THE THEORY OF THE FIRM

Ask a roomful of business people what the goal of their business is. "Maximize profit" will be the answer you hear most often, maybe exclusively. But is the individual manager really concerned with maximizing profit, or maximizing anything for that matter? Are you?

The basic financial decisions of a company are concerned with (a) capital investments ” for plants, equipment, working capital, etc., (b) pricing, (c) the level of production, and (d) the source of the money ” either debt or equity ” to do it all. How we make those decisions was the subject of Adam Smith's book, Wealth of Nations , published in that distinguished year 1776 (also known for the issuance of Gibbon's Decline and Fall and some local political events).

Smith told how the pernicious sins of covetousness, gluttony, sloth, and greed were somehow led by an "invisible hand" to benefit society. His remarkable work was the cornerstone of those studies now called microeconomics, and a good many business decisions can still be explained with Smith's basic doctrine: Knowing their product's demand, competition, and cost, business people will act to maximize profits.

However, despite its simplicity and power, the theory suffers in real world application for two reasons. First, our information about product demand and competition is usually slight , at best, and even costs ” though largely under our own control ” occasionally veer away from expectations. Second, the wide separation of ownership and management in the modern corporation has brought additional motives to the mix; the invisible hand now guides by remote control, and the guided managers have ideas of their own.

New theories have come forth since the 1950s to improve and update the original model. They attempt to include the impact of the manager's motives, and because they concern you and me and what abides in our hearts, they are rather interesting.

One theory has it that companies are concerned more with maximizing sales than profits. That might explain, for example, the current fascination with mergers and acquisitions that produce instant sales growth yet from a profit standpoint are often failures, about one third of them according to experts.

You cannot be in management very long without seeing examples of profits sacrificed to sales: special discounts , loose credit terms, "prestige" products, low bids. Why? Because the size of a company, as measured by sales (a la the Fortune 500 list), is what brings managers the greatest satisfaction, salary, distinction, and seeming success.

Moreover, we all identify with the company we keep and the one that keeps us. We take unto ourselves a bit of the power, reputation, and recognition associated with our employer. That may be only a small satisfaction, but it is considerably larger than the one we get from making profits for unknown shareholders. In fact profits, if they are too large, may be thought unseemly and become an embarrassment to us. When we are offered a bonus that is tied to net income, it is in part an attempt to overcome our natural qualms about "excess" profits.