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Various
models of managerial and behaviour theories are discussed below:
Managerial Theories of Firm Behaviour
During
the mid-20th century it became common-place in the modern world for companies
to be owned by a large number of individual (and institutional) shareholders.
The Joint Stock Company was (and still is) the normal method for business
ownership of large-scale firms. This type of ownership introduces a problem
that is not relevant to owner-managed firms, namely separation of ownership from
control or principals from agents. Under this type of business structure the
owners (shareholders) are not the decision makers. Instead, professional
managers (agents) are employed to make business decisions on behalf of the
shareholders, who as a collective body have the right to replace the management
but are not otherwise involved in the management of the firm.
There
have been a number of managerial theories of the firm advanced to explain the
nature of business objectives:
- The revenue maximization hypothesis (Baumol,
1959)
- The managerial discretion model (Williamson,
1964) and
- The growth maximization model (Marris, 1964).
The revenue maximization hypothesis(Baumol, 1959)
Baumol
(1959) developed the “Revenue Maximization Hypothesis”. This theory stated that
after a minimum amount of profits have been reached firms that operate in an
oligopolistic market will aim for sales revenue maximization and not profit
maximization. This means that the firm will produce beyond the profit
maximizing level of output. This can be tested by looking at the number of
firms which have a minimum profit constraint. Baumol suggested that firms are
more interested in sales for various reasons. Falling sales may make it
difficult to raise finance and may offer a negative impression of the firm to
potential buyers and distributors. Executive pay is often linked more closely
to sales than to profits. Baumol was not suggesting that firms attempted to
maximize sales because it may lead to greater market share and profits in the long
run. In this model sales maximization was the ultimate objective.
The
most apparent weakness of the model is that it does not address the period of
time over which sales are to be maximized. It is possible that the managers of
the firms in question may have wanted to maximize their short run sales, to
gain market share in order to maximize their long run profits. This behaviour
is not consistent with the model in question as Baumol stated that sales were
the ultimate objective. The managers were not maximizing sales because of some
other benefits that are linked to increased sales; a maximum level of sales was
the aim. If mangers are interested in sales maximization it is likely to be
because of the benefits that they gain from increased sales (power, salary, and
prestige).
If
mangers are interested in sales maximization it is likely to be because of the
benefits that they gain from increased sales (power, salary, and prestige). If
this is the case, as it is in model developed by Williamson (1964) then
maximizing sales is not the ultimate objective, the objective is to gain
salary, power etc. Sales maximizing is then a means of achieving your
objectives and not an objective in its own right.
Bamoul
(1959) developed his model to include advertising and his model predicts that a
sales revenue maximizing firm will advertise, no less than, and most likely
more than, a profit maximizing firm – as additional money spent on advertising
will lead to more sales – the only constraint is one of minimum profit. Bamoul
makes no attempt to test this assumption empirically and offers no support for
the validity of the hypothesis.
The managerial discretion model(Williamson, 1964)
The
managerial discretion model was based on the separation of ownership from
control. Williamson (1964) hypothesised that managers of joint stock firms
would have a different set of objectives from that of profit maximizing. The
model started out as a marginal model, with both the price and output being
determined in the traditional profit maximizing method (MR=MC). Williamson then
developed the idea that managers will gain utility from discretionary
expenditure on perks such as additional staff, special projects and other
spending that increases costs without increasing profit.
The
model was developed from a profit maximizing frame; price and output were
determined by the intersection of the marginal revenue and marginal costs
curves. Total costs increase as the mangers waste money, therefore, the profits
left to be paid, as dividends to shareholders, are less than they would be
under profit maximization. The managerial discretion model was a development of
the classical model, and shares many of the same traits.
The
model developed by Williamson is a mathematical equation that seeks to explain
managerial behaviour. Two new variables (discretionary expenditure and staff
expenditure) are added to the marginalist model. As it is impossible to model
human behaviour in the most complex equation, it is also impossible with a
simplified equation. The managerial discretion model, like profit maximization,
fails if it is taken to literally tell how businesses set price and output, but
it may still be valid at the level of managers’/businesses’ objectives.
The growth maximization model (Marris,1964).
