Module 3  The Organ i zational Form and Alternat iv e   Mo tive s   of the F i rm The organizational form of a firm may restrict the choice of the goal or motive to be pursued. For example, a small firm run by a sole proprietor may intend to pursue the motive of profit maximization but for a large corporation this objective may not have any validity in view of the separation of the management from the ownership. The managers in this situation may be interested in maximizing their own utility rather than the profits. One may look at the whole-matter from the opposite direction. It is the goal to be pursued that determines the choice of the organizational form for a firm. 3.1 Types of organizational formIn industrial economics a business firm may be identified on the basis of certain characteristics like the type of business it is doing, its size, the pattern of ownership, and so on. The third characteristic, that is, the pattern of the ownership is conventionally used to describe the type of organizational form for the firms. According to this, we can classify the firms in categories like proprietorship, partnership, and the corporation. This kind of classification is a legally recognized institutional pattern. With in which business firms operate all over the world. In the traditional theory of the firm we do not find such classification. The firm, conceived as a technical unit in that theory, is doing the job of production of goods and services for the sake of profits. It is run by· an entrepreneur who is taken as an owner-cum-manager. This is a narrow view of the firm. If we wish to take a broader perspective, then classifying the firms on the basis of ownership is desirable. By doing so, we may incorporate the possibility of separation of the management from the ownership as is the phenomenon in the corporate sector now-a-days. This helps us in understanding the decision making process in reality. Further, we can study the impact and purpose of the government regulation of the business sector in a better way. We can say that when we take a firm as an 'organizational' unit rather than as a 'technical' one, then we will be able to integrate the marginal, the behavioral!, and the managerial approaches to study the firm's economic behaviour.'All firms doing business can be first classified into three categories: (i) Private ·Sector (ii) Public Sector, .and (iii) Joint Sector. The meaning of these sectors is self-explanatory. In the private sector the ·ownership is exclusively in the hands of private individuals, whereas in the public sector, the State (Central or State Government) owns the firm. In the case of joint-sector,

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the government, private entrepreneurs and the public together share the ownership, management and control of the firm. The organizational forms of the firms in each of these three categories may be described briefly as follows:  Privat e   Sec t or    (i)   S o l e P r o p r i e t o rship:  This is the simplest kind of business organization which is owned and controlled by a single individual. Alternatively, it is called” one-man business". The sole proprietor may have any number of persons working for him but they will be just paid employees or family member’s having no share in the ownership of the business. In terms of numbers, this is the most common form of business organization and is found mainly in retail trades, services industries, cottage and small industries and the professions. There are advantages as well as disadvantages of this type of organizational form. The points on the basis of which it is preferred are as follows:  1. It is easy to be established. With very little formalities one can go through the formation of the firm.2. There is incentive to earn more in the sole proprietorship. The entrepreneur puts his best effort in the business and gets the appropriate reward for that.3. There is independence of control over the business.4. The decision-making is very prompt.5. The secrecy of the affairs of business can be maintained.6. The proprietor being in touch with the work of the firm can ensure efficient performance. 7. The operations become flexible according to the conditions prevailing in the business. He can expand or curtail production, if the situation demands, without any hitch. 8. Sole proprietorship eliminates concentration of wealth and provides equal opportunities to everyone to use his talents and resources to his maximum advantage.T h e   n ega t i v e   point s   o f s o l e   pro prie t ors hi p a r e:    1. There will be limitations both in resource mobilization and managerial capabilities. He may not get adequate finances, raw materials, etc. in time and, being alone, cannot manage every department of his business efficiently.2. The sole proprietor will be personally liable for all kinds of risks attached to his business. His liabilities will be unlimited. Because of this he maybe very orthodox and conservative in the management of

