1.2 (i) The Background to āManagerialā Theories of the Firm
āManagerialā 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 ā even by the owner-manager ā were recognised (Scitovsky, 1943).
Managerial theories spring from a general recognition of all of these points, and the āempty boxā 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 āmanagerialā satisfactions. However, in theory the managerial form remains close to the traditional in possessing a unitary or unified decision making āpersonalityā, maximising a fairly restricted ātop-levelā utility function (see Machlup, 1967, pp. 5-6). Within this broadly defined common ground managerial theories differ widely in their interpretation of managersā objectives. Our purpose will be adequately served by considering one representative managerial model in some detail ā the āstaff and emolumentsā 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) Williamsonās Staff and Emoluments Model
Like the standard theory of the profit-maximising firm, O.E. Williamsonās model of managerial choice (Williamson, 1963 and 1964) is presented in the framework of the firmās short-period cost and revenue functions. Williamsonās managers do not share the same objective as the firmās 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: managersā 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 ā(approximately) general administrative and selling expenseā actually influence demand for the firmās 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 managersā 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 companyās 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 companyās accounts as ācostsā rather than āexecutive remunerationā.
Finally, discretionary investment (Id) is defined as the level of after-tax profit remaining for managers to allocate as they wish once the firmās minimum profit constraint has been met:
where R is the firmās total revenue from sales, C is production cost (a function of output), Ī 0 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 Williamsonās 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 shareholdersā 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.
Demand for the firmās product is a function of price and staff expenditures (advertising, etc.) such that at any level of S the firmās 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:
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 Id 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, Williamsonās 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, āR/āS (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 āR/āS = 1. Spending on S is excessive because staff outlays yield utility to managers apart from their contribution to the firmās revenue. Finally, condition (v) suggests that managers achieve a balance between M and Id 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 āU/āM) and reducing Id (raising āU/āId) 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 Id in condition (v) does not directly influence output or price. However, if managementās appetite for M were to be expressed differently, as a target level of expenditure, a change in that target would affect the firmās policy. This view of M is appropriate, for example, where as seems likely in many cases, managers feel obliged to follow a āgoing market rateā for emoluments. Recognising that a change in the target for M is akin to a change in the firmās fixed costs, the relevant analysis is Williamsonās own comparative static analysis of a change in lump-sum taxation in his āstaff onlyā model (Williamson, 1964, p. 49). In effect, an increase in any component of fixed costs reduces the firmās ability to support an āexcessiveā 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 managementās emoluments policy, as well as its staff policy, has an influence on price and output in Williamsonās framework.