Baumols Theory

Theory of the Firm

‘Managerial Discretion’Models

Baumol’s modelmanagers’ rewards seem to be more closely

linked to size than to profittherefore, firms aim to maximize sales

revenuebut subject to a profit constraint

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Baumol’s Static Sales Revenue Maximising Baumol’s Static Sales Revenue Maximising Model without AdvertisingModel without Advertising

Profit Maximisation Models

Baumol's Theory of Sales Revenue Maximisation

Baumol's Theory of Sales Revenue Maximisation

Two basic models:static single-period model;multi-period dynamic growth model.

Each model can include advertising activity or not.

Rationalisation of the Sales Maximisation Hypothesis

-There is evidence that salaries and other earnings of top managers are correlated more closely with sales than with profits.-Banks and other institutions, which keep a close eye on the sales of firms, are more willing to finance firms with large and growing sales.

Rationalisation of the Sales Maximisation

Hypothesis- Personnel problems are handled more

satisfactorily when sales are growing. Employees of all levels can be given higher earnings and better terms of work in general. Declining sales make the converse and lay-offs more likely.- Large sales, growing overtime, give

prestige to managers; large profits go into the pockets of shareholders.

Rationalisation of the Sales Maximisation

Hypothesis- Managers prefer a steady performance with

satisfactory profits to spectacular profit maximisation projects. If they realise high profits in one period, they might find themselves in trouble in other periods when profits are less than maximum.

- Large, growing sales strengthen the power to adopt competitive tactics, while a low or declining share of the market weakens the competitive position of the firm and its bargaining power vis-à-vis its rivals.

Rationalisation of the Sales Maximisation Hypothesis

The implication of Baumol’s model is that risk avoidance has a statistical effect upon economic activities, eg. R&D in large firms.

Baumol’s Static Models

The basic assumptions of the static models:

- The time-horizon of a firm is a single period.- During this period the firm

attempts to maximise its total sales revenue (not physical volume of output) subject to a profit constraint.


- The minimum profit constraint is exogenously determined by the demands and expectations of the shareholders, the banks and other financial institutions. The firm must realise a minimum level of profits to keep shareholders happy and avoid a fall of the prices of shares on the stock exchange.


-Conventional cost and revenue functions are assumed - cost curves are ill-shaped and the demand curve of the firm is downward sloping.


Four models:- A single-product model, without

advertising.- A single-product model, with

advertising.- A multi-product model, without

advertising.- A multi-product model, with

advertising.

Baumol’s Dynamic Model

The most serious weakness of the static model is the short-time losses of the firm and the treatment of the profit constraint as an exogenously determined magnitude. In the dynamic model the time horizon is extended and the profit constraint is endogenously determined.

The assumptions of the dynamic model

- The firm attempts to maximise the ratio of growth of sales over its lifetime.

- Profit is the main means of financing growth of sales, and as such is an instrumental variable whose value is endogenously determined.


- Demand and of cost have the traditional shape - demand is downward-sloping and costs are U-shaped. Profit is not a constraint (as in the static model) but an instrumental variable, a means whereby the top management will achieve its goal of a maximum rate of growth of sales.

- Growth may be financed by internal and external sources. However, there are limits to the external sources of finance.Thus profits will be the main source for financing the rate of growth of sales revenue.


Growth may be financed by internal and external sources. However, there are limits to the external sources of finance. Thus profits will be the main source for financing the rate of growth of sales revenue.

Marris - Growth Maximisation

Model highlights two important factors as far as management is concerned: the attitude to risk and uncertainty and the desire for utility which may not be maximised by the pursuit of maximum profits.


Marris, like Williamson, suggests that managers have a utility

function in which salary, prestige, status, power, security, etc., are important. The owners

of the firm are, however, likely to be more concerned with profits,

market share, output, etc.


In contrast to Williamson, Marris argues that the owners and managers have one aspect of the firm in common; namely, its size.

He therefore postulates that managers will be primarily concerned with maximisation of the rate of the growth of size rather than absolute firm size.


The attraction of the growth rate of size is thought to stem from the positive effect growth has upon

promotion prospects. Stress is put on an alleged preference of managers for

internal promotion and this is made easier if the firm is seen to be

expanding rapidly.


Managerial utility function may be written as follows:

Um = f (gD,s)

where

gD = rate of growth of demand for the

products of the firm;

s = a measure of job security.


Owners utility function may be written as

U0 = f *(gc)

where gc = rate of growth of capital.


S(a measure of job security) can be measured by a weighted average of three ratios: the

liquidity ratio, the leverage debt ratio and the profit-retention

ratio.

Marris - Growth MaximisationS can be measured by weighted average of S can be measured by weighted average of liquidity ratio, debt ratio and profit retention ratioliquidity ratio, debt ratio and profit retention ratio

Liquidity ratio = Liquidity ratio = Liquid assetsLiquid assetsTotal assetsTotal assets

Debt ratioDebt ratio = = Value of debtValue of debtTotal assetsTotal assets

Retention ratio =Retention ratio = Retained profitsRetained profitsTotal profitsTotal profits


Too low liquidity ratio may lead to insolvency and bankruptcy and there is a threat of take-over in case it being too high.

Too low Retention ratio may upset shareholders and too high ratio may inhibit growth.

Managerial Utility & Constraints

Optimum Managerial UtilityAt point A, utility is lower and the growth rate is

not as high though v is above the minimum constraint.

At B, utility and growth are higher than at A but v is below the minimum constraint.

At C utility is as high as it can be given the security minimum valuation ratio constraint

Profit is important but growth more soThe need to keep v high limits trading off profits

for a higher growth rate.

Cyert and March Behavioural Theory

1. The Firm as a Coalition of Groups with Conflicting

Goalsbased on a large multiproduct group

operating under uncertain conditions in an imperfect market - difference between ownership and control - firm treated as a multi-goal, multi-decision organisational coalition of managers, workers, share-

holders, customers, suppliers, bankers.


2. Goal Formation – The Concept of the Aspiration

LevelIndividuals may have (and

usually do have) different goals to those of the organisation-firm.


3. The Goals of the Firm: Satisficing Behaviour

Goals set by top management.


The main goals:Production goal - smooth running.Inventory goal - adequate stock of

suitable raw material.Sales goal - from sales department. Share of the market goal – also from

sales department.Profit goal – shareholders, finances.


4 Means for the Resolution of Conflict

Conflict is inevitable. Nevertheless the groups and the firm as a whole may

remain in a stable position - limited time to bargain, etc. Behaviour, goals

and decisions are largely based on past history.


5. The Theory of Decision Making - At Top Management Level

Resource allocation - implemented by the budget - share of budget

taken by each department. Largely determined by bargaining power which is itself determined by past

performance.


6. Uncertainty and the Environment of the Firm

Two types of uncertainty:

- market (cannot be avoided)

- competitor's reactions (overcome by tacid collution, eg. trade associations)

Baumols Theory

Documents

large sales

sales of firms

growing sales

declining sales

total sales revenue

sales revenuebut subject

singleproduct model

multiproduct model