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In recent years, new theories of the firm have been developed which emphasize the role of managers and their behavioural patterns in establishing price and output under oligopolistic market conditions. Generally, the managers do not try to maximize profits but they pursue other goals.
Whether, the firm try to maximize profits also depend upon who controls the business conducted by them. In case of sole trader and partnership, it is the owners themselves who take price and output decisions and perform other entrepreneurial functions.
In the case of joint stock companies or corporations, there is a separation between ownership and management. It is the shareholders who are the owners of a joint stock company and bear the risks of business. But price and output decisions are taken by the hired managers who are not the owners of the business. Under these conditions, profits of the business go to the shareholders to the mangers salaries are paid while.
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The owner-entrepreneurs of sole trader and partnership are trying to maximize their profits since it is in their interest to do so. But hired managers of joint stock companies cannot be expected to try to maximize profits since these profits do not go to them. It may be true that when managers are able to earn more profits for shareholders, they may be rewarded by them in some form or the other.
The important managerial theories of the firm which have been developed in recent years are managerial theories of brain Marris and O.E. Williamson. Like the sales maximization theory of Baumol, managerial theories also do not admit the validity of profit maximization hypothesis regarding the working of the business firms. According to Baumol, the managers of the firms are aiming to maximize sales revenue subject to a minimum profit level.
All these managerial theories are emphasizing the role of manger and his seeking self-interest while making decisions regarding price, output, sales, etc. of the corporate firms. Since the managers of corporate firms are motivated by considerations other than the maximization of profits, their decisions regarding price, output sales, etc. are likely to be different from those of the profit-maximizing firm.
1. Marris’ Managerial Theory of Firm:
R. Marris has put forward an important theory of the firm according to which managers do not maximize profits but instead, according to him, they seek to maximize balanced rate of growth of the firm. Maximization of balanced rate of growth of the firm means maximization of the rate of growth of demand for the products of the firm and rate of growth of capital supply.
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If G stands for balanced growth, Gd for the growth rate of demand for the product, GC for the rate of growth of the capital supply, then the goal of the manager is to maximize G, Thus –
G = Gd = GC
In seeking to maximize the balanced growth rate, a manager faces the following two constraints:
1. Managerial Constraint
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2. Financial Constraint
Managerial constraint refers to the strength of the managerial team and their skills.
Financial constraint refers to the following three financial ratios:
1. Ratio of debt (D) to total assets (A) which is simply called debt ratio (D/A).
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2. Liquidity ratio which is the ratio of liquid assets of the firm to the total assets (L/A).
3. Retention ratio (πr/π) which refers to the ratio of retained profits to the total profits.
It is important to note that these financial variables determine the job security of the managers, if these financial ratios set by the manager crosses prudent limits, they expose the firm to the risk of being taken over by others or the mangers can be dismissed which can endanger their job security. Therefore, financial constraints are associated with job security. Managers take into account job security while making business decisions.
Some variables in Marris’ model particularly in the manager’s utility function such as salaries, status, and power are strongly correlated with the rate of growth of demand for the products. Therefore, managers’ salaries will be higher and they will have more power and esteem. The higher the salaries, and power, the faster the rate of growth of the firms. Besides, the higher growth of a firm also ensures better job security to the managers.
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Therefore, utility of function of mangers can be written as –
UM = f (GD, S)
UM = utility of mangers
GD = rate of growth of demand for output of the firm
S = measure of job security of managers
On the other hand, utility of owners depends on the growth of capital supply which is positively correlated with the growth of profits. Thus, owner’s utility function can be written as –
Uowners = f (GC)
Where GC = rate of growth of capital supply
According to Marris, the rate of growth of capital is subject to the constraint set by the decision making capacity of the managerial team. Also the job security of the manger is determined by the weighted average of three financial ratios, viz., (a) debt-asset ratio, i.e., D/A, (b) the liquidity ratio (L/A) and (c) profit retention ratio (πr – π).
