Lecture 7

• Neo-classical theory of firm

  • Firms operate in perfectly competitive environment
  • Given assumptions underlying this model, firms are no more than ‘black boxes’
  • No role for managerial discretion: to survive in this industry firms must maximise profits
  • No theory of managerial behaviour
• Characteristics of ‘modern’ corporation

  • Scale, and capital requirements of technology
  • Divorce of ownership from control
  • Shareholders own company
  • Board of directors take all major strategic decisions
• Why are shareholders not aligned with board of directors?

  • Principal-agent problem (shareholders weak?)
  • Monitoring, incomplete contracts, and opportunism
  • Bounded rationality (Herbert Simon)
  • Asymmetric information
• Baumol’s sales revenue Maximisation Hypothesis

  • Salaries, ‘status’, security of employment are highly correlated with sales revenue
  • Therefore, management have incentive to maximise sales (& possibly market share)
  • But, this incentive is constrained by minimum acceptable level of profit
• Unconstrained sales maximisation


  Implies lower profitability (issues of diversification and advertising spend)
• Shareholder revolt


  Threat of takeover (because share price, and market capitalisation decline)
• Market for corporate control

  allocation all and acquisitional takeovers
• Baumol sales revenue maximisation model

  First diagram:

  • shows standard monopoly outcome (Pm, qm)

  Second diagram:

  • Translates thus price and output into a stylised Total Cost and Revenue diagram; TR is maximised when MR=0

  Third diagram:

  Shows price and output combinations in a stylised profit function (profit is maximised when vertical distance between R and TC is maximised)

  
• Diagram analysis 


  • Unconstrained sales maximisation occurs at Pr and qr; this combination results in πR
  • But πR is less then the monopoly profit:
  • In third diagram there are two profit functions - π1 & π2 which correspond to different minimum acceptable levels of profit (MALP)
  • If profits below MALP, according to MCC company is vulnerable to takeover
  • If MALP = π2 then not binding - firm can pursuer Unconstrained sales maximisation policy as πR > π2
  • But if MALP = π1 then firm would have to reduce sales, move closer to profit maximisation level
• Determinants of MALP


  • Industry disturbance hypothesis (firms imitate merger activity by other firms in their industry)
  • Excess free cash flow (exacerbates the agency problem)
• How realistic is the assumption of Unconstrained sales behaviour?

  Not very:

  • It implies cost inefficiency and managers have some incenative to be efficient to avoid acquisition
  • Welfare implications: Baumol firms sets a price < Pm
  • More inefficient MCC, greater the opportunity for firms to diverge from profit maximisation
  • More realistic to believe that managers wish to increase profits (to avoid takeover), and revenue (to increase their own utility)
  • Can be shown by transposing the marginal utility function onto the TR, TC and π function
• Optimum 


  Assume utility U(π, R) and the relationship is positive w.r.t. both variables

  When output is 0 π & R are 0

  As output increases, π and R incraase

  When π is maximised (π max), R continues to increase until Rmax

  Optimum is when managerial utility function is tangential to π, R function

  
• Williamson‘s ‘expense preference model’


  Diagram shows standard tangency conditions for an optimum:

  • Williamson model necessarily implies some degree of cost inefficiency because of emoluments - which gives utility to managers, Given π = πm - S
  • Where πm is the profit maximising price and output that enables the firm to attain a maximum level of gross profit
  • Monies that would of gone to shareholders goes to management so welfare neutral in this respect
  • But, if S involves employment if excess staff this involves welfare loss which is offset by managers who benefit from having large staff

  
• Marris’s model of growth maximisation

  • Growth maximisation, not profit maximisation
  • Enhances manager’s esteem, security and remuneration
  • But, need for balance rate of demand for firm’s products with rate of growth of the firm’s capital

  Constraints:

  • Price reductions not suitable in long run - reduce profit
  • Limits to product diversification - reduce profitability
• Financial contracts on growth

  • Heavy borrowing increased debt-equity ratio and gearing which increases risk faced by lenders and shareholders
  • Issuing new shares to finance growth is feasible only if accepted by stock market
  • Retained profit - bit only has implications for dividend payouts
• Growth rate and profit rate graph

  • In early stages, growth and profitability are positively related
  • Up to point A (profit max), interests of shareholders and managers are aligned
  • After point A, growth is at expense of profitability

  
• Solve principal—agent problem 


  Alter components of executive remuneration

  Salaries of managers incorporate profit-sharing

  Diagram:

  • Assume manager works 8 hour day with $50,000 salary
  • Salary paid irrespective of manager’s ‘input’
  • Rectangle shoes opportunity set
  • Separation of ownership and control means manager has incentive to move toward A
  • If offered a bonus of 10%, this is remuneration which incentivises manager to shrink less and gain higher total utility

  
• Shirking and salary


  Points to note:

  • Function with intercepts $3m and 8 hours depicts level of firm profits, depends on degree of shrinking
  • If manager shrinks all the time, salary still $50,000, but firm makes no profit
  • If he does not shrink, total remuneration is $350,000 (profit of $3m)
  • Some shrinking (e.g. 2 hours) means lower profits and lower total remuneration to manager - $275000

  
• Shirking and manager bonus

  Points to note:

  • Complete shirking yields $50,000
  • Bonus means manager can move to higher indifference curve
  • Point B indicates profit-sharing incentive scheme is successful as manager reveals preference for B, rather than A
  • Remuneration to manager, even with some shirking, exceeds $50,000
  • Net increase in welfare and firm benefits if bonus is properly designed

  
• Determinants of executive remuneration

  Key issues to consider involve:

  • Need to control for agency
  • Need to control for company size (larger firm needs better managers)
  • Relative performance measures
  • Corporate governance variables
• Dependent and Independent variables


  Dependent variable

  • Usually some measure of top director compensation
  • Not stock options
  • Usually lagged one period to capture ‘persistence’

  Independent variables

  • Measure of company size: level of sales and growth of sales
  • Stock market performance
• Empirical results 


  • Elasticity of executive compensation w.r.t. shareholder return is small, <5%, and borderline stat sig;
  • Relative performance variables often stat insig with (-) coefficient - odd?
  • Company size and lagged depended variable, usually stat sig, with high coefficients