Within our economy owners and managers represent two different groups of decision makers. It is implied that shareholders possess the desire of profit maximization to be the preferable target of any business with which they hold equity, thus providing them with more wealth. However in practice this is not always the case as the debate over the divorce of ownership and control comes into play.
In theory; the shareholders being the owners of the firm will control its activities. However, in practice this can be difficult amongst larger corporations as control often lies in the hands of the directors. It can be tough for any firm to exact change for the thousands of shareholders, each with a small stake. Thus in many firms there is what is called the division of ownership and control. The separation of ownership and control raises worries that the management team may pursue objectives attractive to them but which are not necessarily beneficial to the shareholders. This conflict is what is known as the principal agent theory. As defined by Hornby, Gammie and Wall (Pg 164, 2001), the P-A theory, “considers the relationship between the owners of the firm and the managers and also the relationship between the managers and those they manage.” The relationship occurs when one person, the principle, employs an agent to perform tasks on their behalf. It is assumed that each wants to maximize his or her profit but that each is subject to constraints. In this case, shareholders are the principals who employ the managers to maximize profits on their behalf.
The concept of principal-agent can explore in greater detail the barriers imposed for each party involved. Recited from Worthington, Britton and Rees (Pg 41, 2001), “firstly there is an imbalance in power between the principal and the agent; secondly there is likely to be a divergence of interests between the principal and the agent and the possibility of opportunism exists.” One problem in assuming that businesses set price and output to maximize profits is the decision-taking; where the divorce between ownership and control, can be difficult to monitor. The shareholders may not always be aware that managers making the key day-to-day decisions are operating to maximize shareholder value. Hornby et al. indicates that different problems also associated with the P – A theory include ‘moral hazards’ and ‘adverse selections’. Both factors coincide with information deficiencies for both the shareholders and the managers. Another proposition by Hornby et al. signifies that one way of prevailing such disputes between the principals and the agents would be, “to try and devise contracts which bring about a coincidence of aims” (Pg 164, 2001). Incentives such as bonus schemes or shares and share options could be used. This gives the managers a powerful incentive to act in the interests of the owners by maximizing shareholder value. A predicament affiliated with such rewards may lead to accounting fraudulency. In practice, Enron, the American based energy company abdicated responsibility to their senior managers who then in turn were able to abuse their position and the system to their own advantage. Deakin and Konzelmann (2003) denote that Enron’s collapse “was the consequence of a corporate governance system focused at all costs on the goal of enhancing shareholder value.” This makes an impact on the traditional neo-classical presumption of profit maximization not always being the core objective of the firm, as market survival amongst other things, have a significant role. Also in the case of Enron, presenting employees with share options, the managers dishonestly tampered with the accounts to achieve maximum share prices in order to sell them in the short run to attain more wealth. In the long term this lead to Enron facing their demise. Appendix 1 shows a diagram of other significant objectives to any organisation.
Within the free market economy, there are a range of theories suggesting that oligopolistic organisations are more likely to pursue non-profit goals such as sales revenue maximization or growth maximization. Collectively these are known to economists as the managerial theories of the firm. The main assumption made with all the hypotheses is that profit is no longer the sole aim of the firm. Its relevance acknowledges that the firm’s management cannot totally ignore the wishes of the shareholders involved and that a reasonable growth in value of the shares should be maintained. The initial theory devised was known as the sales revenue maximization model, created by W J Baumol (1958). His theory implied that managers will seek to maximize the number of sales rather than profit. The reason for this is because the managers’ salaries and power may depend directly on sales performance. Another constraint related to the maximization model insists that the shareholders will require a minimum profit level to keep them happy. Once the model has been applied there is continuing scope for managers to pursue their own goals.
Another theory appointed by Williamson (1963) is known as the managerial utility maximization model. As defined by Brewster (1997), Williamson’s theory “examined in detail the discretionary behaviour of managers” (Pg 184). Managers in any business are likely to seek their own satisfaction or utility, although according to Williamson, this is subject to obtaining a minimum level of profit. As with Baumol’s model, Williamson dictates that there is a separation of ownership and control and the pressure to maximize profit is more relaxed. A manager’s utility will hinge upon their power, status and role enjoyment. In turn these are enhanced by expenditure on discretionary items including:
- Increasing personnel levels which increase the managers span of control and relative ‘weight’ in the firm.
- Expenditure on ‘perks’ or non-pecuniary remuneration enhance the manager’s status and power.
- The size of the budget the manager controls and what interests rather than enhancing profit.
Williamson also identified the concept of profit ‘satisficing’. This enables the managers of the firm to make adequate profit to gratify shareholders and create an undeclared view of hidden profit to the expense preferences.
Another theory was created by Marris (1964) which was known as the growth maximization model. According to the model, the core goal is the growth of the company. His research suggested that there is a similar view that a managers salaries and career prospects are all enhanced if they had the responsibility in managing a growing company than simply a large firm as growth brings financial rewards, job security etc. It is assumed that shareholders are also interested in the growth of the firm, as in the long term this will generate the increase in their share value. However, management is faced with a profit constraint whereby future increases in profits depend on supply growth through reducing the risk of loss and new product development. Hornby (1996) argues that the validity of Marris’s model is hard to determine as efficient means are not available for specifying precisely how much profitability or security is regarded by each organisation as being necessary.
The assumptions made within all of the theories identify profit, sales revenue, growth and managers utility to be the main goals or objectives of any orgainisation. Maximization in some way is argued to be the core target. However, these theories have been criticized by a group of economists collectively known as the behaviourists, first by Simon (1959) and then, subsequently by Cyert and March (1963). They focus on the firm’s intricacy and see it being made up of various groups or shareholders, with each group having differing objectives and possibly a conflict of interest. Simon (1959) proposed that firms and their managers are not maximizers and that they should set themselves levels or goals of achievement. Cyert and March (1963) furthered Simons research by focusing on the different groups within the organisation. Worthington et al. (2001) indicates that Cyert and March introduced the concept of the ‘coalition’ to include all those groups who place demands upon the firm.
The traditional assumption of profit maximization can certainly be challenged and criticized as being the core objective of the firm. This was bought into question with the division of ownership and control and the constraints that managers face which would force them to retain profit as their sole objective. In many large modern firms, the owners may no longer run the firm as the decisions made reflect the wishes of a broader range of stakeholders, especially those of managers. Given that the shareholders receive partial income through profit made by the firm, the fact that they no longer have full control over the management means that maximisation of managerial goals may take priority in many firms. Over recent years many theories have been developed to display the priority aims of a business, including how they respond to environmental changes. Managers are likely to pursue multiple objectives, with profits having a significant role.
Appendix 1:
Other objectives of a business:
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Bibliography
Brewster, B. (1997) “Business Economics – Decision-making and the firm” The Dryden Press
Clark, A. (2000) “Organisations, Competition and the Business Environment” Pearson Education Limited
Deakin, S., Konzelmann, S., (2003) “After Enron: An age of enlightenment”, Organisation, Volume: 10 No: 3, Pg: 1 – 2, The Cambridge Business Bulletin: Issue 9
Hornby, W., Gammie, B., Wall, S. (2001) “Business Economics (Second Edition)” Pearson Education
Hornby, W., Macleod, M. (1996) “Pricing Behaviour in the Scottish Computer Industry”, Management Decision, Volume: 34 No: 6, Pg: 31 – 42, MCB Press
Worthington, I., Britton, C., Rees, A. (2001) “Economics for Business – Blending Theory and Practice” Pearson Education
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