These financial ratios reflect the financial policy of the managers. Further, there is a saturation level for job security. Whereas after this saturation level marginal utility from the extra job security is zero, below this level, marginal utility from extra job security is infinite. With this constraint of job security, managerial utility function becomes –
Um = (GD) S̅
Where bar (–) on the job security variable S shows it acts as a constraint for utility maximization of managers. Managers maximize their utility, i.e., growth of demand for output subject to this job security constraint. Financial constraint is reflected in the job security constraint of a manager.
Under the Marris model, a manager works under two constraints:
(i) Managerial constraint set by the decision making capacity of the managerial team and
(ii) Financial constraint determined by three financial ratios which are reflected in the job security of the managers.
It is usually argued by managerial theorists that the division of ownership and management allows the managers to set goals which do not necessarily coincide with those of owners. The utility function of managers includes variables such as salaries, status, power and job security, while the utility function of owners includes variables such as profits, size of output, size of capital, share of the market and public image. Thus, managers want to maximize their own utility.
Um = f*(salaries, power, status, job security)
While the owners seek the maximization of their utility
Uo = f*(profits, capital, output, market share, public esteem).
Marris argues that the difference between the goals of managers and the goals of the owners is not so wide as other managerial theories claim, because most of the variables appearing in both functions are strongly correlated with a single variable – i.e., size of the firm. There are various other measures (indicators) of size- capital, output, revenue, market share and there is no consensus about which of these measures is the best.
Furthermore, Marris argues that the managers do not maximize the absolute size of the firm (however measured), but the rate of growth (= change of the size) of the firm. The size and the rate of growth are not necessarily equivalent from the point of view of managerial utility.
If they were equivalent we would observe a high mobility of managers between firms – the managers would be indifferent in choosing between being employed and promoted within the same growing firm (enjoying higher salaries, power and prestige), and moving from a smaller firm to a larger firm where they would eventually have the same earnings and status. In the real world the mobility of managers is low.
Hence, managers aim at the maximization of the rate of growth rather than the absolute size of the firm.
There is no need to distinguish between the rate of growth of demand (which maximizes the U of managers) and the rate of growth of capital supply (which maximizes the U of owners) since in equilibrium these growth rates are equal.
The utility function of owners can be written as follows –
where Gc = rate of growth of capital.
It is not clear why owners should prefer growth to profits, unless Gc and profits are positively related.
Furthermore, from Marris’ discussion of the nature of the variables of the managerial utility function assumes that salaries, status and power of managers are strongly correlated with the growth of demand for the products of the firm – managers will enjoy higher salaries and will have more prestige the faster the rate of growth of demand. Therefore, the managerial utility function may be written as follows –
Um = f(GD, s)
where GD = rate of growth of demand for the products of the firm
S = a measure of job security.
Furthermore, Marris suggests that ‘s’ can be measured by a weighted average of three crucial ratios, the liquidity ratio, the leverage debt ratio and the profit-retention ratio, which reflect the financial policy of the firm.
As a first approximation Marris treats ‘s’ as an exogenously determined constraint by assuming that there is a saturation level for job security – above the saturation level the marginal utility from an increase in ‘s’ (job security) is zero, while below the saturation level the marginal utility from an increase in ‘s’ is infinite. With this assumption the managerial utility function becomes –
Um = f(GD)S
where ‘s’ is the security constraint.
Thus, in the initial model there are two constraints-the managerial team constraint and the job security constraint-reflected in a financial constraint.
Marris adopts Penrose’s thesis of the existence of a definite limit on the rate of efficient managerial expansion. At any one time period the capacity of the top management is given – there is a ceiling to the growth of the firm set by the capacity of its managerial team. The managerial capacity can be increased by hiring new managers, but there is a definite limit to the rate at which management can expand and are main competent (efficient).
