Type: Research Essays
Sample donated: Marlene Lowe
Last updated: April 15, 2019
We assumed that the firm’s primary objective is to maximize profit. This assumption underlies the competitive environment, which we mapped out using the frameworks of the perfect competition, monopoly, monopolistic competition and oligopoly market models, and which allowed us to establish benchmarks for the analysis and comparison of price-output decisions under different market structures. This approach, often referred to as the traditional (or ‘neoclassical’) approach, can readily be criticized, however, on the grounds that it does not provide a satisfactory explanation of real-world production and pricing decisions.By assuming away many complexities, the simplistic assumption of profit maximization enables us to make very clear-cut predictions about the firm’s behaviour However, it is one thing to make predictions, but another to say how realistic they are or how accurate they are.
The traditional theory of the firm seems to be at its best when analyzing behaviour in perfectly competitive and monopoly market structures. In practice, however, these theoretical extremes are rarely to be found – in reality most firms are confronted with market conditions, which are more readily described as imperfectly competitive with oligopoly being the dominant market form. This is not to say that we should dismiss the analysis presented in the previous chapter – on the contrary, it is essential to the development of a deeper understanding of the fundamental relationships between pricing and production decisions.Most economists sympathize with the defence of the profit maximization assumption, recognizing its usefulness as a mental, theoretical link to explaining how one gets from the ’cause to the effect’. The market models reviewed in the last topics were developed to predict, not describe, behaviour in markets.
Since the 195Os, however, a collection of new, alternative theories of corporate behaviour has been put forward. The purpose of this chapter is to review these theories and to assess their merits in terms of realism alongside the traditional approach. We shall consider these new theories under the following three basic headings:* Agency theory.* Managerial theories.* Behavioural theories.
A fourth area of development has already been discussed last week in the study of oligopoly. There we introduced the concept of ‘game theory’, which represents a major development in understanding real-world corporate behaviourThe new theories which we shall discuss below stem, in the main, from abandoning one or both of the following assumptions which are central to the traditional approach, namely that:* decisions are made under conditions of perfect knowledge; and* the objective of the firm is to maximize profits.There are four main reasons which, can be offered as justification for abandoning these two assumptions. These relate to the following:* The growth in oligopoly;* The growth of managerial capitalism;* Difficulties surrounding profit maximization in practice; and* The organizational complexity of firms.
Before examining the alternative theories of corporate behaviour listed above we shall briefly discuss the significance of each of these developments in turn.As mentioned above, oligopoly is the most common form of market structure in reality and yet it is the structure to which the traditional assumptions fit least well. Empirical evidence of the growing importance of oligopoly can be found by measuring the degree of concentration across industries using the method outlined in topic 4. When an industry is concentrated, but not a monopoly, it displays the characteristics of oligopoly.
Empirical studies of a number of countries have shown a general trend across many industries towards this type of market structure throughout the last century.There are two reasons why the traditional theory of the firm, based on the assumptions of perfect knowledge and profit-maximizing behaviour, fails to provide a satisfactory explanation of market behaviour under oligopoly. These concern:1. the extent to which firms are interdependent; and2.
the degree of uncertainty that exists in oligopolistic markets.These issues have already been fully discussed last week. Briefly, mutual interdependence arises in oligopoly because each firm produces a sufficiently large proportion of the industry’s total output for its behaviour to affect the market share of its competitors. Uncertainty arises because the behaviour of one firm is conditioned not just by what its rivals are doing but also by what it thinks its rivals might do in response to any initiative of its own.
