MANAGERIAL ECONOMICS

An Analysis of Business Issues

Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall

1
Chapter 2:
Business Objectives
and Basic Models of the Firm
Objectives:
After studying the chapter, you should
understand:
1. the assumptions of the neo-classical (or profit-
maximising) model of the firm and the limitations
of the model
2. the differences between the profit-maximising
model and the managerial models of the firm
3. the differences between the profit-maximising 2
model and the behavioural model of the firm
 The Assumptions
The Assumptions ofof the
the Neo-
Neo-
classical Model
classical Model of
of the
the Firm
Firm

1. The firm is a profit-maximiser - it

optimises
2. The firm can be treated in a holistic
way
3. There is perfect certainty

3
Assumption
Assumption 1:
1:
The
The firm
firm isis aa profit-maximiser:
profit-maximiser: itit isis assumed
assumed
to
to make
make as
as much
much profit
profit as
as possible.
possible.
This
This means
means that
that the
the model
model isis an
an ‘optimising’
‘optimising’
model:
model: the
the firm
firm attempts
attempts to
to achieve
achieve thethe best
best
possible
possible performance,
performance, rather
rather than
than simply
simply
seeking
seeking “feasible”
“feasible” performance
performance which
which meets
meets
some
some set
set of
of minimum
minimum criteria.
criteria.

4
The
The profit-maxing
profit-maxing assumption
assumption can
can be
be
interpreted
interpreted in
in two
two ways:
ways:
1.1.Maximisation
Maximisationof
ofprofit
profitin
inthe
theshort-run
short-run
i.e.
i.e.the
thefirm
firmhas
hasaagiven
givenset
setofofplant
plantand
andequipment
equipmentand
and
makes
makesas asmuch
muchprofit
profitas
asititcan
canwith
withthat
that
2.2.Long-run
Long-runprofit
profitmaximisation
maximisation
i.e.
i.e.maximise
maximisethe
thewealth
wealthof
ofthe
theshareholders
shareholders
In
Inmost
mostsituations
situationsthese
theseare
areconsistent
consistentwith
witheach
eachother.
other.
Shareholder
Shareholderwealth
wealthisismaximised
maximisedby byselecting
selectingthe
themost
most
profitable
profitableset
setof
ofplant
plantand
andequipment
equipmentandandthen
thenoperating
operatingitit
in
inthe
themost
mostprofitable
profitableway.
way.BUT
BUTTHERE
THEREMAY MAYBE BE
EXCEPTIONS
EXCEPTIONS--making makingmaximum
maximumshort
shortterm
termprofit
profit
might
mighttrigger
triggerentry
entryor
orgovernment
governmentintervention
intervention
5
Assumption
Assumption 2:
2:
It
It isis aa holistic
holistic model:
model: the
the firm
firm isis aa single
single entity
entity
which
which has has objectives
objectives of
of its
its own
own andand which
which can
can be
be
said
said to to take
take decisions.
decisions.

6
Assumption
Assumption 3:
3:
It
It assumes
assumes perfect
perfect certainty.
certainty. Cost
Cost and
and
demand
demand conditions
conditions are
are perfectly
perfectly known.
known.

..

7
The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 STEP BY STEP TO THE MODEL
$

P1

Demand: Average Revenue

P2

Quantity
Produced
Q1 Q2

8
The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 STEP BY STEP TO THE MODEL
$

Demand: Average Revenue

Quantity
Produced
Marginal Revenue

9
 The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 WHAT IS THE EQUILIBRIUM?
Marginal Cost
$

Profit
maximising
price Demand: Average Revenue

Quantity
Marginal
Profit Revenue
Produced
maximising
output 10
 The Basic Model of the Firm
 The neo-classical model
 The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs.
 MORE DETAIL ON THE EQUILIBRIUM
$
Marginal Cost

Average Cost
Profit
maximising
price Demand: Average Revenue

Quantity Produced
Profit
Marginal Revenue
maximising
output 11
What Can We Do With This Model?
 Comparative Statics
– begin with an initial equilibrium position - the starting point
– change something
– identify the new equilibrium, e.g:
• When demand increases?
• When costs rise?
• When a fixed cost increases?
– This is the main purpose of the model -what it was designed to do
 Normative prescriptions
– it will cost me $30 per unit to supply something which will give me
$20 per unit in revenue- should I do it?
– I must pay $20 billion to set up in my industry. Should I charge
higher prices to get that money back?
 Positive and Normative are linked by “if?” IF the aim of the firm is
to maximise profit what will it do/what should it do?