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his business. This, in turn, may introduce some inefficiency as one can reduce risks at the cost of profits.3. The life of a firm having sole proprietorship is uncertain. After the death of the proprietor there is no guarantee that the business will continue.4. All the qualities required for success in business are rarely found in one man. A sole proprietor is likely to commit certain errors while conducting his business. There will not be anybody else to correct him.   Sole proprietorship is suitable when the markets are limited and highly localized and the commodity or service is to be provided according to individual requirements. Many examples can be cited for this such as tailoring, ornament manufacturing, printing, book-binding, etc. In practice we will find hundreds of such firms in the small scale and tiny sectors of the economy. They will be working hard mostly to get maximum profits from their business.  (ii) Partnership: In this form of organization, the firm is owned and managed or controlled jointly by more than one person. All of them agree to share the profits of the firm. In fact, the sharing of profits is the basis for defining partnership according to the Indian Partnership Act. It is not necessary for the partners to own the capital jointly or to manage the firm jointly. The contribution of the partners in running the business need not be the same. The minimum number of partners is two and the upper limit is twenty as per Section 11 of the Indian Companies Act. The partnership is created by mutual consent and voluntary agreement. Registration of a business under partnership is essential under the Shops and Establishments Act in order to take legal help in enforcing the terms of agreement on the partners. The liability of the partners in the business will be unlimited. The limitation of the liability through mutual agreement is not possible legally under partnership. A variation of the partnership type of organization in India is the Joint Hindu Family business. The head of the family manages the business, other members help him. The profits are shared by all members of the family according to their share or contribution in the business. The family members are free to leave the joint business whenever they like to do so. This type of business continues, since after the death of the head of family anew head will take over to keep the business going. Registration of this type of business is not necessary. Joint ownership of the property is the basis for such an organization. The liability of the members of family except the head will be limited.

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There are many types of partnership depending upon their specific roles in business. There are 'active partners' who bring in capital and take active interest in the conduct of the business. There are 'sleeping partners' who bring in capital, share profit gains but do not take active interest in the conduct of the business. There is a category of partners which is called 'secret partners' being unknown to the public. There are 'nominal partners' who just lend their names and credit to the firm without contributing any capital or without any active interest in the business. In the eyes of the law such partners are equally responsible for the liabilities of the firm. A person who is not a partner actually but acts as a representative for a firm may be treated as a partner who is called as 'quasi-partner' or 'estoppelpartner'. Then there is a category of 'minor partner'. Such a partner does not share any personal liability of the firm. There is yet another category of partnership which is prevalent in Western countries which is called 'limited partnership'. In this case the liability of the partner will not be unlimited but limited. This helps in boosting the partnership organizational form without any danger of losing personal private property of the partner in the case of business losses. In India this type of partnership is not recognized by the law.  The advantages of the partnership are several, such as, ease of formation; larger financial resources; combined managerial abilities and judgment; flexibility and elasticity in operation; combination of management and ownership; mutual cooperation; protection of minority (in the sense of partnership) interests; secrecy in business and adequate credit availability because of unlimited liabilities of the partners. •  The disadvantages are: unlimited liabilities of each partner, risks from dishonest copartners, uncertain life, lesser public confidence, on-transferability or restricted transferability of the partners' interest in the business, and liability of the partner even after his retirement from the firm.  Like a sole-proprietorship the main motive of partnership firm will be profit maximization. This is clear since the very basis of defining partnership is the sharing of the profit. Survival in business may be looked upon as an alternative goal for such a firm.  ( iii)   J o i n t- Stock Com p ani e s or Cor p orations : This is the most important form of the business firm. It is popular all over the world. In India for example, there were 3,05,625 joint-stock companies at work as on 31st March 1994 employing over Rs. 1,04,891 crores of aggregate paid-up capital. A joint-stock

