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MANAGERIAL MODELS OF THE FIRM
THE NEOCLASSICAL MODEL
1. Many Models of the firm based on different assumptions that could be described
as economic models.
2. One particular version forms mainstream orthodox treatment of the firm, that is,
the neoclassical version.
3. The neoclassical version is based on three basic assumptions of the firm
concerning
 The aim of the firm
 Costs
 And output
The assumption of profit maximisation
 Profit maximisation is assumed to be the basic objective of the firm. Profit is
defined as the difference between revenues and costs.
 The above specification of the model is vague, as it does not specify the time
period over which the profits are to be maximized.
 This can be resolved in two ways:
The simplest is to see the model as a one period or short-run model where
the firm’s assumed aim is to make as much profits as possible in the Short
Run. The short run is defined as that period in which the firm is restricted
to a given set of plant and equipment, and has some fixed costs which
cannot be avoided even by ceasing production.
The other version establishes a multi-period setting for the model and it
assumes that the objective of the firm is to maximize the wealth of its
shareholders. Wealth in this case is defined as the discounted value of the
expected future net cash flows into the firm
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 The firm therefore faces two kinds of interrelated decisions:
1. First it has to take the LR or Investment Decisions on the size of the plant
it wishes to install.
2. It also has to decide upon the most profitable use of that set of plant and
equipment-: this is done in the short run. The short run capacity utilization
decisions are essentially the same as those facing the firm which is
maximizing profits in the SR.
Relationship between Single period and multi-period profits
If the profits made in each period are independent of each other there is no problem.
However there is a problem if the profits made in the current period could have an
influence on the profits made in the future, because in that case it could be possible that
shareholders’ wealth could be maximised by sacrificing profits in the current period. For
example if a firm is a monopoly the maximum profit in the current period could be very
large. If this firm uses this monopoly power to make the maximum profit in the short run
two things may happen:
 Other firms may be attracted into the industry
 The firm may draw the attention of anti-trust authorities.
From the above information it can be seen that maximisation of shareholders wealth will
be better achieved by not taking the maximum profit possible in the short run.
The simple neoclassical model of the firm does not consider such complications and it
could be interpreted as being concerned with the maximisation of SR or single period
profits.
 The assumption of profit maximisation gives the basic model of the firm a
number of properties that distinguish it from the other models
1. The firm is seen as an entity that has objectives of its own and can take its
own decisions. This is in contrast to the behavioural model which argues
that only people can have objectives, organizations can not.
2. The other property stems from the assumption of profit maximisation.
This assumption shows that this is an optimizing model where the firm is
attempting ton achieve the best possible performance rather than simply
seeking “feasible performance” which meets some set of minimum
criteria. Again this is in contrast to the behavioural model and to many
quantitative techniques in operations management or operations research
which seek to identify feasible rather than optimal solutions to problems.
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The assumption of costs and output
The firm is assumed to produce a single perfectly divisible, standardized product for
which costs of production are known with certainty. In the SR when some of the costs are
fixed and some are variable the average cost curve will be U-shaped as shown.
Costs per unit falls over the range A to B, as the fixed costs are spread over a larger
number of units, but begins to rise beyond B as the principle of diminishing returns
leads to increasing variable costs per unit.
Short run cost curve
The model depicts a firm that is attempting to maximize its profits with respect to a
particular set of plant and equipment which has a particular SR cost curve. If we also
wish to consider LR decisions then attention needs to be paid to the behaviour of costs in
the LR.
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EQUILIBRIUM AND PROFIT MAXIMISATION
With the knowledge of cost and demand conditions, and the assumption of profit
maximisation that we made we can now move to the next stage of model building which
is to draw out the implications, or predictions that follow from the assumptions.
The mathematical formulation of the model can simply be set out as follows:
Maximise  (q) = R (q) – C (q)
Where  (q) = profit
R (q) = Total revenue
C (q) = Total costs
q = Units of output produced and sold.
Profits are maximised when the following conditions are met:
Necessary Condition: MR = MC
Sufficient Condition: The slope of the marginal cost curve should be greater than the
slope of the marginal revenue curve at the point where they intersect. In other words the
MC curve should cut the MR curve from below.
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Diagrammatic representation: profit maximizing equilibrium
Profit maximizing level of output is X and the profit-maximizing price is P. The decision
that the firm is facing concerns the level of output that should be produced and sold
using the set of plant and equipment that has been installed. This simple model
assumes that sales volume and output are equal, taking no possibility of producing
stock or selling from stock.
It will pay the firm to produce any unit of output for which the extra revenue earned
exceeds the extra cost. At level of output X all such units are being produced. If output is
increased further, the additional units produced will add more to costs than to revenues
and the level of profit will fall.
