Managerial Theories of the Firm

The managerial theories separate ownership from management. The owners are the shareholders, whose power lies in appointing the board of directors, which in turn appoints top management. A firm's managers are agents who work for the firm's owners, who are the principals. The divorce of ownership from management permits top management to deviate from profit maximisation (which maximises utility of the owners) and pursue goals which maximise their own utility. The managers may pursue their own objectives even though this may decrease the profit of the owners. This is referred as principal - agent problem.

However, the managers' discretion in defining the goals of the firm is limited by the need to produce a minimum level of profit necessary to satisfy the shareholders. Therefore, the basic feature of all managerial theories is that the managers maximise their own utility, subject to a minimum profit constraint necessary for the job security. To deal with the principal - agent problem (i.e., different goals of managers and owners), firms often give managers a financial stake in the success of the firm so that they pursue objectives that are close to profit maximisation. Many corporations have adopted employee stock option plans (ESOPs) under which managers can purchase shares .of common stock at less than market price. These plans give managers an incentive to promote profits of the firm and to act in harmony with the interests of the owners. One recent study shows that if managers own between 5 and 20 per cent of ~ firm, the firm is likely to perform better in terms of profitability, than if they own less than 5 per cent. In the US, there are approximately 10,000 ESOPs with 10 million employee owners (ESOP Association, US). Wipro and Infosys, the two largest listed IT stocks in India, were among the first companies to institute ESOPs·

We will discuss three models of managerialism which have the same basic assumption of the maximisation of the utility of the managers subject to minimum profit constraint. They differ in (a) the factors included in a managerial utility function, (b) the key policy variables used by n1anagers to attain their goals, and (c) their predictions of the consequences of changes in parameters. 

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