Explain why managerial theories of the firm have developed, and how the predictions from these models differ from those of the profit maximising approach.

However, it is not only this change in the industrial climate that has led economists to question the authenticity of the neo-classical theory.  Arguments that MR = MC is not an aim for those holding decision making positions in firms; that information about the future is unclear; and that firms are organizationally complex, have also led to economists looking elsewhere for answers as to what exactly the objectives of individual firms are.

In 1939, Hall and Hitch became two of the first people to challenge the validity of the neo-classical hypothesis, carrying out research which suggested that firms appeared not to target profit maximisation by equating MC and MR, but instead setting their prices based on a product’s full average cost, providing a conventional allowance for profit.

Decision makers cannot know precisely how interest rates and exchange rates will evolve in the next period, whether, or to what extent demand will change, or how stable prices of raw materials will be. 

According to the neo-classical theory, profit maximisation is achieved without the use of information relating to either future cost or demand conditions, and it is precisely due to the lack of such knowledge that the ability of firms to aim for profit maximisation is a subject of scepticism.

As mentioned earlier, firms are becoming increasingly bigger, a fact which usually results in activities becoming increasingly separated.  As far as profit maximisation is concerned, this causes problems in that it becomes more and more difficult to ensure that information is both accurate, and communicated rapidly.  As a result, of course, it becomes harder to enforce that the correct decisions are made in order to maximise profits.  Moreover, the breaking up of activities within large firms may result in varied and conflicting objectives, which can cause a trade-off that doesn’t allow for profit maximisation. Thus, the increasing complexity of firms becomes another basis of objection to Smith’s beliefs.

It would appear then, that a combination of the divorce of ownership and control, and the decreasing threat of competition, has, during recent years, given managers the incentive to pursue objectives other than profit maximisation.  However, the precise nature of these objectives has itself become an economic debate in recent times.  

The three alternatives considered most credible are: aim to maximise revenue, aim to maximise growth, and the aim of managers to optimise their own welfare.  W.J. Baumol observed that:

…the salaries of managers, their status and other rewards often appear to be more closely linked to the size of the companies in which they work, measured by sales revenue, than their profitability. 

This sales revenue-maximisation model places emphasis on the firm’s desire to maximise revenue rather than profits, which would lead to a relatively more stable stream of profits in the long run.  As a result, mangers concentrate on increasing the firm’s size, meaning that the firm’s primary objective will be to maximise its sales revenue.  By doing this, ‘managers avoid the risks inherent in the adoption of highly profitable but risky ventures’ and steady performance is seen as preferable to the possibility of losses.

In many respects the revenue-maximisation model shares its basic principles with the profit-maximisation assumption.  Both are optimising models in which a single product firm aims for a sole objective, having perfect knowledge about its cost and demand conditions.  However, differences do exist as displayed in the model below:

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                           £                                                         Total Cost

       

                           B

                           E                                                             Total Revenue

                           C

                                                

                                   D           A                Output

                                                                        Profit

                            Baumol’s revenue-maximising model

Baumol’s model shows that the firm will produce a level of output (A), which will result in giving total revenue (B) and profit (C).  This implies a higher level of output, resulting in a lower price than that which the profit-maximising firm (output (D) and revenue (E)), would charge.

Maximising revenue may well have its benefits, yet this does not necessarily mean that the firm will make a profit.  Indeed, if costs are greater than the firm’s revenues, this will result in losses being made.  To overcome this problem the revenue-maximisation model assumes that the firm maximises sales revenue subject to a minimum profit constraint, as in the model below:

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                           £                                                            Total Cost

                             

                                                               Total Revenue

                                                                          PC3

                                                                             PC2 

                                                                           

                                                                              PC1

                                                

                                  C       B A            Output

                                                                        Profit

                                  Revenue-maximisation, subject to constraints

There are three possible cases in this amended version of the model.  PC1 being the case where the profit constraint does not “bite” and revenue can be maximised at the same time as making enough profit to satisfy shareholders.  PC2 is the case where output has to be reduced in order to make enough profit, thus reducing revenue.  Lastly, PC3 is the case where the minimum profit required to satisfy the shareholders, is equal to the maximum profit that can be made, resulting in the firm acting as if it were a profit-maximiser.

All in all Baumol’s model shares the same static properties as that of Smith’s neo-classical model.  If demand were to increase then both example firms would respond by increasing both output and price.  However, if fixed costs increase, or a lump-sum tax is imposed, a profit-maximising firm would not adjust either output or price, whereas a revenue-maximising firm, whose profit constraint is already “biting”, would suffer a decline in profits forcing it to lower its output and to raise prices.

