Behaviour of Firm in Theory and Practice

The following points highlight the three main aspects of behaviour of firm in theory and practice. The aspects are: 1. Managerial Revolution 2. Executive Compensation 3. Discretionary Profit.

Aspect # 1. Managerial Revolution:

The second half of the ‘past century and the first half of the present saw the development of the limited liability joint-stock enterprises. As Martin Ricketts has noted: “This type of company enabled very large projects to be undertaken by using re­sources purchased by many shareholders, resources coordinated by a specialist management under a board of directors”.

The growing importance of the joint stock enter­prise, the increasing size of various enterprises and the wider dispersion of stock ownership in these enterprises were first discovered by Berle and Means in 1930.

They summarized their findings in the follow­ing words:

‘The concentration of economic power separate from ownership has, in fact, created economic em­pires and has delivered these empires into the hands of a new form of absolution, relegating ‘own­ers’ to the position of those who supply the means whereby the new princes may exercise their pow­ers.

Thus Berle and Means have invested the man­agers of joint stock companies (corporations) with princely authority over vast dominions — authori­ty which the word ‘absolution’ suggests, is untrammeled by constitutional or other restraints. J. K. Galbraith in his New Industrial States (1967) ap­peared to be perhaps the most attractive modern exponent of the thesis.

He ventured to call the managerial elite which is said to govern much of the industries as ‘the techno structure’.

Aspect # 2. Executive Compensation:

The remuneration of senior executive and mana­gerial personnel is undoubtedly an important mat­ter. In the early 1960s data revealed that small percentage of shares were held by directors in very large companies.

The median holding was between 1 per cent and 2 per cent. Managerial shareholding rose during the 1950s and 1960s however, and often the combined interest of corporate directors and management was considerable.

In the period 1973- 82 the ownership interest of corporate directors and management was 19.3% for the middle ten firms in the 1975 Fortune 500 list. For ten randomly selected firms too small to be included in the Fortune 500, the managerial interest was 32.5%.

It was in the very largest size range (the top ten firms), that the percentage interest of managers and directors dropped down to 2.1%. Thus ‘a substantial fraction of outstanding shares is owned by directors and management of corporations, in all but the very largest firms’.

From the point of view of incentives, neither the combined shareholding of management nor the proportionate holding of senior managers is the most important factor. What is more significant is the nature of the remuneration package of the most senior managers. In the early 1960s management in­come was more closely related to company size as measured by total sales than to company profits.

Few sample surveys reported statistical correla­tions between executive compensation, profits and sales in a cross-section of firms in the period 1953- 59. Their evidence supported a positive correlation between sales and executive incomes, although the tests ‘do not completely rule out the possibility of a valid relationship between profits and executive income, too’.

By the early 1970s, cross-section stud­ies of this nature were subjected to considerable criticism. Given the hierarchical structure of large firms the internal incentive arrangement might be expected to result in a different scale of prizes for the contestants in a big tournament, than in a smaller one.

But this would not permit us to deduce that, for a manager at the top of a given firm, an overriding incentive existed to increase the size of that particular hierarchy. A further criticism con­cerned the measure of executive incomes. By concen­trating on salaries, other important components were overlooked.

Masson (1971) constructed a measure of executive compensation which included deferred compensa­tion such as stock options and retirement benefits as well as stock ownership, salary and bonuses. His sample consisted of the top three to five executives of thirty-nine electronics, aerospace and chemical companies for the years 1947-66.

From these data Masson concluded that executives receive a posi­tive reward for increasing stock value, that chang­es in stock value are more important to the execu­tive than changes in profit earned, and that the hypothesis that executives were paid to expand sales was rejected. Similar conclusions were report­ed by Lewellen (1969).

In a survey of fifty of the largest 500 U.S. firms Lewellen found that only about one-fifth of the total remuneration of the top executive came from salary. This study was fol­lowed by a further enquiry by Lewellen and Hunt­sman (1970). One of the measures of executive com­pensation included the current income equivalents of various deferred and contingent pay schemes.

In the case of a pension plan, for example, the extra salary necessary to buy equivalent cover from an in­surance company was estimated and included as a part of the comprehensive measure of managerial compensation. Their results indicated that ‘report­ed company profits appear to have a strong and persistent influences on executive rewards, whereas sales seem to have little, if any, such impact’.

