Why do firms exist - Essay Example

? Table of Contents Introduction 3 Theory of Firm 3 Instrumental and Normative View of Stakeholder 5 Instrumental View 5 Normative View 6 Modern View6 The Alchian-Demsetz Approach 7 The Knowledge-Based Approach 9 Theory of Transaction cost 10 Advantages 11 Disadvantages 11 Conclusion 12 Bibliography 15 Introduction People today are engaged with a number of firms and businesses in their routine. The questions over the existence, advantages and disadvantages of firms have been answered by different researchers in different ways. The idea, however, lies in the understanding about the firms itself. A simple, yet, complete definition of firms may help in starting the debate about why they actually exist. Fisher, Prentice & Waschik (2010), define firm as “a group of workers and managers, collectively called labor, and a group of physical assets, like machinery in a manufacturing operation or computers in a service sector firm, collectively called capital, which produce goods and/or services (p. 14). This definition provides three major areas where people are involved with the firms. People, firstly, work for or manage the firms as labor, secondly they invest in businesses and firms to earn profits and giving firms the strength of progress in the form of capital, and lastly people use the products or services offered by the firms. Hence, our life is, in one way or the other, dependent on firms. It is a way of earning for one group and a way of gathering necessities of life for the other like food stuff, clothing, and professional services like legal, educational or healthcare services and so on. Owing to the importance of firms in our regular activities and modern life, this paper aims to answer the question: why do firms exist? In doing so, this paper will provide perspectives of different researchers and their theories to justify the claims made. Theory of Firm Theory of firm necessitates by trying to predict how the business would carry out their prescribed strategies to achieve their ultimate goal and that is profit maximization. The theory of firm helps predict and explain other alternatives and decision made by the company. Traditionally it was based on having sole goal of profit maximization. But most recent analysis, theories and researches suggest that sales maximization or market share that is satisfying the needs of the customers along with satisfying its legitimate stake holders, combined with satisfactory profits may be the main purpose of businesses in short term as well as in long term to survive. Traditionally companies’ were following stock holder theory that is managers had one objective of maximizing share holder value. For example a company would not mind shutting down a branch in a region or country and resulting in thousands of people being unemployed and affecting the whole economy of that region or country. Despite these factors, the managers would have let the factory moved to another region or country because labor is cheap and plentiful there. Traditional theory suggested companies to disregard safety practices or other practices to preserve social responsibilities, according to theory, as they would have to spend money over it which reduces profit. However, if such avoidance of such actions charges the companies with substantial penalty or case file or dereputation resulting in more expenses (fines) than the companies were encouraged to provide equipment and running the safety policy. The risks of fewer sales by customer boycotting the company’s products are also avoided by adopting such practices in the modern business arena and companies would fall into instrumental form of skate holder theory (Schroeder, Clark, and Cathey 2010, pp. 124-128). Stake holder theory is referred as 21st century theory where the organizations are so large that they can affect the whole society significantly. This broader impact of organizational procedures and processes suggest that they cannot just be responsible to share holders i.e. obeying stock holder theory. Though there is considerable debate on whose interests should be taken into account and the legitimacy of each stake holder’s claim will depend on ethical and political perspective (Rendtorff 2009, p. 101). There is a long-lasting debate on whether those certain groups should be considered as stake holders. For example society at large, neighbors, other species, natural environment, future generations, etc should be considered as legitimate stake holders as they directly face the consequences of procedures and processes involved in the business. Instrumental and Normative View of Stakeholder There are two motivations for organisation responding to stake holder according to Donaldson and Preston: Instrumental view of stake holder and normative view of stake holder. Instrumental View Instrumental view as exampled above reflect the view that organizations have mainly economic responsibility and may be other legal responsibilities they have to fulfill in order to keep trading. In this view of stake holders, directors see responsibility to stakeholders desires because it contributes to companies maximizing the profits hence fulfilling their ultimate goal of maximizing share holder value. The organization is using share holders instrumentally, to pursue other objectives. It merely reflects fulfilling the responsibilities of stake holders whom they cannot upset such as customers looking for green companies (Mejia & Werner 2008, p. 209). Therefore businesses would not have moral standpoint of their own. Today firms are formed in order to fulfill the requirements of the stakeholders at large to benefit from their