Uncertainty and interdependence are best tackled through a game theory approach to market behaviourThe traditional assumption of profit maximization implies that the ‘firm’ somehow has a mind of its own, capable of arriving at independent, rational decisions. In reality, of course, firms do not make any decisions – it is entrepreneurs and managers (i.e.
individuals) who make business decisions. A ‘firm’ is nothing more than an abstract concept covering owners, managers and employees.Over time, the relationship between ownership and control in firms has changed substantially In their earliest form business units or firms were owned and managed by the same people, therefore the assumption of profit maximization did not seem unreasonable. Over time, however, with the growth of large corporations and the dominance of public joint-stock companies, there has emerged a separation of ownership from control. Ownership is in the hands of shareholders who may or may not exercise their voting rights at board meetings. Control, however, is largely in the hands of the managers and directors of the firm. This situation is described as managerial capitalism and has given rise to ‘managerial theories’ to explain the behaviour of firms (see later).
With managers in control it is easy to question the validity of the profit maximization assumption of the traditional theory. Some managers may seek to keep shareholders happy by reporting a certain level of profit while leaving themselves the flexibility to achieve, perhaps personal, objectives (such as business growth, diversification, salary, etc.).
Even if profit maximization is stated as the key objective of the firm as a whole, it is unlikely that every individual within the firm, even within senior management, will be pursuing this objective consistently.There appears, therefore, to be a potential division between the goal of shareholders and the goal of management in the real world. Recently this issue has been approached through agency theory.In practice, businesses may have insufficient accurate information about demand and cost conditions to be able to use the concepts of marginal revenue and marginal cost as the basis for determining the profit-maximizing output. Pricing policies are often determined by other methods, such as on the basis of a mark-up over average unit costs subject to the achievement of a ‘required’ profit margin. As much of the output as possible, will then be sold on the market at this price.Other price guidelines may be followed for different firms in different industries. For example, over the years, two basic-pricing guidelines for state industries have emerged: marginal-cost pricing, and mark-up pricing to achieve a target rate of return.
Full details of these and other pricing policies are given later on. The key point to note here, however, is that the traditional theory of the firm does not provide a particularly useful framework for analyzing the behaviour of state firms.A final reason for questioning the validity of the traditional approach to understanding the behaviour of firms relates to the changing organizational structure of firms. As with the growth of managerial capitalism, this reflects the fact that as firms have increased in size, so too they have become much more complex in terms of their organizational structure. This structure will reflect the often conflicting views of owners, managers, workers and consumers.
Within each grouping there will be still more complex structures: perhaps different categories of shareholders with different share holdings who are interested in different objectives (short-term versus long-term profits perhaps); different managers at different levels with different aims and aspirations; blue-collar workers and white-collar workers with different career expectations and reward packages, perhaps represented by different unions; finally, there will be different groups of consumers to be satisfied (such as the one-off customer versus the long-term, loyal customer).Given the degree of complexity of organizational structures today, some economists argue that it is unlikely that a useful theory of business decisions can be based on a single objective and that instead the subject should be approached through a study of the behaviour of individuals or groups within the firm. Also, it is held that such an approach should start from the position that people in firms, including managers, do not aim to maximize anything they simply aim to ‘satisfy’ a range of objectives. This ‘behavioural’ approach to the firm will be discussed later.
In summary, therefore, the traditional theory of profit maximization as illustrated in various market models may be criticized because:* it is not readily applicable to oligopoly situations;* it is no longer appropriate in today’s environment, where managerial capitalism has taken over from entrepreneurial capitalism and where control has become divorced from ownership;* pricing policies in practice may bear little obvious resemblance to those suggested by the MR = MC principle; and* the complexity of organizational structures today calls into question some of the basic assumptions of the traditional theory.We turn now to discuss some developments that have taken place in the analysis of the behaviour of firms, starting with the concept of agency theory referred to already. This theory recognizes the growth in managerial capitalism and the complexity of modern organizational structures.In many areas of economic activity, people carry out transactions on behalf of others.
That is to say, principals appoint agents to undertake economic transactions on their behalf.The broad thrust of agency theory as a basis for understanding the behaviour of firms is summarized in Figure 1 below which shows the agent-principal relationships that exist in the private and public sectors. In the private sector, the principals are those who ultimately have the rights to the assets or who ‘own’ the firm. in joint-stock companies these are the shareholders and they appoint directors as agents to manage these assets on their behalf.