Penrose’s theory is that decision-making and the planning of the operations of the firm are the result of teamwork requiring the co-operation of all managers. Co-ordination and co-operation require experience. A new manager requires time before he is fully ready to join the teamwork necessary for the efficient functioning of the organization. Thus, although the ‘managerial ceiling’ is receding gradually, the process cannot be speeded up.
Similarly, the ‘research and development’ (R&D) department sets a limit to the rate of growth of the firm. This department is the source of new ideas and new products which affect the growth of demand for the products of the firm. The work in the R&D department is ‘teamwork’ and as such it cannot be expanded quickly, simply by hiring more personnel for this section – new scientists and designers require time before they can efficiently contribute to the team work of R&D department.
The managerial constraint and the R&D capacity of the firm set limits both to the rate of growth of demand (GD) and the rate of growth of capital supply (Gc).
The Job Security Constraint:
The desire of managers for security is reflected in their preference for service contracts, generous pension schemes, and their dislike for policies which endanger their position by increasing the risk of their dismissal by the owners (that is, the shareholders or the directors they appoint). Marris suggests that job security is attained by adopting a prudent financial policy.
The risk of dismissal of managers arises if their policies lead the firm towards financial failure (bankruptcy) or render the firm attractive to take-over raiders. In the first case, the shareholders may decide to replace the old management in the hope that by appointing a new management the firm will be run more successfully. In the second case, if the take-over raid is successful, the new owners may well decide to replace the old management.
The risk of dismissal is largely avoided by- (a) Non-involvement with risky investments. The managers choose projects which guarantee steady performance, rather than risky ventures which may be highly profitable, if successful, but will endanger the managers’ position if they fail. Thus, managers become risk-avoiders (b) Choosing a ‘prudent financial policy’. The latter consists of determining optimal levels for three crucial financial ratios, the leverage (or debt ratio), the liquidity ratio, and the retention ratio.
The leverage or debt ratio is defined as the ratio of debt to the gross value of total assets of the firm.
Leverage or Debt Ratio = Value debts/Total Assets = D/A
The managers do not want excessive borrowing because the firm may become insolvent and be proclaimed bankrupt, due to demands for interest payments and repayment of loans, notwithstanding the good prospects that the firm may have.
The liquidity ratio is defined as the ratio of liquid assets to the total gross assets of the firm.
Leverage or Debt Ratio = Liquid Assets/Total Assets = L/A
Liquidity policy is very important. Less liquidity ratio increases the risk of insolvency and bankruptcy. On the other hand, too high a liquidity ratio makes a firm attractive to take-over raids, because the raiders think that they can utilize the excessive liquid assets to promote the operations of their enterprises.
Thus, the managers have to choose an optimal liquidity ratio neither too high nor dangerously low. In his model, however, Marris assumes without much justification, that the firm operates in the region where there is a positive relation between liquidity and security – an increase in liquidity increases security.
The retention ratio is defined as the ratio of retained profits (net of interest on debt) to total profits.
Retention Ratio = Retained profits/Total profits = πR/π
Retained profits are, according to Marris, the most important source of finance for the growth of capital.
The three financial ratios are combined (subjectively by the managers) into a single parameter a̅ which is called the ‘financial security constraint’. This is exogenously determined, by the risk attitude of the top management. It is stated that it is not a simple average of the three ratios, rather a weighted average; the weights depending on the subjective decisions of managers.
Two points should be stressed regarding the overall financial constraint a̅. First, let
a1 = liquidity ratio = L/A
a2 = leverage ratio = D/A
a3 = retention ratio= πR/π
Marris postulates that the overall a̅ is negatively related to ‘a1‘, and positively to ‘a2‘, and ‘a3‘. That is, a̅ increases if either the liquidity is reduced, or the debt ratio is raised by increasing external finance (loans), or the proportion of retained profits is increased.
