information perspective to investigate the relation between accounting number and stack prices. The information perspective has taught us much about the market’s use of accounting numbers. It was structured as an educational thought of discipline by the efforts of Ross Watts and Jerold Zimmerman which when made known were received with extensive criticism. Summary of the Article Positive accounting can be related with the predetermined opinion of a firm. A firm is regarded as a conception initiative put forth by a number of economists and legal commentators which stresses that corporations are nothing more than a compilation of agreements concerning different parties – mostly shareholders, directors, employees, suppliers, customers and accounting – one tool to expedite the materialization...

Words: 1357 - Pages: 6

Free Essay

Stakeholder

...Sivarama Krishnan, University of Central Oklahoma ABSTRACT This paper attempts reconciliation between the two somewhat extreme views espoused by the shareholder wealth maximization paradigm and the stakeholder theory. The stakeholder theory challenges the basic premise built into corporate finance theory, teaching and practice. Corporate finance theory, teaching and the typically recommended practice are all built on the premise that the primary goal of a corporation should be shareholder wealth value maximization. Extant theoretical and empirical research in financial economics also generally accept shareholder wealth maximization as the normative and ideal goal on which all business decisions should be based. This paradigm assumes that there are no externalities and all the participants engaged in transactions with the firm are voluntary players competing in free, fair and competitive markets. A very different view is offered by what is loosely called stakeholder theory. The stakeholder theory posits that the focus on shareholders and firm value is misplaced and managers should be concerned with all stakeholders of the firm. The paper attempts to address what is felt as a lack of dialogue between the two camps. INTRODUCTION Corporate finance theory, teaching and the typically recommended practice at least in the US are all built on the premise that the primary goal of a corporation should be the maximization of shareholder value. Extant theoretical and empirical...

Words: 4065 - Pages: 17

Premium Essay

Circular Flow Chart

...public sector) of the economy. The course emphasizes the application of economic principles and methodologies to decision-making process of business firms operating under conditions of risk and uncertainty. Managerial Economics, thus, uses concepts, models and analytical techniques of economics to study and analyse the operations of businesses and the type of problems managers face. Hence it provides important conceptual insights for gaining a better understanding of business environment and for making of quality business decisions with minimal trial and errors. 2. Objectives: 2.1 To provide participants with a much clearer view of the applicability and relevance of economics to decision making within business firms. 2.2 To develop students’ knowledge of applied economics 2.3 To develop students’ analytical skills to a higher level. 2.4 To enhance students’ insight into the operation of business and the nature of problems managers face. 3. Course coverage * Introduction of students to Managerial Economics and the use of models and other analytical concepts in decision making process. * Introduction to the concept of risk and uncertainty and adjustment of decisions to reflect decision maker’s attitude towards risk. * Behaviour of consumers and demand side of the firm and demand estimation and forecasting. * Strategic decisions that managers have to make – eg pricing strategies, production decisions, product...

Words: 2791 - Pages: 12

Premium Essay

Competitive Strategy

...Members: Abhishek Rana, Matthew Ross, Michele De Simon, Mohit Kumar How would the different theories discussed by Conner (1991) explain differences in performance among firms? Conner has discussed the differences in performances amongst firms by analyzing the following list of theories: 1. Neo-Classical Theory: Performance is the same across the industry because the industry is characterized by ‘Perfect Competition’. Perfect competition comprises of the following assumptions – Larger number of buyers and suppliers, Homogeneity of the demand, Mobility of resources and Rationality of complete market information. Therefore in such a market setting firms cannot achieve economic profit. 2. Bain-type IO Theory: Above normal performance could be achieved only through collusion encouragement, which in turn leads to monopoly. In an industry characterized by collusion and monopoly, the largest firm has the power to set prices and expand its own market share further, leading to above normal performance. 3. Schumpeter Theory: The core of this theory states that the performance of a firm is driven by Innovation. Monopoly is a more favorable condition for process of innovation because it decreases inherent investment risks involved. Through innovation a firm can achieve indistinctive competence and edge over competitors leading to higher returns and performance. 4. Chicago Theory: This theory is driven by efficiency in production and distribution. Costly information is required...

Words: 1196 - Pages: 5

Free Essay

Foreign Direct Investment

...University: Name: Course: Tutor: Date: Knickerbocker’s theory of horizontal FDI puts forward a pragmatic oligopolistic structure at the centre of reasoning. This theory strives to accord with doubt and risk, and is progressive, which means that it relates with mechanisms and counter-mechanisms (imitative behavioral nature). It alters in the oligopolisitic equilibrium and approach. It was analyzed that K’s theory does not tell why the first firm in an oligopoly makes a decision to take up FDI rather than indulging in exportation or licensing.(Gilles L, 1997) Researchers also proposed that this imitative theory does not clearly map out the efficiency of either FDI or licensing for expanding businesses abroad. However, suggestions were made that the internationalization theory also known as the market imperfections theory consigns the two flaws of the Knickerbocker’s theory relating. As a result of licensing a firm may lose counteract ant technology to an upcoming foreign opponent. Licensing does not completely commit total control over production, retailing and planning to the firm which may be mandatory for maximization of profits. These flaws are looked into in the internationalization theory. In the same industry Knickerbocker’s theory stresses on the interrelation of principal participants. Paralleling is the strategy used by firms where one firm tries to complement the other’s ideas to keep one another in check, so as to not allow an opponent profit in competitive...