If cost and demand conditions remain the same, the firm has no incentive to alter its price
or output, and the firm is said to be in equilibrium.
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APPLICATIONS OF THE SIMPLE MODEL
Profits in the LR: The maximisation of shareholders’ wealth
The profit-maximizing model set out above is concerned with capacity utilization in the
SR. The firm has some fixed costs arising from a given set of plant and equipment and is
keen to make as much profit as possible given the constraints set by that equipment.
However the firm also has to take investment decisions, which are concerned with the LR
in which no costs are fixed and when the firm is free to choose whichever set of plant and
equipment it prefers.
The LR objective of the profit-maximising firm is said to be the maximisation of
shareholders’ wealth, which is achieved by maximizing the value of the firm. This is
measured by the present value of the stream of expected future net cash flows accruing to
the firm. The restatement of the firm’s profit objective in this way allows the SR and the
LR to be properly integrated.
In the LR, the firm decides upon the set of capital equipment to purchase by using
investment appraisal techniques based upon the calculation of present values. However,
these calculations themselves require estimates of revenues and costs that are associated
with each investment project, on the assumption that the equipment once purchased, will
be used to secure maximum profits. Choosing a set or capital equipment in the LR
therefore requires the solution of the questions concerning revenues, costs and profits in
the SR.
If the profits earned in each period, or each SR are independent of each other, then the
maximum of the profit in each period will lead to the maximum of shareholders’ wealth.
However, if the profits in one period depend upon profits in another, there may be a
conflict between the two objectives. A firm with a monopoly position might make
maximise profit in the SR by exploiting that position to the full, but in doing so it might
attract entry into the industry, or anti-trust action from government, which would reduce
profits in the future period.
 Maximising shareholders wealth could require the sacrifice of immediate profits
in order to protect their value in the longer term, depending upon the shape of the
time stream of profits and the discount rate used to calculate present values.
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MANAGERIAL CRITICISM OF THE PROFIT MAXIMISING MODEL
The profit maximising model has been criticized as follows:
 The claim that firms aim for maximum profits is considered as unrealistic
particularly in the modern day economy where OWNERSHIP AND CONTROL
of firms lie with different groups of people. Control lie in the hands of
professional managers and ownership rests with the shareholders. If the interests
of shareholders and managers differ in the case where the shareholders have
relatively limited information about the performance of the firms they own and if
shareholders take relatively little interest in the firms’ operations (provided that a
satisfactory dividend is paid), then the managers may have a good deal of
discretion to pursue their own objectives. This will be true where firms have some
degree of monopoly power and do not need to compete keenly in order to make a
satisfactory level of profit. It has been suggested, therefore, that in such markets
firms do not pursue profit as their major objective.
 The suggestion that profit is not the objective of modern corporations has led to
the search for alternative models based upon different assumptions about the
firm’s objective.
BAUMOL’S SALES REVENUE MAXIMSATION
Baumol’s model stems from his observation that the salaries of managers, their status and
other rewards often appear to be more closely linked to the size of the companies in
which they work, measured by sales revenue, than to their profitability. In that case
managers may be concerned to increase size than to increase profits and the firm’s
objective will be to maximise sales revenue rather than profits.
If the assumption of profit maximisation is then replaced by that of sales revenue
maximisation, then a different model results. In many respects, it shares fundamental
characteristics with the standard neoclassical model, as it is also an optimizing model in
which a single product firm’s aim is sales maximisation, having perfect information
about its cost and demand conditions. The basic version of the model uses Total
Revenue, Total Cost and Profit curves.
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In the figure above the firm will choose to produce level of output A, giving TR B and
profit C. Note that this implies a higher level of output and therefore a lower price, than
the equivalent profit maximizer, who would produce output D and earn revenue E. A
straightforward revenue-maximizer will always produce more and charge less than
a profit-maximizing firm facing the same cost and demand conditions.
In the example above the sales maximizer also makes a profit. However, this may not be
enough to satisfy the shareholders, and in many cases maximising revenue imply making
losses. As a result the simple revenue maximising model needs to be amended to include
a profit constraint.
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Revenue maximization subject to a constraint
As the figure shows there three possible cases in this amended version of the model. The
first is where the profit constraint is as shown by line PC1.
In this case the constraint does not bite (A in the first diagram is the same as A in the
second diagram). This point implies that at the level of output that maximizes revenue,
enough profit is made to satisfy the shareholders.
The second case is where the profit constraint is as indicated by PC2. At the revenue
maximizing level of output (A) insufficient profit is made to satisfy the shareholders.
Hence output is reduced until that constraint is met at level of output B.