Similarly, a̅ declines if the managers increase the liquidity of the firm, or reduce the proportion of external finance (D/A), or reduce the proportion of retained profits (that is, increase the distributed profits), or a combination of all three.
Secondly, Marris implicitly assumes that there is a negative relation between job security’ (s) and the financial constraint a̅ – if a̅ increases (either by reducing ‘a1‘ or increasing ‘a2‘ or increasing ‘a3‘) clearly the position of the firm becomes more vulnerable to bankruptcy and/or to take-over raids, and consequently the job security of managers is reduced. Thus, a high value of a̅ implies that the managers are risk-takers, while a low value of a̅ shows that managers are risk-avoiders.
The financial security constraint sets a limit to the rate of growth of the capital supply, Gc, in Marris model.
The Model – Equilibrium of the Firm:
The managers aim at the maximization of their own utility, which is a function of the growth of demand for the products of the firm (given the security constraint)
Umanagers = f(GD)
The owners-shareholders aim at the maximization of their own utility which Marris assumes to be a function of the rate of growth of the capital supply (and not of profits, as the traditional theory postulated).
Uowners = f(Gc)
The firm is in equilibrium when the maximum balanced-growth rate is attained, that is, the condition for equilibrium is –
GD = Gc = G* maximum
The first stage in the solution of the model is to derive the ‘demand’ and ‘supply’ functions, that is, to determine the factors that determine GD and Gc.
Marris establishes that the factors that determine GD and Gc can be expressed in terms of two variables, the diversification rate ‘d’ and the average profit margin ‘m’.
2. Williamson’s Managerial Theory of the Firm:
A full-fledged managerial theory of the firm has been put forward by O.E. Williamson who emphasizes that managers are motivated by their self-interest and they maximize their own utility function. Again, the objective of utility maximization by the managers is subject to the constraint that after-tax profits are large enough to pay acceptable dividends to the shareholders and also to pay for economically necessary investments.
It may, however, be pointed out that utility maximization by the self-interest seeking managers, like sales maximization model of William Baumol is possible only in a corporate form of business organization where there exists separation between ownership and management.
Managerial Utility Function:
According to Williamson, utility function of the self-seeking managers depends on the following factors:
1. Salaries and Other Forms of Monetary Compensation:
Such compensations which the managers obtain from the business firms. This is a major factor determining the utility of the managers since salary and other monetary rewards received by the manager from the firm determine his private expenditure and standard of living.
However, according to Williamson, salary and other monetary compensations are not the total reward received by the managers from their firms and also these are not the only factor determining the utility of the managers.
2. Number of Staff under the Control of a Manager:
The greater the number of staff under the control of a manager, the greater the status and prestige of a manager and also the greater the power wielded by him. That is, the greater the number of staff under the control of a manager, the greater the salary and the amount of other monetary rewards. Since, according to Williamson, there is a close positive relationship between the number of staff and the manager’s salary, he takes a single variable “monetary expenditure on the staff” in his formal model of utility maximization by the manager rather than the two separate variables of salary and the number of staff.
3. Management Slack:
This consists of those non-essential management prerequisites such as lavishly furnished offices, luxurious company cars, and large expenses accounts, etc. which are not necessary for the efficient and effective operation of the firm. The management slack also enters into the cost of production of the firm.
4. Magnitude of Discretionary Investment Expenditure by the Manager:
This refers to the amount of resources which manager can spend according to his discretion. It should be noted that discretionary investment does not include those investment expenditures (such as periodic replacement of capital equipment), which are economically necessary for the survival of the firm. The magnitude of discretionary investment expenditure by a manager indicates the command over resources which he enjoys.