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company is a legal entity with a perpetual succession and a common seal. It is a voluntary association of certain persons formed to carry out a particular purpose in common. It is just like an artificial man created by the law whose 'life is independent of the lives of the members of its association. According to Chief Justice Marshall in Dartmouth College case in USA: "A corporation (i.e. a company) is an artificial being, invisible, intangible and existing only in contemplation of the law. Being a mere creation of law, it possesses only the properties which the charter of its creation confers upon it either expressly or as incidental to its very existence." The essential characteristics of a joint stock company are asFollows: 1. L ega l Ent i ty : As mentioned- above, a joint-stock company is created by the law. It is a legal entity distinct and independent of the existence of its members who own it. It is capable of holding property, making transactions and legal proceedings in its own 'name. It is the official seal and signatures that matter in the dealings of a joint-stock company.2. C or p o r a t e   Ex i s te n ce :  According to the law, the mode of incorporation and dissolution of the company and the rights of the members to transfer shares guarantee the existence of the company quite independent of the life and tenure of the members. It, therefore, enjoys perpetual succession.3. Co r pora t e   F in a n ce :  A joint-stock company raises basic capital for investment in the form of shares. The shares are purchased by the public who become owners of the company. The number of shareholders depends on the type of company. 4. C e n tr a li ze d   an d D e l eg at e d   M a n ag e m e nt :  A joint-stock company will be having a large number of shareholders. All of them cannot take active part in the management of the company. Actual control and management is therefore delegated by the shareholders to their elected representatives called directors. The directors are assisted by the executives who will be professional managers in their respective fields. All policy decisions are made at the directors' level but routine working decisions are left to the managers' discretions they, in fact, control the Whole business.5.  Tr a n sfe r a bi l it y   o f   Shar es : The shares of a joint-stock company are transferable. They can be sold and purchased just like a commodity, in the share or stock exchange market. Any member can thus withdraw from the ownership of the company and a new one takes his place.

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6.  Lar ge   Nu mb er   of   Me mb e r s : The number of shareholders of a joint stock company will be quite large except in one particular type (see below) where it is restricted to maximum of 50. The ownership of the company will thus be very much diffused or widespread. 7. L i m it ed   Li a bilit y :  The responsibility or liability of the members of a joint-stock company is limited to the extent of the nominal value of the shares held by them. The liability of the company as a whole of course remains unlimited. 8. S t a t u t ory   R eg ulat i ons and C on tr o ls:  In order to maintain certain uniformity of principles with regard to the management of the company, and to avoid clashes of interest in the administration as well as to protect the shareholders, a corporation will be under statutory control of the government. The law will regulate the company or corporation for the benefit of the public in general.9. Publicity   and Complian ce   to Various L eg al F o rmaliti e s : A joint stock company has to file a set of documents with the Registrar of Companies and publish them for the information of the public such as Memorandum and Articles of Association, Balance Sheet and Profit & Loss Accounts and Annual Reports.  A joint-stock company is different from a partnership organization on the ground of its mode of creation, legal status, number of shareholders, limited liability, transferability of shares, separation of ownership from the management and size of resources and business, auditing of accounts, and strict regulation by the law.  All joint-stock companies may be put in the following two categories: (1) Statutory Corporations, and (2) Registered under the Company Act. A company formed by a special Act passed by the Parliament or State Legislature is called statutory corporation. Such companies will be governed according to the provisions of the Act. The liability of the members of such a company will be limited but they may not use the word 'Ltd.' as part of their names. Few examples of such companies are Reserve Bank of India, Industrial Finance Corporation, State Bank of India, etc. The companies formed by registration under the Indian Companies Act (or similar Acts outside India) are called 'registered companies'. Such companies may be limited by shares or limited by guarantee or unlimited companies. In· the case of a company limited by shares the individual liability is determined on the basis of the nominal value of its shares. In the case of the company limited by guarantee, the liability of each member will be limited to the extent of commitment he has given or agreed. There  may not be any

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share capital in such a case. Such companies will be normally non-profit earning ones. In the third case the liability of each member remains unlimited but such companies do not exist in India.  All companies limited by shares may again be classified, as a 'private limited' company and as a 'public limited' company. A private limited company is one which by its Articles of Association (a) restricts the right of the members to transfer shares, (b) limits the number of members to fifty excluding past or present employees of the company, and (c) prohibits any invitation to the public to subscribe for its shares or debentures. Minimum number of shareholders for a private limited company is two.  A public limited company is one which has no restrictions as mentioned in the case of a private limited company. It will have a minimum of seven. Share -holders and the upper limit is open for any number. It has no binding for invitation to public for subscribing capital. Being open to public, a public limited company has to publish its Balance Sheet and Profit & Loss Accounts yearly along with the Annual Report. It will be under greater degree of legal control as compared to a private one. There is yet a third type of limited company. It is called 'Private Company Deemed to be Public'. A private limited company which holds 25 percent or more of the paid-up capital of a public limited company or 25 percent or more of whose paid-up capital is held by one or more public limited companies or whose average yearly turn-over is Q10re than five crore rupees is deemed to be a public limited company. Further, there is another classification of companies according to which a company is called 'Holding Company' if it holds more than fifty per cent of the issued and paid up capital of other company or if it has more than fifty per cent voting power, or by securing itself the right to appoint the majority of directors of the other company directly or indirectly. The other company is called 'Subsidiary Company'.In order to facilitate the choice of the company form, let us examine briefly the merits and demerits of the public and private limited Companies. A public limited company having large number of shareholders is preferable from the social point of view. It has diffused ownership pattern which is desirable from the point of view of wider participation in business and at the same time reduction in the concentration of wealth in society. It will be more democratic and open to the public scrutiny as compared to its counterpart of private company. The financial viability of such a company will be more because of larger number of shareholders which will provide greater scope for growth. States, normally, give

