The theory of prot maximization does not recognize the complexity of the modern organization. Defence of prot maximization Machlup has argued that prot maximization is not a hypothesis that can be tested, but a paradigm that is not itself testable; yet, the paradigm allows a set of possible hypotheses to be dened for subsequent validation.
He argues that rms do not need accurate knowledge to maximize prots. Marginal revenue and marginal cost are subjective concepts, and their use by managers is not deliberate but done in an automatic way. It has been likened to overtaking when driving a car or hitting a cricket or tennis ball. Scientically, each decision requires signicant amounts of information that have to be analysed in a very short time. Yet, most people overtake successfully and can hit a cricket or tennis ball reasonably well with a bit of practice, knowing nothing of the physics or the method of calculation.
An individual rm is also constrained in its choice of objectives by the actions of its rivals. If there is a signicant degree of competition, then prot maximization may be the only goal the rm can adopt for it to survive and maintain its presence in the market. Likewise, pressure from shareholders will force the management of a rm to match the performance of their competitors if they are not to sell their shares. Further, unless the rm is earning a minimum acceptable level of prot it may nd raising further capital dicult.
However, while a certain level of prots are necessary to keep shareholders happy and to raise future capital, it does not necessarily mean maximizing prot, but it does suggest, in line with empirical studies, that prot is an important goal for the rm. Nevertheless, prot maximization remains an important assumption in economic analysis partly because it allows precise and predictive analysis of decisions and because surveys show it remains an important objective.
This model was developed by Baumol who argued that managers have discretion in setting goals and that sales revenue maximization was a more likely short-run objective than prot maximization in rms operating in oligopolistic markets. The reasons are as follows: g. Sales revenue is a more useful short-term goal for the rm than prot. Sales are measurable and can be used as a specic target to motivate sta, whereas prots, which are a residual, are not so easily used in this way. Specic sales targets are thought to be clearly understood by all within the rm.
Rewards for senior managers are often tied to sales revenue rather than prot, as they are for lower levels of sta. It is assumed that an increase in revenue will more than oset any associated increases in costs, so that additional sales will increase prot; therefore, increasing the size of the rm as measured by sales revenue or turnover is seen by shareholders as a good proxy for short-run prot increases. Increasing sales and, hence, the size of the rm makes it easier to manage, because it creates an environment in which everyone believes the rm is successful.
A rm facing falling sales will be seen as failing and lead to calls for managers to reappraise their policies. The rm produces a single product and has non-linear total cost and revenue functions. The impact of the model can be observed in Figure 2. The total revenue curve TR , the total cost curve TC and the prot function are shown.
Sales revenue is maximized at output level OQS at the highest point of the TR curve where marginal revenue is zero and becomes negative for any further increases in sales. For output QS marginal cost is positive and marginal revenue zero. This prot constraint is set at a level below that of maximum prots. The prot constraint for each rm is determined after taking into consideration: g. The level of return that will satisfy shareholders with the rms performance, so that they continue to hold or buy shares rather than sell. If prots fall below expected levels, then the share price will fall and encourage further sales of shares and encourage takeover bids.
A level of prots that will discourage hostile takeover bids would also satisfy the managements desire to retain control of the rm. In Figure 2. The constrained sales revenue maximization output level will be at OQC , which is somewhere between the prot and sales-maximizing outputs. Therefore, where the constrained sales revenue-. In the short run, if the rm assumes it faces linear total cost and total revenue curves, then sales revenue maximization implies selling all the output the rm can produce.
Thus, in this case sales revenue and prot maximization lead to the same outcome. Advertising and the static model The sales revenue-maximizing rm is in a stronger position than the prot maximizer to increase market share, which business strategists see as an important objective. Baumol envisages enterprises moving to new and higher total revenue curves by advertising.
Advertising is used to give information to consumers and to persuade them to buy the product. Baumol assumes that the marginal revenue of advertising is always positive and that the market price of the goods remains unchanged. Thus, additional advertising will always increase sales but do so with decreasing eectiveness.
Advertising is shown as a cost per unit, with total expenditure increasing linearly. Production costs are assumed to be independent of advertising expenditure, but are added to advertising costs, to give a linear total cost curve TC. The total revenue curve TR is drawn showing revenue always increasing as advertising increases.
There is no maximum point to the total revenue. The sales maximizer will therefore spend more on advertising than a prot maximizer. The price charged by a sales-maximizing rm is again lower than that charged by a prot maximizing enterprise. The relationships as postulated by Baumol between sales revenue and advertising, on the one hand, and advertising and production costs, on the other, have been criticized.
The notion that no advertising campaign ever fails is clearly unrealistic. The impacts of advertising expenditure and price reductions are analysed independently, but can in practice be used in combination to increase sales revenue. The model also assumes that price reductions allow the consumer to move along an existing demand curve, whereas advertising is assumed to shift the demand curve, therefore allowing the rm to move beyond the constraint of a single downward-sloping demand curve.
