University of Zimbabwe

Faculty of Business Management Sciences and Economics

University of Zimbabwe Business School

Name : Divine Madoro

Regitration Number: R116614X

Course: Business Economics

Lecturer: Dr S Mukoka
Assignment: Individual Assignment
Question:

(a) While assuming that profit maximisation remains the key objective of the firm,
whatever the competition, alternative theories postulate differing objectives from time
to time. Discuss three (3) Managerial Discretion and one (1) Behavioural Models tied
to the alternative theories of the firm. (25 Marks)
(b) Assuming Mr Tshuma is the Chief Executive Officer of Delta Beverages, Zimbabwe.
With the aid of diagram, the CEO want to comprehend consumer’s utility maximisation
point derived from consuming Zambezi and Castle products by invoking theories of
indifferent curve and budget line under the following scenarios:
(i) Substitution Effect;
(ii) The Income Effect.
(iii) Derive a Price Consumption Line (25 Marks)
Question 1a:

i) William Baumol’s Sales Maximisation Model

Prof. Baumol in his book Business Behaviour, Value and Growth (1967) has presented a
managerial theory of the firm based on sales maximisation.

The model is based on the following assumptions:

 There is a single period time horizon of the firm.

 The firm aims at maximising its total sales revenue in the long run subject to a profit
constraint.
 The firm’s minimum profit constraint is set competitively in terms of the current
market value of its shares.
 The firm is oligopolistic whose cost curves are U-shaped and the demand curve is
downward sloping. Its total cost and revenue curves are also of the conventional type

According to Baumol, with the separation of ownership and control in modern corporations,
managers seek prestige and higher salaries by trying to expand company sales even at the
expense of profits. He suggest that short-run revenue maximisation may be consistent with
long-run profit maximisation. But sales maximisation is regarded as the short-run and long-
run goal of the management. Sales maximisation is not only a means but an end in itself.

William Baumol has constructed a model of business behaviour that yields predictions
contradictory to those of the standard short-run profit maximisation model (Baumol, 1959).
He suggest that the model of the firm that faces a negatively sloped demand curve is assumed
to aim at maximising sales (revenue) rather than profits, subject to the constraints that profits
not fall below the minimum level necessary to keep stockholders satisfied. The model yields
the prediction that: firms for which the profit constraint is operative (constrained revenue
maximizers) will sell in the elastic range of their demand curves, and that firms for which the
profit constraint is inoperative (unconstrained revenue maximisers) will push sales to the
point of unitary price elasticity of demand. These points are conveniently illustrated with the
aid of figure 1 (Baumol, 1959).
 Figure 1

In the figure above are shown illustrative total revenue (TR), total cost (TC) and total profit
(TP) curves. The profit-maximizing firm would aim at output Q Π, while the revenue
maximiser would produce somewhere between QΠ and Qr , depending on the firm’s profit
constraint (PC). If that constraint is at or below the level of PC in the above figure, the
constraint is operative and the revenue maximizing output, Q r , will be produced; if the profit
constraint is above PC, but below maximum profit, it effectively constraints output to be
below Qr ,but permits output to be greater than QΠ. A profit constraint equal to or greater than
maximum profit would cause the firm to produce output Q Π , at least in the short run (Lipsey
and Sleiner, 1966).

ii) Marris’ Growth Maximization Model

Working on the principle of segregation of managers from owners, Marris proposed that
owners (shareholders) aim at profits and market share, whereas managers aim at better salary,
job security and growth. These two sets of goals can be achieved by maximising balanced
growth of the firm (G), which is dependent on the growth rate of demand for the firm's
products (gD) and growth rate of capital supply to the firm (gC). Hence growth rate of the
firm is balanced when the demand for its product and the capital supply to the firm grow at
the same rate.
According to Marris, the goal of the firm is the maximisation of the balanced rate of growth
of the firm, that is, the maximisation of the rate of growth of demand for the products of the
firm and of the growth of its capital supply. This can be written as

Maximise 𝑔=𝑔𝐷=𝑔𝐶

where g is balanced growth rate

gD is growth of demand for the products of the firm and

gC is the growth of the supply of capital

According to Marris, the utility function of owners can be written as: 𝑈𝑜=(𝑔C)

Where, 𝑈𝑜 is the Utility of the Owners and 𝑔C is the rate of growth of capital.

On the other hand, the utility function of the managers may be written as follows

𝑈𝑀=𝑓(𝑔𝐷,𝑆)

Where, 𝑈𝑀 is the Utility of the managers and 𝑔𝐷 is the rate of growth of demand for the
products. S is Job Security

Marris assumes the utility function of managers is a function of rate of growth of demand for
the products and Job security. He assumes that salaries, status and power of managers are
strongly correlated with the growth of demand for the products of the firm. Hence, managers
will enjoy higher salaries and will have more prestige the faster the rate of growth of demand
for the products.

Marris further said that firms face two constraints in the objective of maximisation of
balanced growth, which are explained below:

Managerial Constraint

Among managerial constraints, Marris stressed on the importance of the role of human
resource in achieving organisational objectives. According to him, skills, expertise, efficiency
and sincerity of team managers are vital to the growth of the firm. Non- availability of
managerial skill sets in required size creates constraints for growth: organisations on their
high levels of growth may face constraint of skill ceiling among the existing employees. New
recruitments may be used to increase the size of the managerial pool with desired skills;
however new recruits lack experience to make quick decisions, which may pose as another
constraint.

