Business Decision Making

Alan J. Baker

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781351346856
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Originally published in 1981. Risk is a problem which all business decision makers have to cope with. The problem is not insurmountable, however, as there now exist well-established techniques for minimising risk and for calculating which of various available options is the optimal one to pursue.

This book outlines and discusses these techniques and the theories behind them. Unlike many economic theories which only rarely have any practical applications, the techniques put forward in this book can be used by real businessmen to solve real business problems. The book concentrates on decision-making in two main areas: the allocation of a firm's resources and the selection of new investments; and the techniques and theories discussed fall into three broad groups: linear programming, decision theory and capital market theory.

Intended as an advanced undergraduate textbook for students taking business economics or managerial economics courses, this valuable book will interest specialists and students involved in management studies, microeconomics, strategic planning, operational research, accounting and MBA programmes.

1 The Objectives of the Firm

Don’t put the fate of your business in the delusions of economists.

Peter Drucker

1.1 Introduction

This book deals with the economic analysis of a wide range of business decisions, but its purpose is a wider one than parading an array of ‘problem-solving’ techniques. Where techniques are involved we shall show how they can yield operational answers to the sorts of questions economists would regard as important, e.g. shadow valuations of scarce resources, shadow costs of constraints and the value of information. And where the theoretical foundations of decision models are themselves controversial, for example in the area of capital market valuation theory, we shall attempt to explain rival theories and their differing implications for decision making.

Our purpose in this opening chapter is to prepare the way for those later discussions, both of technique and theory, by establishing a presumption that the business firm does operate in its owners’ interests — or at least that distortions of this principle do not seriously affect the nature of decision making in the situations we shall consider. Our plan is to bring two contrasting themes or traditions in the theory of the firm (broadly defined to include business finance theory) into a brief but productive confrontation. The themes chosen for this purpose are the ‘managerial’ theory of the firm and what may be termed the ‘business finance tradition’. Both of these relate to the standard model of enterprise adopted throughout this book, namely a model in which managers effectively control policy making and the distribution of profit, and equity capital is widely held and traded at prices determined by market forces.

1.2 Williamson’s Managerial Model

1.2 (i) The Background to ‘Managerial’ Theories of the Firm

‘Managerial’ theories represent a form of response to a number of long-established themes in the study of the business environment and business behaviour. Briefly, these themes relate to the emergence of a managerial class of businessmen who have largely replaced owner-managers in the control of large enterprises; and to the weakening of capital market and product market pressures on such firms. Recognition of these trends dates back at least to the 1930s (see Berle and Means, 1932), a period which also saw important theoretical developments in the shape of new market structure models (Chamberlin, 1933; Robinson, 1933) and the beginnings of doubts about the validity of the profit-maximising concept of business behaviour. On the latter point, doubt was expressed as to the practicability of profit maximisation given the information likely to be available to businessmen (Hall and Hitch, 1939); and it was not long before the implausible implications of an exclusive pursuit of profit — even by the owner-manager — were recognised (Scitovsky, 1943).

Managerial theories spring from a general recognition of all of these points, and the ‘empty box’ which managerial theorists have attempted to fill is one in which managers, who possess considerable freedom of action in their product market behaviour, as well as independence and security in capital markets, have to determine exactly which objectives to pursue.

Perhaps surprisingly in view of the long prehistory of its component ideas, managerial theorising as a recognised area of the theory of the firm took a considerable time to develop. Much of the early running in the developing critique of out-and-out profit maximisation was made by models which stressed external constraints rather than internal choices as reasons for failure to pursue profit maximisation to the full. Oligopolistic interdependence and entry-preventive pricing are examples of this type of emphasis (see Koutsoyiannis, 1979, for reviews of these developments).

From the late 1950s, theorists began to formulate models in which the emphasis had shifted from external constraints on would-be profit maximisers to the recognition and formal representation of deliberate compromises between profit and more ‘managerial’ satisfactions. However, in theory the managerial form remains close to the traditional in possessing a unitary or unified decision making ‘personality’, maximising a fairly restricted ‘top-level’ utility function (see Machlup, 1967, pp. 5-6). Within this broadly defined common ground managerial theories differ widely in their interpretation of managers’ objectives. Our purpose will be adequately served by considering one representative managerial model in some detail — the ‘staff and emoluments’ model of O.E. Williamson. (For a general introduction to managerial theories of the firm, and detailed treatment of a number of different models, see Wildsmith, 1973. Other useful texts are Koutsoyiannis, 1979, and Crew, 1975.)

1.2 (ii) Williamson’s Staff and Emoluments Model

Like the standard theory of the profit-maximising firm, O.E. Williamson’s model of managerial choice (Williamson, 1963 and 1964) is presented in the framework of the firm’s short-period cost and revenue functions. Williamson’s managers do not share the same objective as the firm’s owners, who are assumed to prefer maximum profit to all other possible benefits of ownership. In particular, managers derive utility from the various types of expenditure they control. First, expenditures on staff (S) yield utility for various reasons: managers’ own salaries or promotion chances may be related to the size of organisation they control; and non-pecuniary motives such as prestige, authority and security also play their parts. It is vital to the model that staff outlays, which Williamson alternatively describes as ‘(approximately) general administrative and selling expense’ actually influence demand for the firm’s product, at any given price, and as such are an obvious instrument of policy.

