Rationale for a Firm

Essentially, firms exist as organization because the total cost of producing any output rate is lower than if they did not exist. Formation of a firm can help the owners reduce, cost of production broadly through two ways:

Firstly, firms exist to -save on transaction costs. It will be very inefficient and. costly for the manager to enter into and enforce contracts with workers and owners of capital, land and other resources for each separate step of production and distribution process. Instead, entrepreneurs usually enter into long-term, broader contracts with them say labour, to perform numerous tasks for a specific wage and fringe benefits. Such contract is much less costly than numerous specific contracts and is highly advantageous both to the entrepreneur and to the worker and other resource owners. Firms exist to save on such transaction costs. The two parties do not have to negotiate a new contract every time a worker is given a new assignment. There is -one general contract that covers a large number of transactions between resource owners and entrepreneurs.

Secondly, a firm exists to internalize transaction costs. For instance, a firm can save sales tax and avoid price controls and other government regulations that apply only to transactions among firms through internalization of transactions (i.e., by performing many functions within the firm). Sales tax applies usually to transactions between two firms. A construction company may have to pay sales tax on purchase of cabinets from independent cabinet-maker. By hiring that person, this tax is avoided and cost of production reduced. Case 2.1 brings to light this aspect of growth of a firm.

Given that production costs are reduced by organising factors of production into firms, why does this process not continue until there is just one large firm, such as General Motors that produces all goods and services for the entire economy? This is due to the diminishing returns to management, which arise due to two reasons:

Firstly, cost of organizing transactions within the firm tends to rise, as a firm gets larger. A firm will internalize the lower cost transactions first and then higher cost transactions. At some point, these internal cost transactions become equal to the cost of transacting ill the market or the transaction costs between the firms. At that point, the firm will cease to grow. For example, all automobile producers in the world buy tyres from companies specialized in production of rubber products. Ford and General Motors must have considered building plants to produce their own tyres. But the cost of developing the new management skills must have been costly and complicated than purchase from such companies. Similarly, attorneys are not an integral part of the production process but required periodically. Full time attorneys are costly and, therefore, legal services are contracted on need basis. Large firms that have regular need for legal services have an in-house legal staff.

Secondly, organizational skill of the entrepreneur is limited. Resources within the company may not be efficiently allocated if the firms' size exceeds the managers' ability to control the operation. Therefore, many firms are organized in groups of divisions called "profit centers". Up to a point, the firm can overcome the problem of diseconomies of scale (internal disadvantages of large size). But distancing of top management from operations of each division would impose sufficient diseconomies of scale to limit the growth of the firm. K Dandiest, chairman of HLL realized this point and, therefore, he laid emphasis on "keeping antenna high to listen what managers are saying" so as to maintain personal touch. To make the company a 'listening organization', he further gave recognition to the idea of creating new "profit centers" by breaking the existing business in smaller portfolios.

Thus, a rise in per unit cost of production as a firm grows larger because of managerial ability limits the quest of a firm to grow further. It is for this reason, many large firms recognize the problem of excessive size and decentralize by establishing a number of separate divisions or profit centers that act as individual firms. 

Managerial Economics Tutoring - Assignment Help

Our online managerial economics experts are here for your help. Expertsmind.com online assignment help-homework help brings you high grade in your courses and examination, We at Expertsmind.com offers managerial economics assignment help, managerial economics homework help and projects help. We offer complete package of managerial economics online tutoring for 24x7 hours.

ExpertsMind.com - Rationale for a Firm Assignment Help, Rationale for a Firm Homework Help, Rationale for a Firm Assignment Tutors, Rationale for a Firm Solutions, Rationale for a Firm Answers, Objectives of the Firm Assignment Tutors