Marris
(1964) developed the theory of managerial capitalism. In this model the mangers
of joint stock companies are concerned with maximizing the rate of growth of
sales, subject to a share price/capital worth constraint. If the share price
falls too low as a portion of the capital worth of the firm, then the firm may
be subject to a take-over bid. The model states that a managerially controlled
firm will opt for a higher rate of sales growth than an owner controlled firm,
and that profits (profit rate) to the owners (shareholders) will be lower in a
managerially controlled firm than it would be for an owner controlled firm, as
profit will be retained to fund growth (new market development, product
development etc). The model looks at the tradeoff between managers’ desire for
a high rate of sales growth, that can offer them the opportunity to maximise
their own utility (in a similar manor to Williamson’s model), and the need to
offer dividends to shareholders. If managers do not offer a high enough
dividend then they might lose their employment.
Managers
are assumed to (be trying to) maximize the utility function U=U (Ċ, v), where Ċ
and v represented, respectively, the satisfactions associated with power,
prestige and salary and the security from take-over, plus stock–market
approval. Ambiguity of the definition of Ċ and v represent the most apparent
limitation of this model, it is difficult to test theories mathematically if
the two main variables have not been clearly identified.
The
models developed by Willaimson (1964) and Mariss (1964) both attempt to explain
managerial behaviour with a mathematical equation. By using these models the
researchers are trying to move away from the abstract simplification of the
classical theory and construct a more realistic framework for analysing firm
behaviour. But once some of the relevant factors are included then why not
include all relevant factors? The end products are models that offer some
intuitive insight into how separation of ownership form control may affect the
objectives of a firm. The models fail to offer a general rule for a theory of
the firm.
Behavioural Theories of the firm
These
theories were given by a noble prize winner Herbert Simon in 1956. R.M. Cyert
and J.E. Mareh Firms cannot maximise profits, sales etc. due to imperfections
in data and incompatibility of interest of various constituent of an
organisation. The firms should satisfy all the constituents of the firm
comprising of the stock holders, management, employees, customers, suppliers
and government. This objective is a multiple goal and it is very difficult to
practice and achieve. Human beings want satisfaction not only in an absolute
sense but in a relative sense as well. The different constituents of a business
firms have diversified interest.
H.A. Simon’s Satisfying Behaviour Model
According
the satisfying behaviour model given by Simon, managers in their business
decision-making are constrained by the factors like incomplete information,
imperfect data and uncertainty about the future. The management determines a
‗satisfactory aspiration level‘ on the basis of its past experience and judgment
about the future uncertainty. They, therefore, seek a second best solution
which is called the satisfying behaviour. The satisfactory behaviour holds that
a manager will aim for:
(i) Satisfactory
level of profit maximization.
(ii)
Satisfactory level of cost rather than cost minimization.
If
the satisfactory aspiration level is achieved easily, the expiration level is
revised upwards. And if the satisfactory aspiration level is not achieved or
upward as well as downward revisions, the management indulges in search
behaviour to find the reasons for the deviations from the aspiration level. Simon
suggests that if the satisfactory state is not achieved even by lowering the
aspiration level and the search behaviour. The behaviour pattern of managers
becomes that of apathy or aggression.
The
model is positive in the following manner:
(i) The model explains certain real-world
situation. For example, the firms generally use make-up pricing to generate
reasonable profits rather resort to marginal cost pricing to maximize profits.
(ii)
Model is consistent with the theory of motivation where human action is a
function of derives and it terminates when derives are satisfied.
However,
there are serious flaws with the theory of satisfying behaviour as given below:
(i) The
model lacks correctness and complete information. It does not identify the
types of information that are sought by a firm and nature of incompleteness,
the information suffer from.
(ii)
The model fails to appreciate the difference between information about
conditions and information about changes in conditions. It is the information
regarding changes in conditions that is vitally more important.
Cyert and March’s behavioural theory offirm
This model suggests that the firm attempts to achieve multiple goals and managers are content to achieve satisfactory levels of these multiple targets. The model considers firm as an ogranisational coalition consisting of various groups, each group having its aspiration level, the goals of the firms are arrived at by the process of continuous bargaining between groups of the coalition, wherein as many conflicting demands of the various groups as possible are accommodated.
According
to Cyert and March there are five major goals of term as under:
(i)
Production goal- is set by the production unit of the firm.
(ii)
Inventory goals- is set by the inventory unit of the firm.
(iii)
Salary of the market goals- is set by the sales unit of the firm.
(iv)
Share of the market goals- is set by the sales unit of the firm.
(v)
Profit goals- are set by the top management keeping in view the expectations of
the shareholders bankers and other financial institution.
In the
organization-coalition if there is a conflict of goals it needs to be overcome.