Second, managerial emoluments (M) require little explanation as a source of utility. They represent the diversion of profit into expenditures which increase managers’ enjoyment of their working lives, but which are not strictly necessary for the running of the business or for its ability to attract and retain management personnel. The fact that outlays on luxurious office accommodation, expense accounts, company cars, etc., have the effect of reducing the company’s tax burden is only one reason for their widespread use. Another is that in an age of high marginal rates of personal taxation, executives can award themselves untaxed increases in their living (or working) standards in ways which appear innocuously in the company’s accounts as ‘costs’ rather than ‘executive remuneration’.

Finally, discretionary investment (I_d) is defined as the level of after-tax profit remaining for managers to allocate as they wish once the firm’s minimum profit constraint has been met:

Id=(1−t)(R−C−S−M)−Π0⁢(i)

where R is the firm’s total revenue from sales, C is production cost (a function of output), Π₀ is the minimum profit constraint, S and M are staff and emoluments outlays respectively and t is the corporate tax rate. We exclude lump-sum taxes on firms, though these are included on Williamson’s model. (Note that all expenditures, including M, are tax deductible.) The minimum profit constraint is seen as the minimum after tax return necessary to satisfy shareholders’ dividend expectations and prevent any threat of a takeover bid in which another firm might try to enlist the support of disgruntled shareholders.

The full managerial utility function, with U denoting managerial ability, can now be given.

U=U(S, M,[(1−t)(R−C−S−M)−Π0])⁢(ii)

Demand for the firm’s product is a function of price and staff expenditures (advertising, etc.) such that at any level of S the firm’s demand curve is downward-sloping in the normal way; and the outlay on staff affects the level of demand at any given price. Since output, denoted by X, staff outlays and emoluments can all be varied independently, maximisation of U in equation (ii) requires the following three first conditions to be satisfied simultaneously:

∂U∂X=0,implying∂R∂X=∂C∂X⁢(iii)

∂U∂S=0,implying∂R∂S=−∂U∂S+(1−t)∂U∂Id(1−t)∂U∂Id⁢(iv)

∂U∂M=0,implying∂U∂M=(1−t)∂U∂Id⁢(v)

We shall assume that all second-order conditions for the maximisation of U are satisfied. An important assumption Williamson makes is that managerial indifference surfaces in dimensions S, M and I_d do not touch the axes of the space in which they are drawn: this ensures that positive solution values of all three variables will be obtained.

From condition (iii) we can see that in his output decision at least, Williamson’s manager remains a profit maximiser, equating marginal production cost and marginal revenue. Condition (iv), however, marks a departure from full profit maximisation: given that all marginal utilities are positive, ∂R/∂S (the increase in revenue resulting from a unit increase in staff outlays) must be less than unity; whereas a profit maximiser would set S to achieve ∂R/∂S = 1. Spending on S is excessive because staff outlays yield utility to managers apart from their contribution to the firm’s revenue. Finally, condition (v) suggests that managers achieve a balance between M and I_d that depends on the corporate tax rate: a higher rate of tax effectively cheapens emoluments, which are tax-deductible, and managers respond by increasing M (lowering ∂U/∂M) and reducing I_d (raising ∂U/∂I_d) to restore condition (v).

Whereas staff outlays influence demand and hence the level of output (and price) at which marginal cost equals marginal revenue, the balance struck between M and I_d in condition (v) does not directly influence output or price. However, if management’s appetite for M were to be expressed differently, as a target level of expenditure, a change in that target would affect the firm’s policy. This view of M is appropriate, for example, where as seems likely in many cases, managers feel obliged to follow a ‘going market rate’ for emoluments. Recognising that a change in the target for M is akin to a change in the firm’s fixed costs, the relevant analysis is Williamson’s own comparative static analysis of a change in lump-sum taxation in his ‘staff only’ model (Williamson, 1964, p. 49). In effect, an increase in any component of fixed costs reduces the firm’s ability to support an ‘excessive’ level of S, with the result that the price and output combination generated under condition (iii) moves closer to that at which profit would be maximised. Thus it is possible that management’s emoluments policy, as well as its staff policy, has an influence on price and output in Williamson’s framework.

1.2 (iii) An Evaluation of the Staff and Emoluments Model

The essence of Williamson’s model is that managers actually allow their expense preferences to influence the firm’s price and output policy. This is obviously a more radical interpretation than one in which managers maximise profit and then merely divert some of that profit into favoured uses.

The crucial dual role played by staff expenditures — as an element of cost which simultaneously influences demand and yields managerial utility in its own right — seems doubtful as a general proposition. Williamson equates staff outlays with general administr...