The third case is where the minimum profit required to satisfy the shareholders is equal to
the maximum profit that can be made (PC3), in which case the firm has to reduce its
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output from A to C. In this third case the firm behaves in exactly the same way with
respect to output and price as a profit maximiser, despite the fact that it has set itself a
different objective. If the shareholders insist that the maximum level of profit should
be earned then the profit maximising model will provide accurate predictions of the
behaviour of the firm whose management prefers to maximize sales revenue.
If the purpose of the model is to predict the firm’s behaviour, the fact that managers see
their aim as maximising sales revenue and not profit, is irrelevant. The firm behaves as if
it were a profit maximiser.
For a profit maximizer an increase in fixed costs or imposition of a lump sum tax does
not change price and output. However, for a revenue maximizer whose profit constraint is
already biting, a lump sum tax will reduce profits and will force the firm to lower its
output and raise its price.
MANAGERIAL UTILITY MAXIMISING MODEL
In Baumol’s sales revenue model managers’ interests are tied to a single variable with the
addition of a profit constraint. Oliver Williamson’s managerial utility maximising model
takes account of a wider range of variables by introducing the concept of “expense
preference” beginning with the assumption that managers attempt to maximise their own
utility.
The term expense preference simply means that managers get satisfaction from using
some of the firm’s potential profits for unnecessary spending on items from which they
personally benefit. Williamson identifies three major types of expenses from which
managers derive utility. These are:
 The amount managers can spend on staff, over and above those needed to
run the firm’s operations (S). This variable captures the power, prestige, status
and satisfaction that managers experience from having control over large numbers
of people.
 Additions to managers’ salaries and benefits in the form of perks (M). These
include unnecessary luxury company cars, extravagant entertainment and clothing
allowances, club subscriptions, palatial offices and similar items of expenditure.
Such items may also be thought of as “managerial slack” or X-inefficiency.
They appear as costs to the firm, but are not necessary for the efficient conduct of
its activities and are in effect coming out of profits.
 Discretionary profits (D). These are after tax profits over and above the
minimum required to satisfy the shareholders. They are therefore available to the
managers as a source of finance for “Pet Projects” and allow the managers to
invest in developing the firm in directions that suit them enhancing their power,
status and satisfaction.
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Clearly there are conflicts and trade offs between the different objectives in this model,
and it is considerably more complex than those considered thus far.
The basic model is therefore give by the following:
U = f (S, M, D).
This simply means that managerial utility depends upon the levels of S, M, and D
available to managers.
In line with the theory of consumer behaviour it is assumed that the principle of
diminishing marginal utility applies, so that additional increments to each of S, M and D
yield smaller increments of utility to management.
If R = revenue, C = costs and T = taxes, then:
Actual Profit = R-C-S
Reported profit = R-C-S-M
If the minimum post tax profit required by the shareholders is Z, then:
D = R-C-S-M-T-Z
The solution to the model requires the use of calculus in order to maximize the utility
function. However it is possible to set out a simplified version. If managerial utility is to
be maximised, the last pound spent on S, M, and D must yield the same marginal utility.
MUS = MUM = MUD (1-t)
Where “t” is the rate of tax on profits.
Comparative static properties of the model
If demand declines, then at every level of output D will decline. On the assumption of
diminishing marginal utility, MUD will rise, so that the equilibrium condition is no longer
fulfilled. To regain equilibrium the available profits will be distributed towards D and
away from S and M. The level of output will fall. Similarly for a rise in fixed costs, or
lump sum tax.
If the tax on profits increases, then MUD (1-t) will fall and there will be a shift towards S
and M, accompanied by increasing output.
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As in the Baumol case, it should always be remembered that the logic of the utility
maximising model depends upon the management team having the discretion to earn less
than maximum profits. If the minimum profit required by the shareholders is equal to the
maximum possible, the managers will not have the discretion to indulge their taste for
perks and unnecessary staff.
J.WILLIAMSON INTEGRATIVE MODEL
Both of the models outlined above have been based around a single objective function. J.
Williamson’s integrative model goes a step further by combining a single period profit
and sales maximisation with growth maximisation and the maximisation of the present
value of future sales. The outcome depends on the discretion that the managers have to
pursue their own objectives.
BEHAVIOURAL CRITICISMS OF MODELS OF THE FIRM
The managerial models of the firm stem from criticisms of the profit-maximizing
assumption, on the grounds that when ownership and control are separate and many firms
compete in relatively comfortable market structures, managers are able to direct the
resources of companies towards their own ends.
The firm is capable of having objectives, even if those objectives are held by a group of
managers and differ from those of shareholders. The firm is seen as taking and
implementing decisions. The models outlined above are all optimizing models and it is
also assumed that the firm has certain knowledge of the cost and demand conditions
facing it. In effect the managerial models differ from the orthodox only in that they begin
with a different assumption with respect to the firm’s objective.
