Managerial theories of firms

The

managerial theories separate ownership from

management, the owners are the shareholders, whose
power lies in appointing the board of directors, which in
turn appoints top management.

Owners
shareholders

Board of directors

Top
Management

 The managers discretion in defining the goals of the firm is limited by

the need to produce a minimum level of profit necessary to satisfy the

shareholders.
The basic feature of all managerial theories is that the manager
maximize their own utility, subject to a minimum profit constraint
necessary for the job security agent problem
To deal with the principal agent problem(i.e., different goals of
manager and owners), firms often give managers a financial stake in
the success of the firm so that they pursue objectives that are close to
profit maximization.
Many corporations have adopted employee stock option plan(ESOPs)
under which managers can purchase shares of common stock at less
than market price.

 These plan give managers an incentive to promote profits of the firm

and to act in harmony with the interests of the owners.

One recent study shows that if managers own between 5 and 20 per
cent of a firm, the firm is likely to perform better in terms of
profitability, than they own less than 5 per cent.
In the USA, there are approximately 10,000 ESOPs with 10 million
employee owners(ESOP Association, USA).
Wipro and Infosys, the two largest listed IT Stock in India, were
amongst the first companies to institute ESOPs.

Baumol's Theory of Sales Revenue

Maximisation
Baumol has postulated maximization of sales revenue as an alternative to

profit maximization objective.

According to him oligopolistic firm aim at maximizing the sales revenue.
According to the sales-maximization model introduced by William
Baumol and others, managers of modern corporations seek to maximize
sales after an adequate rate of profit has been earned to satisfy
stockholders.
Baumol argued that a larger firm may feel more secure, may be able to get
better deals in the purchase of inputs and lower rates in borrowing money,
and may have a better image with consumers, employees, and suppliers.
Indeed, some early empirical studies found a strong correlation between
executives salaries and sales, but not between salaries and profits. More
recent studies, however, found the opposite.

Assumption
1.
2.
3.
4.

5.

6.
7.

There is a single period time horizon of the firm.

The firm aims at maximizing its total sales revenue in the long run
subject to a profit constraint.
The firms minimum profit constraint is set competitively in terms of
the current market value of its shares.
The firm is oligopolistic whose cost curves are U- shaped and the
demand curve is downward slopping.its total cost and revenue curves
are also of the conventional type.
Advertisment is a major instrument of the firm as non-price
competition is the typical form of competition in oligopolistic
markets.
Production costs are independent of advertising
Price of the product is assumed as constant

The Factor which explain the pursuance of sales goals by the

managers are following.
First, salary and other earnings of managers are more closely related to
sales revenue than profits
Second, banks and financial corporations look at sales revenue while
financing the corporation
Third, trend in sale revenue is a readily available indicator of the
performance of the firm. It helps also in handling the personnel
problem.
Fourth, Increasing sales revenue enhances the prestige of managers
while profits go to the owners.

 FIFTH, managers find profit maximization a difficult objective to

fulfill consistently over time and at a same level. Profits may fluctuate
with changing conditions.
Sixth, growing sales strengthen competitive spirit of the firm in the

market and vice versa.

The implication of Baumols model is that risk avoidance has a
statistical effect upon economic activities, e.g. R&D in large firms.

Sales Maximization Model

(Baumol)

 So far as empirical validity of sales revenue maximization objective is

concerned, factual evidences are inconclusive. Most empirical works

are, in fact based on inadequate data simply because requisite data is
mostly not available. Even theoretically, if total cost function intersects
the total revenue functions(TR) functions before it reaches its climax
,Baumols theory collapses.

Criticism of Baumols Model

1.
2.

3.

4.
5.

Rosenberg has shown that it is difficult to specify exactly the relevant

profit constraint for a firm.
Hawkins has also shown that baumols conclusion that a salesmaximiser will in general produce and advertise more than a profitmaximizer,is invalid
In the case of multi-products,Baumol has argued that revenues and
profit maximization yield the same results. But Williamson has
shown that sales maximization yields different result from profit
maximization
Another weakness of this model is that it ignores the
interdependence of the prices of oligopolistic firms.
The model fails to explain observed market situations in which price
are kept for considerable time periods in the range of inelastic
demand.

