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    Hand Out Baulmo and HL Model

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    Ore.A

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    © All Rights Reserved
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    Managerial e economics for business, Management and | accounting Howard Davies Head of the Depart ramen of Business Studies Hong Kong Polytect and the discount rate used 10 caleulate present values, As the long-run objective, formulated in present value terms, takes account of the relative weighting to be given to profits accruing at different times, it should be given priority if such a conflict between objectives arises, Managerial discretion models of the firm ‘Managerial’ criticisms of the profit-maximising model The textbook model of the profit-maximising firm has been criticised on a number of different grounds. Perhaps the best known of these centres around the claim that it is unrealistic to assume that firms aim for maximum profits in a modern economy where ownership and contro! of firms lic with different groups of individuals. The pioneering work of Berle and Means (1932) in the United States demonstrated clearly that the modern corporation was not simply a larger version of the owner-managed firm, but that ownership and control had become separated. Control lay in the hands of professional managers while ownership rested with shareholders. If the interests of sharcholders and tmmagers differ, if shareholders have relatively limited information about the performance of the firms they own, and if shareholders take relatively litle interest in the firms’ operations, provided a satisfactory dividend is paid, then managers may have a good deal of ‘discretion’ to pursue their own objectives. This will be particularly true where firms have some degree of monopoly power and do not have to compete keenly in order to make a satisfactory level of profit. It has been suggested, therefore, that in oligopolistic markets, firms do not pursue profit as their major objective. The suggestion that profit is not the objective of modern corporations has led to the search for alternative models based upon different assumptions about the firm's objective. There are many such models, but the best-known are: © the sales-revenue-maximising model, developed by Baumol (1958) the managerial-utility-maximising model (Williamson (1963) © the muiti-period profit-maximising rate of growth mode! (Baumol (1967)) © the Marris model (Marris(1964)) ‘© J.Williamson’s integrative model (1966) Each of these merits some attention. Baumol’s sales revenue-maximising model Et e : ns Baumol’s model stems from the observation that the salaries of managers, their status and other rewards often appear to be more closely linked to the sizeof the compariies jn which they work, measured by sales revenue, than to their profitability. dhat case, managers may be more conoemed to increase size than.to increase profitsssand the firm's objective will be to maximise sales revenne rather than profits. imi Rusiness alyectiver and models of tha fim 3 ximisation is replaced by that of sales-revenue If the assumption of profit-ma maximisation, then a different model results, In many respects, it shares fundamental characteristics with the standard model, as itis also an optimising model in which a single product firm aims for a single objective, having perfect information about its cost and demand conditions, Nevertheless, the details are different, as illustrated in Fig. 3.4, which sets out the basic version of the model, using totat revenue, total cost, and profit curves In Fig, 3.4, the firm will choose 10 produce level of output A, giving total revenue Band profit C, Note that this implies a higher level of output, and therefore a lower price, than the equivalent profit-maximiser, which would produce output D and earn revenue E, A straightforward revenue- maximiser will always produce more and charge less than a profit-maximising firm facing the same cost and demand conditions for the following reason: ‘© for revenue-maximisation marginal revenu @ for profit-maximisation marginal revenue= Marginal cost as marginal cost must be greater than 0, then for a profit-maximiser: marginal revenue must be greater than 0 © therefore marginal revenue for a profit-maximiser must be greater than marginal revenue for a revenue-maximiser ‘¢ as marginal revenue slopes downwards to the right, equilibrium output must be higher for a revenue maximiser than for the profit-maximiser. Asit happens, in Fig. 3.4, the sales-maximiser also makes some profit. However, this may not be enough to satisty the shareholders, and in many cases maximising Taleos, “Texal everue Ona Fig, 3.4 Baumol's revenue-maximising model 86 Managenat Economics: revenue may imply making losses. As a result the simple yevenue-maximisinyg model is implausibie, and the model needs to be amended to include a profit constraint Anstead of simply assuming that the firm aims for maximum revenue, without regard to the implications for profit, itis assumed that the objective is the maximisation of sales revenue, subject to meeting a minimum profit constraint. This version is shown, in Fig. 3.5, Tealeost ‘Tl rovense Fig. 3.5 Revenue-maximisation, subject to constraints As the figure shows, there are tree possible cases in this amended version of the model. The first is where the profit constraint is as shown by the line PCI. In this ‘ase the constraint does not ‘bite’. At the leve! of output which maximises revenue, enough profit is made to satisfy the shareholders. The second case is where the profit constraint is as indicated by PC2, In this instance, at the revenue maximising level of output, insufficient profit is made to satisfy the shareholders and output is reduced ‘until chat constraint is met, at level of output B. The third case is where the minimum profit required to satisfy the shareholders is equal to the maximum profit which can bbe made, in which case the