Managerial theory of the firm was further developed by Marris (1963,1966) when he linked the growth in demand for the organisations product with its growth in supply of capital. “Once the link had been established, Marris was able to show that for different combinations of growth in demand and supply there is a balanced level of growth for the organisation.” (Cook & Farquharson, 1998, P.68)
The simple dissatisfaction of the profit maximising model also aided development of the various managerial theories of the firm. There were certain assumptions of the model that a lot of people disagreed with which led to the need to develop alternatives. The first of three main objections to profit maximisation is marginal costs being equal to marginal revenue, a condition under profit maximisation, which by many, is thought not to be a conscious goal of decision makers in firms. Hall and Hitch (1939) found as a result of their research that “the firms interviewed appeared not to aim at profit maximisation by equating MC and MR; instead, they applied what Hall and Hitch called a ‘full-cost’ principle, where the price that ought to be charged was based on the full average costs. The second major objection of profit maximisation is that information is imperfect. “Each time there is a price change or a change in the productive capacity, the position of the profit maximising quantity will alter …… making it very hard to derive the optimal, profit maximising level of production as a result.” (Cook & Farquharson, 1998, P.58). The third main criticism is that organisations are extremely complex and are hard to classify as having simple profit maximising objectives, not forgetting the growing separation between ownership and control as another reason for many individuals growing dissatisfaction with this simple conception of firms.
Although there have been criticisms of the profit maximisation model, it still remains the dominant presumption in the analysis of firms behaviour, and hence there are many that still believe in its predictive ability. As Milton Friedman argues; the test of the assumption is not whether firms are ‘really’ profit maximisers, but whether the predicted aggregate behaviour occurs.
The predicted aggregate behaviour of the profit maximising model of the firm is quite simply to maximise profits. And under the circumstances of a typical firm in this model, i.e. small, owner managed and competing with a large number of similar firms, profit is a rational objective for two reasons. Firstly, maximisation of profits means maximisation of income for the owner, and secondly, because of the fierce competition in the market, any firm that did not maximise its profits would not be able to survive in business.
Economic theory has been served well by the behavioural assumption of profit maximisation. “Because profit is the difference between revenue and costs, once revenue and costs are identified the assumption of profit maximisation enables predictions to be readily made about the consequences of any environmental change.” (Hill, 1989, P50-51) Therefore, from a firms costs (derived from a firms production function), and revenues (derived from the demand schedule), the profit function and the output level at which profit is maximised can be obtained from the vertical difference between total revenue and total cost curves. The largest distance between marginal revenue and marginal cost being where profit is maximised, given by output Q. (see appendix 1) “According to this viewpoint, the true objective of the firm is closely related to profit.” (Hill, 1989, P.53)
As discussed earlier, there has been a move away from the profit maximisation theory of the firm towards more managerial theories, the three most credible of these being Baumol’s model of sales revenue maximisation, Williamson’s model of the maximisation of managerial utility, and Marris’s growth maximisation model, each of which have differing predictions from that of their profit maximising predecessor
Firstly, I will look at sales maximisation theory developed by Baumol (1958). According to Sawyer, (1979, P.92), “the theory of Baumol (1959) has at its centre the view that mangers seek to maximise sales revenue of the firm subject to earning an acceptable level of profits for the firm.” Managers may wish to do this as it brings with it the benefits of growth, market share and status. Various studies have shown that a manager’s income, prestige and aspirations are more closely linked to sales revenue than profit. Moreover, steady performance resulting from sales revenue maximisation, is seen as a more comfortable alternative than the possibility of losses inherent in the adoption of highly profitable but risky ventures. However, the sales revenue maximisation model does have its limits in the shape of a profit constraint that is the minimum amount necessary to satisfy shareholders and to raise finance in order to pay for future expansion of sales. (See appendix 2 for a diagram of the sales revenue maximisation model, of which, X is the profit function, Y is the profit constraint, and output Q is the highest output on the total revenue curve that satisfies the minimum profit constraint, and thus is where the firm will produce.)