Williamson’s Managerial Discretional Model – Concepts of Actual Discretionary and Reported Profits:
Williamson has distinguished between three concepts of profits (1) Actual profits (π), (2) Reported profits (πr) and Minimum profits (πo)
Actual profits are the difference between total revenue earned less the production costs © and expenditure on staff (S). Thus –
where π = R – C – S
R = Total sales revenue
C = Production cost
S = Staff expenditure
Reported profit (πr) is the difference between actual profits and nonessential managerial expenditure as represented by management slack. Thus –
πr = π – M
where M represents management slack
Since π = R – C – S
πr = R – C – S – M
Minimum profits (πo) are the amount of profits (after tax) which are required to be paid as acceptable dividends to satisfy the shareholders who are the owners of the firm. If the shareholders do not have reasonable dividends, they may sell their shares, thereby exposing the firm to the risk of being taken over by others. Or alternatively they will vote for the dismissal of the top management.
Both of these actions by the shareholders will reduce the job security of the top managerial team. Hence, managers must give some minimum profits in the form of dividends to keep the shareholders satisfied so as to promote their job security. To meet this objective the reported profits must be large enough to be equal to minimum profit (πo) plus the tax to be paid to the government. Thus –
πr >< πO + T
Discretionary profits (πD) are the actual profits minus minimum profits and tax to be paid. Thus –
πD = π – π0 – T
πD = Discretionary profits
π = Actual profits
πO = Minimum profits
T = Tax to be paid to the government
Discretionary profits should be carefully distinguished from discretionary investment. Whereas discretionary profits are the amount left after minimum profits (πO) and tax (T) are deducted from actual profits (πD) = (π – πo – T), the discretionary investment equals reported profits minus minimum profits and tax. Thus –
Discretionary Investment ID = πr – πo – T
πR = reported profits
πO = minimum Profits
T = Tax amount to be paid
Since difference between reported profits (πR) and actual profits (π) arises due to management slack, discretionary profits can be stated as under –
πD = ID + expenditure due to management slack
Thus, if management slack is zero
πR = π and πD = ID
Managerial Utility Maximization:
As stated above, Williamson clubs the first two variables, namely (1) salary and other monetary compensations received by the manager and (2) number of staff under his control into a single variable. Utility of a manager in his model is a function of the following three variables –
U = U(S, M, ID)
where, U denotes utility function.
‘S’ stands for monetary expenditure on staff including salaries of managerial team.
‘M’ stands for management slack.
‘ID‘ stands for amount of discretionary investment.
Maximization of above utility function is subject to the minimum profit constraint. This means level of profits must be such so as to pay satisfactory profit to shareholders and pay for economically necessary investment (not included in discretionary investment).
In Williamson’s managerial model, price is regarded as a function of output, the expenditure on staff and a demand shift parameter. Thus –
P = P(X, S, e)
where, P stands for the price function
‘X’ stands for the output level in a period
‘S’ stands for the expenditure on staff
‘E’ stands for a demand shift parameter
Graphic Representation of Williamson’s Managerial Discretionary Model:
In order to present a simplified Williamson’s managerial model we assume that expenditure on account of managerial slack (M) is zero. Given this, managerial utility function becomes –
UM = f(S, ID)
When management slack (M) is zero, then reported profits equal actual profits, then –
ID = π – πo – T
Substituting this formulation in managerial utility function we have –
UM = f{S, (π – πo – T)}
Thus, we have the following simplified model of managerial function which has to be maximized subject to a constraint. Thus –
Maximize- Um = f{S,(π – πo – T)}
Subject to- πr > πo + T
According to Marris, the manager of firm, instead of maximizing profits, tries to maximize the rate of growth of the firm. The ability of the manager will be judged by his performance regarding the successful growth and expansion of the firm and his rewards will reflect this. Further, he argues, the growth of the firm can be best achieved by diversification.
Williamson in his model lays stress on the managerial discretion in determining not only output and price but also the level of staff expenditure and managerial emoluments. He distinguished between desire of manger for discretionary action and the opportunity for managerial discretionary action. Thus, according to Koutsoyiannis, ‘It seems that the distinction between the desire of mangers and the opportunity of mangers for discretionary behavior cannot be disentangled’.
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