In theory, the directors should manage the assets in the interests of the principals but in practice this cannot be guaranteed. In practice, therefore, the agent-principal relationship may involve costs in terms of lower efficiency. This is likely to mean that the principals face costs, not least in terms of the time and effort involved in monitoring the work of their agents.Figure 1 The agent-principal relationship: private V. public sectorThere are, however, ‘control mechanisms’ in the private sector.
Shareholders may attend meetings with management and, in particular, company annual general meetings to question and, if necessary, replace the directors. Perhaps more importantly, the shareholders can exercise their right to sell their share holdings altogether Many economists argue that the existence of such a control mechanism acts as a major constraint on private sector management. If management pursues a quiet life or other objectives, which reduce profitability, then shareholders can react by disposing of their hares.
This will tend to drive down the share price, making the company vulnerable to a takeover by new management.On the other hand, some economists question the significance of shareholder power, arguing instead that shareholders are fairly inert to management performance. Most shareholders rarely attend annual general meetings and the existence of transactions costs and capital gains taxation may reinforce a tendency to hold onto shares in the hope that things will get better. If things do get better those who have held on to their shares, benefit and this produces a ‘free rider’ problem.
Shareholders may be reluctant to sell, hoping, however, that other shareholders do sell. Further, it is not obvious that it is necessarily the less profitable firms, which succumb a takeover. Sometimes what appear to be profitable, well-managed firms face hostile takeover bids.Figure 1 also illustrates the agent-principal relationship, which exists in he public sector. In this case, civil servants and public boards manage industries and services on behalf of the public.
Since there are no shares to sell or annual general meetings to attend, the public are unable to indicate directly dissatisfaction with management performance. Voters can express their views on government performance through the ballot box, but this is a crude indicator of satisfaction and dissatisfaction with particular state activities (such as the postal service, police, education, etc.). Votes reflect broad manifesto pledges and not, usually, views about the quality of service from one particular public industry or state sector. For this reason there appears to be greater scope for managerial discretionary behaviour by management in the public sector compared with the private sector. Consequently, there may be a tendency for production costs in the public sector to be higher than in the private sector – an important rationale for the worldwide privatization programme of the 1990s.
Figure 2 Impact of inefficiency on average costA further constraint on managerial discretionary behaviour relates to the product market. Firms, whether private or public sector (unless backed by considerable taxpayers’ funds), must be efficient to survive in competitive markets. Any inefficiency, which leads to higher prices will be penalized through a loss of market share and eventual bankruptcy. This constraint is illustrated in Figure 2, which shows two average cost curves. Assume that the curve AC1 applies to the firm when it is fully efficient and that AC2, being higher, reflects inefficiency.
If the firm was earning only normal profits when operating with the curve AC1, then when costs rise to AC2 losses will be incurred. As a general rule we can conclude, therefore, that non-profit goals which raise costs are likely to be more prevalent in firms operating where product market competition is imperfect (since if the market was perfectly competitive the firm would not be able to afford the luxury of non-profit goals).Once we acknowledge that managers in the private and perhaps more especially in the public sector are able, to some degree, to pursue their own goals rather than that of profit maximization, the question arises as to what are these goals and what is the effect on prices and outputs. We shall consider the following three possible goals:1.
Sales revenue maximization.2. Managerial utility maximization.
3. Corporate growth maximization.The common feature of the underlying models concerned with these goals is that they each reject the simple profit maximization assumption, replacing it with an alternative target which management aims to achieve.
These targets stem from the study of what motivates different managers where there is a separation of the ownership from the management (control) function, i.e. an agency relationship, which leaves managers with some degree of freedom to pursue non-profit goals, at least in the short term.The idea of sales revenue maximization as a management goal was first put forward by William Baumol in 1959. The argument is based on Baumol’s own research into managerial behaviour and is couched in terms of oligopolistic industry, in which there is a divorce of ownership and management of resources.