Words: 419 - Pages: 2

Premium Essay

Ethical Theories Applied to Enron

...Ethics at Enron Enron was a global energy firm that filed for bankruptcy protection in 2001. The firm’s senior managers had engaged in fraud for an extended period through a scheme in which partnerships owned by the managers could receive payment for goods and services never provided to Enron. In addition, the firm’s external auditing firm, Arthur Andersen, was complicit in the fraud by knowingly certifying false financial statements as accurate. Arthur Anderson participated in the fraud because the firm did not want to risk losing lucrative consulting contracts from Enron, which created a conflict of interest situation (Miller, 2004). The events leading to the collapse of Enron can be analyzed using the ethical frameworks suggested by consequentialist theory, deontological theory, and virtue ethics. Such an analysis can provide an explanation of the failure of Enron’s directors, mangers, and auditors to adhere to their ethical duties to the shareholders, employees, customers and suppliers of the firm. Consequentialist theory suggests that an act is ethically wrong if it results in consequences deemed wrong or harmful by the majority of people in a society (Hooker, 2002). The consequentialist theory requires assessing the actual consequences of the act, which includes both direct and indirect consequences. It also requires using some type of evaluative norm for determining whether the consequence is beneficial or harmful. The theory is prescriptive because the evaluative norms...

Words: 1705 - Pages: 7

Free Essay

Capital Structure and Information Asymmetry

...a discussion on debt maturity structure. The pecking order theory is examined. Finally this paper reveals empirical evidence of capital structure. Arnold Musadziruma 210525268 Clint Kruger 209541568 Kemsley Grantham 209538112 i “Seminar 4- Capital structure and information asymmetry (2013)” Abstract This study is going to discuss capital structure choices of companies in an environment of information asymmetry. Firstly we discuss information asymmetry and how firms attempt to avoid a pooling equilibrium by signalling the quality of the firm. Quality can be signalled through the use of debt. The use of long term debt is a sign that a firm can make the payment obligations of the long term debt which is shown to signal good quality. The pecking order theory makes use of a hierarchy of financing sources and indicates internally generated funds should be used first. Following this, short term debt should be used before long term debt because of the risk and costs involved. Due to the costs involved in issuing equity in an environment of information asymmetry, firms should make use of equity as a last resort. The maturity structure of debt should also match the maturities of those firms’ assets to reduce costs. Empirical evidence suggests there is no common result for which theory is followed in practice; however it is shown that small firms who are high growth firms tend to follow a pecking order and larger firms follow a trade-off model. Due to the clear complexity involved...

Words: 3507 - Pages: 15

Premium Essay

Financial Management Theory Write Up

...efficient market, the value of a firm is unaffected by how the firm is financed. Whether the firm’s capital is raised by issuing stock or selling debt does not affect the value of the firm. This theory is also referred to as the capital structure irrelevance principle, which we have already looked at in previous seminar discussions. There are two propositions which were discussed by Modigliani and Miller. The first proposition states that the value if a firm does not depend on its capital structure. An example would be if two firms with the same business operations and similar kind of assets, where to be assessed after using either stocks or debt to finance the firm of s. On the left side their balance sheets, these firms will look the same, only difference being the right side, i.e. the liabilities and how they finance business activities. M&M proposition 1 therefore says that how the debt and equity is structured in a corporation is irrelevant as the value of the firm is determined by real assets and not its capital structure. Implications of this proposition firstly revolve around the issue of changing capital structure. Assuming that the three conditions identified by M&M apply and considering a company which is financed entirely with equity. The annual cash flows of R100, which are expected to continue forever, if an appropriate discount rate is 10%, we can calculate the value of the firm to perpetuity as PVA=100/0.1= R1000. Since the firm is financed entirely with equity...

Words: 2369 - Pages: 10

Premium Essay

Sabtain

...Dividend policy theories (By Munene Laiboni) 1. Introduction: Dividend policy theories are propositions put in place to explain the rationale and major arguments relating to payment of dividends by firms. Firms are often torn in between paying dividends or reinvesting their profits on the business. Even those firms which pay dividends do not appear to have a stationary formula of determining the dividend payout ratio. Dividends are periodic payments to holders of equity which together with capital gains are the returns for investing in a firm’s stock. The prospect of earning periodic dividends and sustained capital appreciation are therefore the main drivers of investors’ decisions to invest in equity. In this paper, we explore various theories which have been postulated to explain dividend payment behavior of firms. Major Schools of thought: At the heart of the dividend policy theories discussion are two opposing schools of thought: One side holds that whether firms pay dividends or not is irrelevant in determining the stock price and hence the market value of the firm and ultimately its weighted cost of capital. In retrospect, the opposing side holds that firms which pay periodic dividends eventually tend to have higher stock prices, market values and cheaper WACCs. The existence of these two opposing sides has spawned vast amounts of empirical and theoretical research. Scholars on both sides of the divide appear relentless on showcasing the case for their arguments. Several...

Words: 3394 - Pages: 14