The assumption that all costs other than advertising are xed and do not vary with output has also been criticized. This simplifying assumption can be changed and traditional cost curves incorporated into the analysis, as was done by Sandmeyer The impact of both price and advertising on sales revenue can be explained with the aid of Figure 2. Assuming advertising expenditure is increased in discrete steps.
Assuming each level of advertising generates a unique sales revenue curve and demand curve that recognizes that revenue eventually decreases as prices fall. The minimum prot constraint and advertising expenditure are measured on the vertical axis and output or sales on the horizontal axis. Analysis of cost changes The static model also enables predictions to be made about the impact of changes in costs, taxes and demand on price and output combinations.
An increase in xed costs or the imposition of a lump sum tax will lead to a reduction in output. This contrasts with a prot maximizer which would keep output unchanged. Q3 and an increase in price. This helps to explain price increases, following increases in xed costs or lump sum taxes, such as tobacco duty, which are observed in the real world.
This can be observed in Figure 2. Managers nd satisfaction in receiving a salary, knowing they hold a secure job, that they are. Of these, only salary is directly measurable in monetary terms, but the other non-pecuniary benets are related to expenditures on: g g. Sta S , the more sta employed the more important the manager. Managerial emoluments or fringe benets M are rewards over and above those necessary to secure the managers services and are received in the form of free cars, expense accounts, luxurious oces, etc.
Discretionary investments ID , which allow managers to pursue their own favoured projects. Together these three elements comprise discretionary expenditure or managerial slack. Expenditure on these three elements increases costs and reduces the rms prots. The proportion of discretionary prots not used in discretionary spending is added to minimum prots to give reported prots. The choices facing a manager can be illustrated graphically using Figure 2. On the axes are discretionary expenditure and discretionary prots. The managers preferences are shown by a set of indierence curves, each one showing the levels of sta expenditure and discretionary prot, which give the same level of satisfaction or utility.
It is also assumed that a manager will prefer to be on higher indierence curves. The relationship between discretionary expenditure and discretionary prot is shown by a prot curve. Initially, discretionary prot and sta expenditure have a positive relationship, but after point D further discretionary expenditure reduces discretionary prots and, eventually, they fall to zero. The manager will maximize utility at point E, which represents a point of tangency between the highest achievable indierence curve and the discretionary prot curve.
Managers, therefore, do not maximize utility where discretionary prots are maximized but at lower levels of discretionary prot and higher levels of discretionary expenditure. Reactions to changes in economic variables can be analysed. A prot-maximizing rm has no managerial slack since costs are minimized and prots maximized.
A managerial utility-maximizing rm will respond to changes by increasing or decreasing discretionary expenditure. Thus, an increase in demand not only creates opportunities to increase actual prots but also to increase discretionary expenditure. A reduction in demand will reduce actual prots but may not reduce reported prots to the same extent because discretionary expenditure is reduced particularly if reported prots fall below the minimum prot required to keep shareholders happy.
Using case studies, Williamson found that rms were able to make cost reductions in times of declining prot opportunities without hindering the operations of the rm. Behavioural theories set out to analyse the process by which rms decide on their objectives, which are assumed to be multiple rather than singular in nature. The complexity of large modern enterprises means that the rm is made up of a number of separate groups, each responsible for a particular aspect of the rms activities and each with its own objectives: for example, the marketing director and the nance director may have dierent priorities in terms of using the rms resources.
The overall strategy of the rm is based on the conicting objectives of these groups and the processes used to achieve an agreed position. To achieve this, conicts have to be resolved and compromises have to be made. Consequently, the rm tends to have a multiplicity of objectives rather than a single one and to have a hierarchy of goals, so that some are achieved sooner than others. Simon , a Nobel Prize winner for economics, argued that: g g. The rm is not a well-dened individual entity with its own set of goals. Decisions are arrived at through interaction between the various interest groups or managerial departments of the rm.
Set higher objective 1. Set objective 6. Set lower objective No 4. Aspiration level falls 3. Objective achieved YES 5. Aspiration level rises 2. He argues that the overriding objective of the rm is survival rather than the maximization of prot or sales. Survival is achieved if the performance of the rm is satisfactory and satises the various interest groups in the rm, including the owners. Galbraith , p. Simon argued that a rms goal is unlikely to be prot-maximizing and more likely to be about achieving a satisfactory rate of prot.
Simon termed such behaviour as satiscing, implying that the rm aims at outcomes that are satisfactory or acceptable, rather than optimal. He also articulated a process by which the rm arrives at a set of objectives through an iterative process of learning, as a result of either achieving or failing to achieve its set targets.
In the long run this may lead to a performance that is close to the prot-maximizing position, but this is only achieved through revision of achieved targets rather than as the prime objective of the rm. Initially, managers set an objective and, then, the rm or part of the rm tries to achieve it box 1.
The next stage is an evaluation of performance against the goals box 2. If the objective has not been achieved and the managers accept that it was set at too high a level, then they might lower their expectations or aspirations and set a revised lower objective in the next period box 6. If the objective has been achieved, then the managerial team will raise their expectations or aspirations and, as a consequence, raise the objective set in the next period box 7.
