WEEK 9

MANAGERIAL THEORIES OF THE FIRM

AND MANAGERIAL CONSTRAINTS
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LEARNING GOALS
The purpose of this lecture is to
•Explain and explore the implications of the
separation of ownership from control (the principal-
agent problem).
•Examine alternative models to neoclassical
economic theories of the firm based on different
assumptions – i.e. managerial & behavioural theories.
•Examine alternative constraints and approaches for
containing managers from furthering their own
interests at the expense of shareholders.
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LIMITATIONS OF
STANDARD THEORY
Standard theory of the firm is for a Single Period
Profit Maximising Firm.
(Modern theory extends this to long run.)
is both a holistic and an optimising model.

Criticisms of the Profit Maximising Model are that is

makes assumptions that might not in reality exist.
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LIMITATIONS OF
STANDARD THEORY
Assumptions that may not in reality exist:

1. Perfect market assumptions:

• Firms are price-takers (have no market power)

• Homogeneous products

2. Perfect information (knowledge about prices etc.)

3. Firm knows its MC & MR curves (optimum MC=MR)

4. “black box” production

5. Firm wishes to maximize profits

THE SEPARATION OF 5
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL
A principal-agent problem applies whenever one person
(the Principal) hires another person (the AGENT) to carry
out work on their behalf.
There is Asymmetric information.
1.Principal & Agent likely have different objectives.
2.The Agent has hidden information which cannot be
observed by the principal and can take actions not in the
interests of the principal.

Problem – how to make the agent work in the

principal’s best interest?
THE SEPARATION OF 6
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL

There is also MORAL HAZARD (hidden actions) in

contractual situations.

Example – Mobile phone contracts:

How does your mobile phone seller provide incentive for
you to look after your phone?
Example – Employment contract:
How can an employer employing you for a fixed number
of hours per day working from home be certain you are
working those hours (and not surfing the internet!)?
THE SEPARATION OF 7
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL
Example - Employment contracts:
• Workers can produce 5 acceptable quality products
per hour with effort but with little effort can produce 2.
• Compare incentives:
• Pay all workers a flat rate wage of £6 per hour
• Pay a piece-rate i.e. £3 per item produced.
• Both systems likely result in average cost £3 per unit,
HOWEVER piece-rate production benefits from
incentive not to “slack off” - total production is 5 per
hour versus 2 per hour.
• Principal has overcome the ‘moral hazard’ Problem.
THE SEPARATION OF 8
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL
Incentive payments can be offered by the Principal in
other types of business situations.

Other examples:
• Commissions paid to salespersons;
• Tips or bonuses paid to workers;
• Managers Performance Contracts e.g. firm shares
THE SEPARATION OF 9
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL
Direct monitoring, incentive schemes etc. incur costs, but
loss of control incurs costs called ‘AGENCY COSTS’

AGENCY COSTS are loss in value to shareholders

(owners) of managers’ actions in pursuit of their own
interests.
THE SEPARATION OF 10
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL
Example:
Mr. A is the owner-manager of a company who sells 50% of
company shares to Ms. B, who will not manage the company.
She is therefore a Principal who is “hiring” Mr. A (the Agent) to
act on her behalf managing the company. 
Suppose profits this year are £100,000. If split 50-50%, both
Mr. A & Ms. B should earn £50,000.
Mr. A (manager) now leases a £10,000p.a. ‘company car’.
Now profits left will be £100,000 - £10,000 = £90,000.
Ms. B gets only £45,000 while Mr A gets £45,000 + £10,000.
Agency Cost = £50,000 - £45,000 = £5,000
THE SEPARATION OF 11
OWNERSHIP FROM CONTROL
PRINCIPAL – AGENT MODEL
Q: What could Ms. B do to minimize agency costs?
ANS: Design of Appropriate Incentive scheme!
However, these schemes have problems:
•Managers may also be motivated by non-monetary rewards -
difficult to devise schemes (see managerial theories next)
•Gregg et al (1993) study found that direct remuneration (pay
and bonuses) of top managers were only WEAKLY linked to
the Company’s performance in the Stock Market.
EMPIRICAL EVIDENCE: Labour federation study on Growth
of senior executive pay ratio (including perks) 1980 to 2000
highlights issue from $1:$42 to $1:$531.
EXPLANATIONS OF NON- 12

