Managerial Theories of the Firm
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Managerial theories of the firm
Managerial theories of the firm place emphasis on various incentive mechanisms in explaining the behaviour of managers and the implications of this conduct for their companies and the wider economy.
According to traditional theories, the firm is controlled by its owners and thus wishes to maximise short run profits. The more contemporary managerial theories of the firm examine the possibility that the firm is controlled not by its owners, but by its managers, and therefore does not aim to maximise profits. Although profit plays an important role in these theories as well, it is no longer seen as the sole or dominating goal of the firm. The other possible aims might be sales revenue maximisation or growth.
CLASSICAL THEORIES OF THE FIRM
Profit maximisation
Profit maximisation is the traditional approach to what is the objective of the firm. This theory assumes that the owner of the firm, who seeks to maximise personal wealth, controls the company. In order to maximise personal wealth the owner will seek to maximise the profits of the company (Griffiths and Wall 2001). Profits are maximised where marginal revenue equals marginal cost, that is where the distance between the total revenue curve and the total cost curve is greatest.
In order for the firm to achieve profit maximisation, they need to know the cost and revenue conditions in the market so that marginal revenue and marginal cost can be found. The firm is unlikely to know its demand curve, and it is therefore impossible to obtain a marginal revenue curve. The main problem with maximising profits is therefore the lack of information (Sloman 2000).
MANAGERIAL THEORIES OF THE FIRM
The traditional theory of the firm assumes that it is the owners of the firm that make price and output decisions, but in public limited companies the shareholders are the owners and they elect directors who in turn employ managers. According to the managerial theories there is therefore a separation between the ownership and the control of the firm (Sloman 2000). Because mangers determine company strategy, future investments and promotions they are able to dominate the decision making (Worthington 2001).
The managerial theories are also maximising theories, but the firms are no longer considered to be profit maximisers. Managers want to maximise their own utility while owners, or shareholders, want to maximise their own personal wealth. The conflicting aims of managers and owners might cause what is known as the principal-agent problem (Griffiths and Wall 2001, Sloman 2000). In order to control the behaviour of the management (the agents), and make sure that they act in the interest of the shareholders (the principals), the principals can monitor what the managers do by using incentives that encourages the agent to act in the best interests of the principal, i.e. by linking the managers salary to the firms profitability. Ryanair solved the principal-agent problem by offering their pilots a share scheme in January 2001. This ensures that the pilots act in the best interest of the company because they will benefit from profit growth (Ryanair 2005).
Managers are driven by their personal need for higher salaries, prestige, security and power. These needs can be satisfied in several different ways. The managerial theories of the firm emphasises the incentives used by shareholders when they explain the behaviour of the managers and the effect their behaviour have on their companies. The theories are different from one another because they assume that managers have different objectives and that these objectives can be achieved in different ways.
Sales revenue maximisation
Baumol argues that seeking to maximise sales revenue is the most logical goal for the manager, because the managers salary and prestige are most frequently connected to high levels of sales revenue and not with the level of profit achieved (Worthington 2001). According to Williamson maximising sales revenue is the easiest way of getting the means necessary for staff expenditure, and that way building the managers empire. Personnel problems can also be handled more easily as a result of better employee remuneration and more favourable contracts (Griffiths and Wall 2001). The manager also tends to prefer satisfactory levels of profit to exceptional levels that might be difficult to sustain in the future.
Sales revenue maximising will normally make the business produce and sell a higher level of output at a lower price than a business seeking to maximise its profits. Though lower prices are normally good for the consumer, a company that maximises its sales revenue will need to advertise in order to drive sales growth, and the cost of advertising will normally fall on the customer.
Even though the management will want to maximise its sales revenue, it still has to take into account the wants and needs of the shareholders. The introduction of a profit constraint is the shareholders way of controlling the management. Low profits may cause the share price to fall and therefore open for the possibility of a takeover bid. If the shareholders are not content with the amount of profits earned they might vote for a new board of directors. This means that the management is motivated to keep profits above a certain level to avoid a takeover bid and jeopardise their jobs (Douglas 1992). But the management will still seek to maximise profits subject to the profit constraint, and can therefore bee seen as profit satisficers.
With a profit constraint the firm will achieve higher profits and satisfied shareholders. There is no need to worry about a takeover bid. Achieving this minimum profit required by the shareholders will help keep the share price at an acceptable level, because low profits often will cause a fall in the market value of the shares (Douglas 1992).
Maximising sales revenue in the short run can also be seen as an alternative for longer term profits. Low prices will inhibit the entry of new firms into the market and therefore secure the firms future position in the market. Having low prices will also create goodwill and brand loyalty among the firms customers and the firm will therefore be able to keep its customers if a rise in price is necessary, or if new firms enter the market.
Managerial utility maximisation
Williamson argued that as long as satisfactory levels of profit are being achieved, the manager has the discretion to choose what goals to pursue in order to maximise