MANAGERIAL MODELS OF THE FIRM

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1 MANAGERIAL MODELS OF THE FIRM THE NEOCLASSICAL MODEL 1. Many Models of the firm based on different assumptions that could be described as economic models. 2. One particular version forms mainstream orthodox treatment of the firm, that is, the neoclassical version. 3. The neoclassical version is based on three basic assumptions of the firm concerning The aim of the firm Costs And output The assumption of profit maximisation Profit maximisation is assumed to be the basic objective of the firm. Profit is defined as the difference between revenues and costs. The above specification of the model is vague, as it does not specify the time period over which the profits are to be maximized. This can be resolved in two ways: The simplest is to see the model as a one period or short-run model where the firm s assumed aim is to make as much profits as possible in the Short Run. The short run is defined as that period in which the firm is restricted to a given set of plant and equipment, and has some fixed costs which cannot be avoided even by ceasing production. The other version establishes a multi-period setting for the model and it assumes that the objective of the firm is to maximize the wealth of its shareholders. Wealth in this case is defined as the discounted value of the expected future net cash flows into the firm

2 The firm therefore faces two kinds of interrelated decisions: 1. First it has to take the LR or Investment Decisions on the size of the plant it wishes to install. 2. It also has to decide upon the most profitable use of that set of plant and equipment-: this is done in the short run. The short run capacity utilization decisions are essentially the same as those facing the firm which is maximizing profits in the SR. Relationship between Single period and multi-period profits If the profits made in each period are independent of each other there is no problem. However there is a problem if the profits made in the current period could have an influence on the profits made in the future, because in that case it could be possible that shareholders wealth could be maximised by sacrificing profits in the current period. For example if a firm is a monopoly the maximum profit in the current period could be very large. If this firm uses this monopoly power to make the maximum profit in the short run two things may happen: Other firms may be attracted into the industry The firm may draw the attention of anti-trust authorities. From the above information it can be seen that maximisation of shareholders wealth will be better achieved by not taking the maximum profit possible in the short run. The simple neoclassical model of the firm does not consider such complications and it could be interpreted as being concerned with the maximisation of SR or single period profits. The assumption of profit maximisation gives the basic model of the firm a number of properties that distinguish it from the other models 1. The firm is seen as an entity that has objectives of its own and can take its own decisions. This is in contrast to the behavioural model which argues that only people can have objectives, organizations can not. 2. The other property stems from the assumption of profit maximisation. This assumption shows that this is an optimizing model where the firm is attempting ton achieve the best possible performance rather than simply seeking feasible performance which meets some set of minimum criteria. Again this is in contrast to the behavioural model and to many quantitative techniques in operations management or operations research which seek to identify feasible rather than optimal solutions to problems.

3 The assumption of costs and output The firm is assumed to produce a single perfectly divisible, standardized product for which costs of production are known with certainty. In the SR when some of the costs are fixed and some are variable the average cost curve will be U-shaped as shown. Costs per unit falls over the range A to B, as the fixed costs are spread over a larger number of units, but begins to rise beyond B as the principle of diminishing returns leads to increasing variable costs per unit. Short run cost curve The model depicts a firm that is attempting to maximize its profits with respect to a particular set of plant and equipment which has a particular SR cost curve. If we also wish to consider LR decisions then attention needs to be paid to the behaviour of costs in the LR.

4 EQUILIBRIUM AND PROFIT MAXIMISATION With the knowledge of cost and demand conditions, and the assumption of profit maximisation that we made we can now move to the next stage of model building which is to draw out the implications, or predictions that follow from the assumptions. The mathematical formulation of the model can simply be set out as follows: Maximise (q) = R (q) C (q) Where (q) = profit R (q) = Total revenue C (q) = Total costs q = Units of output produced and sold. Profits are maximised when the following conditions are met: Necessary Condition: MR = MC Sufficient Condition: The slope of the marginal cost curve should be greater than the slope of the marginal revenue curve at the point where they intersect. In other words the MC curve should cut the MR curve from below.

5 Diagrammatic representation: profit maximizing equilibrium Profit maximizing level of output is X and the profit-maximizing price is P. The decision that the firm is facing concerns the level of output that should be produced and sold using the set of plant and equipment that has been installed. This simple model assumes that sales volume and output are equal, taking no possibility of producing stock or selling from stock. It will pay the firm to produce any unit of output for which the extra revenue earned exceeds the extra cost. At level of output X all such units are being produced. If output is increased further, the additional units produced will add more to costs than to revenues and the level of profit will fall. If cost and demand conditions remain the same, the firm has no incentive to alter its price or output, and the firm is said to be in equilibrium.