Baumol argues that managers are likely to attach a great importance to achieving high sales revenues for the following reasons:1. High and expanding sales revenues help to attract external finance to the firm – larger firms generally find it easier to raise capital, while financial institutions may be less willing to deal with a firm suffering from declining sales.2. High sales assist the distribution and retailing of products – resulting in economies from selling in bulk.3.
Consumers may view a firm with falling sales in a less favourable light this may deter consumers from buying and reduce sales even further.4. The distributive trade may be less co-operative, for example to extend credit lines, when a firm’s sales are declining.5. Falling sales may result in reductions in staffing levels, including managerial staff, as costs are cut.6. Last, but not least, managers’ salaries may well depend on fast growth of sales revenues – managers are rewarded for expanding the business.Baumol’s theory does not ignore profit altogether but is presented in terms of sales revenue maximization subject to a minimum profit constraint.
As long as this constraint is met, based on the assumption that this will be sufficient to pacify shareholders, the firm’s management will aim to maximize sales revenues. The needs of shareholders cannot be ignored but the minimum profit constraint will usually be less than the maximum profit feasible. Presumably this will especially hold true where shareholders do not know what is the maximum profit that could conceivably be achieved. Lack of information on the part of shareholders may lead them to accept the reported profit. We might expect this to be most prevalent where there are no competitor firms reporting profits to facilitate comparisons.Figure 3 illustrates the principles of the sales revenue maximization model where the total revenue (TR) and total cost (TC) curves are drawn for a typical firm.
The curve ‘ef’ shows the total profit or loss and is derived from the TR and TC curves for each level of sales. It will be seen that the output, which maximizes profit is q3, i.e.
where the vertical distance between TR and TC is at its greatest. At outputs q1 and q6 TR = TC and therefore profit is zero. To the left of q1 and to the right of q6, TR is less than TC and therefore losses are being made.Figure 3 Sales revenue maximizationIn the absence of a minimum profit constraint, management could pursue sales revenues by expanding output to q5 where TR is at its maximum (the firm would not wish to increase output beyond this point because total revenue would fall). With the imposition of a minimum profit constraint, such as a level X as shown in Figure 3, sales can now only be expanded up to q4. Expansion beyond this point would lead to a reduction in total profits below the minimum level considered acceptable to shareholders (note that the profit constraint is also met at output q2 but since output q4 provides a higher level of sales revenue, a sales revenue-maximizing management would not choose q2 over q4).
With the pursuit of sales revenue constrained by the required profit level, any increase in this level (shifting the profit constraint line at X upwards) would lead to a reduction in output, whereas any reduction in the required profit would lead to an expansion in output. Note that only if the profit constraint line passes through point A would production be at the level to maximize profits. From this model we can conclude that, in contrast to management which attempts to profit-maximize, a sales revenue-maximizing management will tend to:* Produce at a higher output level.* Set prices lower (since given a normal downward sloping demand curve a higher output can only be sold at a lower price).
* Invest more heavily in measures that boost demand, such as advertising (to increase demand without reducing price).In later formulations of his model Baumol substituted as the objective of management the maximization of the growth of the firm for the maximization of sales revenue. The two goals are, of course, related, though growth maximization is a more dynamic concept. Also, whereas in the sales revenue maximization model the profit constraint could be at any level (whatever keeps the shareholders happy), in the growth model it is set by the ‘means for obtaining capital needed to finance expansion plans’, i.e. by the need to attract finance for investment.
