MANAGERIAL MANAGERIAL THEORIES THEORIES

BAUMOL THEORYBAUMOL THEORY

• According to Baumol, sales revenue According to Baumol, sales revenue maximization is the most important maximization is the most important goal of managers.goal of managers.

Models Models

Static Model of Sales Maximization

Dynamic Model ofSales Maximization

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STATIC MODEL OF SALES STATIC MODEL OF SALES MAXIMISATIONMAXIMISATION

• Given minimum acceptable level of profit, Given minimum acceptable level of profit, the basic assumptions of the model are :-the basic assumptions of the model are :-

-The time horizon of the firm is a single period.-The time horizon of the firm is a single period.-The firm is aiming for only that particular -The firm is aiming for only that particular

period it ignores what will happen in the period it ignores what will happen in the subsequent periods as a result of decision subsequent periods as a result of decision taken in current period.taken in current period.

-The certain minimum profit constraint is -The certain minimum profit constraint is determined by the market conditions.determined by the market conditions.

-Demand curve is downward sloping curve and -Demand curve is downward sloping curve and average unit curve is U-shape.average unit curve is U-shape.

STATIC MODEL WITHOUT STATIC MODEL WITHOUT ADVERTISEMENTADVERTISEMENT

• In figure TC – Total Cost, TR – Total Revenue ∏- In figure TC – Total Cost, TR – Total Revenue ∏- Profit. XProfit. X11 – Output level where profit level is – Output level where profit level is maximum.Xmaximum.X22 – Output level where profit is less – Output level where profit is less than at Xthan at X11 but sales are more. but sales are more.

• Sales maximiser sells at price Sales maximiser sells at price lower than profit maximiser. lower than profit maximiser.

• Firm will not increase its sales Firm will not increase its sales beyond Xbeyond X22, because if profit is , because if profit is less than less than ∏ ∏ SMSM , , It will not be It will not be acceptable to share holder and acceptable to share holder and other lending Institutions and other lending Institutions and Managers.Managers.

STATIC MODEL WITH STATIC MODEL WITH ADVERTISMENTADVERTISMENT

• We assume that sales revenue We assume that sales revenue increases with advertising expenses.increases with advertising expenses.

• An Oligopolistic firm will prefer to go An Oligopolistic firm will prefer to go for sales maximization via an increase for sales maximization via an increase in advertisement rather than a price in advertisement rather than a price cut.cut.

• The sales maximiser decides on The sales maximiser decides on optimum advertisement by examining optimum advertisement by examining its impact on sales revenue.its impact on sales revenue.

• TC – Total cost (CCTC – Total cost (CC11+AC), BC – Production cost, +AC), BC – Production cost, TR – Total Revenue, TR – Total Revenue, ∏ - ∏ - Profit (TR-TC), Profit (TR-TC), ∏∏maxmax - -

Maximum Profit, Maximum Profit, ∏∏SMSM = =Sales maximization profit, Sales maximization profit, A A ∏∏ = Advertisement expenditure incurred by a = Advertisement expenditure incurred by a profit maximiser, Aprofit maximiser, ASS = Advertisement = Advertisement expenditure incurred by a sales maximiser.expenditure incurred by a sales maximiser.

• This implies that with increase in This implies that with increase in advertisement expenditure, total cost, sales advertisement expenditure, total cost, sales revenue and hence profit, all increase revenue and hence profit, all increase proportionately.proportionately.

• Production cost shown by BC line is Production cost shown by BC line is assumed to be independent of advertising assumed to be independent of advertising cost.cost.

• If price is such as to enable the firm to sell If price is such as to enable the firm to sell an output yielding profit above the an output yielding profit above the minimum acceptable profit level, firms will minimum acceptable profit level, firms will go for higher advertisement expenditure go for higher advertisement expenditure and yield greater revenue.and yield greater revenue.

• However, if profit falls below However, if profit falls below ∏ ∏ SMSM , the , the firms cost become too high and firm will firms cost become too high and firm will cut back on advertisement.cut back on advertisement.

• Thus sales maximiser will spend more on Thus sales maximiser will spend more on advertisement than a profit maximiser.advertisement than a profit maximiser.

LIMITATIONS OF STATIC LIMITATIONS OF STATIC MODELMODEL

• Assumption of constant price for all product is Assumption of constant price for all product is not realistic.not realistic.