6. The model ignores not only actual competition, but also the threat of
potential competition from rival oligopolistic firms.
7. The model does not show how equilibrium in an industry, in which all
firms are sales maximizes, will be attained. Baumol does not establish
the
relationship between the firm and industry.
8. Professor hall in his analysis of 500 firms came to the conclusion that
firms do not operate in accordance with the objective of sales
maximization.

Marriss hypothesis
According to robin marris, managers maximize firms balanced growth

rate subject to managerial and financial constraints

The firms balanced growth rate(G) is defined as
In this executive actions are limited by the need for management to
protect itself from dismissal or takeover raids in events of failure
maximize G =GD = Gc
Where GD = Growth rate of demands for firms product and GC=Growth
rate of capital supply to the firm.
A firms growth rate is balanced when demand for its product and

supply of capital
to its firm increase at the same rate. The two growth rates are
according to marris,translated into two utility functions:1) managers
utility function and 2) owners utility function

The managers utility function(Um) and owner's Utility function( Uo) may
be specified as follows.
Um=f(salary,power,job security,prestige,status)
Uo =f(output,capital,market-share,profit,public esteem)
Model highlights two important factors as far as management is

concerned: the attitude to risk and uncertainty and the desire for utility
which may not be maximised by the pursuit of maximum profits.
Owners utility function may be written as

U0 = f *(gc)
where gc = rate of growth of capital.

 s can be measured by a weighted average of three ratios: the liquidity ratio, the
leverage debt ratio and the profit-retention ratio.

1.

2.

3.

Liquidity ratio = Liquid assets/

Total assets
Debt ratio

=Value of debt/
Total assets

Retention ratio =Retained profits/

Total profits

 Too low liquidity ratio may lead to insolvency and bankruptcy and there is a
threat of take-over in case it being too high.
Too low Retention ratio may upset shareholders and too high ratio may inhibit
growth.

Criticism of marris hypothesis

1.

2.
3.
4.

Marris assumes a given price structure for the firms.he therefore, does not
explain how prices of products determined in the market.this is a serious
weakness of his model
Another defect of this model is that it ignores the problem of oligopolistic
interdependence of firms in non-collusive market.
This model also does not analyse interdependence created by non-price
competition.
The model assumes that firms can grow continously by creating new
products. This unrealistic because no firm can sell anything to the
consumers.After all,consumers have their preferences for certain brands
which also change when new products enter the market.

5.

6.

7.

8.
9.

According to koutsoyiannis, marris model is applicable basically to those

firms which produce consumers goods,The model is not appropriate for
analyzing the behaviour of manufacturing businesses or traders.
Marris lumps together advertising and R&D expenses in his model. This Is a
serious shortcoming of the model because the effectiveness of these two
variables is not the same in any given period.
Marris assumes that firms have their own R&D department on which they
spend much for creating new products.But,in reality,most firms do not have
such departments.For product diversification,they imitate the inventions of
other firms and in case of patented inventions they pay royalties for using
them.
The assumption that all major variables such as profits,sales and costs
increase at the same rate is highly unrealistic.
It is doubtful that a firm would continue to grow at a constant rate,as
assumed by marris.The firm might grow faster now and slowly later on.

Williamsons model
A

more useful model of managerial utility is given by

o.williamson,known as the 'Model of Managerial Discretion.
In Williamson model, manager are free to pursue their own selfinterest once they have achieved a level of profit that will pay
satisfactory dividends to shareholders and still ensure growth.

Assumptions
Market is non perfectly competitive
Ownership of the firm and management of the firm are divorced from each
other

A minimum profit constraint is imposed on the managers by the capital

market(or, shareholders) which cannot be ignored by the management.

 The management utility function is expressed as:

U=f(S,M,ID)
Where,S is staff expenditure(including managerial salaries,the
administrative and sellingexpenses),M depicts managerial emoluments
and Id is discretionary investment.
Criticism of Williamsons Model
1. He does not clarify the basis of the derivation of his feaibility curve.in
particular,he fails to indicate the constriant in the profit staff relation
in the feasibility curve.
2. He lumps together staff and manager emoluments in the utility
curve.
3. This theory not deals with oligopolistic interdependence and of
oligopolistic rivalary.

