UNIVERSITY OF ZIMBABWE

GRADUATE SCHOOL OF MANAGEMENT

MANAGERIAL ECONOMICS - GROUP 10 ASSIGNMENT

LECTURER: DR. KADENGE

LYDIAH MUTAMUKO R102923A

TAFADZWA MUTETE R101757E

KINGSTONE MUKANDIONA R1810316

JOYCE RUMBIDZAI MOTSI R1810760

TAWANDA USAVI R1810622

MELODY R NYAMUDANDA R113833D

CLEMENCE NHUNHA R1810763

MAKETO NCUBE R113886J

GRACIANO PEDZISAI R181149A

QUESTION: Outline differences among various models of the firm you know. Which model
is most applicable to Zimbabwe.
The theory of the firm consists of a number of economic theories that explain and predict the nature
of the firm, company, or corporation, including its existence, behaviour, structure, and relationship
to the market. This document is going to consider a number of models in some considerable degree
of detail to enable us to fully outline the differences of the models and their applicability to the
current Zimbabwean situation. Their principal differences lie mainly in their assumptions
(Mansfield, 2002). The models discussed in this document are Neo-classical, Principal agent
model, Managerial discretion (Baumol’s model and the Managerial Utility model) and the
Behavioural model.

1. Neo-classical model

The Neo-classical model generally assumed that individuals are in pursuit of their own interest
when making economic decisions; firms are assumed to know what they want, and to know how
to go about getting it within the constraints set by the scarce resources at their command as asserted
by Samuelson and Marks (2015). The model assumes that the objective of the firm is to maximise
profits defined as the difference between the firm’s revenue and its costs.

Wilkinson (2005) agrees with Samuelson and Marks (2015), that the model views the firm in two
ways, firstly as a one period or short run model where the firm aims to make as much profits as
possible. In this period, the firm has restriction to a given set of plant and equipment and it incurs
fixed costs which it can’t avoid even if it stops production. Secondly, the model assumes the firm
in a multi-period setting where its objective is to maximise shareholders value in the long term
which is equal to discounted value of its future net cash flows through taking long term investment
in plant and equipment. The model seeks to achieve optimisation where the firm attempts to
achieve the best possible performance rather than seeking feasible performance.

PV = C1/(1tr) +C2/(1+r)2 +…+Cn/(1+r)n

The firm is assumed to have perfect knowledge about its production costs. The model also assumes
that the firm produces a single product, perfectly divisible and standardised. According to Davies
& Lam (2001), the average cost average cost curve will be U shaped in the short run, as some costs
are fixed. Costs per unit fall as fixed costs are spread over a large volume of output. Diminishing
returns start to increase cost per unit as output exceeds optimal level (Wilkinson, 2005).
Shortrun cost curve

Neo-classical model also assumes that there is perfect knowledge of volume output that can be
sold at each price. It considers a monopolistic situation where there is one supplier of each product.
There is only one demand curve which serves for both the firm and the industry. The demand curve
slope downwards from left to right indicting that more of the product can be sold at lower prices.

The profit maximisation equilibrium is a point where profit equals revenue minus costs, and where
both revenue and costs depend upon the amount of output that is sold. At this equilibrium point
the firm’s marginal cost (MC) = marginal revenue (MR), that’s where the highest profit could be
made.

Profit Maximising Equilibrium Curve

MC
Price AC
Revenue
Cost

Po

PC
A
AR=D

MR

Q
Output Level

The graph above illustrates the profit maximizing price and output which is denoted by point A
with price Pc and quantity Q. This shows that firms produced at the point where the marginal cost
curve intersected with the marginal revenue curve, that is, the point where the cost of making the
last unit is just covered by the revenue from selling it. This means that the profit margin would
have fallen to zero and total profits will be at their greatest (Bamford, et al., 2002).

2. Principal Agent

Agency theory examines situations where agents are charged with carrying out the desires of
principals. According to Wilkinson (2005), different individuals are generally attempting to
maximize their own individual utilities hence there is often a conflict of interest between the
principal and agent. The nature of the resulting problem is a misalignment of incentives, and much
of agency theory is concerned with designing incentives so as to correct for this situation in the
most efficient manner.

