Managerial Economics

Managerial Economics • Group 2B - Presentation • Explain the central elements of the behavioral model of the firm and consider its strengths and weaknesses relative to the maximizing models • Presented by • Thomas Leung, Angus Leung, Jeff Lee & Bonnie Chiu

Presentation Outline • The Maximizing Models : A Glance • The Central Elements of Behavioral Approach • A Comparison of alternative models of the firm • Strengths & Weaknesses of Behavioral approach • Conclusion

Maximizing Models of the Firm • Neo classical Model • Profit Maximizing Model • Managerial Approaches • Sales Revenue Maximizing Model (Baumol) • Managerial Utility Maximizing Model (Williamson)

Profit Maximizing Model • Objective • To maximize profits, defined as the difference between the firm ‘s revenues and costs • The firm attempts to achieve the best possible performance, rather than simply seeking “feasible” performance which meets some sets of minimum criteria • Short run profit Vs Long run profit

Profit Maximizing Model • Assumptions –It is a holistic model The firm is treated as a single entity which has own objectives and makes decision. – It optimizes The firm is a profit-maximizer. – Perfect Certainty There is perfect certainty and complete knowledge about demand and cost conditions.

MC AC AR MR Profit Maximizing Model $ Profit Max Price • The firm aims to maximize profit by choosing the level of output which gives the biggest difference between revenue and costs MR = MC Profit Max Qty Level of Output

Managerial Approaches of a firm • Arguments • Firms are owned by shareholders and but controlled by Managers;Their interests are different • Managers have the discretion to use the firm ‘s resources in their own interests • 2 models • Sales-Revenue Maximizing Model (Baumol) • Managerial Utility maximizing Model (Williamson)

$ TC TR Level of Output qo q Profit Managerial Approaches of a firm • Sales Revenue Maximizing Model (Baumol) Based on the observation that the salaries of managers, their status and other rewards often link to the size of the companies which measured by sales rather than profitability Hence managers are more concerned to increase sales rather than profits

Managerial Approaches of a firm • Managerial Utility Maximizing Model (Williamson) Manager have “expenses preference” maximization of utility derived from • Amount spent on staff (S)- Additions to managers salaries and benefits in the form of perks (M) • Discretionary profit (D) which exceed the min. required to satisfy the shareholders available as a source of finance for pet project)

Criticisms to Maximization Models • Arguments • Firms do not attempt to maximize • The world is an uncertain place • Firms may not have a unified purpose • Firm is not a single entity – not holistic Maximizing Models really satisfying all needs of a firm?

Behavioral Approach of a firm Central Elements - A Glance • The firm hardly exists - It is a shifting coalitions of individual with multiple objectives; • Decision makers exhibit “satisficing” behavior rather than “optimizing” behavior; • Decision maker with limited information about the environment reduces the certainty of a decision. • Problem - oriented search using “rule - of - thumb” is adopted to solve unmet objectives; • Dynamic behavior of aspirations of the individuals within firm due to “organizational learning”

Behavioral Approach of a firm The firm hardly exists - It is a shifting coalitions of individual with multiple objectives Investors Distributors Employees Consumers The Firm Creditors Suppliers Adverting Agent Others

Behavioral Approach of a firm Decision makers exhibit “satisficing” behavior rather than “optimizing” behavior Consider a three - person committee, suppose they have individual goal as C1, C2 and C3, with corresponding weights a, b and c. Thus, company goal C is expressed as: C = aC1+ bC2 + cC3 Instead of maximizes C1, C2 and C3 that posed conflicts, aspiration level is specified and try to meet

Behavioral Approach of a firm Decision makers exhibit “satisficing” behavior rather than “optimizing” behavior • For a new Project, not all data can be available. • Thus the project is go if : • Excepted Market Share is “sufficient”; • Contribution of the product is “reasonable” • Development cost is “ not too high” • This is described as “SATISFICING” in which decision maker to the searching for a solution that meets aspiration levels and therefore is acceptable

Behavioral Approach of a firm Decision makers with limited information about the environment reduces the certainty of a decision • Information available to Marketing • Information available to Production • Information available to Engineering • Information available to PPMC • All are different and different expectation of decision maker will be included in the decision making

Behavioral Approach of a firm Problem - oriented search using “rule - of - thumb” is adopted to solve unmet objectives Bargaining power of individuals come from contribution e.g. Marketing and Sales is more powerful

Behavioral Approach of a firm Dynamic behavior of aspirations of the individuals within firm due to “organizational learning” If inducement (Salary, Retire plan and Job satisfaction) over the aspiration level of the participant, he will stay with the coalition. If inducement (Salary, Retire plan and Job satisfaction) stay long over the aspiration level of the participant, he will increase his aspiration and dissatisfied at one day.

Behavioral Approach of a firm Case Study - G2 Company • HK based manufacturer with manufacturing plant in China • Overhead is absorbed into production cost by total absorption of 100 Million Turnover • Limited capacity of facilities and 1000 workers, no expansion plan and budget for year 2002 • Stock policy of Raw material is Two weeks in advance of production • Stock policy of Finished goods is Zero

Behavioral Approach of a firm The firm hardly exists - It is a shifting coalitions of individual with multiple objectives Marketing Increase 2 weeks Stock Engineering Increase budget for 20% overtime expenses CEO Increase 10% Revenue PPMC Increase 2 weeks safety stock of raw material Accounting Minimizes all costs, keep minimum stock level

Behavioral Approach of a firm Decision makers exhibit “satisficing” behavior rather than “optimizing” behavior Marketing Increase 1 week Stock Engineering Increase budget for 10% overtime expenses CEO Increase 10% Revenue PPMC Increase 1 week safety stock of raw material Accounting Minimizes all costs, keep minimum stock level

Behavioral Approach of a firm Problem - oriented search using “rule - of - thumb” is used to solve unmet objectives • Reactive • By Past Experience • Not scientific Marketing Increase 1 week Stock Engineering Increase budget for 10% overtime expenses CEO Increase 10% Revenue X PPMC Increase 1 week safety stock of raw material X Accounting Minimizes all costs, keep minimum stock level X

Behavioral Approach of a firm Dynamic behavior of aspirations of the individuals within firm due to “organizational learning” Marketing Keep original stock level market slow down Engineering Keep original budget of overtime expenses CEO Increase 10% Revenue, But no penalty if failure PPMC Keep original safety stock of raw material Accounting No additional order, no additional work

Comparison of different approaches Profit -max Managerial Behavioral Objective Profit - Sales - Revenue or Satisficing and maximizing Managerial Utility Feasible solutions maximizing Ownership Same Different Different Management Decision Optimizing Optimizing Rule of Thumb Making Environment Certainty Certainty Un-certainty Holistic? Yes Yes No

Behavioral Approach of a firm Strengths of Behavioral Approach • More accurate and realistic description of what happen inside the firm • Easy to understand: Qualitative approach that good at describing the behaviour of the firm

Behavioral Approach of a firm Weaknesses of Behavioral Approach • Not a good economic model: it can not make prediction, cannot tell the firm how to respond to environmental changes • Lack of an objective decision rule: using “rule of thumb” and past experiences to solve the problem are too subjective • If shareholders are a powerful group and their aspiration level requires maximum profit making, the firm will again behave in the same way as the maximization model

Conclusion of the presentation Though Behavioral approach is NOT a good economic model, it is a useful complement to the profit-maximizing and managerial approaches, not a substitute for them.

End of Presentation Questions and Answers

Managerial Economics