The Job Security Constraint:

This is natural that the managers want job security. This desire of security by managers is
reflected in their preference for service contracts, generous pension schemes, and their dislike
for policies which endanger their position by increasing the risk of their dismissal by the
owners. The risk of dismissal of managers arises if their policies lead the firm towards
financial failure (bankruptcy) or render the firm attractive to be take-over by other
competitors. In the first case the shareholders may replace the old staff in the hope that by
appointing new management the firm will be run more successfully whereas in the second
case, if the take-over is successful, the new owners may decide to replace the old
management.

iii) Williamson’s Theory of Managerial Discretion

Williamson’s model of managerial discretion was developed by Oliver E. Williamson in

1964. Williamson like other managerial theory of the firm assumes that utility maximization
is the sole objective of the managers of a joint stock organization. It is also known as
“Managerial discretion Theory”. Williamson emphasize that managers are motivated by their
own self-interest and they tries to maximize their own utility function. Alike Baumol sales
maximization model, the utility maximization objective of the managers are subject to the
constraint that after tax profits are large enough to pay dividends to the shareholders.
However, it is pointed out that utility maximization by the self-interest seeking managers is
possible only in corporate form of the business organization as there exists separation of
ownership and control. This is basically the principal agent problem. It explains the
relationship between the principal (owner) and the agent (who performs owner’s works). The
principal agent shows that whenever the difference between ownership and control exist, then
the self-interest of agent makes profits lower than in a situation where principals act as their
own agents.

Profit works as a limit to the manager’s utility maximization as the shareholders require a
minimum profit to be paid out in the form of dividends. If this minimum profits is not
covered, then job security of the managers is put in danger. But, the managers are able to hold
a powerful position if (i) firm is showing a reasonable rate of growth, (ii) minimum dividends
are paid to the shareholders and (iii) profits at any time are at acceptable level. Here the
manager’s decision on price and output differs from the manager’s decision on price and
output of profit maximization firm.

Assumptions: The Williamson’s model is based on some assumptions. These are:

(i) Imperfect Competition

(ii) Separation of Ownership and management.

(iii) A minimum profit to be able to pay to the shareholders.

The factors that affect the interest of the self-seeking managers are:

a. Salary and other form of Monetary Compensation: The salary and other form of monetary
compensation is one of the most important factor in determining the utility of the managers.
Higher the income the managers receive, the better is the standard of living and status. So,
higher the salary and other monetary compensation and perks, higher is the utility of the
managers.

b. Management Slack or Non-essential Management Perquisites: The second factor that is

determining the utility of the managers is the amount of management slack. The management
slack consists of non-essential management perquisites such as well-furnished office,
luxurious cars, entertainment expenses etc. These perks are giving the incentive to the
managers to enhance their status and prestige in the organization which in turn contributing to
the efficiency of the firm’s operation. These non-essential perquisites are also the part of the
cost of production of the firm.

c. Number of Staff under the Control of a Manager: The third factor that is determining the
utility of the managers is the number of staff under the control of a manager. The greater the
number of staff under the control of a manager, the more powerful is the manager. More staff
under manager enhances his status and prestige. According to Williamson, there exist
positive relationship between the number of staff and salary of the managers. In the utility
maximization model of Williamson, he used a single variable for the number of staff and
salary of the managers as “monetary expenditure on the staff”.

d. Magnitude of Discretionary Investment expenditure by the Manager: The fourth important

factor that is determining the utility of the managers is the magnitude of discretionary
investment expenditure by the manager. The discretionary investment refers to the amount of
resources left at a manager’s disposal to be able to spend at his own discretion. This enhances
his status and prestige in organization. Here, the discretionary investment by the managers
does not include those investment expenditures that are necessary for the survival of the firm.
The discretionary investment by the manager includes spending on furniture, latest
equipment, decoration material etc.

Graphical Representation of the Williamson’s model:

The graphical representation of the equilibrium of the firm requires the construction of the
indifference curves map of managers and the profit curve. An indifference map is the family
of indifference curves. An indifference curve is a curve which shows different combination of
two goods yielding the same level of satisfaction to the consumer. In other words, it identifies
the various combinations of goods among which the consumer is indifferent. Here, the
indifference curve under Williamson model shows the relationship between monetary
expenditure on the staff and the discretionary investment. These are the two variable that are
determining the utility function of the managers. The indifference curve is shown in the
figure where staff expenditure (S) is measured on x-axis and discretionary profit (Π D) on y-
axis. Each indifference curve shows various combinations of staff expenditure (S) and
discretionary profit (ΠD) which give the same level of satisfaction to the managers.

Figure 2: Indifference Map

It is assumed that the indifference curves of managers are of well behaved:

  Indifference curves are downward sloping
 They are convex to the origin implying diminishing marginal rate of substitution of
staff expenditure and discretionary profit.
 Two indifference family of indifference curves can never intersect each other
 Higher the indifference curve higher is the level of satisfaction.

The indifference curves do not intersect the axes. The indifference curves do not intersect the
axes. This is very important property and need to be explained properly. We have seen that
expenditure on staff and discretionary profit are positively related to utility function of the
managers. Any increase in expenditure on staff or discretionary profit or in both results in an
increase in the satisfaction of the managers by increasing the utility. This assumption restricts
the choice of managers to positive levels of both staff expenditures and discretionary profits,
implying that the firm will choose values of Π D and S ‘that will yield positive utility. It is
shown in the figure. If the indifference curves do not intersect the axes then the model
excludes the corner solutions, such as points A, B, C, D etc., where discretionary profit (Π D)
would be zero in the final equilibrium of the firm.