consumption and loyalty. The modern organizations are well aware of the fact that firms generate goodwill by meeting the demands and expectations of the stakeholders. Hence firms are formed to gather the specialized people from different fields to work together and meet the demands of the consumers keeping the business activities lawful, socially and morally acceptable and ethical. Normative View Normative view as contrast to instrumental view of stake holder, have moral stand point of their own. As having moral duties to its stake holders, company would recognize the claims and views of its stake holders in its decision making process. It is based on considering moral duty to take account of the concerns and opinions of others and not to do so would result in breakdown of social cohesion leading to everyone being morally worse off and possibly economically worse off as well. And this form of view would have social, ethical and philanthropic responsibilities along with economic and legal responsibilities (Gossy 2008, p. 8-12). Thus firms are formed in order to meet the different needs and expectations of customers and other stakeholders effectively. Modern View In these days companies and managers are following normative view of stake holders because they think it is good for the stakeholders as well as the organizations. Just as living beings need water, oxygen and food to live, same goes with organizations. For organizations, suppliers, employees and customers are its basic needs to survive. Organizations need suppliers to provide goods from which they would process finished goods by the help of employees and sale it to customers. If any of these elements are absent the firm would not be able to survive. Hence, firms are formed to use efficiencies and skills of people to meet the demands, needs and expectations of other people. Without firms the higher demands of people would not be met and individual production would not be able to purchase the demands of the vast population. Hence, firms are formed organizing, managing and controlling the activities of the business keeping the quality of the service or the product stable at all times. However, management, control and review of the company’s performance form a major reason of forming firms. The management, control and review of performance provide the basis of stability in the quality of the product or service which leads to stakeholder satisfaction. Without these concepts, there would be a decrease and loss which would ultimately lead to companies winding up (liquidation) which would affect share holder value as well as society). Because of this and other reasons many economists of today say that theory of firm needs a complete revision. This theory of firm of 19th century does not fit in 21st century’s complex and fast growing businesses. Furthermore new theories relevant to today’s businesses does not support old theory of firm as for example corporate social responsibility which states that businesses has a duty to her society because this is from where she gets the job done (employees or raw materials, etc) and drives power. If she neglects their rights then she would have problems surviving. The Alchian-Demsetz Approach The reason why firms exist lies in the value and benefits of cooperation. The Alchian-Demsetz approach is important in understanding the reasons behind forming firms. This approach identifies the measurement issue that arises as a result of team formation. This theory, hence, emphasizes more on the benefits and issues related to team formation. If we look closely, firms are formed by incorporating a number of individuals with a collaborative aim to achieve. This directs towards the concept of team or group work. Team production is the process, whereby, cooperation plays a major role within the team activities. The team production process shares the complex production activities with all its members. This theory is based on the concept of synergy. Knoll (2008) describes synergy as combined returns give a higher result as compared to the sum of the returns produced by individual parts i.e. 2+2=5 (p. 14). Hence, the team production theory defines the concept of cooperation in the working environment resulting in greater outputs as a major reason of forming firms. The underlying theory is that the team members are capable of producing more products by cooperating with each other rather than by working independently. The cooperation phenomenon as proposed by this theory, however, is not completely free of risks as human beings have different nature and desires which lead to uncalled and inappropriate behaviors. The cooperation in team production is, hence, affected by shirking within the team members. The shirking concept is understood as a behavior of merely cheating and finds its roots to place less than ‘agreed-to’ efforts by one or more members of the group. The risk of shirking is higher in the groups than in working individually due to the fact that shirking costs higher to individuals working independently than in teams. An example may be a team of 5 members producing 9 door locks per day and selling them at a price of $10 each, i.e. total revenue of $90 per day. Their regular revenue is distributed equally between the members with each member getting $18 per day. One of the team members starts shirking and this change in his behavior leads to a reduction in the total team production volume to 7 per day, reducing the total revenue to $70 per day. This results in the distribution of revenues of $14 to each member. It should be noted that the cost born by the member who was shirking is just $4 as compared to the total revenue