A surprising aspect of this finding was that it ap­plied to the simpler measure of executive compen­sation (salary plus bonuses) as well as to the more sophisticated measure.

Meeks and Whittington (1975) concluded in contrast that managerial com­pensation was strongly correlated with sales in cross-section tests. Meeks and Whittington did not, however, deduce from this that incentives are primarily in the direction of increasing size at the expense of profits.

It is simply not open to managers or direc­tors suddenly to choose to be as big as IBM or ICI in order to raise their salary. Although cross-section correlations are strong, large proportionate increas­es in size would be necessary to have a noticeable effect on a managers’ income.

In practice the man­ager does not choose the size of the firm but may have some influence over the rate of growth. When Meeks and Whittington considered the relative in­fluence of higher growth and higher profits on managers’, rewards, however, their data suggested that’ profits were more important.

Aspect # 3. Discretionary Profit:

If one accepts the major premises of managerial critics, specially that of Williamson, then it fol­lows the management in large businesses, being ex­empt from pressures to devote all their efforts to maximising profits, must be subject to some discre­tion in their behaviour. How is this discretion or freedom exercised?

Williamson suggests, on the ba­sis of his own empirical study, that management may seek satisfaction of goals in the following are­as:

i. Salary

ii. Security

iii. Dominance

iv. Professional excellence

From this formulation of managerial goals Wil­liamson arrives at his concept of an ‘expense prefer­ence’.

By expense preference I mean that managers do not have a neutral attitude toward all classes of expenses. Instead, some types of expenses have pos­itive values attached to them and they are in­curred not merely for their contributions to produc­tivity (if any) but, in addition, for the manner in which they enhance the individual and collective objective of managers.

Conventional economic theo­ry treats all expenses symmetrically: individuals are indifferent toward costs of all types. Expense preference replaces this attitude of indifference by positive tastes for certain classes of expenses. Asymmetry thus develops in the attitude toward costs.

The particular forms of expense thus chosen can be classified into Staff, Emoluments and Discretion­ary Profit. Spending in each of these areas satisfies one or more of the managerial goals listed above. Thus, if management is free from the constraints of shareholder control, product market competition or takeover, one would expect profitability to be sac­rificed to one or more of these goals.

What Williamson essentially suggests is that because external pressures upon management, (i.e. shareholders, product competitions of management of more aggressive firms) are dormant, ineffective or face institutional friction is operating, the man­agement is freed from the basic obligation to oper­ate at greatest efficiency to maximise profits.

The managerial discretion which is thereby created is used to satisfy more individual or personal mana­gerial objectives.

These, Williamson contends, “find expression in the recruitment of otherwise ex­cessive numbers of staff, in unnecessarily high man­agement salaries (i.e., when the element of econom­ic rent is a significant component), or the earning of some discretionary level of profit above the mini­mum level required by shareholders or creditors, so as to finance these other discretionary expenditures internally.”

What is of some significance about William­son’s thesis is that he has himself gone some way towards suggesting more recently that changes in organisational structure within firms may elimi­nate managerial discretion and the consequent pur­suit of non-profit goals.

This almost behavioural revision on Williamson’s part may suggest that a neo-classical analysis of firm behaviour may not be as inappropriate as many suggest.

Speaking of the modern large business firm, Williamson suggest that its vitality is attributable in large part to or­ganizational innovations that have permitted the corporation to limit the degree of control loss and sub-goal pursuit that, without innovation, were predictable consequences of large size.

Rather than be overcome by what otherwise would have been serious bureaucratic disabilities, the corporation has responded with a demonstrated capacity for self-renewal.

The organisational innovation upon which Wil­liamson concentrates is the change in organization­al structure from a functional or unitary (U-form) basis to a multidivisional 9M-form) basis.

That is to a business divided into autonomous product oper­ating units such as Motor Cars, Diesel Engines, Do­mestic Appliances, etc. as exposed to the more the traditional establishment of functional units — for example, Purchasing, Sales, Finance and Personnel.

This change is held to eliminate inter-functional dispute and co-ordination failure, both of which lead to either a loss of efficiency and reduced prof­its or a more conscious pursuit of non-profit mana­gerial objectives.

As Hoe has pointed out, business­es organised on an M-form basis create smaller, more operationally accountable and more easily managed operating units. Multi-divisionalisation may be carried out on the basis of product or geo­graphical area.