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more protection and help to such companies. The transferability of shares through stock-market mechanism is another big advantage of public limited Company from the point of view of valuation of shares. In the case of private company, there is rigidity in every aspect. That is, more or less, like a family business with corporate tag. Protection shareholders will be less in such a company. Decision-making will be of course, an advantage of the form. Personal touch will be more here as compared to the public limited companies where shareholders will be passive and the .business will be run by the managers. A private limited company may start its business quickly without waiting for the governmental clearance, but a public limited company has to get the certificate of commencement of business. Looking at the corporate picture in a country, both these types of companies are equally popular. Public limited companies are larger in size than the private ones in most of the industries.  There are advantages as well as disadvantages of the joint-stock companies. In the context of advantages, there is no controversy over the assertion that the growth of the corporate-sector (i.e. joint-stock companies) in modem economies has contributed a lot in fostering the commercial and industrial activities all over the world. The favourable points to which we can attribute the popularity of the joint-stock companies are as follows.1. Limited liability which reduces the risks in business from individual investors' point of view.2. Perpetual succession which guarantees continuity of business for longer period. The business will be more stable, durable and enduring3. Transferability of shares which secures freedom to withdraw from the business and to increase wealth through share price escalation without affecting the life of the company.4. Financial strength becomes stronger because of the contributions of shares from a large number of persons5. Centralized team management through board of directors ensures better decision-making.6. The scope for expansion improves due to better financial and managerial resources.7. Better confidence from the creditors as a result of better position of the company regarding its credit-worthiness.8. Democratic set-up with dispersion of business ownership and thus reduction in the concentration of wealth in society.

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9. Lesser burden of taxes as compared to the other forms of organization since being a corporate body it gets many concessions from taxation.10. Cheaper and better production because of large scale production with the use of modern technology which the company can afford11. Greater market power as a result of its size which helps in reduction of the uncertainties in business.Th ere are so m e   un fav ora b le   p o int s a l so:    1. Too much legal formalities right from the time of formation as. Well as in its day-to-day working. This may disturb toe normal working of the company.  2. Divorce between ownership and management. This is a serious limitation. The shareholders become passive and the control of the business goes in the hands of managers who may not care much about the interests of the owners. There is no guarantee that enterprises run by professional managers are more efficient than those managed by the owners. Few shareholders having greater number of shares at their credit may not care much about the minority shareholders. Promotion of frauds is possible under joint-stock system because of lack of control from the shareholders on its operation. Speculation in the stock exchange market about the company shares may spoil its goodwill in the goods market. 3. There may be considerable delays in the decision-making and their timely implementation because of administrative red-tapism.   Weighing the merits and demerits of the joint-stock companies the balance tilts towards the favourable side and that is why this system is gaining more and more popularity. In India, for example, every month about 400 to 500 new joint-stock companies come into existence.  (iv) Cooperative Society: A cooperative society is a form where people associate voluntarily for the furtherance of their common economic interest. Consumers' cooperative credit societies, cooperative farming societies, and housing cooperatives are some examples of this type of organizations. The basic motive of such societies is to provide maximum service to its members and not to make profits. There may be some surplus in profit form coming from the business but that is a secondary thing. Normally, cooperative societies are formed to protect the weaker section from the stronger one in the situation of scarcity of goods and services. All cooperative societies will be formed through