loss of $20. The fact that individuals working independently are wholly responsible for the costs that occur due to shirking by them reduces the risks of shirking in their behaviors when working separately. However, the shirking behavior in team working distributes the totals costs between the members and the benefits of shirking are enjoyed by only those who are involved in the shirking activities. It, thus, enhances the risk of it in team production. Hence we can say that although team production brings greater revenues in the form of synergy, it still carries risks related to it. The issue with this theory is the inability to assess the performance of individual members. Since the team’s overall production is enhanced or reduced, it is not possible to assess, monitor or reward the members individually. Alchian and Demsetz, however, provide a solution to this problem in the face of supervision to assess the performance of the team members individually. This way the performance will be assessed and each member of the team will be remunerated as per the competence and efficiency level (Cobbaut & Lenoble 2003, p. 70). Firms are, hence, formed to increase the production but the need for supervision and control over the performance of its employees and workers is an important phenomenon to be addressed. The costs related to the management, supervision, performance measurement and control of operations may not override the advantages it brings for the company in the form of goodwill, increased sales and higher profits. The Knowledge-Based Approach The knowledge based approach alters the perception `from the historically dominant theme of value appropriation to the one of value creation’ (Nahapiet & Ghoshal, 1998, p. 242). This approach mainly concentrates on the problem solving aspect of the firms. This approach emphasizes on the resources that firm has and the processes it follows rather than the costs and benefits related to its transactions (Madhok, 1996, p. 578). This theory is mainly in support of those firms and businesses that have competent and specialized products and services to offer which other firms find hard to imitate or produce. The firms are, hence, formed with a view to earn returns for the specialized operations and rent out their equipments and services to gain competitive advantage. The knowledge based approach is, therefore, dependent on the skills and knowledge which provides distinct status to the business and generate profits for the business owners. Firms, according to this theory, are formed for specialized operations of a group to meet the complex needs of stakeholders. This theory suggests that knowledge, qualification and expertise are the crucial resources for the firm (Nelson & Winter, 1982). Firms are formed to gather the knowledge and expertise of people at one place to aid the complex needs and meet the expectation by organizational processes utilizing the resources available. The knowledge-based approach does not direct towards rewards or remuneration levels as a means of motivation for employees sharing their knowledge like in transaction cost theory. But it provides an extrinsic motivation in the form of benevolence and opportunism without any rules that restrict their individuality and independence (Foss & Manhke 2000, p. 82). The business market consists of knowledgeable people working in the best interest of them. They have ample information about prices, suppliers and production techniques. Hence, firms are formed to integrate a number of people who are informative and competent in their relevant fields. Such collaboration results in better outputs, quality and efficiency of the group work. Kay (1995) argues that firms’ success is measured by the value added by the firm. He defines the value added by the firm as the difference between the outputs generated by the firm less the value of firm’s input. Value of firm’s output - Value of Firm’s input = value added by the firm This concept provides that the major reason of forming firms is to add value. The firm exists in order to add value and the added value is the contribution or goodwill which would be lost if the firm is liquidated. Theory of Transaction cost Theory of transaction cost is similar with agency theory as they both deal with same problem of conflict of interest between the principal and agent and acting in best interest of the company or principal. However transaction cost theory is based on the company trying to in house as many as possible its transactions so as to achieve economy of scale or operations, synergy, reducing uncertainties accompanied with supplier relationship, quality, price, etc. To do this, companies would try vertical integration that is being involved in all stages of production or of the supply chain (Dietrich 1994, pp. 76-80). Advantages This approach would create barrier to entry in that market or industry as heavy investment is needed and our company is already having market share and ready to defend easily A share of the profit is created at all departments (Though problem will be created if there are poor departmental price policies). Stronger relationship with the final consumer of the product as company would have required raw materials of specified quality within time to produce products. Lower supplier bargaining power. More effective pursuit of a differentiation strategy that is of being different to the products supplied by other rival companies hence a strategy of acquiring market share and ultimately increasing the share holder value. Disadvantages A company places ‘more eggs in the same end market basket’ (Ansoff). And it is inflexible and increases the company’s