Cyert and March model Although satiscing generates a realistic learning process, the objectives associated with outcomes are rather vague compared with the precise objectives of prot and. This would appear to make the construction of a predictive behavioural theory rather dicult. Nevertheless, Cyert and March developed such a model. They identify the various groups or coalitions which exist within the rm, dening a coalition as any group that shares a consensus on the goals to be pursued.
The rm is seen as a collection of interest groups or stakeholders, each of which may be able to inuence the set of objectives eventually agreed. The agreed goals for the rm are the outcome of bargaining and, to some degree, satisfy everyone. It is assumed that salaried managers have both personal objectives and others that derive from membership of a group within the rm. The varying personal motivation of individual managers and their desire to see their own section succeed creates conicts with other managers and with other groups which have to be resolved.
Cyert and March identify areas of activity within the rm where objectives have to be set. These might include specic goals to cover production, stocks, sales and market share. These specic objectives then guide decision making in the individual sections of the rm as follows: g. Production goal: the production division is largely concerned with decisions about output and employment.
They want the latest equipment, to be able to utilize it fully and to have long production runs. If sales fall, the production division would tend to favour an increase in stocks rather than a reduction in output. Stock goal: the warehouse division holds stocks of raw materials and nished products. Sucient stocks are held to keep both production and sales divisions happy, but too many stocks cost money and will therefore be regarded by the nance department as unprotable.
Sales goal: the marketing division will be interested in increasing sales that could be set in terms of revenue or in terms of output. Clearly, if sales were pushed too far this might lead to conict with the nance department seeking to maximize prots. Market share goal: the marketing division might prefer to see their goal set in terms of a market share goal rather than just a sales objective. Raising market share might be seen to raise managerial utility because the rm becomes more important. However, such a goal might conict with the concerns of the nance department.
Prot goal: the objective is a satisfactory prot that enables the rm to keep its shareholders happy and to satisfy the needs of divisions for further funds. The goal is not set as a prot maximization goal because managers are always willing to trade o prots to full other goals. To achieve an agreed set of goals for each of the above categories requires the various groups to resolve any disagreements about appropriate specications. Dierences can be resolved so that a consensus is agreed by: g.
The payment of money or additional allocation of resources to groups or individuals to make them content with the course chosen by the rm. And the making of side payments or policy commitments to keep groups or. These are not paid directly to individuals but enhance the work or importance of the group. Once goals are agreed, the problem is then to set the level of prices, advertising and so on so that the goals can be achieved. Generally, rules of thumb are used to guide such decisions. A summary of the assumptions of the model and those of prot-maximizing are presented in Table 2. The behavioural model makes use of a more realistic decision-making process for a large enterprise where the power of decision making is not in the hands of a single individual and helps to build a picture of the rm as an actual organization.
It points to the way real organizations might operate and make decisions through the use of aspirational goals. However, it does adopt a rather short-term vision of what the rm is trying to achieve. The theory does not explain the behaviour of rms nor does it predict how actual rms will react to any given change in the external environment, because these will depend on the individual enterprises rules of thumb. It also takes no account of the behaviour of other rms. In the market economy the pursuit of self-interest is presumed to be in the general interest of Table 2.
Contrary to this view, Matthews argued that the the main-spring of the system appears to be a standard of behaviour, which, in a non-economic context would be regarded as deplorable. Self-interest in both business and social contexts is not always in the interest of the wider community. Economics identies various market failures that make the community worse o see Chapter It also identies various actions by rms which have adverse external impacts on others and on the welfare of the community.
Economic models of the market assume that private and social costs and benets coincide. Where they diverge they are termed externalities. The pursuit of self-interest in the presence of externalities is not necessarily in the interest of the community or of the rm, so it may therefore wish to modify its pursuit of prots, and incorporate other goals into its utility function.
For example, the major commercial banks in the UK have closed numerous rural branches leaving many small market towns without a branch of any bank or building society. Although such a policy may be in the private interest of the bank, it imposes signicant costs on rural communities and helps to destroy their development prospects. Such branch closures may also harm the image of the bank in the customers mind and lead to a further loss of customers at non-rural branches.
The notion of corporate social responsibility can be dened as the extent to which individual rms serve social needs other than those of the owners and managers, even if this conicts with the maximization of prots Moir This means that the rm might: g g g g. Internalize social goals. Represent concerns of groups other than owners and managers. Undertake voluntary action beyond that required by law. Recognize the social consequences of economic activity. Charitable giving. Seconding sta to help with the management of community projects. Sponsorship of arts and sports, though at some point such expenditure might be regarded as advertising.
And behaving in an environmentally responsible way by not polluting rivers, etc. Firms that serve any interest other than that of the shareholders have been criticized by some economists, such as Friedman. They argue that managers should not make ethical decisions that rightly belong to society or use prots for social ends that rightly belong to the shareholders. Various arguments have been put forward for the rm explicitly recognizing externalities and the wider social context in which it operates.