Behavioral Theories of the firm

Behavioral theories combine industrial economics and organisational

theory.
Unlike managerial theories,behavioural theories view the firm as
engaged in non- maximizing behavior.
According to behavioral theories, the firms sub-optimal behavior arises
from uncertainty and conflicting goals of various groups within the
firm
Behavioral theory analyse the organization of the firm,the way in which
decisions are reached,and the inter-group conflicts within the
organization.
Thus while managerial theories emphasize the role of management,the
behavioural theories argue tahat groups within the firm other than
managers influence the behavioue of the firm.

Simons Satisficing Model

The advocates of satisficing theory say that firms goal should be

satisficing rather than optimizing. Satisficing means acceptance of less

than the best. They argue that the behavior of real-world managers is
not always consistent with the profit-maximization goal.
Because of the great complexity of running the large modern
corporation a task often complicated by uncertainty and a lack of
adequate data managers are not able to maximize profits but can only
strive for some satisfactory goal in terms of sales, profits, growth,
market share, and so on.
Simon called this satisficing behaviour. That is, the large corporation
is a satisficing, rather than a maximizing organization.
The model helps in explaining real world situation.for example,the
firms generally use mark up pricing to generate reasonable profits
rather than resorting to marginal cost pricing to maximise profits.

Cyert and march model

The theory focuses on the way of decisions are made in the modern large multi
product firm under certainity in an imperfect market
They base their theory on the internal structure of such firms and to analyze
the typical organizational problems which the internal structure of such firms
creates and the effects of these problems on the decision making process.

Cyert and march(1963)makes four major research commitments:

1. To focus on the small number of key economic decision made by the firm.
2. To develop process-oriented models of the firms.
3. To link models of the firm as closely as possible to empirical observations.
4. To develop a theory with generality beyond the specific firms studied.

 The cyert and the march model can be studied

in the following sequence:
1.
Firms as a coaliation of groups with conflicting goals:the theory focuses
on the decision making process of a large multi product firm under
uncertainity in an imperfect market.
2.
Process of goal formation-the aspiration level:each member or group of

3.

4.

the coaliation firm has a multiplicity of demands on the organization,often

conflicting with the demand of the other members and with the overall goals
of the firm.
GOALS OF THE FIRM:The goals of the firm are set by top
management.There are five main goals of the firmproduction,inventory,sales,share of the market and profit.
Means for resolution of the conflicts: given the limited resources of the
firm in any one period and the impossibility of satisfying all
demands,conflicts is invitable.

5.Decision making process: decision at top management level and

decision taken at lower level of management
6.Uncertainity and The Environment of the firm: market uncertainty
and uncertainty of competitors reactions
7.Simple model for illustration of theory: the model refers to the duopoly.
The decision process involves the determination of the output which is
homogeneous, so that single price will ultimately prevail in the market
Criticism:
1. The behavioural theory deals realistically with the firms activity,it does
not explain the firms behaviour under dynamic condition in the long run.
2. It cannot be used to predict exactly the future course of firms activities
3. The theory does not deals with the equilibrium of the industry
4. The theory fails to deal with interdependence of the firms and its impact
on firms behaviour

Agency Theory
There has been a new development in the theoretical analysis of the firm which

suggests that profit maximisation can be a realistic assumption.This is known asthe

agency theory.This theory explains the agent-principal relationship in private and
public firms.
Agent-principal relationship in private firm:The firm is seen as a network of
contracts between the principal and a group of agents.A firms principal is its owner
and manager are its agents.
Agent-principal relationship in public enterprise:The agent- principal
relationship in a public enterprise(company run by the government) is quite
different from that of a private firm.In a public enterprise,the principal is the public
and agents are parliament,civil servants and public boards that manage industries
and services.if people are not satisfied with its working,they can show their
resentment by voting out the ruling party through the ballot box in the election.