• Production cost is assumed to be independent Production cost is assumed to be independent of advertising expenditure. However with of advertising expenditure. However with advertisement, the sales increase and advertisement, the sales increase and physical volume of output increases leading to physical volume of output increases leading to economies of sale, a firm already producing at economies of sale, a firm already producing at maximum possible efficiency may face maximum possible efficiency may face diseconomies of sale. This will effect the diseconomies of sale. This will effect the production cost of the firm, whether it strives production cost of the firm, whether it strives for sales maximisation or profit maximisation.for sales maximisation or profit maximisation.

DYNAMIC MODEL OF DYNAMIC MODEL OF SALES MAXIMISATIONSALES MAXIMISATION

• AssumptionAssumption:-:-The objective of the firm is to maximise the The objective of the firm is to maximise the

rate of growth of sales revenue over its rate of growth of sales revenue over its lifetime. Sales revenue (R) grows at the rate lifetime. Sales revenue (R) grows at the rate of ‘g’ percent.of ‘g’ percent.

Profit is not taken as a given exogenous Profit is not taken as a given exogenous variable, which acts like a constraint in the variable, which acts like a constraint in the static.static.

Demand and cost curves have traditional Demand and cost curves have traditional shapes as in the static model.shapes as in the static model.

• R,R(1+g), R(1+g)R,R(1+g), R(1+g)22, ----R (1+g), ----R (1+g)nn

The present value of this stream of future The present value of this stream of future revenue is estimated by discount formula.revenue is estimated by discount formula.

Where i is rate of discount. The total Where i is rate of discount. The total present (discounted) value of all future present (discounted) value of all future revenue is revenue is

n

i

gR

i

gR

i

gRR

1

1,

1

1,

1

1,

2

n)---0,1,2,-(n 1

1

0

tn

t i

gRS

S = Future stream of sale

• The growth function is derived from The growth function is derived from profit function, as growth of firm is profit function, as growth of firm is mainly financed by retained profits.mainly financed by retained profits.

• Highest attainable growth rate is Highest attainable growth rate is achieved when profit is maximised. achieved when profit is maximised.

• To find equilibrium a firm, we will use iso To find equilibrium a firm, we will use iso present value curve, which shows all present value curve, which shows all present value of g & R which yield same present value of g & R which yield same value of S. value of S.

ga

aS

aR

RSa

aS

2

1

2

11

21

1

a

a -

1 g

R ag

2

• Point E in the figure represents the point of Point E in the figure represents the point of tangency of iso present value curve to the growth tangency of iso present value curve to the growth curve . Thus firm will choose gcurve . Thus firm will choose gee & R & Ree to get the to get the highest possible level of S subject to the growth highest possible level of S subject to the growth constraint.constraint.

LIMITATIONSLIMITATIONS

• It try to explain long run behaviour It try to explain long run behaviour of sales maximising firm. However of sales maximising firm. However in long run market demand, prices of in long run market demand, prices of factors of production etc. change. factors of production etc. change. This model does not take these This model does not take these changes into account.changes into account.

MARRIS MODEL OF MARRIS MODEL OF MANAGERIAL ECONOMICSMANAGERIAL ECONOMICS• Aim – firm’s aim at balanced rate of growth Aim – firm’s aim at balanced rate of growth

(G)(G)• This can be achieved by maximization of rate This can be achieved by maximization of rate

of growth of demand for the product of firm of growth of demand for the product of firm (G(GDD) and the rate of growth of capital supply ) and the rate of growth of capital supply (G(GSS))

• To achieve the above growth management To achieve the above growth management faces two types of constraint on its growth-faces two types of constraint on its growth-

Managerial ConstraintManagerial ConstraintFinancial constraintFinancial constraint

Managerial ConstraintManagerial Constraint

• Decision making and planning skills Decision making and planning skills of the managerof the manager

• Co-ordination, cooperation and good Co-ordination, cooperation and good team work – this requires experienceteam work – this requires experience

• Research and development Research and development

Financial ConstraintFinancial Constraint• Job securityJob security• Fear of takeover and mergerFear of takeover and mergerTo avoid these risk, manager should choose a prudent To avoid these risk, manager should choose a prudent

financial policy consisting of three financial ratios – financial policy consisting of three financial ratios – Debt equity ratio – value of debts to total assetsDebt equity ratio – value of debts to total assets Lower the value better it isLower the value better it is Liquidity ratio – total liquid assets to total assetsLiquidity ratio – total liquid assets to total assets

ratio is too low – risk of insolvencyratio is too low – risk of insolvencyratio is too high – risk of take over ratio is too high – risk of take over

Retention ratio – retained profit to total profitRetention ratio – retained profit to total profit important source of finance for growth of capital, important source of finance for growth of capital,

but firms needs to distribute a part to satisfy the but firms needs to distribute a part to satisfy the shareholdersshareholders