The nature of the resulting problem is a misalignment of incentives, and much of agency theory is
concerned with designing incentives so as to correct for this situation in the most efficient manner.
There is high information asymmetry between the principals and the agents, as put forth by
Wilkinson (2005). Information asymmetry is when one party to a transaction has more information
regarding the past that is relevant to the transaction than the other party or parties.

Two chief problems relating to information asymmetry are adverse selection and moral hazard.
Adverse selection gives rise to a situation where only the products or customers with the worst
quality characteristics are able to have or make transactions and others are driven from the market
and therefore making the market inefficient. In insurance industry, buyers with more risk are
anxious to take up insurance products and as a result driving prices of premiums up. Moral hazard
is a post contract phenomenon where the behaviour of a party cannot be reliably or costlessly
observed after entering a contract. Managers are involved in day to day running of the business
and therefore they have better information relating to firm’s profitability which the owners might
not have.

A manager is known to other goals in mind beyond owner’s welfare such as job perks and building
personal empire. All these reduce the profit available to owners and are against the profit
maximisation plan.
In order to align principal interest with firm’s interest, the owners incentivise the agents by
allowing them to participate in share option schemes and share ownership schemes. These may be
structured in such a way that the share ownership or share options may not be exercised within a
period of say seven years. This will motivate executives to act in the long run interest of the firm
and discourage short term manipulation of the share price.

3. Managerial Discretion

The model of profit maximizing firm has been termed unrealistic in a modern economy where
ownership and control of firms lie with different groups of individuals, (Davies & Lam, 2001).
There is a divergence in the interest of owners and managers. Control lies in the hands of
professional managers while ownership lies in the hands of shareholders. Where interests of
managers and shareholders differ, and shareholders have limited information about performance
of the company and they take little interest in the firms’ operations then managers have the
discretion to pursue their own goals, (Wilkinson, 2005). There are two models that best describe
managerial discretion.

i. Baumol’s sales revenue maximizing model

Baumol observed 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
more than their profitability and this motivates managers to increase the size of the firm through
sales revenue maximization rather than the increase of profits (Davies & Lam, 2001). This goes
on to show that if managers are left to their own devices would dictate that the firm maximizes
sales revenue. Baumol in suggesting that firms maximize sales revenue rather than profits had
noticed that firms cannot make a loss if they are to survive in the long term, so at least some profit
has to be made (Anderton, 2008).

In this model, firms are prepared to accept a lower price and produce above the profit maximizing
output in order to increase its market share in a growing market (penetration pricing policy) where
a firm would raise output beyond MC = MR until MR has fallen to zero because extra sales beyond
this point would contribute nothing to total revenue, therefore it is at its maximum (Bamford, et
al., 2002). Managers use their discretion to maximize sales revenue mainly because their salaries
and performance are usually linked to the total value of sales.

Figure 3.1 sets out the basic version of the model by showing total revenue, total cost and the profit
curves. The firm will choose to produce level of output q3, which implies a higher level of output,
and therefore a lower price, than the equivalent profit-maximizer, who would produce output q1.
With the full consideration of this situation, Davies & Lam (2001)stated that a straightforward
revenue-maximizer will always produce more and charge less than a profit-maximizing firm facing
the same cost and demand conditions. In figure 3.1 the output level was dictated by the minimum
profit constraint that was set by the shareholder at πmin because without that the managers would
make insufficient profits to satisfy the shareholders and worse than that revenue maximization may
imply making losses.

ii. The managerial utility maximizing model

Williamson postulated that managers use their discretion in pursuing policies which maximize
their own utility rather than attempting the maximization of profits which maximize the utility of
the shareholders. The managerial utility function includes variables as salary, security, power,
status, prestige and professional excellence. In particular, staff expenditures on emoluments and
funds available for discretionary investment give a positive satisfaction (utility) to managers
because these expenditures are a source of security and reflect the power, status, prestige and
professional achievement of managers. However, profits acts as a constraint to this managerial
behavior in that the financial markets and the shareholders require a minimum profit to be paid out
in the form of dividends, otherwise the job security of managers is endangered, Williams. (1963)

However, Williamson’s utility maximization model was criticized for failure to deal with the core
problem of oligopolistic interdependence of strong oligopolistic rivalry. The model is applicable
in markets where the rivalry is not strong or for firms who have some advantage over their rivals.
In the long run, such advantages which shelter a firm from competition are usually weakened, and
competition is enhanced.