PROFIT-MAXIMISING
BEHAVIOUR
Explanations of Non-Profit-Maximising behaviour
based on the principal-agent problem fall under 4
broad headings of MANAGERIAL THEORIES:
(i) SALES REVENUE MAXIMISATION
(ii) GROWTH MAXIMISATION (+ more next lecture)
(iii) MANAGERIAL UTILITY
(iv) BEHAVIOURAL THEORIES
BAUMOL’S SALES 13

REVENUE MAXIMISING
MODEL
Baumol (1958) observed that that status, salaries and
other rewards of managers often linked to size of firms
- measured by sales revenue rather than profitability.
•Managers incentivized to maximise sales (not profits).
•Instead of producing at profit max MC=MR managers ignore
cost and maximise MR, i.e. produce at MR=0.
•More realistically a minimum profit constraint
(shareholders expectations) considered first.
This creates a new optimizing model…
BAUMOL’S SALES REVENUE 14
MAXIMISING MODEL

q4
BAUMOL’S SALES 15

REVENUE MAXIMISING
MODEL
π = TR – TC (i.e. profit = total revenue – total cost)
At C(q1): Profits are maximised i.e. A-B distance is highest.
At. G(q4): Highest Sales quantity at break-even (TC = TR).
After G: Higher sales quantities possible but firm making losses –
so not likely.
At D(q2): Sales revenues maximised without minimum profit
constraint. Shareholders may be dissatisfied with low profits.
At F(q3): Sales revenue is maximised given the minimum profit
constraint expected by shareholders.
q3 is chosen by the managers trying to maximise sales
revenues given a minimum level of profit that has to be made to
satisfice shareholders.
MARRIS’ GROWTH 16
MAXIMISATION
THEORY
In Marris’ (1964) balanced growth maximization
model managers’ salaries, status etc. depends upon
size of their department.
Expanding activities under manager’s control leads to
firm growth and firm growth expands activities under
manager’s control.
Therefore, due to divorce of ownership and control,
MANAGERS TRY TO MAXIMISE GROWTH NOT
PROFIT.
MARRIS’ GROWTH 17
MAXIMISATION
THEORY
Marris’ model (diagram next slides) depends on the interaction
between DEMAND GROWTH and FINANCIAL GROWTH.

DEMAND GROWTH:
Short-term - increase growth using existing products by
increasing Demand (via price cuts, marketing campaigns etc.),
but there are limits to activities without affecting profits.

Long run growth - must introduce new products or diversify

into new markets.
Constraints to this diversification also:
•MANAGERIAL CONSTRAINT ON GROWTH - as new products/new
markets are introduced, capacity of managers and firm’s resources more
thinly spread (leading to inefficiencies and decline in profits).
MARRIS’ GROWTH 18
MAXIMISATION
THEORY

FINANCIAL GROWTH constraint also arises:

•if firm borrows money for its growth activities its gearing ratio
increases i.e. it becomes a more risky proposition.

•if firm issues new shares, they must show an acceptable rate
of return for potential shareholders to invest.

•if firm uses retained profit, is a trade-off between paying

dividends to shareholders and keeping profits for re-
investment.
 MARRIS’ GROWTH 19
MAXIMISATION
THEORY
Growth of Capital (to
finance the growth):
•Assume finance as retained
profit and a linear relationship
between rate of profit and
maximum growth rate
sustainable.
•Thus, the higher the profit rate,
the higher the maximum rate of
growth of capital the firm can
sustain.
Profitability of Demand growth initially rises as
managers able to exploit products then diversify
and increase growth rate.
But due to MANAGERIAL CONSTRAINT, the
profitability of increasing diversification (and hence
growth rate) tends to decline (i.e. after point A).
MARRIS’ GROWTH 20
MAXIMISATION
THEORY
The shaded area
gives all possible
combinations of profit
and growth.
 
