Question

One of the main Limitations of the Theory of the Firm , Is that “ Seeking satisfactory rather than optimal results”….explain this limitation , illustrate your answers with a real case .

Answer 1

                                    The ‘Theory of the Firm’ is microeconomic concept in neoclassical economics which states that a firm would always make decisions so as to maximise the profits for the firm. Thus, the firms are expected to create as much difference as they can between the revenue and the costs. This is being referred to in the given case as ‘satisfactory results’ rather than having the focus on generating ‘optimal results’ which would always help in meeting the long-term projects of the firm and could bring in long-term benefits to the firm.

                                    For the successful implementation of a company’s policy, there has to be a co-ordination between the company, consumer, investor and the public. The limitation can be explained in this regard wherein if the company focus on making profits alone, this would result in creating disadvantages among the consumers which would finally result in causing detrimental effects on the firm itself in the longer term. There are various processes in a firm like resource allocation, pricing adjustments, production mechanism, managing the volume of production etc that governs the final output of a firm. In this regard, the firm has to identify optimal allocations and pricing mechanisms so that the befits for the firm would remain in the longer term.

                                    Now, let us consider an example. Consider a firm that manufactures and assembles mobile phones. If the firm follows a profit motive, it can be seen that with a lot of competitors in the current scenario, the advantage of having a market for the firm would be lost in the longer run. For example, if the firm tries to increase the profit by the addition of a special feature and increasing the price by a margin that is more than the value addition offered by that feature, then it may attract some of the existing consumers, but as a whole, majority of the consumers would remain with many other similar competitors in the market and thus the market advantage would be lost by the firm which would cause a reduction in the overall profits that would be acquired by the firm considering the lost opportunity cost with the loss of existing consumers. Thus, we can see that with more focus on the satisfactory allocations rather than the optimal result oriented methodology, this would create additional burden on the firm and hence the limitation would persist.