dependence on a particular industry. The company fails to benefit from any economies of scale or technical advances in the industry into which it has diversified for example in publishing industry, most printing is sub contracted to specialist printing firms who can work for many other companies. Chances of negative synergy increases as more integration is made. Problem of transaction cost theory is that the directors may raise the conflict of interest by being opportunistic in making decisions. An example may be of a food industry Chief Executive Officer or Chief Operation Officer try on acquiring luxury fast car manufacturing company. It would obviously be for his personal interest that is because he likes luxury fast cars or the prospects of his salary or other financial benefits is greater in this industry. However, this decision would turn out to be odd for the conglomerate group because the directors would not have the knowledge of that industry. Their experience is in the food industry which is a different line and manufacturing of luxury fast cars is totally different. Directors will also be influenced by the amounts or return that they personally would gain from that transaction or decision. A concept of good corporate governance is of making sound judgment. Directors or board as whole are required to make sound judgements based on having accurate information and the alternatives available and for the interest of the company as whole (Colley 2003, p. 245). What if the customers have limited knowledge of alternatives or what if they are fed less knowledge or have less competence and skills? All these questions would result in bad decision being made and ultimately share holders and stake holders being disadvantaged by the decision of acquiring a company and vertically integrating. Conclusion In conclusion, we can say that firms, in today’s economy are inseparable part of our society. The firms we deal with or work with are a part of our daily life and give a proper and complete market of goods and services that we need. The question of why firms exist is no longer a mystery. Every individual in today’s society knows one or the other benefit of firms. The aim of firms in the past was to increase shareholders wealth. However, with the passing time, other stakeholders are also involved when setting aims of any organization. The increased importance given to other stakeholders is due to the fact that stakeholders like government, employees, customers, suppliers, media and the society plays a major role in the success of the firms. Firms, in modern environment, are formed to meet the expectations and demand of the stakeholders with a view of earning profits. The reduction and elimination of scarcity of products and services available in the market is another reason why firms are given such fame and importance in the today’s globalized business world. The firms have made it possible for countries to do business with each other keeping the prices low and utilizing cheap resources like labor and material. The purpose of firms is not longer limited to benefitting shareholders but now, it comprises adding value to the firm in economic, social, financial and legal manner. During the research many points have been observed which directly point towards the reasons of forming firms. Firstly, firms are formed in order to reduce costs (especially transactions costs), reduce uncertainty by employing management skills, increasing customer satisfaction by maintaining quality of the output and providing opportunities to the skilled professional who lack resources to use their knowledge and skills. Firms provide employment opportunities to people, provide cheap availability of products and services to public, maintain a level of profitability for the shareholders and enhance the stability of the country’s economy in turn. Firms are formed to incorporate a number of skilled labors and produce a high quality service or product which may perfectly answer the needs and demands of the consumer. Firms are incorporated with an aim to achieve synergy and specialization. The negative impacts like lack of concentration due to repetitive work and shirking behaviors act as a threat to the formation of firms. However, the theories of management, supervision and motivation may help in curbing such issues. The firm’s basic purpose to meet the high demand of the overwhelmingly large population is met successfully today. Firms are of immense importance for our society today. Individual efforts of people reduce the risk of fraud and shirking behavior, however, team formation helps in gaining new ideas, concepts and skills to grow the business and profits for the owner. The firms are flexible and more efficient due to the distinct staff it holds and the ideas which are incorporated in a single entity to produce better results. The skillful staff working together achieves synergy and specialization which in turn reduces the risks of low-quality products and poor performance. The management needs are, however, higher in the firms than in the individual efforts made by people. Firms are generating greater profits and lowering the costs using the modern management concepts like pricing policies, strategic decision making, cost cutting techniques, motivational plans and other conceptually rich ideas. Bibliography ARNOLD, R. A. (2008). Microeconomics. Mason, OH, Thomson/South-Western. COBBAUT, R., & LENOBLE, J. (2003). Corporate governance: an institutionalist approach. The Hague, Kluwer Law International. COLLEY, J. L. (2003). Corporate governance. New York, McGraw-Hill. DIETRICH, M. 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