Download traditional theory of the firm

CHAPTER 10.
Managerial objectives and the firm
• Principal-Agent theory.
• Managerial theories.
• Behavioural theories.
Learning outcomes
This chapter will help you to:
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Analyse the different objectives firms may choose when
deciding on their production and pricing decisions.
Appreciate the meaning and significance of principal–agent
theory and its relationship to business objectives and corporate
governance.
Recognise the nature of different managerial theories of the
firm, namely sales revenue maximisation, utility maximisation
and corporate growth maximisation models.
Distinguish between managerial and behavioural theories of
the firm and the contrast between maximising and satisficing
strategies
Understand the importance of business ethics within the
framework of managerial decisions in today’s business
environment.
Challenging the traditional assumptions
The traditional approach is based on two key assumptions:
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Decisions are made under conditions of perfect
knowledge.
The objective of the firm is to maximise profits.
There are five main reasons which can be offered as
justification for abandoning these two assumptions.These
relate to the following:
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The growth in oligopoly.
The growth of managerial capitalism.
Difficulties surrounding profit maximisation in practice.
The organisational complexity of firms.
Recognition that real life decisions are often made in the
face of imperfect or incomplete information.
In summary, therefore, the traditional theory of profit maximisation
featured in previous chapters may be criticised because:
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It may not be readily applicable to oligopoly markets.
It takes inadequate account of the need to gather and utilise
information.
It is no longer appropriate in today’s environment,where
managerial capitalism has taken over from entrepreneurial
capitalism and where control of businesses has become
divorced from their ownership in many industries.
Pricing policies in practice may bear little obvious resemblance
to those suggested by the MR =MC principle.
The complexity of organisational structures today calls into
question some of the basic assumptions of the traditional
theory and draws attention to the process of decision-making.
Principal-agent theory
Figure 10.1 The principal-agent relationship: private v public sector
Figure 10.2 Impact of inefficiency on average cost
Managerial theories
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Sales revenue maximisation.
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Managerial utility maximisation.
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Corporate growth maximisation.
Sales revenue maximisation
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High and expanding sales revenues help to attract external
finance to the firm 僕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.
High sales assist the distribution and retailing of products 睦
resulting in economies from selling in bulk.
Consumers may view a firm with falling sales in a less
favourable light 釦this may deter consumers from buying and
reduce sales even further.
The distributive trade may be less co-operative,for example in
extending credit lines, when a firm’s sales are declining.
Falling sales may result in reductions in staffing levels,
including managerial staff, as costs are cut.
Last,but not least,managers’ salaries may depend on a fast
growth of sales revenues
卜managers are often rewarded for expanding the business.
Figure 10.3 Sales revenue maximisation
Managerial utility maximisation
Williamson’s model suggests that managers’
self-interest focuses on the achievement of
goals in four particular areas, namely:
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High salaries
Staff under their control
Discretionary investment expendtirue
Fringe benefits
U =f (S ,Id ,M )
Corporate growth maximisation
The valuation ratio for any company is its current share price multiplied by the
number of its issued shares divided by the net book value (assets less liabilities)
of the company.
Figure 10.4 The corporate growth maximisation model
Behavioural theories
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Production . A goal that output must lie within a certain
satisfactory range.
• Sales .A goal that there must be a satisfactory level of sales
however defined.
• Market share .A goal indicating a satisfactory size of market
share as a measure of comparative success as well as of the
growth of the firm.
• Profit . Still an important goal,but one amongst a number
rather than necessarily the goal of overriding importance.
In these circumstances,the objectives of the firm are
eventually determined by factors such as the following:
• Bargaining between groups and the relationship between
groups within the firm.
• The power and influence of different groups within the firm.
• The method by which objectives are formulated within the
organisation.
• How groups and,therefore,the ’firm’ react to experiences and
make adjustments .
10.13 Business ethics
Firms now recognise the importance of issues such as:
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The public’s growing interest and concern about
environmental challenges ,involving pollution, the use
of non-renewable resources,energy
efficiency,etc.leading to the so-called ‘greening of
business’.
The rights of workers and human rights in general,
the development of fair pay,equal opportunities,health
and safety at work,etc.
Ethical marketing involving limitations on the selling of
products such as tobacco and alcohol that may
damage public health and general well-being.
Key learning points
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The traditional theory of the firm, based on the assumptions of
perfect knowledge and profit-maximising behaviour, may not be
readily applicable, given the complexity of markets and
organisational structures today.
Principal -gent theory recognises the growth in managerial
capitalism and the complexity of modern organisational structures
based on a growing separation between the owners of the firm (the
principals) and the firm’s senior management or directors (the
agents). This theory leads to a focus on corporate governance
arrangements.
Baumol concludes that management which attempt to maximise
sales revenue will tend to produce at a higher output level,set
lower prices and invest more heavily in measures that boost
demand than management which attempt to maximise profits.
Key learning points
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Williamson ‘s managerial utility maximisation model argues that
managers seek to maximise their own self-interest based on the
achievement of goals such as high salaries,authority over staffing,
discretionary investment expenditure decisions and fringe benefits.
Marris’s corporate growth maximisation model suggests that
management seek to maximise the growth of the firm subject to an
optimal dividend-to-profit retention ratio, in order to safeguard the
firm from a hostile takeover bid.
The satisficing explanation of managerial behaviour is associated
with behaviouralist theory and argues that there is no single
objective of the firm; instead, there are multiple goals.These emerge
from the potential for conflict amongst interest groups within the
firm, such that the aim will be to achieve a satisfactory performance
for each of the goals without necessarily any single, maximisation
objective.
Key learning points
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Business ethics is concerned with the social responsibility of
management towards the firm’s major stakeholders, the
environment and society in general. There is a growing belief
that ethical and ‘green’ business are linked to improved
business performance over time because of increased public
concern for human rights and the world environment.
Business ethics extends to treating all stakeholders ‘fairly’;
hence the growing emphasis on health and safety
issues,’good 蜘working practices and the like in business
decision-making.