Week 9

Question 1

what is standard theory of the firm?

Answer 1

Standard theory of the firm is for a Single Period Profit Maximising Firm.
(Modern theory extends this to long run.)
- its both a holistic and an optimising model.

Question 2

what are the criticisms of the standard theory of the firm?

Answer 2

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

Question 3

what is the principal-agent problem?

Answer 3

• 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.

Question 4

what are agency costs?

Answer 4

AGENCY COSTS are loss in value to shareholders (owners) of managers’ actions in pursuit of their own
interests.
- Direct monitoring, incentive schemes etc. incur costs, but loss of control incurs costs called ‘AGENCY COSTS’

Question 5

what are the 4 explanations (managerial theories) of non-profit maximising behaviour based on the principal-agent problem?

Answer 5

Explanations of Non-Profit-Maximising behaviour based on the principal-agent problem fall under 4 broad headings of MANAGERIAL THEORIES:
(i) SALES REVENUE MAXIMISATION by Baumol
(ii) GROWTH MAXIMISATION by Marria
(iii) MANAGERIAL UTILITY by Williamson
(iv) BEHAVIOURAL THEORIES by March and Cyert

Question 6

what is sales revenue maximisation? Baumol

Answer 6

Baumol (1958) observed 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.
- Sales revenue will be maximised at the top of the TR curve. Profits, by contrast, would be maximised at Q 2 . Thus, for given total revenue and total cost curves, sales revenue maximisation will tend to lead to a higher output and a lower price than profit maximisation. The firm will still have to make sufficient profits, however, to keep the shareholders happy. Thus firms can be seen to be operating with a profit constraint. They are profit satisficers.

Question 7

what is Marris’ growth maximisation theory?

Answer 7

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.
- theory that assumes managers want to maximise growth in revenue not profits

Question 8

what does Marris’ growth maximisation theory depend on?

Answer 8

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 and FINANCIAL GROWTH

Question 9

what are the constraints on demand and financial growth in the growth maximisation model?

Answer 9

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).

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.

Question 10

describe the growth maximisation theory graph?

Answer 10

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.

Question 11

what point on a graph will a manger interest in growth maximisation choose?

Answer 11

But a manager, interested in growth maximisation, given constraints, they will choose where Growth of demand = growth of capital).
This is called the BALANCED GROWTH RATE

Question 12

what is managerial utility maximisation? WILLIAMSON

Answer 12

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).
- its explain why firms are able to CUT COSTS when required
by acquisition or economic downturn.

Question 13

what is the conclusion Williamson drew from the managerial utility maximisation?

Answer 13

One important conclusion was that average costs are likely to be higher when managers have the discretion to pursue their own utility. For example, perks and unnecessarily high staffing levels add to costs. On the other hand, the resulting ‘slack’ allows managers to rein in these costs in times of low demand. This enables them to maintain their profit levels.

Question 14

what is behavioural theories?

Answer 14

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

Question 15

what do managers dislike?

Answer 15

• 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.
  -Trade-off depends on relative bargaining power of groups.

Question 16

what are external constraints?

Answer 16

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)

Question 17

what do managers have to comply with?

Answer 17

Managers must comply with Company Law or ‘Corporate governance’.
In the UK the main reports associated with this are:
* The COMBINED CODE (1998)
- Cadbury Committee (1992)
- Greenbury Committee (1995)
- Hampel Committee (1998) combined ^^
* Higgs Report (2003) - mostly concerning NEDs
* Walker Review (2009) - mostly banks/ financial institutions
* Stewardship Code (2010) - mostly institutional investors

Question 18

what should each company have in their combined code?

Answer 18

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.

Question 19

what must annual reports include?

Answer 19

• 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

Question 20

what are internal constraints?

Answer 20

these are constraints company’s place on themselves
1. HIERARCHICAL MONITORING (VOTING POWER)
2. MANAGERIAL REMUNERATION
3. MARKET CURTAILMENT OF AGENCY COSTS
- FIRM SPECIFIC HUMAN CAPITAL & DEBT-BONDING
- MANAGERIAL REPUTATION

Question 21

who are the 3 groups in hierarchal monitoring (voting power)?

Answer 21

Internal constraints through VOTING POWER.
there are 3 groups - NEDS, shareholder and stakeholders

Question 22

who are NEDs in hierarchal monitoring? what is the problem?

Answer 22

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.

Question 23

who are the shareholders in hierarchal monitoring? what is the problem?

Answer 23

(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’

Question 24

who are the stakeholders in hierarchal monitoring? what is the problem?

Answer 24

Stakeholders e.g. Institutional investors such as pension funds, banks who loan money to the
.
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).

Question 25

what are some alternative systems of corporate governance?

Answer 25

Some countries have other ways of controlling directors called ‘insider systems’:
eg 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.

Question 26

what is managerial renumeration?

Answer 26

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.

Question 27

what is the problem with managerial renumeration?

Answer 27

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).

Question 28

what is managerial reputation?

Answer 28

Managers gain a reputation value in the managerial labour market for successful running of the firm..
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’.

Question 29

what is debt term bonding? (managerial reputation)

Answer 29

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