Managerial Theories Of Firm


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Managerial Theories Of Firm

  3. 3. Three theories of Managerialism <ul><li>1. Baumol’s Model of Sales Revenue maximisation. </li></ul><ul><li>2. Marris’s Theory of Managerial Enterprise </li></ul><ul><li>3. Williamson’s Theory of Managerial Discretion </li></ul>
  4. 4. Baumol’s Model of Sales Revenue Maximisation <ul><li>W.J.Baumol suggested </li></ul><ul><li>Sales Revenue maximisation as an alternative goal to profit maximisation. </li></ul><ul><li>Managers only ensure acceptable level of profit, pursuing a goal which enhances their own utility. </li></ul>
  5. 5. Baumol’s Model : (contd.) <ul><li>Rationale of the Hypothesis: </li></ul><ul><li>Management has been separated from ownership in modern times. </li></ul><ul><li>This has given powers to Managers who pursue their own goals rather than the goal of the owners. </li></ul><ul><li>Managers ensure a minimum acceptable level of profit to satisfy the shareholders, but would pursue a goal which enhances their own utility. </li></ul>
  6. 6. Baumol’s Model : (contd.) <ul><li>Why Managers attempt to maximise sales rather than profits:- </li></ul><ul><li>Incomes of top executives are closely related to sales rather than profits. </li></ul><ul><li>Banks and financial institutions are impressed by the amount of sales and treat this as a good indicator of the performance of the firm. </li></ul><ul><li>Large and continuing sales enhance prestige of the Managers, who ensure regular distribution of dividends. </li></ul>
  7. 7. Baumol’s Model : (contd.) <ul><li>4 A steady performance with satisfactory amount of profits is preferably to irregular spectacular profits in some one or two years. Having shown high profits, if the level is not maintained, it will lead to discontent of shareholders. </li></ul><ul><li>5. Large sales strengthens the competitive power of the firm vis-avis competitors, while low or declining sales diminishes this power of bargaining. </li></ul>
  8. 8. <ul><li>Separation of ownership and management combined with the desire for steady performance which ensures satisfactory profits, tend to make the managers risk avoiders . Top Managers in the modern firm are generally reluctant to adopt highly promising but risk-prone projects. But this approach stabilises the economic performance of the firm and leads to development of orderly markets. </li></ul>
  9. 9. Basic assumptions in Baumol’s Static Models: <ul><li>A firm’s decision making is limited to a single period. During this period, the firm attempts to maximise total revenue rather than physical volume of sales. </li></ul><ul><li>Sales revenue maximisation is subject to provision of minimum required profit to ensure a fair dividend to shareholders, thus ensuring stability of his job. </li></ul><ul><li>Conventional Cost and Revenue functions are assumed – Cost curves are U-shaped, Demand curve is downward sloping. </li></ul>
  10. 10. <ul><li>“ In Corporate firms, there is structural division of ownership and management which allows managers to set goals which do not necessarily conform with those of the owners. The shareholders are the owners. Their utility function includes variables such as </li></ul><ul><li>profits, </li></ul><ul><li>size of output, </li></ul><ul><li>size of capital, </li></ul><ul><li>market share and </li></ul><ul><li>public image. </li></ul>Marris’s Theory of The Managerial Enterprise
  11. 11. Marris’s Theory of The Managerial Enterprise(contd.) <ul><li>“ </li></ul><ul><li>The Managers have other ideas. Their utility function includes variables such as </li></ul><ul><li>Salaries, </li></ul><ul><li>Job security, </li></ul><ul><li>Power and status. </li></ul>
  12. 12. Marris’s Theory of The Managerial Enterprise(contd.) <ul><li>The owners want to maximise their utility while the managers attempt maximisation of their own utility. </li></ul><ul><li>Both utilities do not necessarily clash, because the most of the variables of both the utilities, have a strong relationship with a single variable </li></ul><ul><li>i.e., size of the firm. </li></ul><ul><li>It is reasonable to assume that maximising the long-run growth of any indicator is equivalent to maximising the long-run growth rate of the others. </li></ul>
  13. 13. Marris’s Theory of The Managerial Enterprise(contd.) <ul><li>Owners being interested in the growth of the firm want maximisation of the growth of the supply of capital , which is assumed to maximise the owner’s utility. </li></ul><ul><li>Managers wanting to maximise rate of growth of the firm rather than absolute size of the firm, believe that growth of demand for the products is an appropriate indicator of the growth of the firm. </li></ul>
  14. 14. <ul><li>There are two constrains in the Marris’s Model: </li></ul><ul><li>1. The Managerial Team Constraint. </li></ul><ul><li>Since Management is a teamwork, hiring new managers does not expand managerial capaqcity immediately. New managers take time to get integrated in the team. Managerial tream constraint sets limits to both the rate of growth of demand and rate of growth of capital. </li></ul><ul><li>2. The Job Security Constraint. Managers want job security. Job security attained by pursuing a prudent financial policy which requires the three crucial financial ratios to be maintained at optimum levels. </li></ul>
  15. 15. <ul><li>Liquidity Ratio: Current ratio – ratio of liquid assets to total assets. </li></ul><ul><li>Low liquidity increases the risk of insolvency (risk=+ve) </li></ul><ul><li>Leverage/Debt or Debt-Equity ratio: ratio of debt to total assets. </li></ul><ul><li>High debt-equity ratio exposes the firm to bankruptcy.(risk=+ve) </li></ul><ul><li>Profit retention ratio: High retention of profits, adds to the reserves contributing to the growth of capital.(risk= -ve) </li></ul><ul><li>Combining all the above into a single parameter will amount to financial constraint of the firm. </li></ul>