Cyert and March suggests two ways in which the conflict can be avoided:
Conflict may be phase out overtime in the sense that they are dealt with one by
one, as they arise. Conflicts may be segregated to diffuse their impact on the
whole organization. Each conflict may be localized into its respective
department and decisions taken accordingly.
Criticism of Cyert and March behvaiouraltheory:
Cyert
and March are the leading exponents of the behavioural theory. Cyert and March
based their theory on four actual case studies and two experimental studies
conducted with hypothetical firms. It is thus, obvious that their attempt to
develop a generalized behavioural theory of firm is flawed by lack of adequate
empirical evidence.
Marris’ Managerial Theory of Firm:
Growth
of the firm is obviously the cornerstone of corporate strategy. The goal of the
firm is the maximisation of the balanced rate of growth of the firm. Marris
interprets the goal as the maximisation of the rate of growth of demand for the
firm‘s products and the growth of its capital supply. Marris‘s hypothesis is
that, executive actions are limited by the need for management to protect
itself from dismissal or take-over raids in the event of failure. Marris tried
to improve upon Baumol‘s model. He offered a variation of Baumol‘s model that
stressed the maximisation of growth subject to the security of management‘s
position. Marris approach is also based on the fact that ownership and control
of the firm is in the hands of two different set of people. Like Williamson,
Marris suggests that managers have a utility function in which salary, status
power; prestige and security are important variables.
Owners
of the firm (shareholders) are however, more concerned about profits, market
share, output etc. In other words, goals of the managers and shareholders
differ from each other.
The
utility function of managers (Um) and that of the owners (Uo) may, therefore,
be defined as : Um = f (salaries, power, status, job security)
UO =
f (Profits, market share, output, capital, public esteem).
Robin
Marris believes that most of the variables entering into the utility function
of managers owners are strongly correlated with a single variable- the size of
the firm. He, therefore states that the managers would be mainly concerned
about the rate of growth of size. Marris takes the view that the owners being
interested in the growth of the firm want maximisation of growth of the supply
of capital which is assumed to maximise their utility. The utility function of
owners may be depicted as follows:
UO = f (gc )
Where,
UO = utility of owners,
gc
= rate of growth of capital.
Managers
want to maximise rate of growth of the firm rather than absolute size of the
firm. They believe that growth of demand for the products of the firm is an
appropriate indicator of the growth of the firm. Further, salaries, status and
power of managers are strongly correlated with the growth of demand. The managerial
utility function can be illustrated as under:
Um =
f (gD, s)
Where,
Um = utility of managers.
gD =
rate of growth of demand for the products of firm
s = a
measure of job security.
Marris
has suggested that the decision making capacity of the managerial team sets a
constraint to rate of growth of demand for the products of firm. Furthermore,
he argues that job security can be measured by a weighted average of the
liquidity ratio, the leverage / debt ratio and the profit retention ratio which
together reflect the financial policy of the firm. Marris assumes that there is
a saturation level of job security. Below the saturation level marginal utility
from an increase in job security is infinity while above the saturation level
it is zero. With this assumption, Marris considers job security an exogenously
determined constraint. The marginal utility function thus becomes.
Um =
f (gD) s
Where
s is the security constraint.
In
Marris model, there are two constraints:
(a)The
managerial team constraint
(b)
The job security constraint
(a)
The managerial team constraint:
Marris
is of the view that the capacity of the top management is given at any one time
period. Since management is a team work, hiring new managers does not expand
the managerial capacity immediately. New managers take time to get integrated
in the team which is extremely essential for the efficient working of the firm.
Moreover, the research and development (R & D) department also sets a limit
to the growth of managerial capabilities of the firm. The managerial team
constraint sets limits to both the rate growth of demand for the products of
the firm (gD) and the rate of growth of capital supply (gc).
(b)TheJob Security Constraint:
Managers
want job security. Their desire for security is reflected in the preference for
service contracts, generous retirement benefits and their dislike for policies
which may result in their dismissal. Job security is assumed to be attained by
pursuing a prudent financial policy which requires that the three crucial financial
ratios must be maintained at optimum levels.
To judge the prudence of a financial policy,
Marris proposes the concept of financial constraint which is mainly determined
by the risk attitude of the top management. A risk-loving management would
prefer a high value of a, while a risk averting management would prefer a low
value of Marris defines “a” as the
weighted average of the following three ratios:
Liquidity Ratio (a1 ) = Liquid
Assets / Total Assets
Leverage
Ratio (a2) = Value of Debts
/ Total Assets
Retention
Ratio (a3) = Retained
Profit / Total Assets
The
low liquidity ratio, that is, the ratio of liquid assets to total assets
increases the risk of solvency. Likewise, a high leverage / debt ratio, that
is, the ratio of debt to value of total assets, poses the firm to a high degree
risk of bankruptcy. A high retention ratio which refers to the ratio of
retained profits to total profits, contributes most to the growth of the firm‘s
capital.