The theories of the rm considered in this chapter limit the objectives of the rm to those established by either the owners or the managers. There is little recognition of stakeholders within the rm, such as labour, or outside the rm such as customers and suppliers, or the wider community. Some, such as Cyert and March, see the rm as part of a wider negotiated. The managerial group in some rms will take into account the role of stakeholders in formulating their objectives, because, individually, they might have a signicant impact on whether the rm is successful or not: for example, employees and customers are important to the success of the rm.
Unhappy customers or workers can adversely aect the sales and costs of the rm. Arguments in favour of rms explicitly incorporating social concerns into their objectives include: g. Long-run self-interest of the rm: socially responsible behaviour generates additional revenue and prots in the long run compared with rms that are less socially responsible; this has been termed winning by integrity.
Stakeholders: it is benecial to the rm to keep in line with ethical, social and cultural norms, because this keeps workers, customers and suppliers happy and minimizes the risks to the reputation and protability of the rm. Regulation: bad corporate behaviour may lead to the imposition of an expensive and inexible regulatory regime to curb antisocial behaviour, while good corporate behaviour may lead to the avoidance of government regulation and be a more benecial outcome for the rm.
In many industries, such as advertising, governments have preferred self-regulation by the industry rather than government-imposed regulation. The potential relationship between expenditure on social responsibility and prot can be viewed in two ways. The rst relationship is illustrated in Figure 2. The frontier assumes decreasing returns to social spending. Where the rm chooses to be on the curve will be a function of the preferences of management and are summed into a set of indierence curves.
The rm chooses to be at point E where the two functions are tangential. The rm could have chosen a dierent point including point A where no social spending takes place or pointB where all discretionary prots are spent on social concerns. The second relationship is illustrated in Figure 2. The line AB represents prots that would be earned if the rm did not engage in social expenditure. Initially prot is reduced below AB when the rm starts social expenditures, but after point E social expenditure raises protability to higher levels.
Prots and social responsibility In the USA a number of researchers have tried to test statistically whether socially responsible rms earn higher or lower prots than companies who spend less. The diculty lies in identifying and quantifying social corporate responsible behaviour SCR : this not only involves expenditure but also good behaviour.
Aupperle et al. They found no statistically signicant relationships between a strong orientation to social responsibility and nancial performance Aupperle et al. They concluded that it was, neither benecial or harmful for a rm to full a social contract. Another study by McGuire et al. The pressure on companies to modify their goals beyond those that maximize or make satisfactory returns to shareholders and managers varies at dierent times and from country to country.
In the s and s the right of management to manage, irrespective of the social consequences, was reasserted. However, the impact of business decisions in pursuit of shareholder value has led to various pressure groups questioning the unfettered right of managers to decide: for example, Shell was forced to abandon dumping an old oil platform at sea because of criticism by environmental groups, which led to harming the image and the protability of the company.
Short surveying 26 studies nds that the majority give some support to the proposition that owner-controlled rms earn higher prots than managerially controlled rms. The results, however, are not always statistically signicant Short , p. In studies of the UK, Radice found owner-controlled rms to be not only more protable but also to have greater variability in prots than managerially controlled rms.
Holl found no signicant dierence between owner-controlled and managerially controlled rms when the industries in which they operated were taken into account. Steer and Cable found owner-controlled rms outperformed managerially controlled rms, as did Leach and Leahy These results do not necessarily imply owner-controlled rms maximize prots but merely that ownercontrolled rms achieve higher prots, conrming the comparative static outcomes of prot and sales revenue-maximizing models. A visit to a companys website or a reading of its annual report will usually give some indication of the firms objectives.
A few examples follow: g. Stagecoach states in its Annual Report for Stagecoach aims to provide longterm shareholder value by creating a global transport business, focussed on innovation and quality, which benets both our customers and employees. Our strategy remains focussed on our core bus and rail operations where we believe there remains signicant opportunities to generate shareholder value.
BT in its annual report for states: BTs strategy is to create value for the shareholders through being the best provider of communication services and solutions for everybody in the UK, and for corporate customers in Europe, achieving global reach through partnership. The National Express Company in its annual report for states: We manage each of our businesses for growth by investing in all aspects of our services, by working in partnership with our customers and by integrating our services with the wider public transport network.
An important element of our business philosophy is. Our 30, employees are dedicated to improving continuously the quality, value for money and, above all our services for our passengers. It also states that, growth is important, both to the shareholders need for a return on their investment and to enable employees to hone their skills. However, growth must not be generated at the expense of lower protability p. It recognises that prots are too low to provide a satisfactory return to shareholder and that to increase its prot margin it will be necessary to cut costs and increase growth.
The statements in annual reports tend to give a broad indication of the firms objectives. Rarely does one find a simple objective such as shareholder value without additional objectives such as growth and internationalization. Some companies do stress growth ahead of shareholder value but tend to see this as a means to increasing profitability and long-run shareholder value.