A shareholder, who
wishes to maximise
profits, will want to
choose point A.

But a manager, interested in growth maximisation, given constraints,

will choose point B (where Growth of demand = growth of capital).
This is called the BALANCED GROWTH RATE
MANAGERIAL
21
UTILITY
MAXIMISATION
Williamson asserts that subject to satisficing a
minimum level of profit to shareholders, Manager’s will
maximise THEIR utility, which includes unecessary or
‘discretionary’ expenditures such as:
S – spending on staff
M – Management “Perks”
ID – Discretionary investments
As DIMINISHING MARGINAL UTILITY applies for each, they
will optimize the best mix (after necessary expenditure).
Can explain why firms are able to CUT COSTS when required
by acquisition or economic downturn.
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BEHAVIOURAL THEORIES
Behavioural theories consider how people actually
behave.
The firm is a coalition of individual interest groups
which can have Multiple goals, often oposing. Cyert &
March identify 5 competing Goals of the firm:
1. Production
2. Inventory
3. Sales
4. Market share
5. Profit

Trade-off depends on relative bargaining power of groups.

Mangers dislike costly conflict so set easy to attain targets and
use rules of thumb – i.e. Organisational Slack, i.e.
Satisficing rather than optimising behaviour.
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QUESTIONS?
Either:

Or:

Question / Discussion Board

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MANAGING THE MANAGERS:

CONSTRAINTS ON
MANAGERIAL BEHAVIOUR
We have established the Principal-Agent problem
and theories of managerial behaviour, but
managerial behaviour is subject to both:
•EXTERNAL CONSTRAINTS
•INTERNAL CONSTRAINTS
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EXTERNAL
CONSTRAINTS
External constraints arise mainly from the ‘market’ in the
Company’s shares or other debt/investment interests.

1.External holders of shares

2.People acquiring shares

3.Bidders in take-overs

4.Debtors/Investors

5.External regulators (Corporate Governance)

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CORPORATE
GOVERNANCE
Managers must comply with Company Law or
‘Corporate governance’.
In the UK the main reports associated with this are:
•The COMBINED CODE (1998) (detailed on next slide)
• Cadbury Committee (1992)
• Greenbury Committee (1995) combined
• Hampel Committee (1998)
•Higgs Report (2003) - mostly concerning NEDs
•Walker Review (2009) - mostly banks/ financial institutions
•Stewardship Code (2010) - mostly institutional investors
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CORPORATE
GOVERNANCE
Combined Code Guidelines – recommendations
 
Each company should have:
•A non-executive chairman and a chief executive with a
clear division of responsibility between them
•3 non-executive directors independent of management
•A renumeration committee made up mainly of non-
executive directors to look at the reward of directors
•A nomination committee composed wholly of non-
executive directors to appoint new directors.
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CORPORATE
GOVERNANCE
Must issue an Annual Report to include:
•Narrative accounts of how they apply the Code and if they
depart from it, they have to give an explanation
•Disclosure of payments to CEO and highest paid UK
director
•Appropriate training for Directors
•Majority of non-executive directors to be independent and
this must be disclosed

MUST be lodged with the regulators

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INTERNAL
CONSTRAINTS
1. HIERARCHICAL MONITORING (VOTING POWER)
2. MANAGERIAL REMUNERATION
3. MARKET CURTAILMENT OF AGENCY COSTS
• FIRM SPECIFIC HUMAN CAPITAL & DEBT-
BONDING
• MANAGERIAL REPUTATION
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[1] HIERARCHICAL
MONITORING - NEDS
Internal constraints through VOTING POWER.
3 groups important:
(i) Non-Executive Directors (NEDs)
Key role is to exercise scrutiny
Cadbury Committee determined that NEDs should be in a
majority on pay and remuneration committees.
 