Marriss also ‘saw managers as having both the ability and motivation to pursue objectives other than profit.  He believed that managers will seek objectives such as salary, status and job security, so as to achieve personal satisfaction, whereas the owners, (shareholders), of the firm will seek to maximise profit, sales and market shares.  This contrast of objectives led Marriss to think that through concentrating on a growth in size of the firm both sets of objectives could be met.

Marriss’s model sees growth as taking place through diversification into new products, as opposed to an increase in the output of an existing product.  The relationship between growth and profitability has two dimensions.  Firstly, there is the “supply-growth” dimension where growth is a function of profits.  The greater the level of profits the more funds there will be to reinvest in the growth of the firm.  Secondly, there is the more complex “demand-growth” relationship, which operates in the opposite direction to “supply-growth” with growth determining profits.  This type of growth consists of two levels.  At low levels of growth the relationship is said to be positive with growth providing more profits, where the firm is seen to be producing the most profitable new products from those at its disposal.  However, as growth rates increase, the relationship changes and becomes negative, for the costs of having to cope with increasing burdens, such as putting together a larger management team or increasing diversification, can only be met by increasing expenditures on advertising and research, and development.  Marriss’s model is shown below with the two types of growth displayed.

                       

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                                      SG1                     Supply Growth       

                 Profit Rate

                                                        B              X

                                     A

                                                                         Demand Growth

                                                                           

                                                                                       Growth Rate

                             The Marriss Model

As both types of growth have to be satisfied, the combination of growth and profitability that the firm achieves must be at point X.  The line SG1 shows the supply-growth curve when nearly all the profits are retained by the shareholders, with the combination of growth and profitability that the firm achieves now being at point A.  Point B is the point where profit would be maximised, but because managers are willing to risk their jobs through channelling profits into growth, the firm is unlikely to be positioned here.

The final alternative to the neo-classical theory is Williamson’s managerial utility model.  This theory again neglects the profit maximisation approach in favour of the belief that managers chase alternative objectives, by spending any profits above the profit constraint on items that will increase managerial satisfaction or utility.  Williamson believed that those items that would increase managerial satisfaction or utility were; staff expenditure, managerial emoluments and the discretionary power for investment.  Expenditure on staff beyond the profit maximising level takes place because it is seen to represent both ‘power and prestige to the manager’.

Managerial emoluments include expenditure on items such as new offices, company cars, business holidays and give rise directly to managerial satisfaction, as writes Stephen Hill:

This non-salary expenditure on personal comfort and well-being of managers appears in the company accounts, but adds little to the operating efficiency of the organisation.

Furthermore, the manager gains prestige and status by being able to finance projects that are not necessary to the functioning of the firm.  The manager is able to spend more money on items such as fashionable new technology and again put it down in the company accounts as being a necessary expenditure.

The managerial theories of the firm are based on the managers of the firm, whose objectives are translated into the objectives of the firm.  However, the pursuit of these objectives is not unrestrained, as managers remain ultimately answerable to the firm’s shareholders - those who ultimately decide on who to employ as their manager.  Other objections to managerial theories include the fact that ‘profit is considered to be “given”, that is, exogenous to the model.  Profits are assumed to fund growth, and the managerial models consider no alternative ways in which this may be achieved.  Finally it has been argued that the managerial theories only give a snapshot of the firm’s position.  There is no knowing what future situations may be like, and therefore the theories only provide a one-off explanation of what organisations may look like and the manner in which they act.

Taking into consideration all of the above, it is difficult to ascertain an unambiguous conclusion, regards the suitability of any of the suggested models in preference to another.  Nevertheless, it cannot be denied that enough evidence exists against the use of the managerial theories, for economists to continue to use Smith’s two hundred and twenty six year old assumption of profit maximisation, as the foundation for their model of the firm.

Word Count: 2,228

Bibliography

Cook, Mark and Farquharson, Corri, Business Economics, (Pitman Publishing, London, England, 1998)

Davies, Howard, Managerial Economics For Business, Management and Accounting, (Pitman Publishing, London, England, 1989)

Hill, Stephne, Managerial Economics: The Analysis Of Business Decisions, (Basingstoke, England, 1989)

Jacobson, David and Andreosso-O’Callaghan, Bernadette, Industrial Economics and Organization – A European Perspective, (McGraw-Hill Publishing Co., Maidenhead, England, 1996)

Sawyer, Malcomn C., Theories Of The Firm, (Weidenfeld and Nicholson, London, England, 1979)

Thompson, Steve and Wright, Mark, Internal Organisation, Efficiency and Profit, (Philip Allan Publishers Limited, Oxford, England, 1988)

Weir, C., ‘Internal organization and firm performance: an analysis of large UK firms under conditions of economic uncertainty’, Applied Economics, Vol 28, No 4, 1996.

Web Sources

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