Some also mention satisfactory levels of profit to meet shareholder expectations. This might be more important in countries where share trading is more limited. To do this we analysed: g g. How the chosen objective inuences the decision-making process of the rm. How, despite a single objective leading to clarity of analysis, in practice rms are likely to pursue a multiplicity of objectives. The main models: which were prot-maximizing reecting the preferences of managers, on the one hand, and sales and utility maximization reecting the preferences of managers and behavioural theory, on the other.
In practice, an individual rm may well have multiple objectives and satisce rather than maximize. Select a small number of annual reports and try to: a b Identify the primary objectives of the rm. Decide whether the rm has single or multiple objectives. Decide whether it is trying to maximize prots or not.
Identify whether the rm has reported any social responsibility concerns and the extent of them. Discussion Questions 1 What rules must a rm follow to maximize prots? Can it be defended as a reasonable description of the behaviour of rms? Why should rms expend resources on such concerns. Carroll and J. Hateld An empirical investigation of the relationship between corporate social responsibility and protability. Baumol, W. Macmillan, London. Cyert, R. M and J. March A Behavioural Theory of the Firm. Galbraith, J. Penguin, Harmondsworth, UK.
Griths, A. Wall Firm objectives and rm behaviour. Applied Economics Chapter 3. Longman, London. Intermediate Microeconomics Chapter 5. Longman, London, Holl, P. Hornby, W. Jones, T. Pickering The rm and its social environment.
In: J. Pickering and T. Cockerill eds , The Economic Management of the Firm. Philip Allan, Deddington, UK. Leach, D. Leahy Ownership, structure, control type, classication and the performance of large British companies. Koutsoyannis, A. Leibenstein, H. Machlup, F. Matthews, R. McGuire, J. Sundamen and T. Schineeweis Corporate social responsibility and rm nancial performance. Sandmayer, R. Shipley, D. Short, H. Simon, H. Steer, P. Cable Internal organization and prot: An empirical analysis of larger UK companies. Thompson, A.
Prentice Hall International, London. Wildsmith, J. Martin Robertson, London. Williamson, O. E The Economics of Discretionary Behaviour. At the end of the chapter you should be able to: t Understand the dierence between risk and uncertainty.
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In this chapter we explore ways in which economists have incorporated risk, uncertainty and the time value of money into decision making and objective setting. Risk refers to outcomes where the range of potential future outcomes is known from past experience. Future values and objective probabilities can therefore be attached to all possible outcomes. The values of possible alternative outcomes are known and so too are the likelihoods of the given outcomes occurring: for example, the failure of machinery and the keeping of spares can be based on past experience.
Uncertainty refers to outcomes where estimates have been made but no probabilities can be attached to the expected outcomes; this is because there is no experience to guide decision makers about possible outcomes. Therefore, no objective probabilities can be assigned to outcomes, though subjective likelihood or condence levels can be ascribed on statistically unveriable grounds.
The source of expected probabilities are the decision makers guesses and hunches about future patterns of events e. Situations also arise which might be described as pure uncertainty, where there is no information available about the future states of the world to help a decision maker. Consequently, the decision maker is in a position of complete ignorance. Introducing a completely innovative product has to be based on positive expectations of how the product might or might not sell: for example, the introduction of the home computer was successful, though many rms tried but failed to sell sucient machines and make a prot.
Similarly, the next major innovations in terms of new products or new technology which might adversely aect the sales or costs of existing products may, at present, be completely unknown. The nature of demand can change as consumer tastes and incomes evolve. Some of these changes may be predictable, while others may be unforeseen and take suppliers by surprise. An individual enterprise, for example, can misunderstand the changes taking place. For example, a company might introduce a new, larger, more luxurious car in the expectation that, as consumers become better o, their tastes will change in that direction.
In practice, they may nd that, when the new model is introduced, consumers favour smaller, more fuel-ecient models, and the new model will not sell in the number expected when the decision was taken to introduce it. In production a rm may face unforeseen increases or decreases in the price of raw materials, or shortages or gluts of important components. Such changes could either adversely or favourably aect the forecast cost levels on which a decision was taken. Another source of uncertainty on the supply side lies in decisions made by competitors or new entrants about investment in new capacity.
Decisions by either could lead to excess capacity and falling prices, on the one hand, or capacity shortages and increasing prices, on the other. Invention and innovation are important sources of uncertainty. Firms undertake such activity in the belief that it will increase their long-run protability. For other rms, invention and innovation means their products and production systems become outdated and make them less competitive.
Firms can be leaders or followers in product and process development. Some choose to be leaders and spend signicantly on research and development to produce new products and technological advances. The outcome of such a strategy is uncertain because the outputs and usefulness of the innovations are unknown. However, if they are successful, then the innovative rm will benet from being rst in marketing products or from using new process technology.
Being rst is not necessarily a guarantee of a highly protable outcome; some new products may disappoint the consumer, while new process technology may face a number of teething problems. The alternative is for the rm to become a follower rather than a leader. It may be able to avoid the problems of being rst, and benet from waiting until market prospects become clearer and the use of the new technology is clearly benecial.
