As a result of the separation of ownership and control, many have claimed it is unrealistic to assume that firms will be concerned solely with maximising profits. In the late 1950s William Baumol observed that manager’s salaries, status and remunerations were not so closely associated with profits, but were in fact linked to sales revenue. The performance of managers is often judged on sales revenue, and Sloman (2006) proposes that sales figures are often used as an indicator of an organisation’s condition. Baumol therefore suggested that managers were motivated by remuneration (from achieving large sales), and increasing the size of the firm. Baumol devised a model known as the sales revenue-maximising model. Much like the profit-maximising model, it is an optimising model whereby a single product firm has a sole objective. Figure 1 has been constructed from hypothetical figures to outline Baumol’s (1958) model.
The traditional profit-maximiser would select output A, where profits are maximised as a result of keeping total costs (TC) low relative to the total revenue (TR). A sales revenue-maximiser would select an output that maximised total sales revenue. To try to overcome this, shareholders may insist on a minimum acceptable dividend, and so Davies (1991) describes how the firm may define a minimum acceptable profit level (PC1). The firm would therefore be inclined to produce at output B, which achieves the highest possible revenue whilst still making a profit acceptable to the shareholders. This is an example of constrained sales revenue-maximisation, but the firm is still not maximising profits. If the shareholders set a minimum acceptable profit level of PC2, the firm would choose output C. This means that the firm would be able to maximise its total revenue but still have profits above the minimum acceptable level (Hawkins, 1970). Baumol suggested that the manager would spend this extra profit on advertising in an attempt to boost sales further (Sloman, 2006). Baumol’s (1958) model of sales revenue-maximisation illustrates how the objectives of the manager and shareholder can diverge. There are however a range of solutions that aim to align the manager’s interests with those of the shareholders. Nosal (2006) examined how a principal could acquire additional information on a particular matter. However he concluded that the costs in obtaining information, particularly in large firms with complex structures, are likely to outweigh the benefits and will inevitably result in a reduced return for the principal.
A much more popular approach to tackling the principal-agent problem is to offer managers particular incentives and one option is outlined by Bayless & Diltz (1991) who describe how firms will issue equity in order to try to reduce levels of asymmetric information. Margiotta & Miller (2000) investigated how managerial compensation, including stock options, can align the goals of managers and shareholders. They studied the correlation between managerial compensation and the stock returns of the firm. Margiotta & Miller (2000) claimed that a firm would suffer significant losses if moral hazard was disregarded and suggested that shareholders offering compensation packages that linked a manager’s wealth to the value of the firm could successfully align the interests of the two parties. Margiotta & Miller (2000) also proposed that the benefits gained from offering additional compensation to a manager would far outweigh the costs incurred. However Bruhl (2003) outlines the dangers of offering stock options to CEOs. Bruhl (2003) describes how supplementing a CEO’s salary with corporation stock effectively allows the CEO to act as a “privileged principal” as well as an agent. The CEO has an advantage over other stockholders and can use inside knowledge of the firm to buy and sell stocks. To overcome this Bruhl (2003) suggests compensating the CEO completely in stock, but the shares only become available for withdrawal to him or her after a set time period after they have left the corporation. This will eradicate insider trading and ensure that it is in the CEOs interest to ensure long-term success for the firm. Cassano (2003) has also been critical of the use of stock options as remunerations for managers and CEOs. If the managers’ compensation package is closely linked to the share value of the firm, Cassano (2003) claims that it will give managers an incentive to exaggerate the firm’s performance. The dangers of overstating the performance of a firm, and insider trading, can be seen from analysing the collapse of the former American energy company Enron Corporation. Enron was one of the worlds leading energy companies, and in 2000 it claimed a profit of $1 billion (Sloman, 2006), however just a year later it filed for bankruptcy. Enron’s downfall was that it’s true financial position was not being represented accurately in its financial statements. Enron had huge debts from funding expansion plans, however officers at Enron were recording expected future profits as current profits in order to paint the picture of a highly profitable corporation. Ultimately when it was time to write off the debts it was revealed that Enron didn’t have the revenue to cover them. On top of this senior managers at Enron were using the unpublished information to partake in insider trading for their own benefit. Although offering incentives can successfully align the interests of the agent with those of the principal, there are risks involved and these should be considered before designing an agents contract.