The ‘optimal profit stream’ is that which is consistent with raising adequate investment funds to achieve the highest rate of growth of output over the firm’s lifetime.Baumol’s model outlined above implies that management has some choice in the trade-off between profit and sales revenue in business decision making. This recognition has led to the development of other models, which explain firms’ behaviour in terms of managerial discretion. An important approach developed by the American economist Oliver Williamson in the 1960s, indicated that managers in large firms have enough discretion to pursue those policies, which give them personally most satisfaction. Whereas shareholders are assumed to equate their level of satisfaction (i.e. ‘utility’) with profit management is considered to have a utility function, which includes a number of personal goals and personal measures of ‘wellbeing’. These goals may include the achievement of a plush office, a large company car, a high salary, etc.
In fact, the goal of sales revenue maximization could even be interpreted as a special case where that single goal dominates all other managerial goals or is even the means by which the other managerial goals are realized.Williamson’s model makes allowance for markets not being perfectly competitive and for the agent-principal relationship in firms described by Figure 1. He suggests that managers’ self-interest could be seen in terms of the achievement of goals in four particular areas, namely:1. High salaries.
This includes not just take-home pay but also all other forms of monetary income such as bonuses and share options. The desire for large salaries reflects a desire for a high standard of living, and a high status.2. Staff under their control.
This refers to both the number and quality of subordinate staff as a measure of status and a measure of power (reflecting the ‘I hire them, I fire them’ type of management philosophy).3. Discretionary investment expenditure. This does not refer to investment that is essential for the success of the firm but rather to any investment over and above this amount. This includes any pet projects of the management that are excused as necessary to the general development of the firm (such as sponsorship, say, of Formula One motor racing in the case of a petrol company). The manager may be able to further his or her own personal interests and hobbies (sponsoring staff golf outings, for example).
The extent of the manager’s authority over discretionary expenditure may be taken as an indication of his or her status.4. Fringe benefits. Managers might strive for an expense account, a lavishly furnished office, a company car, free club memberships, etc. These perks may be part of the ‘slack’ in the organization – i.e.
non-essential expenditures that force up the firm’s costs.Williamson expresses these goals in terms of a utility function. Believing that the first two goals (concerning salaries and staff) are closely related, he combines them under the symbol S. Discretionary investment is represented by 1d while M represents expenditure on managerial perks.
Using U to denote utility, which the manager seeks to maximize, Williamson presents the following managerial utility function:U=f(S, Id, M)Profits are not ignored by Williamson and like Baumol, he recognizes that a minimum profit must be paid to shareholders but argues that managers will strive to increase their utility as long as this profit constraint is being satisfied. Equally, however, it is possible to conceive of management desiring higher profits because they derive satisfaction from business achievement. Profitability is a measure of business success and buoyant profits provide a fertile environment in which managers can then pursue other goals.The third and final variation of the managerial theory of firms’ behaviour, which we present here also sees managerial motivation in terms of striving to maximize a target.
This time the target is growth. The model is associated with the work of the economist Robin Marris in the 1960s. Again, competition is assumed to be limited, with ownership divorced from management so that there is scope for managerial discretionary behaviour.
This theory stems from Marris’s view of the institutional framework and organization of the modern corporation. He sees the firm as typically a bureaucratic organization – a self-perpetuating structure where corporate growth and the security that it brings is seen as a desirable end in itself. Managers are expected to see a relationship between the growth of the company and hence profits ploughed back into investment, and their own personal goals (such as increased status, power and salary). At the same time, managers are expected to balance growth against the impact on profits and dividends – they must beware of the danger of low dividends depressing share prices, which may leave the firm vulnerable to a hostile takeover bid.
Therefore, growth and security compete as objectives and each requires a different approach to risk in terms of investment and capital raising.In particular, there may be a trade-off between securing profits to pay dividends and taking risks when investing to increase the growth of the firm. At the same time, while profits provide the retained earnings to help finance new investment, which leads to growth, excessive company liquidity may attract predators. Cash-rich companies attract takeover bids.
In the Marris’s model this conflict is summarized as management seeking the optimal dividend-to-profit retention ratio.