Neoclassical Economics

But what can shareholders do to mitigate, Baumol's suggestion that management controlled firms will wish to maximize sales revenue was based on the belief that the earnings of executives are more closely related to firm revenue than to firm profits ?

"Constrained" sales maximization...

Behavioural Model [2] : Simon, Herbert

Argues that the overriding objective of the firm is survival rather than maximization of profits or sales... Survival is achieve if the performance of the firm is satisfactory and satisfies the various interest groups in the firms including the owners.. Uses the term "satisficing"...the firms learns hence there are revised targets rather than a prime objective..

Sales revenue maximization

Banks and other financial institutions are more willing to finance firms with large and growing sales. Personnel problems can be handled more satisfactorily...(e.g. If sales are good and growing, employees at all levels can be given higher earnings and better terms in general) Large sales give prestige to the managers while large profits go to the shareholders. Large and growing sales strengthen the power to adopt competitive strategies and tactics

Marris's growth maximization theory and Baumol's sales maximization

Both models are "managerial school" of thought - managers deviate from profit max. to pursue their own utility! Demand for product is maximise in both models with Baumol measuring growth of demand in terms of the change sales revenue while Marris - in terms of diversification rate. Both models also determine the level of profits to finance the optimal rate of growth (or sales)..both recognise the role of profits linking to financing growth (e.g. need money to ensure the necessary equipment for sales max..)

Other Theories: "Satisficing"

Achieving a satisfactory level of profits or a satisfactory level of revenue or a satisfactory level of growth..

"principal-agent problem"

The agents (managers) may not always act in the manner desired by the principal. Profit maximizing [4]

Criticisms of profit-maximizing theories assumption [2]

1. Other more important objectives besides Profits. 2. No single objective may be maximized. 3. Marginalism is a poor description of the processes used by businesses to decide on price and output 4. Profit is a residual and its outcome is uncertain 5. Issue of time: producers may trade off short term profits for long term gains! Strategic moves? 6. Organization is usually complex - single goal not realistic!

Organization theories

theories of 'statisficing', portfolio planning theories, contingency theories or and so on. Portfolio theory differ from traditional theory of the firm : it's more about investors rather than manufacturing firms. Concerned about uncertainty faced by agents in decision making (not acknowledged in the neoclassical theory of the firm as producer in competitive firms assumed to know the prices). Diversification to reduce uncertainty risks. Investors select portfolio of securities.

Some criticisms on Baumol's sales maximization theory [1]

Cannot be tested against competing behavioral hypotheses unless the demand and cost functions of firms are known but these data are seldom disclosed.... Does not explain how equilibrium in the industry is attained if all firms are sales maximizers. Assumes that firms has market power hence it has control over price and expansion policies.

Behavioural Model : Cyert and March [3]

Identifies the various groups or coalitions which exist within the firm, defining a coalition as any group that shares a consensus on the goals to be pursued... The firm is seen as a collection of interest groups or stakeholders, each may be able to influence the set of objectives eventually agreed.. The agreed goals for the firm are the outcome of the "bargaining between the groups".... Identified areas of activity within the firm where objectives have to be set: production, stocks, sales and market share.. To achieve an agreed set of goals for each of the above categories the various groups need to resolve any disagreements about appropriate specifications...Differences can be resolved by : payment of money or side payments

Profit Maximizing Rule

In short, when Marginal Revenue (MR) = Marginal Cost (MC) Marginal Concepts in Marginal revenue (MR) = The increase in revenue by producing (and selling) one more unit of output Marginal cost (MC) = the cost incurred by producing one more unit of output Profit-maximizing (MR=MC)

Corporate social responsible Arguments in favour of this

Long run greater profits - winning by integrity. By keeping in line with ethical, social and cultural norms, workers, customers and suppliers happy - better reputation and hence profitability. Avoidance of government regulation

Growth Maximization (2)

Marris (1964), sees growth as a separate and main goal of the firm. Funds to be retained rather than distributed back to shareholders.... The retained profits could be used to fuel greater growth and hence leading to higher share prices.. ??