firm has to reduce its output to C. In this third case, the firm behaves in exactly the same way with respect to its output and price as a profit-maximiser, despite the fact that it has set itself a different objective. This is ‘an important point, which takes the analysis back to 2 point made above in the discussion on the purpose of models. If shareholders insist upon the maximum level of profit being carned, then the profit-maximising model will provide-adcutate Predictions of the behaviour of a firm whose management prefer to'maximise sales Tevenuc. If the purpose of the mode! is to predict the firm's behaviour the Fact that Business objechver and models of the rin a7 amt. The managers see their aim as maximising sales revenue, and not profit, is irrcle firm behaves ‘as if” it were a profit-maximises ‘maximising model can be compared to the profit-naximising model reveals both similarities and The rev With respect to its comparative static propestics, whi diferences. If demand increases, both types of fim eespond in the same way, with an increase in output and price. On the other hand it bas been shown above for a profit maximiser that if fixed costs increase, or lump-sum tax is imposed, price and oupat will not change, However, fora revenuc-maximiser whose profit eonsisaint is ready biting, a lump-sum tax will reduce profits and will free the firm to lower its output and raise its price. The managerial utility-maximising model In Baumol's sales-revenve-maximising model, managers’ imerests are tied to asingle Nariabs, with the addition of a profit constraint. Williaasoa's managerial-wtility, inaximising model takes account of a wider range of vatiables by introducing the SruceP! oF “expense preferences’ and beginning with the assumption that managers attempt to maximise their own utility. The term ‘expense preference’ simply means that managers get satisfaction from using some of the firm’s potenti profits fo Hanecessary spending on items from which they personally benefit. Williamson ‘dentifiestnree major types of expense from which managers derive utility. These ave 1 The amount whick managers can spend on staff, over and above those needed {o rum the firm's operations (8). Ths variable captures the power, prestige, status and satisfaction which managers’ expetience from having control over larger humbers of people, 2 Addidons to managers’ salaries and benefits in the form of ‘perks’ (M). These include unnecessarily luxurious company cars, extravagant entertainment and clothing allowances, club subscriptions, palatial offices and similar items of expenditure. Such items may also be thought of as ‘managerial slack" or *X- insifciency’ (See below). They appear as costs to the firm, but are not necessary for the efficient conduct of is activities and are in effect coming out of profits, 3. Discretionary profits (D). These are after-tax profits over and above the miinaung ‘eauired to satisfy the shareholders, They are therefore availabe to the managers a& a souree of finance for ‘pet projects’ and allow the managers to invest in developing the firm in directions which suit them, enhancing their power, status and satisfaction, Clearly there are conflicts and trade-offs between the different objectives in this model, and it is considerably more complex than those considered thus far. The Setaled workings ofthe model go beyond the requirement ofthis text. Nevertheless, ‘he main outlines are reasonably accessible. The basic form of the model is follows: U=RS.M,D) ~ managerial utility (U) depends upon the levels of §,M and D available to the managers. Fusinesss objectives: aut models of the frm 37 sales vevenue, and uot profit, is irrelevant. ‘Nhe firm behaves “as i were a prosit-maximiser the revenue maximising model can be compared to the profit-maximising model With respec! to its comparative static properties, which reveals both similarities end Uitferenees. f demand increases, both types of Firmn sespond in the saine way, with prota in output and price. On the other hand it has been shown above for a Profirmaximiser tha if fixed costs incrense, or a lump-sum taxis imposed, price and output will no change. However, fr arevenue-masinisr whe profit eonsteaine 'S already biting, a lump-sum tax wil reduce profits and will free the firm to loner its output and raise its price. The managerial utility-maximising model 4n Bautnol’s sales-revenue-masimising model, managers interests are tied to a ngle rade ity the addition of a profit constraint. Williamson's managerial-utlity, concen model lakes account of a wider range of variables by introducing the SruceD of ‘expense preferences’ and beginning with the assumption that managers anemps wo maximise theit own utility. The term ‘expense preference’ simply means {hat managers get satisfaction from using some ofthe firm's potenti profite he dena cPetding on items from which they personally benefit. Williamson identifies three major types of expense from which managers derive tlty. These ane i 1) The amount which managers can spend on staff, over and above those needed {o run the firm's operations (S). This variable captures the power, prestige, status i and satisfaction which managers’ experience from having control over larger i numbers of people. | 2. Additions fo managers’ selaries and benefits in the form of ‘perks’ (M). These include unnecessarily luxurious company cars, extravagant entertainment snd clothing allowances, club subscriptions, palatial offices and similar items of expenditure. Such items may also be thought of as ‘managerial siack’ or inefficiency’ (see below). They appear as costs to the firm, but are not necessary for te efficent conduct of its activities and ate in effect coming out of profits, : 3. Disereionary profits (D), These are after-tax profits over and above the mininang i required to satisfy the shareholders. They are theteforeavalable tothe managers Fc pee Of finance for ‘pet projects’ and allow the managers to invest in

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