According
to Marris, managers subjectively assign weights to financial ratios and combine
them into a single parameter “a”,
which is called the financial security constraint. “a” is negative lineated
liquidity ratio and positively to leverage / debt ratio and retention ratio. Moreover,
there is a negative relation between job security (S) and the financial
security constraint “a”. Thus a Low
value of “a” implies that the
managers are risk averters while a high value of a means that the managers are
risk takers. In Marris model, the financial security constraint “a” sets a limit to growth of the supply of
capital gc. (“a” is financial security management).
The
managers of corporate firm aim at maximisation of their own utility which is a
function of the growth of demand for the product of the firm, given the job
security constraint
Um - f (gD)
The shareholders
of corporates aim at maximisation of their own utility which according to
Morris, is a function of the growth of the supply of capital. The firm is
considered to be in equilibrium when it attains the maximum balanced rate of
growth. Thus, the condition for equilibrium of the firm may be written as
follows :
gD = gC = g* maximum
In
order to follow the above condition for the equilibrium of the firm, it is necessary
to grasp the factors that determine gD
and gC.
Marris
argues that the two variables, the
diversification (d) and the average
profit margin (m) adequately represents the factors that determine gD and gC.
Marris
suggests that the corporate first decides subjectively its financial policy. In
other words the firm first determines the value of the financial constraint “a” . Subsequently, the rate of
diversification (d) and profit margin (m) will be chosen.
To
achieve balanced growth rate would be to identify the factors that go in to
determine gD and gC. According to Marris, these determines can be expressed in
terms of two variables :
a)Diversification
rate (d) ; and
(b) Average profit margin (m)
Both
these variables can be, however determined only after the management has decided
about its financial policy “a”. The
diversification rate can be chosen either by changes in style of the production
cost, the average profit margin would be affected by the levels of advertising
and D, Higher the expenditure on advertisement (A) as well as R and D, lower
would be the average profit margin (m). Thus, the Marris gave three policy
variables : a, b and m.
Marris
also points out that there can be a conflict between managers’ objective of
maximising growth and shareholders’ objective of maximising profits. Therefore,
if the growth maximising solution does not generate sufficient profits, growth
rate will have to be reduced to increase given to meet shareholders
expectations.
In
brief, in Marris model, the management, whose actions are limited by the
motivation to protect it itself dismissed or take-over bids, takes to the
following course :
(a)
The management must walk on a knife-edge between a debt/asset ratio high enough
to stimulate growth but not low enough to suggest financial imprudence.
(b)
The management must also maintain a low liquidity ratio, i.e., liquid
asset/total assets. But this ratio must not be so low that it endangers paying
all obligations on time.
(c)
The management must try to keep a high retention ratio, viz. retained
earnings/total profits. But this ratio should not be so high that shareholder
are not paid satisfactory (gd) and growth rate of capital supply (g):
Max.
g = gd = gc
g =
balanced growth rate
gd =
growth of demand for products
gc =
growth of supply of capital
By
this process the managers achieve maximisation of their own utility as well as
that of the share-holders. In case the management wants to expand too rapidly,
it runs the risk of job security. On the other hands, if it wants to expand too
slowly, it would be considered as an inefficient management, again impairing
job-security.
R.
Marris has made a significant contribution in the form of incorporation of
financial policies into the decision making process of the corporate firm. His
theory suggests that although the managers and the owners have different goals,
it is possible to find a solution which maximizes utility of both. Still there
are certain weaknesses of the theory as under:
(i) The
assumption of given production costs and a price structure is the weakness of
Marris theory.
(ii)
Marris theory does not explain the determination by either costs or prices.
(iii)
Oligopolistic interdependence is not satisfactorily dealt with, within Marris
Model.
(iv)
Marris brushes aside the mechanism by which prices are determined.
(v)
Marris‘s assumption that the growth of the firm is achieved mainly via the
introduction of new products which will be imitated by competitors, does not
hold the ground.
Thus
the maximisation of the goal of balanced growth (maximise g = gd = gs) is that
by jointly maximising the rate of growth of demand and capital, managers
achieve maximisation of their own utility as well as utility of the
shareholders.