Some criticisms on Baumol's sales maximization theory [2]

Rules out interdependencies...with other firms' decisions. Oligopoly and game theory strategies? Sometimes a firm's decision is based on what it perceives others will do! Also ignores potential competitors which could affect their discretion in expanding sales.... Even if the company want to maximize sales, its ability may be hampered by presence of intense competition from other firms!

Sales revenue maximization

Sales may be a more useful target because it is measurable and can be used to motivate staff. Rewards for senior (top) managers tied to revenue of firm. Assumption that increases in revenue more than offsets increases in costs hence the former is usually seen as increasing profits by shareholders (owners) Finally, increasing sales is seen as "doing well"

Criticisms of profit-maximizing theories

Shipley (1981) studied a sample of 728 UK firms and found that only 15.9% of responding firms were "true" profit maximizers. Hornby (1995), from a sample of 74 Scottish companies found that only 24.7% of them can be regarded as "true" profit maximizers.

What is the manager's Utility function?

Sometimes referred to as the principal agent problem (see Lectures 4, 5) problem. Managers more interested in maximizing their own benefits rather the principal's (owner's or shareholders') interest. This problem can be mitigated by tying the manager's compensation with the performance of the firm ( i.e. pay for performance) Model (3) Managers maximize their own utility function..(salary, number of staff, fringe benefits, discretionary investments which allows managers to pursue own favoured projects) Discretionary expenditure or "managerial slack". These expenditures reduce firms' profits but such expenditures may still be afforded if actual profits is still higher than the minimum profits needed to keep shareholder (owners) happy! Model (4) Discretionary profits (difference between actual and minimum profits needed to keep owners happy) will be used to increase the managers' benefits (utilities)... A profit maximizing firm firm would have no managerial slack since costs are minimised and profits maximized.

The Behavioural Theory of the Firm

The interaction of various groups could influence a firm's objective. The complexity of large modern enterprises mean that the firm is made up of a number of separate groups, each responsible for a particular aspect of the firm's activities but each has its own objectives... The overall strategy is based on the conflicting objectives of these groups and the processes used to achieve an agreed position.

Managerial Economics

(Other theories of the firm - e.g. "Sales" Maximization, "Growth" Maximization and so on) owner is not the manager of the firm - principal agent problem. Need to align the interests of the employees with the interest of the firm. The owner and the manager may not necessarily share the same goal hence decision-making by managers may not necessarily reflect profit maximizing motives

Neoclassical Economics

(production theory of the firm, efficient use of capital and labour, K,L) vs Managerial Economics (e.g. Behavioural Theories of the firm; "Satisficing" rather than "maximizing"??) firms are profit maximizers (owner = manager of the firm; no agency problems no principal agent problem) Firms are holistic entities that are only interested in maximizing profit

Non-maximizing theories

1. Businessmen may not understand the marginal concepts. 2. Business calculations are cruder than assumed by profit maximizing theories 3. Imperfect information by firms may render profit-maximization decisions impossible.

Some basic weaknesses of managerial theories

1. Fail to explain interdependencies in decision-making (e.g. like in an oligopoly setting) both in terms of price and non-price issues. 2. The assumption that firms have unlimited power to create demand

Does growth maximization benefits both the managers and the shareholders (owners)?

1. For the managers (want growth in demand): status, power, reduced potential takeover threat... 2. For the shareholders (want growth in capital) : better returns? Better share prices? Better dividends? Better shareholders' wealth??

To achieve profit maximizing, firms have 2 choices

1. Given a level of budget (cost), it will try to maximize production (output)... 2. To try to produce a given output at the minimum level of cost....

Managerial Theories of the Firm & Other theories

1. Growth Maximization Managerial 2. Sales revenue maximization theories of 3. Managerial utility maximization the firm Others... 4. corporate social responsibility (CSR)

Defence of Profit-maximizing theories

1. If there is competition, profits may be the only way to survive thus even if the manager is NOT the owner, his priority may still be trying to do the best for the company for his own sake... 2. Pressure from shareholders will force the managers to match the performance of rivals... 3. Unless the firm is making a reasonable level of profits, it may find that raising capital may be tricky..

Why firms "satisfies"?

1. Issue of bounded rationality (Simon, H) 2. The firm may have more than one single objective function. Why? Many parties involved in a firm and its decisions..... [look at the topic on "Behavioural Theory of the Firm" in lecture 6]

Why CSR?