Equilibrium of firmEquilibrium of firm

• U U managersmanagers = f(G = f(GDD))• U U ownersowners = f(G = f(GSS))• Condition of equilibrium is GCondition of equilibrium is GDD = G = GSS = =

GG

Where GWhere GDD = f(d,k) = f(d,k)

and Gand GSS = r( = r(∏∏) ) d= diversification / differentiation of productd= diversification / differentiation of productk= success rate of new productk= success rate of new productr= financial security ratio assumed to be r= financial security ratio assumed to be

constant proportion of profit(constant proportion of profit(∏∏))

Critical EvaluationCritical Evaluation• Marris assumes cost structure and price to be Marris assumes cost structure and price to be

given, thus profit as given which is not truegiven, thus profit as given which is not true• Marris theory does not account for the Marris theory does not account for the

interdependence in firm’s decision makinginterdependence in firm’s decision making• During industrial slowdown the manager’s During industrial slowdown the manager’s

aim will be to retain the existing power in the aim will be to retain the existing power in the market rather than a balanced rate of growthmarket rather than a balanced rate of growth

• During industrial slowdown process firm may During industrial slowdown process firm may not be doing well not because of managerial not be doing well not because of managerial inefficiency but because the overall inefficiency but because the overall atmosphere is not conducive to businessatmosphere is not conducive to business

• Marris talks about only two constraint. In real Marris talks about only two constraint. In real life – firm face social, cultural, environmental life – firm face social, cultural, environmental etcetc

BEHAVIOURAL MODELBEHAVIOURAL MODEL

• Behavioral theory view business firm Behavioral theory view business firm engaging in non- maximizing engaging in non- maximizing behavior. Firm emerges as a satisfier behavior. Firm emerges as a satisfier rather than maxi miser.rather than maxi miser.

• Simaon Satisfying ModelSimaon Satisfying Model• Cyert and March ModelCyert and March Model

Simon Satisfying ModelSimon Satisfying Model

• Constraint of incomplete information, Constraint of incomplete information, imperfect data and uncertainty about future imperfect data and uncertainty about future creates difficulty for managers to get to creates difficulty for managers to get to optimum decisionoptimum decision

• Thus managers look for the second best Thus managers look for the second best situation, which is called the satisfying situation, which is called the satisfying behavior.behavior.

• Thus manager look for satisfactory level of Thus manager look for satisfactory level of profit rather than profit maximizing behavior profit rather than profit maximizing behavior and satisfactory level of cost rather than cost and satisfactory level of cost rather than cost minimizing behavior.minimizing behavior.

Critical EvaluationCritical Evaluation

• Simon assumed that organizational Simon assumed that organizational behavior and individual behavior are behavior and individual behavior are comparable.comparable.

• Model is not concrete – talks about Model is not concrete – talks about incomplete knowledge and information but incomplete knowledge and information but doesn’t specify the kind of informationdoesn’t specify the kind of information

• Model talks about satisfactory level – Model talks about satisfactory level – subjective conceptsubjective concept

Model of Cyert and Model of Cyert and MarchMarch

• They have stressed on decision making They have stressed on decision making process of multi product firm under process of multi product firm under uncertainty in an imperfect marketuncertainty in an imperfect market

• Assumptions –Assumptions – In a firm there are many groups with In a firm there are many groups with

conflicting behavior on interest.conflicting behavior on interest. One has to develop the goals of various groups One has to develop the goals of various groups One has to develop the overall environment of One has to develop the overall environment of

the firm the firm There has to be treatment of uncertainty There has to be treatment of uncertainty

Goals of individual groupGoals of individual group

• Firm is considered to have multi- goalFirm is considered to have multi- goal• Organization comprises of workers, Organization comprises of workers,

managers, shareholders, suppliers, managers, shareholders, suppliers, customers, bankers, tax collectors each customers, bankers, tax collectors each having different goals.having different goals.

• To know the goals one needs to know To know the goals one needs to know the origin and decision making the origin and decision making process which leads to their formation process which leads to their formation

Goal of the firm Goal of the firm

Demand of the members of the Demand of the members of the coalitioncoalition

Factors such as aspirations of the Factors such as aspirations of the members, past achievements, their members, past achievements, their expectations, the achievements of expectations, the achievements of other groups in same or other firms, other groups in same or other firms, the information available to them.the information available to them.

