MANAGERIAL ECONOMICS Topic 2 The Objectives of the Firm and Alternative Models

‘Managerial’ Criticisms of the Profit-Maxing Model n Berle and Means (1932) –firms are owned by shareholders but controlled by managers –owners’ and managers’ interests are different –managers have discretion to use the firm’s resources in their own interests

‘Managerial Discretion’Models n Baumol’s model –managers’ rewards seem to be more closely linked to size than to profit –therefore, firms aim to maximize sales revenue –but subject to a profit constraint

Baumol’s Model TR TC Profit $ Level of Output

Comparison of Baumol’s Model with the Profit-Maxer? n A. The unconstrained version –Price? –Output? –Profit? n B. The constrained version –depends where the constraint is –note what happens if the constraint is so tight that maximum profit is required

Comparative Statics of Baumol’s Model n What if demand rises? n What if fixed costs change? n What if variable costs change?

O.Williamson’s Managerial Utility Maximizing Model n What do managers want? –UTILITY = happiness, satisfaction n What gives them utility? –Spending on staff - S –Managerial perquisites - M (cars, expensive offices etc) –Discretionary investment - D (the ability to spend on ‘pet projects

O.Williamson’s Managerial Utility Maximizing Model n How to solve the model? What gives them utility? –Maths must be used, more complex n What results does it give? The comparative statics?

Note the Common Characteristics Shared by Managerial Models and the Profit Max Model n Optimising –the firm aims for a maximum n ‘Holistic’ –the firm has purpose and takes decisions and actions as a single entity n Deterministic –full knowledge of market opportunities and costs is assumed

The Behavioural Approach n ‘organizations do not have objectives, only people have objectives’ n the firm does not exist -it is a set of shifting coalitions of individuals n individuals and groups do not maximize - they ‘satisfice’ n information about the environment is very limited

The Behavioural Approach n Aspiration levels, which adjust according to experience n Problem-oriented ‘rules of thumb’ based on past experience n A dynamic model n not ‘holistic’ n not ‘deterministic’ n not optimising

The Behavioural Approach n If all aspirations are being met - everyone is satisfied - do nothing n BUT then aspiration levels will rise until someone is not satisfied n THEN rules of thumb used to find solutions to ‘the problem’

Which Approach is Most Useful? n Behavioural approach is a more accurate description of what happens INSIDE the firm n BUT it tells us almost nothing about how the firm will respond to changes in the environment n To use it to make predictions about how the firm will react to changes in the environment we need to know everything about the individual firm n However, if shareholders are a powerful group and their aspiration level requires making maximum profit the firm will again behave in the same way as a profit-maxer

In Conclusion? n The Behavioural Approach is a useful complement to the profit-max and Managerial approaches, not a substitute for them.