However, the rm might nd that it is prevented from selling new products or using new technology if licences cannot be obtained from the innovative enterprise. Macroeconomic risks are linked not to changes in the market but to the economy as a whole. Economic activity at the aggregate level tends to be cyclical with periods of growth followed by periods of decline. Timing the launch of a new product to take place in a slump will be harmful for sales, while launching in a boom will be benecial.
Uncertainty may be associated with political change. Changes of government, even by democratic means, may lead to adverse conditions for business in general or some businesses in particular: for example, the election of a Green government would make the future extremely uncertain for resource-depleting, pollution-causing enterprises. Changes of government by non-democratic means, by military takeover or revolution, may change the business environment adversely and threaten foreign ownership of domestic enterprises.
To take account of risk or uncertainty, corporate planners will assign to each pay-o a probability or likelihood of occurrence; this is then used in calculating the expected value and statistical indicators of the comparative uncertainty associated with each project.
Expected value The expected value EV is the outcome anticipated when the range of pay-os have attached to them some estimate of objective probability or subjective likelihood of potential outcome. For example, depending on market and macroeconomic conditions, the sales of the rm may vary in ways the planning department believes can be quantied.
In Table 3. The estimated prots depending on economic conditions are shown in column 2, while the estimated likelihood of each condition prevailing is to be found in column 3. Coecient of variation Although decisions A and B have the same expected prots, we cannot ascertain which of the projects is the more uncertain. To measure the degree of uncertainty or risk associated with each decision, it is usual to measure variance, standard deviation and the coecient of variation. The process of calculation is illustrated in Table 3. Column 3 is the prot in column 1 minus the expected value in column 2 to give the deviations of each occurrence from the expected value.
This deviation or dierence is squared and shown in column 4, which is then multiplied by the likelihood column 5 and shown in column 6; these are then summed to give variance, the square root of which gives the standard deviation for each decision. Thus, for decision A the standard deviation is , for decision B it is and for decision C it is 1,; these are shown in column 7. In column 8 the. Column 7: standard deviation is the square root of variance Column 8: coecient of variation is the standard deviation divided by the expected value Source Author Note.
The standard deviation and the coecient of variation calculated in columns 7 and 8 can be used by decision makers to obtain an indication of the dispersion of the likely outcomes for each project given the risks. If the standard deviation is used, then the decision with the lowest standard deviation is considered the least risky of the three, because any outcome is likely to be closer to the expected value.
Decisions B and C are in this instance indistinguishable, with the same standard deviation. However, the expected value of decision C is greater than that for decision B. To distinguish further between the three decisions it is suggested that the coecient of variation be used. It combines both the expected value and the standard deviation. It is a relative measure, rather than an absolute measure, of the risk or uncertainty associated with each project.
The coecient of variation has a value between 0 and 1: for project A it is 0. Thus, project C has the lowest coecient of variation and all the projects can be distinguished. Whereas using the standard deviation projects B and C could not be distinguished, they are now clearly dierentiated and the lower the value the less risky the project is considered to be.
This is because the worse outcome is relatively closer to the expected value and the majority of outcomes will also be closer to the expected value for a project with a lower rather than a higher coecient of variation. Time and discounting Time is accounted for in economics by discounting future benets by an appropriate discount rate see Chapter 12 on investment appraisal to measure the net present value.
The logic of this process is that: g g. Money earned in future time periods has dierent values in the current period. Future earnings have to be discounted by the interest rate they could have earned had they been held today. Thus, in a world of certainty, future streams of prots, sales or cost should be discounted to measure the net present value.
If future streams are uncertain, then for each year being considered the expected value should be calculated using the subjective likelihoods of occurrences in that year. Thus, with uncertainty the present value of a future stream of prots lasting n years can be expressed as follows: Present EV! Thus, the objective of the rm is to maximize the net present value of expected future prots calculated to allow for uncertainty. Typically, choices are not made between a limited number of independent projects but between a series of interacting and interdependent outcomes. Decisions have to be made in sequence.
The sequence of choices can be shown using a decision tree in which decisions are seen as branching out from one another. Each choice is assigned a potential prot and a probability, or likelihood, of occurring. The aggregated net present values of prots, weighted by their appropriate probabilities, may then be compared to indicate the most appropriate route to choose. Figure 3. A rm may have to make a decision to cut, hold or raise its price. The consequences depend on the reaction of rivals not only in terms of price changes but also in terms of changes in advertising expenditure and product specications.
If we restrict potential outcomes purely in terms of price, then a simple tree can be constructed: for example, if the rm increases its price then its rivals can increase, hold or cut their price. Let us assume the rm currently makes prots of It reviews its prices and has to decide whether to increase, hold or decrease its price. The outcome of either policy depends on the reaction of rivals. Therefore, the rm has to estimate the likelihood of rivals holding or altering their prices. This, given the expectations, results in an expected value of Holding prices results in an expected value of and cutting prices in Given the assumptions, it would appear that the rm should hold its prices.