1. Long run revenue profits (winning by integrity) 2. Keeping stakeholders (e.g. suppliers, customers, workers) happy? 3. Regulatory issues - avoidance of costly governmental control may be an incentive to be CSR. 4. Adopting CSR strategies may also be a fist-mover advantage as well. Why?

usefulness of the Neoclassical theory of the Firm

1. The neoclassical firm is a good positive model of how firms act. 2. Firms that profit maximize will drive out firms that don't by a process of natural selection. 3. Managers are pressured to profit maximize because they will be fired if they do not and when their firm are taken over by a corporate raider. 4. Pressure from shareholders will force the managers to match the performance of rivals... 5. Unless the firm is making a reasonable level of profits, it may find that raising capital may be tricky. 6. Owners (shareholders) of a firm are interested in profit maximization and can create incentives to ensure managers profit maximize

Discretion investments

= gives satisfaction to mgrs because it allows them to materialise personal favourite projects..self-fulfillment

Staff expenditures

= if increase, in the form of increase in staff can be equivalent to promotion since they increase the range of activity and control of managers over resources.. Being head of a large staff is a symbol of power, prestige and status as well as a measure of professional success.....

Managerial emoluments

= managers' prestige, power and status..(slacks that are received in the form of luxurious office, expense accounts, company cars..etc). They are discretionary expenditures made possible by the strategic position of the managers....

Growth Maximization (1)

Meanwhile, Marris (1964), believes that owners and managers have a common goal ---- that is "growth maximization". Managers seek a growth in demand for the firm's products (services), to raise power or status.. Note: Marris emphasized that it is the "rate of growth" rather than the absolute size that managers are trying to maximize.... Refers to diversification rate - in the context of product differentiation.

Williamson's Managerial Utility Model

Model (1) Introduced a model of management utility maximization --- with the advent of the modern corporation with results in the separation of the owners and the managers, managers are more interested in maximizing their utility. Managers have some discretion in pursuing policies to maximize their own utilities.. Utility to managers : Compensation (salaries, fringe benefits, stock options etc...), the size of their staff, extend to control over the corporation , lavish offices ....

Contingency theory of organization:

No universal or best way to manage an organisation. Design of the organization must "fit" with the environment. Environmental factors (e.g. economic condition, demographic trend, political factors, legal factors etc..) and other factors (like supplier variables, industry structure variables, competitor variables, market and consumer behaviour variables, organizational characteristics and resources) will affect business strategies.

Corporate Social Responsibility (CSR)

The notion of corporate social responsibility (CSR) can be defined as the extent to which firms serve social needs rather than those of shareholders

managerial utility

a managerial utility firm will and may have to respond to economic changes by increasing or reducing discretionary expenditures.... Hence, an increase in demand will not only increased actual profits but also increase discretionary expenditures... A reduction in demand will reduce actual profits but may not reduce reported profits to the same extent because discretionary expenditure is reduced. Hence firms can make cost reductions in times of declining profits opportunities without hindering the operations of the firm (Williamson, 1964)......

Constrained sales revenue maximization theory

both Baumol and Williamson Since maximization of sales revenue is usually considered to occur at output well above the level that maximizes profits, the shareholders may demand at least a certain level of distributed profits, so that sales revenue can only be maximised subject to this constraint, i.e. constraint sales max.

Sales Maximization

could be going after the market share. Increase in market share is an important objective by business strategists.....[note: sales maximization is more likely to increase market share than profits..] Baumol (1959) suggested that the manager controlled firm is likely to have sales revenue maximization as its main goal rather than the profit maximization goal that is favoured by shareholders (owners of the firm).

Other theories of the firm [4] Behavioral theory of the firm

firm seek to make "satisfactory" profits. Firms seek to achieve satisfactory levels on a number of different objectives rather than just concentrating on profit maximization.

Neoclassical Microeconomics

firms are assumed to be profit maximizers.

Evolutionary theory of the firm

organizations follow their "routines" and are resistant to change. Evolutionary perspectives direct our attention to the development of organizational forms in their interaction with the environment. Successful routines will survived the environmental selection process.