Problem:
• NEDs are often appointed by executive directors(!)
• There may be too few non-executive directors on the Board.
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[1] HIERARCHICAL
MONITORING
(ii) Shareholders (‘common stock’) have voting
privileges.
Voting rights can be used at the AGM to remove /
elect executive directors or determine policy.
Problem:
In practice - this is difficult requiring a majority of those voting
at the AGM to vote in favour.
Experience shows most shareholders are passive. If
dissatisfied, tend to sell shares rather than effect change i.e.
‘vote with their feet’.
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[1] HIERARCHICAL
MONITORING
(iii) Stakeholders e.g. Institutional investors such as
pension funds, banks who loan money to the
Company, have started taking more interest.
Problem:
This sometimes takes place behind the scenes (rather
than at AGM).

NOTE:
In some countries these can include employees and e.g.
Germany has supervisory boards which also often also
includes both purchasers and suppliers (i.e. broader
stakeholders).
ALTERNATIVE SYSTEMS 33

OF CORPORATE
GOVERNANCE
Some countries have other ways of controlling directors
called ‘insider systems’:
JAPAN (ZAIBATSU)
•Manufacturing firms with extensive cross shareholdings and
interlocking directorships
GERMANY (SUPERVISORY BOARDS)
•Concentrated and long-term shareholdings
•Supervisory boards - consist of: shareholders, employees, external
trade unions and often also includes both purchasers and suppliers
(stakeholders)
• Reduces irresponsible managerial behaviour
• Reduces tendency to ‘side’ with management's interests as in
the UK.
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[2] MANAGERIAL
REMUNERATION
Incentives can encourage managers to act in ways
which are in the interests of the shareholders
•e.g. Schemes which give managers an equity stake in the
business, or the right to acquire one as in a share option
scheme, give managers a direct interest in shareholder value.
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[2] MANAGERIAL
REMUNERATION
However, they suffer a number of drawbacks:
a)Stock option schemes provide option to buy shares in the future at
a price agreed in the past. The danger is managers are incentivized
to manipulate share prices.
b)Profit share schemes suffer the problem that profit figures are
subject to manipulation.
c)Incentive schemes can suffer from creating too strong a focus on
the short-term.
d)Problems isolating contribution of senior management to firm
performance.
e)Criticism that statistical studies looking at the overall determinants
of remuneration still find size of the organisation to be the major
factor (not performance).
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[3] MANAGERIAL
REPUTATION
Managers gain a reputation value in the managerial
labour market for successful running of the firm.
Fama (1980) has suggested that long term, the labour
market will "settle up" with slack managers.

The threat of acquisition is also a potential discipline

on managers (tend to be weaker performing firms).
However, are a variety of methods management can use in
order to reduce the likelihood of takeover such as ‘golden
parachutes’, ‘poison pills’ and other ‘shark-repellents’.
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[3] MANAGERIAL
REPUTATION
If managers invest in firm-specific human capital,
gives them an interest in guarding against firm failure.

Debt term bonding

Taking on debt may signal managers commitment
to the firm for the debt term to be able to meet
interest payments and avoid liquidation (which would
be damaging to their reputation).

Debt term bonding helps explain a number of

innovations in corporate financing e.g. leveraged buy
outs involving substantial debt finance.
 38

QUESTIONS?
Either:

Or:

Question / Discussion Board

 39

SUMMARY
• We explained and explored the implications of the
separation of ownership from control (the
principal-agent problem).
• Then examined alternative models to neoclassical
economic theories of the firm based on different
assumptions – i.e. managerial & behavioural
theories.
• Finally we examined alternative constraints and
approaches for containing managers from
furthering their own interests at the expense of
shareholders.
 40

READING
Sloman, Garrat, Guest & Jones (2016) ch. 14;
Begg & Ward (2016), ch. 8.1-8.4 (very good);
Jones chs. 1 & 2;