Another well known managerial theory of the firm that’s predictions differ from that of the profit maximising model, is Williamson’s (1963) managerial utility maximisation model. This model is similar to Baumol’s model in the sense that it also assumes that once again, subject to minimum profit constraint, managers have both the discretion and desire to pursue objectives other than profit maximisation. Management achieve their objectives directly by “ spending any profits above the profit constraint on items that give rise to managerial satisfaction or utility.” (Hill, 1989, P. 58) Williamson identified these items that gave rise to managerial utility and introduced the notion of ‘expense preference’ whereby managers have a preference for some types of expense. The three forms of expenses suggested where staff expenditure, managerial emoluments and the discretionary power of investment, all of which go some way to realising such managerial motives as power, prestige, salary, status and security. This theory allows managers in times of depressed markets, a cushion against economic adversity, in the sense that they can reduce spending on these items without adversely affecting output.
The third model that forms the basis of modern day managerial theory is the model of growth maximisation developed by Marris (1966). This model, whilst having certain similarities with the models developed by Baumol and Williamson, for example, it assumes that managers have both the ability and motivation to pursue objectives other than profit, contrasts to Baumol and Williamson’s models, as it is concerned with a long run situation in which these managerial objectives will be achieved through growth rather than sales. While growth is their main aim, “managers are also motivated by the need for job security, which depends on the satisfaction of the shareholders, who are assumed to be wealth maximisers concerned to keep share prices and dividends as high as possible.” (Davies, 1991, P.40)
The model has two curves (see appendix 2), the supply growth (SG), where growth is a function of profits, and the demand growth (DG), which operates in the other direction, with growth, which is diversification into new products, determining profits. The supply growth curve gives a direct and positive relationship between growth and profits because a higher level of profit allows for a higher level of growth as higher profits facilitates more investment from retained earnings and allows more funds to be raised on the capital markets. The demand growth is more complex and the links between profits and growth are seen as different at different levels of growth. The profit rate at low levels of growth is higher because “at these levels, it is argued that the firm will be introducing the most profitable new products from those that are possible and managers will be motivated to be more efficient by more growth.” (Davies,1991,P.40) However, as the growth rate increases, with more diversification of products, the relationship becomes negative, and as a result, leads to lower profitability.
So managers face a trade of between their desire for growth, from which they gain utility, and the strength of their desire for job security, which may become threatened if they fail to keep the shareholders happy by maximising their wealth or if there is an active threat of a take-over coming from a drop in share price resulting from a large number of unsatisfied shareholders selling their shares. Depending on how big this threat is and the relative preference of managers for job security and growth, will govern the slope of the supply growth curve.
Overall we have seen that the profit maximisation theory and the models in managerial theory, depending on the objectives presumed and the form of constraints operating, generate substantially different comparative predictions. Although, “it has been argued by some economists that the alternatives to profit maximisation,………. such as growth or sales, or even satisficing models, merely place the organisation in a better position to maximise profits in the long run.” (Cook & Farquharson, 1998, P.74) There is little doubt about the attraction of the non-profit maximising theories, but “the assumption of profit maximisation has the enormous advantage of enabling decisions to be modelled simply and sufficiently, and allows decision rules to be developed to cope with a variety of changing circumstances”. (Hill, 1993, P. 63) That’s why to many people, regardless of the development of more modern theories of the firm, the profit maximising approach is still the most effective predictor of a firms behaviour.
Matthew Flint
MN – 2004 Market Driven Management Essay
Mark Burridge
28th April 2003
Bibliography
Books
Hill, S. Managerial Economics: The Analysis of Business Decisions, (The MacMillan Press Ltd, 1993)
Davies, H. Managerial Economics, 2nd Edition, (Pitman Publishing, 1991)
Sawyer, M. Theories of the Firm, (Weidenfeld and Nicolson, 1979)
Cook & Farquharson. Business Economics, (Pitman Publishing, 1998)
Hay & Morris. Industrial Economics and Organisation, 2nd Edition, (Oxford
University Press, 1991)
Jocabson & Andreosso-O’Callaghan. Industrial Economics and Organisation, (McGraw-Hill Publishing Company, 1996)
Appendix 1
Appendix 2
Appendix 3