The previous model assumes managers’ sole objective will be to maximise revenue and the size of the firm, in order to experience the benefits of monetary rewards. Hall (1967) examined the sales revenue-maximisation theory by analysing how sales were affected by profits made above a desired level. After reviewing the results Hall (1967) concluded that his findings did not support the sales revenue-maximisation thesis, but also highlighted how they lent little support to the profit maximisation theory either. In fact Hall (1967) stated that there were many other additional variables, such as Williamson’s expense preferences, that ate into profits above the desired level. In 1963 Williamson argued that a manager is concerned with a wide range of variables, not just one as proposed in the sales revenue-maximisation model. Williamson produced his managerial utility-maximisation model and Sloman (2006) describes how the model assumes that, provided profits are acceptable, managers will aim to maximise their own utility. Davies (1991) outlines how Williamson introduced the concept of ‘expense preferences’, which he described as unnecessary spending by managers on items that will personally benefit themselves, using the firm’s profits. The four main areas that Williamson claimed affected a manager’s utility were “salary, job security, dominance and professional excellence” (Sloman, 2006 p. 210). Williamson then identified how expenditure on staff, personal benefits (perks) and discretionary investment were all major sources of expenditure from which the manager could derive utility. Yermack (2006) was one of the first to investigate whether perks were an efficient way to pay managers and hence could enhance the value of a firm, or whether the firm performance would suffer as a result. Yermack (2006) analysed the performance of firms in relation to CEO perk consumption and focused on the personal use of company aircraft by CEOs. Yermack (2006) discovered that, when compared with market benchmarks, the average returns to shareholders was 4% less for firms that allow the CEO access to the company jet. There was found to be no relationship between the lower returns and CEO compensation, CEO shareholding or monitoring variables that other theories have predicted. There did however appear to be a strong link between perk consumption and certain CEO characteristics and Yermack (2006) describes how there seemed to be a strong connection between aircraft use and long distance golf-club memberships.
The two models that have been discussed so far both contrast with that of the traditional profit maximising theory. Clarke & McGuinness (1987) describe how they both assume that managers will aim to maximise a particular objective, be it sales or utility, dependent on a given profit constraint. Herbert Simon carried out initial work on behavioural theories of the firm in the 1950s. The approach aims to introduce a more realistic view of how decisions are made within a firm, given the uncertainty of the environment. Clarke & McGuinness (1987) describe how the behavioural theory of the firm offers a more comprehensive overall view of the firm, compared to managerial theories. Cyert & March (1963) outlined that firms are made up of different individuals and groups, all with their own conflicting interests. Many modern organisations often have several departments, and Sloman (2006) illustrates how each department is likely to conflict with the others as they all try to achieve their own set of goals and objectives. The theory states that, realistically, the firm does not have perfect information on the environment that it operates in and obtaining information is costly. Because of this, the theory claims that ‘pure’ profit maximisation is unfeasible, and describes that, because managers face such uncertainty, they can only exercise ‘bounded rationality’. The firm will therefore set minimum acceptable levels of performance and Clarke & McGuinness (1987) explain how the firm will tend to ‘satisfice’, by achieving limited attainable objectives, rather than ‘maximise’. Shipley (1981) analysed the pricing objectives of firms in the UK in order to evaluate if the firms were motivated toward profit maximisation. Shipley (1981) approached 728 manufacturing firms, and they were asked to consider a range of pricing objectives that best fit with their own objectives. Nearly half of the firms claimed to be pursuing profit maximisation, and profit maximisation objectives are evident to a small extent. However Shipley (1981) describes how only about 16% realistically satisfied the criteria of profit maximisers. Around 50% of the firms admitted they were focused on achieving satisfactory profit targets, and Shipley (1981) concluded that the majority of the firms analysed were in fact ‘satisficers’.