6 APPLICATIONS OF THE SIMPLE MODEL Profits in the LR: The maximisation of shareholders wealth The profit-maximizing model set out above is concerned with capacity utilization in the SR. The firm has some fixed costs arising from a given set of plant and equipment and is keen to make as much profit as possible given the constraints set by that equipment. However the firm also has to take investment decisions, which are concerned with the LR in which no costs are fixed and when the firm is free to choose whichever set of plant and equipment it prefers. The LR objective of the profit-maximising firm is said to be the maximisation of shareholders wealth, which is achieved by maximizing the value of the firm. This is measured by the present value of the stream of expected future net cash flows accruing to the firm. The restatement of the firm s profit objective in this way allows the SR and the LR to be properly integrated. In the LR, the firm decides upon the set of capital equipment to purchase by using investment appraisal techniques based upon the calculation of present values. However, these calculations themselves require estimates of revenues and costs that are associated with each investment project, on the assumption that the equipment once purchased, will be used to secure maximum profits. Choosing a set or capital equipment in the LR therefore requires the solution of the questions concerning revenues, costs and profits in the SR. If the profits earned in each period, or each SR are independent of each other, then the maximum of the profit in each period will lead to the maximum of shareholders wealth. However, if the profits in one period depend upon profits in another, there may be a conflict between the two objectives. A firm with a monopoly position might make maximise profit in the SR by exploiting that position to the full, but in doing so it might attract entry into the industry, or anti-trust action from government, which would reduce profits in the future period. Maximising shareholders wealth could require the sacrifice of immediate profits in order to protect their value in the longer term, depending upon the shape of the time stream of profits and the discount rate used to calculate present values.

7 MANAGERIAL CRITICISM OF THE PROFIT MAXIMISING MODEL The profit maximising model has been criticized as follows: The claim that firms aim for maximum profits is considered as unrealistic particularly in the modern day economy where OWNERSHIP AND CONTROL of firms lie with different groups of people. Control lie in the hands of professional managers and ownership rests with the shareholders. If the interests of shareholders and managers differ in the case where the shareholders have relatively limited information about the performance of the firms they own and if shareholders take relatively little interest in the firms operations (provided that a satisfactory dividend is paid), then the managers may have a good deal of discretion to pursue their own objectives. This will be true where firms have some degree of monopoly power and do not need to compete keenly in order to make a satisfactory level of profit. It has been suggested, therefore, that in such markets firms do not pursue profit as their major objective. The suggestion that profit is not the objective of modern corporations has led to the search for alternative models based upon different assumptions about the firm s objective. BAUMOL S SALES REVENUE MAXIMSATION Baumol s model stems from his observation that the salaries of managers, their status and other rewards often appear to be more closely linked to the size of the companies in which they work, measured by sales revenue, than to their profitability. In that case managers may be concerned to increase size than to increase profits and the firm s objective will be to maximise sales revenue rather than profits. If the assumption of profit maximisation is then replaced by that of sales revenue maximisation, then a different model results. In many respects, it shares fundamental characteristics with the standard neoclassical model, as it is also an optimizing model in which a single product firm s aim is sales maximisation, having perfect information about its cost and demand conditions. The basic version of the model uses Total Revenue, Total Cost and Profit curves.

8 In the figure above the firm will choose to produce level of output A, giving TR B and profit C. Note that this implies a higher level of output and therefore a lower price, than the equivalent profit maximizer, who would produce output D and earn revenue E. A straightforward revenue-maximizer will always produce more and charge less than a profit-maximizing firm facing the same cost and demand conditions. In the example above the sales maximizer also makes a profit. However, this may not be enough to satisfy the shareholders, and in many cases maximising revenue imply making losses. As a result the simple revenue maximising model needs to be amended to include a profit constraint.