• The demand of the different groups are competing for the The demand of the different groups are competing for the given resources of the firm, and there is a continuous given resources of the firm, and there is a continuous conflict conflict

• The relationship between demand (aspirations ) and the The relationship between demand (aspirations ) and the past achievements depends on the performance of the firm past achievements depends on the performance of the firm and the changes in the environment and the changes in the environment

Steady situation – aspirations tend to be equal to past Steady situation – aspirations tend to be equal to past achievements.achievements.

Dynamic situation – aspirations lag behind achievements Dynamic situation – aspirations lag behind achievements excess profit / surpluses.excess profit / surpluses.

Recession situation - aspirations are larger than past Recession situation - aspirations are larger than past achievements achievements

Goal of the firm Goal of the firm

• The five main goal set by the firm The five main goal set by the firm are – are –

Production goalProduction goalInventory goal Inventory goal

respective dept.respective dept.Market share goalMarket share goalProfit goal top Profit goal top

managementmanagement

Resolution of conflictResolution of conflict

• Money paymentsMoney payments• Side payments Side payments

monetarymonetary• Slack paymentsSlack payments• Sequential hearing to demandSequential hearing to demand• Decentralizing decision making Decentralizing decision making

qualitativequalitative

Treatment of uncertaintyTreatment of uncertainty

• Market uncertaintyMarket uncertainty

Due to - incomplete information about Due to - incomplete information about changingchanging

taste & preferences, changes in taste & preferences, changes in methodsmethods

of production.of production.

Minimize -market survey and R& DMinimize -market survey and R& D• Uncertainty about competitor’s reactionUncertainty about competitor’s reaction

Minimize –Minimize – by forming collusion with rivalsby forming collusion with rivals

Critical EvaluationCritical Evaluation

• The model fails to address as to how The model fails to address as to how interdependence of firms will influence interdependence of firms will influence the action taken by top management to the action taken by top management to solve various conflicting situations.solve various conflicting situations.

• Cyert and March deal with one form of Cyert and March deal with one form of slack i.e. the managerial slack. Other slack i.e. the managerial slack. Other important forms of organizational important forms of organizational slacks were ignored by them.slacks were ignored by them.

WILLIAMSON MODELWILLIAMSON MODEL

• Managers have discretion in pursuing Managers have discretion in pursuing policies which maximise their utility policies which maximise their utility rather than that of owner shareholder.rather than that of owner shareholder.

• Profit acts as a constraint to this exercise.Profit acts as a constraint to this exercise.• The utility function includes one The utility function includes one

measurable variable namely, salary and measurable variable namely, salary and other non-measurable ones like security, other non-measurable ones like security, power, status, prestige, professional power, status, prestige, professional excellence.excellence.

• To formalize the model, one has to take To formalize the model, one has to take proxy variables to these non-measurable proxy variables to these non-measurable ones.ones.

WILLIAMSON MODELWILLIAMSON MODEL• These proxy variables taken are emoluments of These proxy variables taken are emoluments of

managers or slack in the form of luxury offices, managers or slack in the form of luxury offices, company car, etc. or the expenditure which are company car, etc. or the expenditure which are incurred at the discretion of the managers. This incurred at the discretion of the managers. This reflect their power, status, prestige, professional reflect their power, status, prestige, professional excellence.excellence.

• These remunerations have their own advantage These remunerations have their own advantage (comparison to salaries), as the person getting these (comparison to salaries), as the person getting these will get tax benefits. will get tax benefits.

• Such payments catch less attention from the Such payments catch less attention from the shareholders and labour force.shareholders and labour force.

• Also, status & power of managers is associated with Also, status & power of managers is associated with the discretion they have in undertaking investment. the discretion they have in undertaking investment. Discretionary investment expenditure gives Discretionary investment expenditure gives satisfaction to manager because it allows them to satisfaction to manager because it allows them to materialize their personal favorite projects.materialize their personal favorite projects.

WILLIAMSON MODELWILLIAMSON MODEL

The model can be written as follows:The model can be written as follows:

UUmm ~f (s,m,i). ~f (s,m,i).

s = staff expenditure, including managerial salary.s = staff expenditure, including managerial salary.

m = managerial remunerations (slack).m = managerial remunerations (slack).

i = discretionary investment.i = discretionary investment.

The aim is to maximize the value of UThe aim is to maximize the value of Umm..

Critical EvaluationCritical Evaluation

• Model is valid for large firms where Model is valid for large firms where there is scope of product there is scope of product differentiation an discretionary differentiation an discretionary investmentinvestment

• This model doesn’t talk about the This model doesn’t talk about the managerial behavior of firm in managerial behavior of firm in relation to the rival firms and its relation to the rival firms and its impact on utility functionimpact on utility function