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voluntary association of the persons as members contributing their shares in the finances to run the business. Each member will have equal voting right. They will be highly localized and small in size. Whatever is the profit, it will be partly distributed as bonus to its members. Some fixed return on individual contribution of capital is assured by taking into account the opportunity cost of capital. Where individual contribution in the capital is very low, say one share of Rs. 10 or Rs. 20 or like that, nobody bothers about the return on that. All cooperatives will be non-political, non-religious bodies. They are registered under the Cooperative Act. Government will have control over their working and supervision; they are encouraged by the state and soThey get considerable help in this regard.  .  In the context of industrial economics, producers' cooperative societies are relevant for us. Such societies are formed by small producers to face the powerful capitalists. They may either work independently or pool their production for marketing through the cooperative or a producer member a re treated as employees and paid wages or salaries for their work. Whatever be the organization, the society does its best to supply the raw materials and tools, and take effective measures to sell the products at reasonable prices. Such producers' societies’ arc quite different from the joint-stock companies. They are small; localized, primarily established for protection of the member, but the joint-stock companies operate with some business motive. The shares of a producers' society cannot be transferred as in the case of a joint-stock company. The management will be different in both the cases. Both, of course, are democratic set-ups having considerable patronage from the state. Holding companies:Holding companies is the product of modern advancement in the field of industrial combination to cover the difficulties that have been experienced in the previous form of combination. When the trusts were declared illegal in U.S.A, they, in turn, gave rise to the formation of holding companies. If a company acquires a sufficient number of shares of another company so as to establish a controlling interest in the latter’s company, the company which acquires the controlling interest is known as a ‘holding company’ while the other is termed as a ’subsidiary company’. But at the same time the two companies continue their separate existence by retaining their original names and good will. The shares may be purchased directly in the open market or may be acquired by agreement with the share holders. Thus, a company

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acquires controlling interest in a number of companies may have further subsidiary companies. Both vertical and horizontal type of combination shall be possible at a high level under this method of combination.Holding companies can be categorized under different types. A.B. Company (Holding company) | Subsidiary company

M.N Co X.Y Co S.T.Co R.P Com (Intermediate holding company)

C.H. Co C. D. Co

In the diagram A.B.Company is not managed by any other company. So, we call it as ’parent holding company’. Where MN, XY, ST, RP, Companies are subsidiaries to it.XY and ST are termed as intermediate holding companies because there is no direct connection between AB Company and CD or CH Company, but still AB Company can control both the companies through XY Company and ST Company.In other words an intermediate holding company is one which holds the shares of other companies but it is a subsidiary company to another company. If the holding company acquires the shares of another company for the purpose of only investment and does not exercise its control on the subsidiary, it is called ‘pure holding company’.Even though holding companies and trusts are different in organisation, the functions of both of them are the same. But the degree of control is different from different angles. The holding company takes direct interest in the management of subsidiary companies whereas in the trust, the boards of trustees take interest in the management of different industrial units.In the case of trust the share holders have nothing to do with their companies because they have to transfer the shares to the trust and receive dividend directly from the company.Corporations:

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The bulk of economic activity in an advanced market economy takes place in private corporations. Centuries ago, corporate charters were awarded by special acts of the monarch or legislature. The British East India Company was a privileged corporation and as such it practically ruled India for more than a century. In the 19th century, railroads often had to spend as much money on getting a charter through the legislative as on preparing their roadbeds. Over the past century, laws have been passed that allow almost anyone the privilege of forming a corporation for almost any purpose.Today, a corporation is a form of business organisation chartered in one of the 50 states or abroad and owned by a number of individual stockholders. The corporation has a separate legal identity and indeed is a legal ‘person’ that may on its own behalf buy, sell, borrow money, produce goods and services and enter into contracts. In addition, the corporation enjoys the right of limited liability, where by each owner’s investment and financial exposure in the corporation is strictly limited to a specified amount.The central features of modern corporations are the as follows:1. The ownership of a corporation is determined by the ownership of the company’s common stock. If you own 10% of a company’s share, you have 10% of the ownership. Publicly owned corporations are valued on stock exchanges like New York Stock Exchange, Bombay stock exchange. It is in such stock markets that the titles to the largest corporations are traded and that much of the nation’s risk capital is raised and invested.2. In principle, the share holders control the companies they own. They collect of the dividends in proportion to the fraction of the shares they own. They elect directors and vote on many important issues. But the shareholders do not have a significant role in running giant corporations; exercise virtually no control because they are too dispersed to overrule the entrenched managers.3. The corporation managers and directors have the legal power to make decisions for the corporation. They decide what to produce and how to produce it. They negotiate with labour unions and decide whether to sell the firm if another firm wishes to take it over. When a newspaper announces that a firm has laid-off 20,000 workers, this decision was made by the managers. The share holders own the corporation, but the managers run it.Advantages and disadvantages of a corporation:A corporation is a legal person that can conduct business. The corporation may have perpetual succession or existence, regardless of how many times the shares of