9 Revenue maximization subject to a constraint As the figure shows there three possible cases in this amended version of the model. The first is where the profit constraint is as shown by line PC1. In this case the constraint does not bite (A in the first diagram is the same as A in the second diagram). This point implies that at the level of output that maximizes revenue, enough profit is made to satisfy the shareholders. The second case is where the profit constraint is as indicated by PC2. At the revenue maximizing level of output (A) insufficient profit is made to satisfy the shareholders. Hence output is reduced until that constraint is met at level of output B. The third case is where the minimum profit required to satisfy the shareholders is equal to the maximum profit that can be made (PC3), in which case the firm has to reduce its

10 output from A to C. In this third case the firm behaves in exactly the same way with respect to output and price as a profit maximiser, despite the fact that it has set itself a different objective. If the shareholders insist that the maximum level of profit should be earned then the profit maximising model will provide accurate predictions of the behaviour of the firm whose management prefers to maximize sales revenue. If the purpose of the model is to predict the firm s behaviour, the fact that managers see their aim as maximising sales revenue and not profit, is irrelevant. The firm behaves as if it were a profit maximiser. For a profit maximizer an increase in fixed costs or imposition of a lump sum tax does not change price and output. However, for a revenue maximizer whose profit constraint is already biting, a lump sum tax will reduce profits and will force the firm to lower its output and raise its price. MANAGERIAL UTILITY MAXIMISING MODEL In Baumol s sales revenue model managers interests are tied to a single variable with the addition of a profit constraint. Oliver Williamson s managerial utility maximising model takes account of a wider range of variables by introducing the concept of expense preference beginning with the assumption that managers attempt to maximise their own utility. The term expense preference simply means that managers get satisfaction from using some of the firm s potential profits for unnecessary spending on items from which they personally benefit. Williamson identifies three major types of expenses from which managers derive utility. These are: The amount managers can spend on staff, over and above those needed to run the firm s operations (S). This variable captures the power, prestige, status and satisfaction that managers experience from having control over large numbers of people. Additions to managers salaries and benefits in the form of perks (M). These include unnecessary luxury company cars, extravagant entertainment and clothing allowances, club subscriptions, palatial offices and similar items of expenditure. Such items may also be thought of as managerial slack or X-inefficiency. They appear as costs to the firm, but are not necessary for the efficient conduct of its activities and are in effect coming out of profits. Discretionary profits (D). These are after tax profits over and above the minimum required to satisfy the shareholders. They are therefore available to the managers as a source of finance for Pet Projects and allow the managers to invest in developing the firm in directions that suit them enhancing their power, status and satisfaction.

11 Clearly there are conflicts and trade offs between the different objectives in this model, and it is considerably more complex than those considered thus far. The basic model is therefore give by the following: U = f (S, M, D). This simply means that managerial utility depends upon the levels of S, M, and D available to managers. In line with the theory of consumer behaviour it is assumed that the principle of diminishing marginal utility applies, so that additional increments to each of S, M and D yield smaller increments of utility to management. If R = revenue, C = costs and T = taxes, then: Actual Profit = R-C-S Reported profit = R-C-S-M If the minimum post tax profit required by the shareholders is Z, then: D = R-C-S-M-T-Z The solution to the model requires the use of calculus in order to maximize the utility function. However it is possible to set out a simplified version. If managerial utility is to be maximised, the last pound spent on S, M, and D must yield the same marginal utility. MU S = MU M = MU D (1-t) Where t is the rate of tax on profits. Comparative static properties of the model If demand declines, then at every level of output D will decline. On the assumption of diminishing marginal utility, MU D will rise, so that the equilibrium condition is no longer fulfilled. To regain equilibrium the available profits will be distributed towards D and away from S and M. The level of output will fall. Similarly for a rise in fixed costs, or lump sum tax. If the tax on profits increases, then MU D (1-t) will fall and there will be a shift towards S and M, accompanied by increasing output.

12 As in the Baumol case, it should always be remembered that the logic of the utility maximising model depends upon the management team having the discretion to earn less than maximum profits. If the minimum profit required by the shareholders is equal to the maximum possible, the managers will not have the discretion to indulge their taste for perks and unnecessary staff. J.WILLIAMSON INTEGRATIVE MODEL Both of the models outlined above have been based around a single objective function. J. Williamson s integrative model goes a step further by combining a single period profit and sales maximisation with growth maximisation and the maximisation of the present value of future sales. The outcome depends on the discretion that the managers have to pursue their own objectives. BEHAVIOURAL CRITICISMS OF MODELS OF THE FIRM The managerial models of the firm stem from criticisms of the profit-maximizing assumption, on the grounds that when ownership and control are separate and many firms compete in relatively comfortable market structures, managers are able to direct the resources of companies towards their own ends. The firm is capable of having objectives, even if those objectives are held by a group of managers and differ from those of shareholders. The firm is seen as taking and implementing decisions. The models outlined above are all optimizing models and it is also assumed that the firm has certain knowledge of the cost and demand conditions facing it. In effect the managerial models differ from the orthodox only in that they begin with a different assumption with respect to the firm s objective. The behavioural theorists argued that organizations cannot have objectives only people can. The behavioural theorists also rejected the assumption that those taking decisions are perfectly informed. The assumption of certainty is abandoned and emphasis is placed on the idea that most organisations are so complex that the individuals within them have only limited information with respect to both internal and external developments.

