Second, consider the impact of an increase in variable cost. This causes the total cost curve in Figure 6.1 to pivot upwards and become steeper at all levels of output (i.e. marginal cost has increased) and the profit function to shift downwards and to the left as illustrated in Figure 6.3. With an ‘operative profit constraint’ of π2, the sales maximiser decreases output from Qb' to Qb** and raises price. The increase in marginal cost also causes the ‘profit maximiser’ to increase price and reduce from Qm to Qm'. Note, how- ever, that the ‘sales maximiser’ reduces output more than the ‘profit maximiser’ and in consequence raises prices more, albeit from a lower initial level.
What might we say in conclusion regarding Baumol’s basic model?
Although there is certainly some evidence to link managerial salaries and perks to sales revenue, the model fails to explicitly consider the interdependence and uncertainty within oligopolistic markets.
7 A further point involves the nature of the profit constraint.Would it really be so precise a figure as we have assumed and what might determine its size? In reality, the constraint might better be seen as a band (or range), with management seeking to obtain profits within that band. Achieving profits at the lower end of the band increases the probability of shareholder dissatisfaction. In contrast, shareholders will almost certainly be satisfied with profits towards the top end of the band. This still leaves us with the question of what might determine the size of the profit constraint, or the range of the band. Various factors could determine this. These could include profits achieved in previous time periods, the current economic climate and the profit performance of close competitors.
The original model is also basically static in that the firm is assumed to maximize sales revenue in a single time period irrespective of the impact upon future time periods. However, Baumol later developed a dynamic multi-period model where the firm was assumed to maximise the rate of growth of sales over its lifetime. In this dynamic model, profit now appears as the main source of financing the growth of sales revenue and becomes an instrumental and determined variable within the model rather than an exogenous constraint upon managerial behaviour.
O. E. Williamson’s model of managerial utility maximization
Williamson (1964), like Baumol, assumes managers have the discretion to maximise their own utility. Profit is again seen as a necessary constraint to ensure managerial job security.
Williamson in fact considered his model to be of more relevance to those firms operating with a strong management hierarchy and little decentralisation of decision making, referred to as a U-form (unitary-form) of organisational structure (see Chapter 2). He believed, however, that managerial discretion would be better controlled (and profit maximisation maintained) in organisations with central control and a multidivision structure, with each division working as a separate profit centre and a strong degree of managerial independence. This is generally referred to as an M-form (multi-form) structure. Williamson therefore believed that managerial discretion was better explained by organisational structure than the existence of a separation of ownership from control. However, although M-form structures might be more efficient in certain circumstances, it remains in question whether managers would then by necessity always choose to act in accordance with the wishes of shareholders.
The variables within Williamson’s managerial utility function include salaries, status, security, power and prestige. Of these variables, only salary is directly measurable in monetary terms and therefore operational within the utility function. Other variables are deemed non-pecuniary and therefore non-operational. These variables then become operational by being measured by other pecuniary variables to which they are assumed correlated. These proxy variables are staff expenditures, emoluments and discretionary investment. Management is then assumed to have an expense preference for these variables: that is, a preference for expenditure on such variables above that required for the profit maximisation of the firm.