The behavioural theorists argued that organizations cannot have objectives only people
can.
The behavioural theorists also rejected the assumption that those taking decisions are
perfectly informed. The assumption of certainty is abandoned and emphasis is placed on
the idea that most organisations are so complex that the individuals within them have
only limited information with respect to both internal and external developments.
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THE BEHAVIOURAL MODEL
Key elements of the behavioural model
 A firm has multiple objectives which are in conflict with each other and which
cannot be reconciled through a concept like the utility function. For example the
accountants in a firm may wish to keep the level of stocks down in order to reduce
the costs of holding them. At the same time the sales department may wish to hold
high level of stocks in order to be able to meet orders quickly. The research
department may wish to employ a large number of qualified scientists, while the
marketing department would prefer to spend more on advertising. Longer
established employees may wish to avoid interruptions to their routine while
newly employed executives may be anxious for change. Each individual will
themselves have multiple objectives, arising from their personal histories,
preferences and position within the firms, and these multiple sets of objectives
cannot be reduced to any simple overall statement that explains what the
organisation as a whole is attempting to achieve.
 Decision makers exhibit “satisficing” and not optimizing behaviour. Each
person or group has a satisficing level for each of its objectives. If these levels are
reached they will not seek for more, in the short term at least, but if they are not
met, action will be taken in order to remedy the problem. An important
consequence of satisficing behaviour is that firms acting in this way will not keep
costs down to a minimum. Instead they will exhibit “organizational slack”
incurring higher costs than are absolutely necessary.
 If one of the multiple objectives is not met so that someone within the firm is
dissatisfied, a search will take place for a means of meeting that objective.
However, the search will use rules of thumb to attempt to put the problem right.
The rules of thumb are not arrived at through any detailed analysis, but are a
function of past experience of the firm and the people within it. For instance if
revenue falls, the firm may automatically raise its price, because that has been
tried in the past and appeared to be successful.
 The aspirations of the individuals within the firm which determine the levels of
each objective with which they will be satisfied change over time as a result of
“organizational learning”. If the firm succeeds in meeting all of its objectives
for a period of time then eventually the individuals and groups raise their
aspiration levels demanding more of whatever it is they care about.
Eventually a situation will be reached where not everyone achieves satisficing
levels with respect to all their objectives, at which point a problem- oriented
search will take place to seek a solution to the problem. If one is found, the
process of gradually increasing aspirations can continue. On the other hand, if a
solution is not found despite a number of searches, aspiration levels with respect
to the particular variable concerned fall.
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THE CONCEPT OF X-INEFFICIENCY
A useful concept that links the behavioural model and the managerial utility model is that
of X-inefficiency. In the standard neoclassical profit-maximizing model it is assumed that
the firm incurs the minimum cost achievable for the level of output being produced,
given the set of plant and equipment installed. In terms of the diagram, the firm is on its
cost curve. Such a firm may be described as being X-efficient or operationally efficient.
However this may not be the case.
A firm that is maximising managerial utility, for instance will tend to spend more on staff
and on perks for the management than is necessary, in which case it may be said to be
“X-inefficient”. In terms of a diagram it will be above its cost curve as shown below.
Point E illustrates this.
An x-inefficient firm
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Similarly, a firm that conforms to the behavioural model will incur higher costs than are
strictly necessary; and be X-inefficient, or have organizational slack.
FACTORS THAT ENCOURAGE / DISCOURAGE X-INEFFICIENCY
 The degree of X-inefficiency will be partly determined by factors that are internal
to the firm. If contracts between PRINCIPALS (OWNERS) and AGENTS
(MANAGERS and WORKERS) are not efficient, then workers and managers will
not be motivated to keep costs down, and the firm will be X-inefficient. If larger
firms are more difficult to control, with a greater degree of bureaucratic rigidity,
then they will also tend to be more X-inefficient.
 The second set of factors that determine the degree of X-inefficiency is to be
found in the external environment in which the firm operates. If the firm is forced
by its environment to aim for maximum profit, it must eliminate X-inefficiency.
On the other hand, if the management has the discretion to avoid profit
maximisation, it will allow its costs to rise above the level that is strictly
necessary. The environmental factors that lead to X-inefficiency are therefore the
converse of the factors that force the firm to aim for maximum profits. If
shareholders are diffused among a large number of relatively ill-informed small
shareholders, there may be little pressure from that direction. If the threat of
takeover is limited, perhaps because the firm is too large to be under serious
threat, or because anti-trust legislation prevents takeover, then the likelihood of
X-inefficiency is correspondingly higher.
 Similarly the degree of X-inefficiency will tend to be higher as the market
structure in which the firm operates is less competitive.