13 THE BEHAVIOURAL MODEL Key elements of the behavioural model A firm has multiple objectives which are in conflict with each other and which cannot be reconciled through a concept like the utility function. For example the accountants in a firm may wish to keep the level of stocks down in order to reduce the costs of holding them. At the same time the sales department may wish to hold high level of stocks in order to be able to meet orders quickly. The research department may wish to employ a large number of qualified scientists, while the marketing department would prefer to spend more on advertising. Longer established employees may wish to avoid interruptions to their routine while newly employed executives may be anxious for change. Each individual will themselves have multiple objectives, arising from their personal histories, preferences and position within the firms, and these multiple sets of objectives cannot be reduced to any simple overall statement that explains what the organisation as a whole is attempting to achieve. Decision makers exhibit satisficing and not optimizing behaviour. Each person or group has a satisficing level for each of its objectives. If these levels are reached they will not seek for more, in the short term at least, but if they are not met, action will be taken in order to remedy the problem. An important consequence of satisficing behaviour is that firms acting in this way will not keep costs down to a minimum. Instead they will exhibit organizational slack incurring higher costs than are absolutely necessary. If one of the multiple objectives is not met so that someone within the firm is dissatisfied, a search will take place for a means of meeting that objective. However, the search will use rules of thumb to attempt to put the problem right. The rules of thumb are not arrived at through any detailed analysis, but are a function of past experience of the firm and the people within it. For instance if revenue falls, the firm may automatically raise its price, because that has been tried in the past and appeared to be successful. The aspirations of the individuals within the firm which determine the levels of each objective with which they will be satisfied change over time as a result of organizational learning. If the firm succeeds in meeting all of its objectives for a period of time then eventually the individuals and groups raise their aspiration levels demanding more of whatever it is they care about. Eventually a situation will be reached where not everyone achieves satisficing levels with respect to all their objectives, at which point a problem- oriented search will take place to seek a solution to the problem. If one is found, the process of gradually increasing aspirations can continue. On the other hand, if a solution is not found despite a number of searches, aspiration levels with respect to the particular variable concerned fall.

14 THE CONCEPT OF X-INEFFICIENCY A useful concept that links the behavioural model and the managerial utility model is that of X-inefficiency. In the standard neoclassical profit-maximizing model it is assumed that the firm incurs the minimum cost achievable for the level of output being produced, given the set of plant and equipment installed. In terms of the diagram, the firm is on its cost curve. Such a firm may be described as being X-efficient or operationally efficient. However this may not be the case. A firm that is maximising managerial utility, for instance will tend to spend more on staff and on perks for the management than is necessary, in which case it may be said to be X-inefficient. In terms of a diagram it will be above its cost curve as shown below. Point E illustrates this. An x-inefficient firm

15 Similarly, a firm that conforms to the behavioural model will incur higher costs than are strictly necessary; and be X-inefficient, or have organizational slack. FACTORS THAT ENCOURAGE / DISCOURAGE X-INEFFICIENCY The degree of X-inefficiency will be partly determined by factors that are internal to the firm. If contracts between PRINCIPALS (OWNERS) and AGENTS (MANAGERS and WORKERS) are not efficient, then workers and managers will not be motivated to keep costs down, and the firm will be X-inefficient. If larger firms are more difficult to control, with a greater degree of bureaucratic rigidity, then they will also tend to be more X-inefficient. The second set of factors that determine the degree of X-inefficiency is to be found in the external environment in which the firm operates. If the firm is forced by its environment to aim for maximum profit, it must eliminate X-inefficiency. On the other hand, if the management has the discretion to avoid profit maximisation, it will allow its costs to rise above the level that is strictly necessary. The environmental factors that lead to X-inefficiency are therefore the converse of the factors that force the firm to aim for maximum profits. If shareholders are diffused among a large number of relatively ill-informed small shareholders, there may be little pressure from that direction. If the threat of takeover is limited, perhaps because the firm is too large to be under serious threat, or because anti-trust legislation prevents takeover, then the likelihood of X-inefficiency is correspondingly higher. Similarly the degree of X-inefficiency will tend to be higher as the market structure in which the firm operates is less competitive.

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