4. The Behavioural Model

Davies and Lam (2001) agrees with Wilkinson (2005) that, in this model, attention is focused on
the behavior within the firm which is not seen as a single entity but as a set of coalitions among
individuals, each of which has their own set of objectives. Anderton (2008) added that decision
making within the company is done not by any one group but by all groups involved in the firm
and it is only by studying the relative power of each group and the power structures within the
organization that the way in which a firm behaves can be understood. Wilkinson (2005) further
asserts that an assumption is made that each group has a set of minimum demands, for example,
shareholders demand that the firm makes a satisfactory level of profit, the government demands
that laws be obeyed and taxes be paid, workers will require a minimum level of pay and work
satisfaction if they are to stay within the company, consumers demand a minimum level of quality
for the price they have purchased goods for and environmentalists may be able to exert enough
moral pressure on the company to prevent gross over-pollution.

The behavioural model exhibits satisficing behaviour rather than optimizing behaviour in that
neither the firm nor its component coalitions, nor individuals are seen as attempting to maximize
or minimize anything such that each person or group has a satisficing level for each of its objectives
(Davies & Lam, 2001). This means that if one objective has been met, there will be no effort that
will be directed to achieve more than what has already been achieved. A direct consequence of
this is the emergence of organization slack or X-inefficiency where the groups in the organization
will not have the drive to keep costs down or minimize them.
 Differences Among the Models

With the indepth analysis of the above given models, the differences that are seen to exist between
these models are as folows:

i. Maximizations

Whilst the neo-classical models aims to maximize profits by equating marginal revenue to
marginal cost, the managerial discretion models aim to maximize revenue by producing where
marginal revenue is at zero and the behavioural focuses on satisficing by doing that which is just
enough.

ii. Efficiency

Whilst the neo-classical model show cases of high levels of X-efficiency by producing at minimum
possible costs (producing along the average cost curve) to maximize profits, managerial and
behavioral models exhibits X-inefficiency because higher salaries, expensive company cars,
unnecessary staffing levels have to be paid for and result in the failure to keep costs down
(Anderton, 2008).

iii. Output

In managerial and behavioural models, firms will produce at higher outputs than the neo-classical
theory would predict because higher output and higher sales will lead to more staff being
employed, which is beneficial to the utility of the managers as explained by Wilkinson (2005).
Higher output levels are more important to managers in determining salary levels rather than
profitability.

iv. Decision making

Under Neo- classical model decision making is centered on the owner of the firm alone and it also
assumes that the owner has perfect information with regards to the decision to be made. Whereas
in the managerial models decisions are collectively by both the managers and the owners. However
because of information assemetry and levels of involvement in the operations of the firm, managers
tend to make decisions that maximize more of their utilities at the expense of the owners. On the
other hand, in the behavioural model decisions are made the various groups involved according to
the different goals they have, for instance for the finance department’s objective is cost
minimization, sales department aim to maximize revenue whilst for the employees it is good
salaries and working conditions.

Most Applicable Model in Zimbabwe

After some careful consideration, the model that is most applicable to Zimbabwe is the
Behavioural Model for the firm. According to Cyert and March (1963), they define a firm as a
coalition of groups with conflicting goals and conflicts.

i. The firm as a coalition of groups

The theory argues that most large firms are coalitions of individuals or groups which participate
in goal setting and making decisions, however, priorities and information may vary by group,
potentially creating conflicts. This is seen in most companies where even a single organisation
would have departments with different goals at the expense of costs, that is a need for high salaries
by employees, a high dividend payout by shareholders, and a low price by customers. This will
however lead to conflicts which are managed by top management with the satisficing goal in mind.
The below listed goals explains how the order in which the goals are to be met.

Production goal: The production goal is set by the production department, however, the Chief
Executive officer wants the production process to be smoother, without fluctuations so that the
plant is neither overworked nor idle.

Inventory goal: Inventory goal is set by the Inventory Department or jointly by the production
and sales department, since the production department wants adequate stocks of raw materials for
uninterrupted production while sales department wants adequate stocks of goods produced for
meeting market demand.

Sales goal: The Slaes department determines both the sales goals and the market share goals and
decides the strategy to achive them.