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stock changes hands. Corporations are hardly little democracies, so their managers can make decisions quickly, and often ruthlessly, which is in stark contrast to the way economic decisions are made by the legislatures.In addition, corporate stockholders enjoy limited liability, which protects them from incurring the debts or losses of the corporation beyond their initial contribution. If we buy $1000 of stock we cannot lose more than our original investment.Corporations face one major disadvantages, the government levies an extra tax on corporate profits. For an unincorporated business any income after expenses is taxed as ordinary personal income. The large corporation is treated differently, in the sense that some of its income is doubly taxed.First as corporate profits and then as individual income on dividends.Sometimes, corporations undertake actions that provoke public outrage and government actions. In the late 19th century, corporations engaged in fraud, price-fixing, and bribery, which led to enactment of anti-trust and securities fraud legislation. In the last few years, corporate scandals erupted when it was discovered that some companies engaged in massive accounting fraud and many corporate executives feathered their nests with huge bonuses and stock options. In private and in public life, power sometimes corrupts.Efficient production often requires large-scale enterprises, which need billions of dollars of invested capital. Corporations with limited liability and a convenient management structure, can attract large supplies of private capital produce a variety of related products and pool investor’s risks.

THE CHOICE OF THE ORGANIZATIONAL FORMWe have discussed so far the types of organizational forms for a business firm. Each type, as we have seen, gets opportunities as well as constraints from the legal, financial and economic sides. It is important, therefore, for an individual investor to analyze the implications of these opportunities and constraints so that an appropriate choice of the type of organizational form can be made which will enable him to get the maximum gain from the business. There is no one single criterion on the basis of which the choice can be made. If one is interested in ownership and control of business by himself then the sole proprietorship is the best and the public limited company is unsuitable because of the complete divorce between ownership and management. Suppose one is interested in minimizing the business risk, then sole proprietorship is at a disadvantage because of unlimited

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liability as compared to a public company where individual liability is limited. From the ease of formation and legal requirements, the sequence for favorability is sole-proprietorship to public limited company, but, from the financial strength, we get the opposite picture, i.e. public company to the sole proprietorship. Taxation may be taken as an important determinant of the organizational form. A public limited company may get maximum tax advantages from individual shareholder's point of view as compared to a private company or a partnership or a sole proprietor. However, the sole proprietor as well as the partnership being small business may get some benefit of doubt. Nothing can be said with confidence on this point. The tax provisions are to be studied first and then judged with respect to the organizational forms of the business for the choice. About the business prospects or profitability in the different types of organization there is no a priori criterion for judgment. It all depends on the managerial efficiency together with the market opportunities available.One may argue that the whole question of choice is closely related to the objectives of the owners. Generally, one begins his business with a simpler form of organization such as sole proprietorship or partnership and moves to the more complex forms when his economic position allows him. However, we cannot take this proposition as always valid. Many businessmen jumped directly to a large private or public limited company form of organization without going through the earlier ones. One thing is clear now-a-days: the modern technology has paved the way for large scale production of many goods and services. Such things cannot be taken up by a sole proprietor or even few partners. The only possibility for their manufacturing is the joint-stock company because of the financial, managerial and technological complexities. A public sector company or corporation is the alternative choice of the form for them. You may say, at the end, that the choice of organizational form is very much a personal issue. No specific guidelines can be laid down for this. The individual investor will be balancing the institutional requirements, economic opportunities, and risk and uncertainty factors in his own perspective of the business.

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