The majority of this discussion has focused on the relationship between the shareholder and the manager of firms, and the principal-agent problems that arise. However further down the organisational hierarchy it may be that a manager, who is employed as an agent by a shareholder, employs a workforce to carry out tasks on his behalf. The manager, now acting as the principal, must therefore motivate his workforce to act in his interest. Shapiro & Stiglitz (1984) explain how monitoring employees effort is difficult and very costly, and because the utility of a worker decreases with increased work effort, workers are likely to ‘shirk’, in other words put in less effort, unknown to their employers. In order to address the situation, firms have two real options. They can increase surveillance of the employees, but as previously stated this can be difficult and very costly. Another option for the firm is to increase wages. Known as the efficiency wage hypothesis, Sloman (2006) illustrates how the effort of employees will increase as a result of increased wages. Figure 2 represents a typical supply and demand diagram for the labour market.
If the firm pays employees the equilibrium wage (We), supply of labour will be equal to the demand for labour. The market will therefore clear and there will be no unemployment. However, if there is no unemployment, workers are likely to shirk. This is because they will not be afraid of losing their job as they could easily find work elsewhere due to the clear market, and so getting caught ‘shirking’ will incur no penalty. This is why firms often pay an efficiency wage (W*) above that of the equilibrium wage. This causes the invisible hand to fail and the market is thrown into disequilibrium, which causes unemployment (represented by Q2-Q1). The higher wages discourage ‘shirking’ but unemployment in the labour market adds an extra incentive for employees to work harder as the cost of losing their job would be greater. Sloman (2006) also emphasises how a firm can reduce its costs by having a lower labour turnover and also increase worker’s morale by paying efficiency wages. Offering above equilibrium wages can be seen as an effective way of solving the principal-agent problems between employer and employee. However it does have repercussions and Shapiro and Stiglitz (1984) explain that involuntary unemployment is unavoidable. When deciding how to solve the principal-agent problem among employers and workers, considering the nature of labour is vital. Highly skilled workers who have undergone expensive training are costly to replace and paying them efficiency wages is a logical option. However unskilled workers who conduct simple tasks are more easily monitored and the cost of labour turnover is less, and Sloman (2006) describes how a firm is likely to pay them as little as possible.
Conclusion
In large modern organisations shareholders often employ managers to act on their behalf. The principal-agent problem in this instance stems from information asymmetry between the shareholder and the manager. The overall aim of the shareholder is to maximise profits and hence the value of the firm. The manager has more information than the shareholder, however, hence he has economic power over the shareholder. Managers therefore have some scope to pursue personal goals and interests. This paper has considered two alternative maximisation theories of the firm, which illustrate that managers will aim to either maximise sales revenue (Baumol, 1958), or maximise their own utility (Williamson, 1963). The paper has also studied behavioural theories and how firms will ultimately satisfice rather than maximise, due to the complex and uncertain environment in which the managers operate within. The majority of the solutions examined involved attempting to align the interests of the two parties by offering monetary and share option incentives to the agent based on performance. On the whole this approach can be effective, as outlined by Margiotta & Miller (2000). However, reflecting on the work of Bruhl (2003), Cassano (2003) and the bankruptcy of Enron, a detailed share option system must be agreed as to eliminate the potential for insider trading by managers. Also the manager’s incentives must be linked to the long-run performance of the firm, including after the manager has left, to ensure any future shortcomings that he may have known of but didn’t disclose will effect his remunerations. On top of this, CEO and manager ‘perks’ should be disclosed and monitored to evaluate whether they are damaging the firms performance.
Principal-agent problems operate within firms at all levels and another relationship studied in this paper is the relationship between employers and workers. The main problem observed in this relationship is that the employer cannot completely monitor his workforce, and so they are likely to ‘shirk’. The employer has two real options to combat this, he can either increase the surveillance of his workers or he can pay his workforce efficiency wages above the equilibrium wage rate. Paying efficiency wages does inevitably throw the labour market out of equilibrium and cause unemployment. However this only exaggerates the incentive for workers not to ‘shirk’. Shapiro & Stiglitz (1984) explain how monitoring employees effort is difficult and very costly, however employers should not just pay efficiency wages to every Tom, Dick and Harry in order to motivate them. When deciding on a solution, considering the nature of labour is crucial. Highly skilled workers who have undergone expensive training are costly to replace and therefore promoting loyalty and increasing their morale by paying them efficiency wages would be beneficial in the long run. However unskilled workers who conduct simple tasks are more easily monitored and therefore increasing surveillance is not that costly. Also the cost of labour turnover is much less and so workers can easily be replaced.
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