Profit goal: This is set by the top management, keeping in view the expectations of the
shareholders, bankers and other financial institutions. Since profits generate resources for further
expansion, the top management sets a profit target consistent with the growth of the firm.
ii. Satisficing behaviour

In classical economics, the theory of firms is based on the assumption that they will seek profit
maximisation, however, in real world, managers and owners behave differently. The Behavioural
model states that decision makers exhibit satisficing behavior rather than maximising their results
that is some groups may settle for ‘good enough’ achievements rather than striving for the best
possible outcomes. This came from the concept known as bounded rationality which means
prudent behaviour under a given set of circumstances. This is supported by most of the production
companies in Zimbabwe, such as Olivine Pvt Ltd, their profit base is generally low due to a number
of challenges which includes limited access to raw materials from the inception of the Statutory
Instrument number 64.

iii. Organisational slack

To keep the various groups in the roagnisation, payments had to be in excess of what was required
for the efficient working of the firm. The difference between the otal resources and the necessary
payments is called organisational slack. According to Cyer and March (1963), organisational slack
plays a stabiling and adaptive role. This is supported by most modern firms in Zimbabwe, where
high salaries are given to workers, and Zimbabwe has expensive labour as compared to other
countries in the southern region. Also, there is a considerable reduction in prices as a way to
increase market share.

iv. Separation of ownership and control

The behavioural model assumes that there is separation of ownership and control. Ownership rests
with shareholders while control rest with managers. Standard Chartered Bank follows the same
model in that the shareholders are not the managers of the business. In fact group approvals will
be sought first for the bank to deal with any representative of Temasec who are the bank’s owners.
The whole idea is to ensure there is separation of ownership and control so that there won’t be
undue influence from shareholders on day to day running of business.

v. Individuals maximizing own utility

It has been a common feature in Zimbabwean organizations that the super primary objective of
every individual is maximizing one’s own satisfaction. This has resulted in rampant conflict of
 interest. Standard chartered Bank ensures that its employees sign a group code of conduct which
prohibits staff from engaging in activities which directly or indirectly conflicts with the interest of
the banking group. Every employee is requested to declare any activities being involved in, which
generate income other than pay every year. The bank is careful about this to ensure that the staff
does not use firm resources to further their personal interest at the expense of the bank.

vi. Asymmetric information

In the behavioral model, information asymmetry is very common between groups within the firm
due to separation of ownership and control as well as the level of participation in business
activities. One party has more information regarding the past that is very relevant to a transaction.
Listed companies in Zimbabwe including Econet, Delta Beverages and Larfarge among others,
follow the regulation that no close member of an employee of the listed companies are allowed to
trade in the shares of a publicly listed company, a certain prior to release of its published accounts.
The reason being to avoid insider trading which gives unfair advantage to closer members of
employees making the market imperfect.

vii. Dominating objectives

It is a fact that Zimbabwean firms due to the vuca (turbulent) environment, consider production,
inventory, market share, sales and profit as their dominating objectives.

Conclusively, various firms are still applying different models. ZIMRA a government institution
is largely applying the sales maximisation as it is the prime focus of government arm to generate
revenue to be allocated to other non-revenue generating arms. The private sector seeks profit
maximization as the bulk of them are owner managed. Listed companies adopt the principal agency
model as a primary requirement of securities commission on good governance that there be
separation of ownership and control.
References

Anderton, A., 2008. Economics. 5th ed. Essex: Pearson Education.

Allen, B., N. Doherty, K. Weigelt and E. Mansfield (2009) Managerial Economics: An Analysis
of Business Issues, Prentice-Hall

Bamford, C. et al., 2002. Economics. New York: Cambridge University Press.

Davies, H. & Lam, P.-L., 2001. Managerial Economics: An Analysis of Business Issues. 3rd ed.
Harlow: Prentice Hall.

Dobbs, I. M. (2000) Managerial Economics: Firms, Markets, and Business Decisions, Oxford
University Press

O. Williamson, 'Managerial Discretion and Business Behaviour',American Economic Review, vol.

53, December,p. 147-162.

R. Cyert and J. March, Behabiour and Theories of the Frim, Englewood Cliffs, NJ ,Prentice
Hall,1963.

Samuelson, W. F. and S. G. Marks (2015) Managerial Economics, 7th Edition. Boston: John
Wiley and Sons.

Wilkinson, N. (2005) Managerial Economics: A Problem—Solving Approach, Cambridge

University Press