Some individuals are willing to pursue high-risk options, while others will prefer to avoid risk. These various attitudes to risk can be summarised as risk-averse, riskneutral or risk-seeking. Decision makers and managers in large enterprises may be risk-averse, trying to avoid serious errors to keep their positions, while entrepreneurs may be risk-loving and seek out high-risk opportunities.
These notions can be explained by use of the marginal utility of income or money. The marginal utility of money refers to the additional utility or benet an individual receives from, say, an additional 1 of income received. If the value of utility received from the additional unit is less than the previous one, then there is diminishing marginal utility of money. If the value of utility gained from an additional unit is the. These relationships are illustrated in Figure 3.
Utility is measured on the vertical axis and money income on the horizontal axis. The marginal utility of income for individual A decreases with additional increments; such individuals are described as risk averse. The marginal utility of money is constant for individual B; such individuals are described as risk-neutral.
The marginal utility of money is increasing for individual C; such individuals are described as risk-loving or risk-seeking. The rationale for these statements can be explained by referring to Figure 3. In money terms each individual stands to gain or lose the same amount of money, but in terms of utility the picture is rather dierent. The individual with a diminishing marginal utility function will gain less utility LM from winning.
Such an individual will tend to be risk-averse because the gain in utility will decrease as income increases. An individual with a utility function exhibiting increasing marginal utility of income will gain more utility FG from winning than from losing EF. Such individuals will be risk-loving because increments of income will bring increasing increments of utility. An individual with a utility function exhibiting constant returns to income will be indierent between an increase or decrease in income because the gain in utility will be exactly equal to the loss of utility.
Thus, the attitude of an individual to risk and uncertainty will depend on the nature of the utility of money income function. A lottery is a game of chance that in the UK, and many other countries of the world, attracts a high proportion of the population to play on a regular basis. On a typical Saturday between 40 and 50 million lottery tickets are sold to the UKs population of around 60 million. The UK lottery involves buying tickets for 1 each.
The buyer selects six numbers from the 49 available.
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Twice a week a televised draw takes place and six numbers plus a bonus number are drawn. The winners of the jackpot are those ticket holders whose chosen six numbers match those drawn.
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The allocation of the prize fund to winners is shown in Table 3. Those getting three numbers correct receive The remaining funds are then allocated by a predetermined ratio to the other prize winning categories. The odds of winning the jackpot prize are approximately one in 14 million and of winning 10 are one in The expected value of participating in the lottery can be calculated as previously explained. The calculation is shown in Table 3. The odds of winning are converted into probabilities in column 3, allowing the expected value of the average prize to be calculated as The measured variance is Thus, for every 1 ticket bought the buyer can expect to receive only Why then do people buy lottery tickets given the low expected value and the approximately 1 in 14 million odds of winning the jackpot prize?
The reason it may appear irrational is that we are assuming that the monetary rewards reflect the utility gained and that buyers exhibit constant utility of income. However, buyers appear to be risk loving because the. The willingness to buy a lottery ticket despite the unlikely chance of winning the jackpot prize reflects the lack of opportunities the vast majority of the population have to acquire such large single sums of money.
For them the prize of more than 2 million, is more than their lifetime earnings. Therefore, buyers of lottery tickets value them more highly than the implied expected value assuming constant utility. Thus, lotteries appeal to many people because of the large prize relative to their income and the small amount of money required to buy a ticket. Thus, normally risk-averse individuals exhibit risk loving behaviour in relation to the lottery or they are motivated by altruistic concerns because of the proportion of revenue going to good causes.
Table 3. In Figure 3. Thus, any point within the diagram shows the level of expected return and the risk attached. We have argued that dierent individuals have dierent attitudes to risk and uncertainty. These attitudes can be represented by indierence curves. They show the dierent combinations of risk and return that give an individual an equal level of satisfaction or utility. Each curve slopes upward from left to right, the starting point is D because OD is the risk-free rate of return.
Other points on the indierence curve I1 will give equal satisfaction or utility, so that points D, A, B and C are equivalent in terms of utility, but each successive point is associated with a higher degree of risk. Thus, a risk-averse individual requires a higher rate of return to oset the additional risk. The more risk-averse the individual the steeper will be the slope of the indierence curves. I3 I2 I1 Expected returns Expected returns. Further, indierence curve I2 represents a superior position to curve I1 , so that higher returns for any given level of risk will be preferred to lower rates.
For any given level of return a less risky position will be preferred to a riskier one. Risk-neutral individuals would have horizontal indierence curves because risk or uncertainty do not inuence their choices. Such a set is shown in Figure 3. Higher expected returns are preferred irrespective of the associated risks. Risk-loving individuals view risk as a source of utility in a similar way to any other good. They prefer to give up expected returns for a greater amount of risk, so that their indierence curves slope downward from left to right as shown in Figure 3.
They also prefer combinations of higher returns and higher risks to those less risky with lower returns Douglas , pp. The choice of an equilibrium position will depend on the nature of the asset or project to be undertaken and the trade-o between risk and return. A risk-free asset or project is one where future income streams are known with certainty.