A central co-ordination and control staff ensures that profit targets in each division are achieved, and may adjust top divisional man­agement salaries and the availability or other­wise of expansion capital, in the light of profit performance. Williamson summarizes his own con­clusions as follows:

The transformation of a large business firm for which divisionalization is feasible, from unitary, to a multi-division form organization, contributes to (but does not assure) an attenuation of both the con­trol loss experience and sub-goal pursuit (mainly staff-biased expansion) that are characteristics of the unitary form.

Realization of these attenuation effect, however, requires that the general office be aggressively constituted to perform its strategic planning, resource allocation, and control functions.

Both the form and substance of multi-division or­ganization are required for this transformation to be effective.

Expressed in conventional goal pursuit and efficiency terms, the argument comes down to this: the organization and operation of the Urge enterprise along the lines of the M-form favours goal pursuit and least-cost behaviour more nearly associated with the neo-classical profit maximi­zation hypothesis than does the U-form organiza­tional alternative.

Williamson’s model postulates the existence of expense preference’. This means that the manage­ment does not have a neutral attitude towards costs. Directly or indirectly certain classes of ex­penditure have positive values attached to them. In particular staff expense, expenditure for emoluments, and funds available for discretionary in­vestment have value additional to that which de­rives from their productivity.

Staff expansion is very difficult to resist because ‘not only is it an in­direct means to the attainment of salary but it is a source of security, power status, prestige and pro­fessional achievement as well’. By ’emoluments’ he means discretionary pay and perquisites, which thus constitute part of the so called ‘organizational slack’. For various reasons staff may prefer to obtain this slack in non-monetary form.

However, “the existence of satisfactory profits is necessary to assure the interference-free opera­tion of the firm to the management”.

Furthermore, management “will find it desirable to earn profits that exceed the acceptable level. For one thing, managers derive satisfaction from self-fulfilment and organizational achievement and profits are one measure of this success. In addition profits are a source of discretion. Williamson has combined the various managerial goals into a utility function and postulates that the objective of utility- maximization with the hypothesis that those ex­penditure that promote managerial satisfactions should show a positive correlation with opportuni­ties for discretion and tastes”.

His conclusion was that the evidence generally supports the implica­tions of the utility-maximization approach.

Al­though it is not strong enough to provide a discrimi­nation between the utility and profit-maximising theories, it does suggest that either firms are oper­ated as indicated by the managerial model, or, if ‘actual’ profits are maximised, that reported prof­its are reduced by absorbing some fraction of actual profits in executive salaries and possibly in per­quisites of a variety of sorts.

In similar way Monsen and Downs suggest that owners seek maximum profits whereas managers ‘act so as to maximise their own lifetime incomes’. Stockholders are generally considered unlikely to switch from holding shares in one company to hold­ing them in another because of uncertainty about the outcome of the switch and because capital gains are taxed.

Thus they tend to accept ‘satisfactory’ profit levels without much fuss. Nevertheless, managers are aware of the likelihood of an upris­ing among shareholders if they perform very bad­ly. On the other hand managers do not expect opti­mum performance to be commensurately rewarded. Hence ‘the punishment for grievous error is greater than the reward for outstanding success’.

Thus, sub­ject to the necessity to earn satisfactory profits for shareholders, managers seek to maximise ‘the present value of their lifetime incomes in dollar terms’ (where such incomes include both monetary and non-monetary elements.) Unfortunately no empiri­cal justification of the theory is provided.

The above sentiments are also reflected in Papandreou’s concept of the maximisation of a prefer­ence function. He conceives of a ‘peak coordinator’ who formulates the firm operating budget or strat­egy. The selection of the strategy requires the spec­ification of some value premises (preference sys­tem) and factual premises.

The preference system is regarded as being a resultant of all the influences which affect the value premises of enterprise strategy selection. Over a period of time the peak coordinator is subject to a changing structure of con­scious influence which largely arises out of the sep­aration of ownership from control and from the rise of the trade unions.

The firm thus seek to maximise its general pref­erence function instead of profit. The sort of factors which tend to enter a firm’s preference function are a desire for a quiet life, for power control or prestige. But as Papandreou him­self points out, the difficulties of quantifying a preference function are considerable.