Optimal Size of the Firm - Essay Example

Optimal Size of the Firm In the academic literature, the size of the firm and its relationship with organizational performance has received considerable attention in the recent years. Many academicians and theorists believe that the size of the firm should be limited as it impairs organizational performance. While the other professionals argue that there is no optimum size of the firm but rather it is believed that size is the by-product of the process of growth therefore it should not be restricted. Penrose (1959) defined an organization as a collection of productive resources that produces product and services through a process of planning, staffing, monitoring and controlling which are mainly described as the administrative tasks. An essential feature of this firm is that it is an autonomous administrative planning unit. Its activities are interrelated and coordinated by policies of the organization as a whole. In most of the organizations, the central management is responsible for administrating the roles and laying down policies. However, they are great variations in the number, range, and nature of the tasks in different organization. Many of them believe in empowerment, while others are engaged in bureaucracy. As a whole, they are an administrative unit engaged in the process of managing the organization. An organization mainly deploys two kind of resources; Human and Physical Capital. The human capital is the knowledge, acumen and expertise of the management team. Physical Capital is related with the assets such as equipment and the technology that the entity employs. The utilization of these resources is dependent on the internal dynamics of the organization. The classical economic theory such as Neoclassical Price theory viewed the growth of an organization as a function of the quantity of inputs it employed in the production. Coase (1937) was amongst the first to formulate a neoclassical model calling it as a transaction cost theory. It contended that a time reaches when the coordination within the organization becomes troublesome gives rise to diminishing returns and increasing cost of operations. This traditional economic analysis emphasizes that the firm size is limited due to falling market demand and the presence of diminishing returns. Decreasing returns are evident since as the organization grows, coordination among the organizational units suffers which results in a fall of productivity. As per this theory the organization has a limit to its size. Since, the purpose of an organizational existence is to have costs lower than the market; the upper limit of an organizational size is determined by costs rising to the point where an additional transaction cost equals the cost of making the transaction in the market. Williamson (1967) stressed that the size of the firm is limited partly due to two factors; Costs of delegation (inefficiencies in coordination) and the inability to replicate the motivation of an individual owner. A study conducted by Milgrom and Roberts (1990) reported that the cost of management increases as there is an incentive for employees to provide false information which is beneficial to themselves. Leibenstein (1966) views organization culture to be contingent upon its history of management, labor relations and other factors which affect the productivity and hence there is a size of a firm where it is most productive. Thus we can that there is a “most profitable” size, and profits and costs are the measure taken into account while determining the size of the firm. Based on these assumptions, we can reject our analysis that size is a byproduct of the process of growth and there is an optimal size of the firm. However, the recent literature emphasizes that the size of the firm is built through the growth of the firm thus there is no optimal size. The classical theory differs from the administrative theory in the effect that the classical model only incorporates the limited internal factor such as quantity of input in determining the optimal size. The administrative theory differentiates itself from the classical theory by incorporating the external factors as well. For instance, two companies with same amount of input can differ in productivity because of differences in administration. A comprehensive theory must take into account the internal and external factors influencing the growth. For instance, Toyota & Ford being two huge companies in the automobile industry may have the same size but their productivity differs due to difference in processes and resources which provides a competitive edge to one of the organization. Penrose (1959) has developed his theory on the grounds that the assumption of diminishing returns presumes a static environment while he believes that the environment is dynamic which is a practical assumption. He believes that inefficiencies in coordination can be eliminated by decentralizing the structures. Furthermore, he affirms that firms can adapt to the changing environment therefore these problems can be easily confronted. The only impediment in the way of size of the firm lies in internal dynamics of the organization. Hence, the factors which inhibit growth are the ability of employees to function efficiently which is basically how they administer and perform their tasks. Microsoft is a prime example of how efficiently it has been managed and has been able to sustain itself in such a stiff competition due to its creativity and human resource which it derives from its human resource. The fundamental idea lies in the fact how competitive advantage is derived from the bundle of it resources which comprise of human and physical capital. Penrose (1959) idea has given emergence to the resource based view of the organization. The resource based view highlights that there are certain differences in the marketplace and those distinctive capabilities are unique to each firm which gives them edge over their competitors. Penrose based its assumption that all strategic management gurus take for granted that firms are heterogonous. The neoclassical assumption of homogeneity is comparatively weak and if appropriate resources with core competencies are available than anything can be produced for which demand can be created. Even Gibrat Law (1931) states that growth rate is independent of size of the firm. But the empirical evidence has violated Gibrat Law since larger firms grow faster (Mukhopadhyay & AmirKhalkhali, 2010). From the above critical analysis we can deduce that both the classical and recent theories are valid in light of their assumptions but since technology has emerged and environment is changing rapidly, we can infer that the size of the firm is a by-product of the process of growth and thus there is no optimum size of firm based on the assumptions of this theory. References Coase, R., 1937. The nature of the firm. Economica, 4, p.386-405. Gibrat, R. 1931. Les inegalites economiques, Paris: Librairie du Receuil Sirey Leibenstein, H., 1966, Allocative Efficiency and X-efficiency. American EconomicReview, 56, p.392- 425 Milgrom, P., and Roberts, J. 1990.Perspectives on Positive Political Economy.Cambridge: Cambridge University Press Mukhopadhyay , A. & AmirKhalkhali, S. 2010, Profitability Performance And Firm Size- Growth Relationship. Journal of Business & Economics Research, 8( 9), pg. 121 Penrose, E. T. 1959. The Theory Of The Growth Of The Firm. New York, Wiley. Williamson, O.E. 1967. Hierarchical Control and Optimum Firm Size, Journal of Political Economy, 75(2), p.123-138. Read More