Managerial rationality and profit maximization

As indicated in Chapter 2, the profit maximization hypothesis has been subject to repeated criticism. Some of this criticism has been directed at the notion of marginal analysis itself. We shall not be concerned with this class of criticism. More fundamental, perhaps, have been the criticisms that challenge the propriety of treating profit maximization as being the entire objective of the firm without regard for the conditions of competition in which the firm operates. Thus, whereas the assumption of profit maximization may lead to accurate predictions of behavior where competition is vigorous, it is not clear that this assumption should be carried over uncritically to firms for which the conditions of competition are weak.

However, as long as it was plausible to assume that the ownership interests in the firm played the dominant role in determining the firm’s activi-ties, the profit maximization hypothesis could be supported on grounds other than competitive necessity — namely, on grounds of self-interest seeking. But, given the conditions of absentee ownership characteristic of many of our major corporations, this basis also becomes suspect. Indeed, as Shackle has pointed out, a broader framework than profit maximization is needed to understand the performance of firms sheltered from the rigors of competition: “Security surely ranks in importance, amongst the ideas which should concern the economist [and presumably do concern the manager], with scarcity itself; but how different is its place in the theoretical literature.” Although offering stock options to management and tying bonuses to profit performance can enhance the profit incentive, there is little reason to believe that, for a management operating on a general preference function, this will lead to the single-minded pursuit of profits. Moreover, the relation between managerial rewards and profits is often much less than explicit. Yet, despite the fact that both the incentive and the necessity for profit maximization may well be weak, the profit maximization hypothesis has continued to play a dominant role in economics both for the class of firms for which its a priori claims are clear and for the firms where its claims are less certain. That this is true may speak highly for the power of the hypothesis, but this may also be due to “…the failure of any coherent, self- consistent alternative to be developed and be widely accepted.”

It is the purpose of this chapter to examine an alternative to profit maximization by isolating for special consideration the objectives of the group that effectively controls the activities of the firm — the management. Thus, whereas the logic of self-interest requires that managers operate the firm in their self-interest, their effective control insures that this objective will be pursued. Although a state of vigorous competition will prevent a management from manipulating the activities of the firm to conform to personal objectives, the absence of such competitive conditions will permit managers to pursue their own goals. In these circumstances, therefore, the rules of profit maximization will not necessarily allocate the residual funds in firms which, after satisfying their minimal profit demands, possess additional uncommitted resources. Although our preference function allows the single-minded pursuit of profit maximizing-objectives, this occurs not as a general, but as a special case.

Whether, as in the usual treatment of the theory of the firm, this special case is the only interesting one is an empirical question. Although the evidence from the studies of the firm’s decision-making processes (see Chapters 3-7) indicates that our model is based on more “reasonable” assumptions than is the profit-maximizing hypothesis, there may well be less than unanimity on this matter. Moreover, the differences will not be settled by conjecture. Thus, it is less the assumptions of the behavioral model (as discussed in Section 9.2) than the implications that flow from them  (as developed in Sections 9.3 and 9.4) that put our model to the hard test.

Source: Skyttner Lars (2006), General Systems Theory: Problems, Perspectives, Practice, Wspc, 2nd Edition.

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