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The
The assumptions
assumptions ofof profit-maximisation
profit-maximisation
has
has been
been criticised
criticised in
in aa number
number of
of ways;
ways; so
so
we
we have:
have:
1.
1. The
The “Managerial
“Managerial School”
School”
2.
2. The
The “Behavioural
“Behavioural School”
School”

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 ABC TELECOM
ABC TELECOM
Chief Executive

Finance Executive Deputy Deputy Director of

Director Director Chief Chief Human
Customer Executive Executive Resources
Service
Director of Director of
Group Director of Director of Corporate
Accounting Inter- Corporate Affairs
Services national Market
& Property Director of
Customer Director of
Service Director of Regional
Director of Information Business
Director of Regulatory Technology
Corporate Affairs Chief
Finance Representa-
& Treasury tive China
Team 14
Questions for Discussion:

 What
What are
are the
the objectives
objectives of
of different
different
divisions
divisions or
or departments?
departments?
 Are
Are these
these objectives
objectives compatible?
compatible?
 If
If not,
not, how
how to
to resolve
resolve conflicts?
conflicts?

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“Managerial” Criticisms of the
Profit-Maximising Model
 Berle and Means (1932)
– firms are owned by shareholders but
controlled by managers
– owners’ and managers’ interests are
different
– managers have discretion to use the firm’s
resources in their own interests

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The Managerial School argues that:
1. Ownership and control are in the hands of different
groups of people.
2. The interests of owners (shareholders) and
Controllers (managers) are different.
3. Managers have the power to let their interests over-
ride those of the shareholders.
4. Therefore firms are run in the interests of the
managers.
In place of the profit-maximising model, the managerial
school substitute a variety of alternatives - sometimes
referred to as managerial discretion models
Sales-revenue maximising (Baumol)
Managerial utility maximising (Williamson)
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Managerial Discretion Models
of the Firm
 Baumol’s Sales Revenue Maximising
Model
– managers’ rewards seem to be more
closely linked to size than to profit
– therefore, firms aim to maximise sales
revenue
– but subject to a profit constraint

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Baumol’s Model
$
TR
TC

Profit

Level of
Output
19
Comparison of Baumol’s Model
with the Profit-Maximising:
 A. The unconstrained version
– Price?
– Output?
– Profit?
 B. The constrained version
– depends where the constraint is
– note what happens if the constraint is so
tight that maximum profit is required
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 Comparative Statics of
Baumol’s Model
 What if demand rises?
 What if fixed costs change?
 What if variable costs change?

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Williamson’s Managerial
Utility maximising Model
 What do managers want?
– UTILITY = happiness, satisfaction
 What gives them utility?
Utility = f(S, M, D)

22
 Williamson’s
Williamson’sManagerial
ManagerialUtility
Utility
Maximising
MaximisingModel
Model
Managers have “expense preferences”,
maximisation of utility derived from
a) amount spent on staff (S)
b) additions to managers’ salaries and benefits
in the form of “perks” (M)
c) discretionary profit (D) which exceed the
minimum required to satisfy the shareholders;
available as a source of finance for “pet
project” 23
Williamson’s Managerial
Utility maximising Model
 How to solve the model? What gives
them utility?
– Maths must be used, more complex
 What results does it give? The
comparative statics?

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 Note the Common Characteristics
Shared by Managerial Models and the
Profit Maximising Model
 Optimising
– the firm aims for a maximum
 “Holistic”
– the firm has purpose and takes decisions
and actions as a single entity
 Deterministic
– full knowledge of market opportunities and
costs is assumed
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Behavioural
Behavioural Model
Model of
of the
the Firm
Firm [Simon
[Simon (1959),
(1959),
Cyert
Cyert and
and March
March (1963)]
(1963)]
• the firm hardly exists; it consists of a group of
people with multiple objectives
• decision-makers exhibit “satisficing”
behaviour; organisational slack/X-inefficiency
• problem-oriented search using rules of thumb,
which are a function of the past experience of
the firm and the people within it
• organisational learning: meeting all objectives;
then raising aspiration levels. If cannot meet;
then reducing aspiration levels 26
The Behavioural Approach
 “organisations do not have objectives,
only people have objectives”
 the firm does not exist - it is a set of
shifting coalitions of individuals
 individuals and groups do not maximise
- they “satisfice”
 information about the environment is
very limited
27
The Behavioural Approach
 If all aspirations are being met -
everyone is satisfied - do nothing
 BUT then aspiration levels will rise until
someone is not satisfied
 THEN rules of thumb used to find
solutions to “the problem”

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The Behavioural Approach
 Aspiration levels, which adjust
according to experience
 Problem-oriented ‘rules of thumb’ based
on past experience
 A dynamic model
 not “holistic”
 not “deterministic”
 not optimising
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A comparison of alternative models of the firm
Profit-max Managerial Behavioural

Objective Profit-
maximising
Ownership Same
management

Decision- Optimising
making

Environment Certainty

Holistic? Yes
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Which Approach is Most Useful?
 Behavioural approach is a more accurate
description of what happens INSIDE the firm.
 BUT it tells us almost nothing about how the firm
will respond to changes in the environment.
 To use it to make predictions about how the firm
will react to changes in the environment we need
to know everything about the individual firm.
 However, if shareholders are a powerful group and
their aspiration level requires making maximum
profit the firm will again behave in the same way
as a profit-maximiser.

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In Conclusion?
 The behavioural approach is a useful
complement to the profit-maximising
and managerial approaches, not a
substitute for them.

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