A risky asset or project is one where future income streams are uncertain. The individual is assumed to be risk-averse, so that the individual maximizes utility at point E. The slope of the line RF T can be viewed as the price of risk, because it shows how much extra return is required for an individual to accept extra risk. To discuss these decision criteria, use will be made of. This presents returns for three projects depending on the state of the economy.
The nal two columns show the minimum and the maximum return for each project. Maxi-min decision criterion The rst of these is the maxi-min criterion; this is a risk-averse test, because the individual identies the worst possible outcome for each course of action being considered. He then selects the project with the highest value from the list of least values.
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By choosing the best of the worst, the decision maker avoids pursuing courses of action that will lead to signicant losses. This is illustrated by reference to Table 3. The decision maker chooses the best of the worst outcomes. The worst outcome for each of the projects is associated with recession. The highest value of the worst outcomes is 13, for project B. This project is chosen by a risk-averse decision maker.
Maxi-max decision criterion The second of these is the maxi-max criterion; this is a risk-loving test, because the individual identies the best possible outcome for each course of action being considered. He then selects the project with the highest value from the list of the best values. By choosing the best of the highest outcomes, the decision maker seeks to achieve the highest return irrespective of the chance of making losses; this is illustrated in Table 3. The best outcome for each of the projects is associated with boom.
The highest value of the best outcomes is 21, for project C. This project is chosen by a risk-loving individual. Mini-max regret decision criterion The third of these decision criteria is the mini-max regret decision; this makes use of the opportunity cost, or regret, of an incorrect decision and allows the decision maker to. A regret matrix may be devised for the projects in Table 3.
If we consider project A, then assuming recession prevails it would earn 12, compared with the best outcome, which is 13, The regret of having chosen the wrong project is therefore 1, The regret for each project can be calculated for each state of the world and is shown in the nal column of Table 3. If project A had been chosen, then the maximum regret is 1, If project B had been chosen, then the maximum regret is 6, If project C had been chosen, then the maximum regret is 2, Thus, using the risk-averse mini-max regret rule the chosen project would be A, because it has the lowest regret; this contrasts with the choice of C using the maximax and B using the maxi-min test.
Thus, depending on attitudes to risk and uncertainty, dierent individuals will choose dierent courses of action. Bayes Laplace decision criterion The Bayes Laplace criterion assumes that there is no information about the probabilities of future events occurring and that the decision maker should assume the equal probability of the unknown. This means that each outcome would be assigned the same probability and a weighted average calculated; this is illustrated in Table 3. The rm would choose the alternative with the highest expected weighted average or in this case either project A or project C.
Hurwiczs alpha decision criterion The Hurwicz alpha decision test is used to select the project with the highest weighted average, where the average is made up of the maximum and minimum outcomes; this is illustrated by reference to Table 3. The results show that project C would be chosen. The assignment of likelihood or expected probability values could reect expectations about how the economy might perform or the attitudes of decision makers. In , Louis Edwards, a Manchester businessman was elected to the board at the behest of the then manager Matt Busby.
In he was elected chairman owning only 17 of the 4, issued shares. By , he had acquired a majority and controlling interest in the club. In his son Martin became chief executive of the club. In the club was floated on the stock exchange. It won the first Premier League title in , five more in the next seven years and the European Cup in — the latter a feat they had previously achieved in Payments from television companies are a significant source of income for the club.
It was agreed to by the board of directors, but was vetoed by the government after a reference to the Monopolies and Mergers Commission. This left BSkyB owning 9. Watkins C. The club was owner-controlled when Martin Edwards was chief executive and the largest shareholder. There appeared to be a period when the company was managerially controlled when the board of directors controlled a small proportion of the shares and the largest shareholders were said to be investors rather than active owners.
However, that position appears to have changed with the emergence of dominant shareholders who may wish to control the company. The former they describe as outsider systems and the latter as insider systems. The characteristics that distinguish the systems are listed in Table 1. Shares are infrequently traded, but when they are they often involve large blocks.
Takeover activity is largely absent, and where mergers take place they are largely done by agreement.
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These characteristics, it is argued, lead to more active owner participation. Ownership lies within the corporate sector rather than with a multiplicity of individual shareholders. Germany Germany is an example of an insider system. It has according to Franks and Meyer around quoted companies compared with nearly 3, in the UK.
Large ownership stakes tend to rest in the hands of families or companies with interconnected holdings. Stefan Quandt is one of four deputy chairmen, and his sister Susanne is a member of the supervisory board. The supervisory board appoints the management board. Owners and other stakeholders are not represented on the boards of companies. Shareholders are seen as passive investors who only rarely question the way in which a company is being operated. Thus, dissatisfaction with the performance of a company leads the shareholder to sell shares, rather than initiate moves to change the management or even company policies.
The monitoring of managers is said to be superior in insider systems, with deteriorating performance more quickly acted on. In the outsider system, changing management and policies is a slower process and may involve the takeover of the failing business by other enterprises. Acquirers of blocks of shares so View Full Document. I cannot even describe how much Course Hero helped me this summer.
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