  16. 16. Policy variables in Marris’s balanced growth model are as follows: <ul><li>1. The firm has the freedom to choose its financial policy, as it subjectively determines the three financial ratios, liquidity ratio, leverage/debt ratio and retention ratio. </li></ul><ul><li>2. The firm can decide its diversification rate, either by expanding the range of its products, or by merely effecting a change in the style of its existing range of products. OR it can adopt the two policies simultaneously. </li></ul><ul><li>3. Price is not a policy variable of the firm. It is a parameter. Price is taken as given by the oligopolistic structure of the market. Production costs are also taken as given. </li></ul><ul><li>4. The firm has the freedom to decide the level of it advertising and R&D. Since Price and Production Costs are given, increase in advt. & R&D, will imply lower profit margin and vice-versa. </li></ul>
  17. 17. Marris’s Model: The rate of growth of demand for the products of the firm: <ul><li>The firm is assumed to grow by diversification and not by merger or acquisition. </li></ul><ul><li>The growth of demand for the products of the firm depends on the rate of diversification and the proportion of successful new products. </li></ul><ul><li>The rate of growth of capital supply: </li></ul><ul><li>The shareholders who are the owners, wish to maximise company's capital, which is the measure of the size of the firm. </li></ul><ul><li>The main source of finance for the growth of the firm is profit but the management can retain only part of it, for another part has to be distributed as dividend. </li></ul><ul><li>The rate of growth of capital is determined by three factors: the three financial ratios determined by the managers constituting the financial security constraint, the average rate of profit, and the rate of diversification. </li></ul>
  18. 18. Critically examine Marris’s Theory: <ul><li>R. Marris has made a significant contribution in the form of incorporation of the 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 maximises utility of both. Nonetheless Marris shows that growth and profits are competing goals. His model implies that both managers and owners are conscious of the fact that the firm cannot simultaneously achieve maximum growth and maximum profits. Marris seems to be correct in arguing that owners of the corporate firms do prefer the maximisation of the rate of growth and for this they do not mind sacrificing some profits. </li></ul>
  19. 19. Critically examine Marris’s Theory:(contd.) <ul><li>The main weakness of Marris’s Theory is that he assumes given production costs and a price structure. He does not explain determination of either costs or prices. </li></ul><ul><li>A. Koutsoyiannis writes “Oligopolistic interdependence is not satisfactorily dealt with in Marris’s model. Really Marris brushes aside the mechanism by which prices ar determined. This is a serious shortcoming of the model, in view of Marris’s assumption that the growth of the firm is achieved mainly via the introduction of new products which will (sooner rather than later) be imitated by competitors.” </li></ul>
  21. 21. WILLIAMSON’S THEORY OF MANAGERIAL DISCRETION <ul><li>Williamson is of the opinion that the managers of a modern business firm organised as a corporate unit do not maximise the profits which result in the maximisation of the utility of the owners. Onstead they maximise their own utility using their discretion. However, for their job security, managers attempt to ensure a certain minimum of profit to shareholders in the form of dividends. Thus profit is a constraint to the manager’s discretion. </li></ul>
  22. 22. WILLIAMSON’S THEORY OF MANAGERIAL DISCRETION <ul><li>Managers’ utility depends on such variables as salary, job security, power, prestige, status, job satisfaction and professional excellence. Of these variables only salary can be quantified. Therefore, Williamson uses measurable variables like staff empenditures, managerial emoluments and discretionary investment in the utility function of managers on the assumption that these are the source of the job security and reflect power, prestige, status and professional achievements of managers. </li></ul>
  23. 23. WILLIAMSON’S THEORY OF MANAGERIAL DISCRETION  <ul><li>Basic Concepts: </li></ul><ul><li>The demand for the firm . The firm’s demand curve is assumed to be downward sloping and is defined by the function </li></ul><ul><li>X = f 1 (P, S, e) </li></ul><ul><li>P = f 2 (X, S, e) </li></ul><ul><li>Where X = output, P = price, S = staff expenditure </li></ul><ul><li>e = a demand shift parameter reflecting autonomous changes in demand. </li></ul><ul><li>The demand is negatively related to price and is assumed to be positively related to staff expenditure and to the shift factor. </li></ul>
  24. 24. Basic concepts: <ul><li>Various concepts of Profit: </li></ul><ul><li>The actual profit : Sales Revenue minus production costs and less staff expenditure. </li></ul><ul><li> R – C – S </li></ul><ul><li>The reported Profit :  is the profit that the firm reports to the tax authorities. It is the actual profit less tax deductible managerial emoluments.(M) </li></ul><ul><li> R – C – S -  </li></ul>
  25. 25. Various concepts of profit: <ul><li>Minimum Profit :  is required to satisfy the shareholders. If this profit is not earned, the shareholders will either sell their shares or change the top management, adversely affecting the job security of managers. </li></ul><ul><li> <   R – T (T= Tax) </li></ul><ul><li>The Discretionary Profit:  D is the amount of profit left after subtracting the minimum profit and the tax from the actual profit. </li></ul><ul><li> D  </li></ul><ul><li>Discretionary Investment: I D - Discretionary investment is the amount that is left from the reported profit after subtracting the minimum profit and the tax from the reported profit. </li></ul><ul><li>I D =  R  - T </li></ul>