Managerial Discretion in Imperfect Markets 9819915368, 9789819915361

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Managerial Discretion in Imperfect Markets

T. V. S. Ramamohan Rao

Managerial Discretion in Imperfect Markets

T. V. S. Ramamohan Rao Indian Institute of Technology Kanpur Kanpur, Uttar Pradesh, India

ISBN 978-981-99-1536-1 ISBN 978-981-99-1537-8 (eBook) https://doi.org/10.1007/978-981-99-1537-8 © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Singapore Pte Ltd. The registered company address is: 152 Beach Road, #21-01/04 Gateway East, Singapore 189721, Singapore

Preface

To understand the corporation, and the important role it plays in the economy, we need to build our analysis on a richer behavioral foundation. —Mueller (1992, p.148)

The modern corporation is an amalgam of several activities: the acquisition of inputs for production, obtaining the finances utilized by the firm, undertaking the production of a variety of products through the employment of labor (including the managers), and selling the output to consumers. Similarly, in every corporation, some activities are coordinated through markets, organized within the firm through individuals employed by the firm (implicit contract), or a governance relation with decisionmaking by outside board of directors.1 Expanding the activities of the firm may also result in subsidiaries, franchising, or carveouts and spinoffs depending on the financial arrangements. These organizational mechanisms may be directed to achieving synergies within a division and synergies between divisions so as to attain the overall objective of the firm. It would be fairly realistic to suggest that businessmen encounter a much broader variety of problems in their daily transactions compared to the studies of industrial organization that only scratch the surface. Clever businessmen devise strategies to deal with each such problem though academic and terminological constraints of scholars consider both the identification of the wide range of problems and designing solutions for them to be intractable. The ultimate purpose of the firm is maximizing the value of the assets of the firm, the welfare that consumers derive in their interface with the firm, achieving stability of the position that the managers value, the maximization of the dividends paid that

1

Hoenack (1983, p.17) summarized this in the following manner. “Much of economic behavior within an organization involves choices about application of inputs … , and an organization’s internal suborganization can be characterized in terms of discretion over choices of inputs and outputs that it delegates among its employees.” v

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shareholders prioritize, maximize the benefit of each firm relative to those of others, and several other intermediate goals of organizational subunits, and so on.2 It would be unrealistic to expect that all these objectives can be achieved simultaneously. Similarly, a single decision-maker cannot coordinate all the activities of various divisions due to the information overload and the competence of the general manager. Perforce, divisional autonomy emerges. Each division will be made to operate under the constraints imposed by a higher level manager in the interest of the overall objective of the firm. It is necessary to infer the combination of the above aspects that a management pursues as goals and those that they consider as constraints. However, it must be acknowledged that separating the constraints placed on different constituents of the firm from the objectives that they pursue may itself be subjective. The bulk of theorizing about the mechanisms design is ambivalent when it comes to this distinction. Similarly, explaining the reasons for the specific combination that emerges in the context of any corporation remains ambiguous. The specification of market imperfection has not stabilized as yet. Usually, it is described in relation to the conditions required to make the market operation efficient, the number of rival firms and the interrelationships between them, uncertainties in the demand and cost curves, unwillingness or inability of firms to provide the maximum value to consumers and/or shareholders, opportunism and organizational slack, and price discrimination that deviates from the market price. Further, the planned and desired efficiency in the functioning of a corporation may not be achievable due to (a) an improper judgment about the goals of the consumers and/or agents of finance, (b) the inability of the managers to anticipate or adapt to new technologies and materials, etc., and (c) the desire of the management to maintain stability and continuity. In general, as Heath (2010, p. 313) observed, “we can observe people’s actions, but we cannot observe their motives. We don’t really know what people are thinking or what they are trying to achieve.”3 Market imperfection may manifest itself in these forms and many other related aspects. There is no unambiguous specification of the methods of choosing instruments to achieve the multiplicity of objectives of the constituents of the firm. Consequently, the management retains some discretion, in addition to the inefficiency of the markets, with respect to goals, policies, and other organizational arrangements. As of now, a complete specification of the technological constraints, behavioral restrictions, the contours of efficient management, choice of objectives, and the evaluation of their justification (from either the consumer viewpoint or the perspective of the shareholders of the firm) is not available. It would be fair to say that the specification of market imperfection and the restrictions it places on the choices of the management, and an approach to the nature and specification of managerial discretion have been 2

One argument is that pursuing short-term goals consistently will lead to the attainment of longterm objectives. The other viewpoint is that long-term objectives of survival, e.g., large market share, and the market value of the firm, are the utmost priority, and short-term goals are subservient to this pursuit. 3 Similarly, Williamson (1984, p.196–7 ) quotes Bridgeman as saying that “the principal problem in understanding the actions of men is to understand how they think—how their mind works.”

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fragmentary. Similarly, it has been difficult to say whether any aspect of managerial discretion is due to the nature of the market imperfection, the objectives that the management pursues, and/or the constraints placed on the management by the product or financial markets. The only certainty is that market equilibrium does not define the choices of firms. Studies of industrial organization must be predominantly empirical in nature for them to be useful for managerial or economic policy. However, a vast proportion of studies tend to be theoretical. Many conventionally defined economic concepts do not portray empirical behavior. Further, they do not pay adequate attention to the translation of concepts to empirically measurable reality. Similarly, most studies do not suggest methods that can be utilized to test them against empirical reality. As a result, it has been necessary to construct, albeit heuristically, explanations of observed phenomenon. This approach would be useful even if it is not possible to classify the experiences into a finite set based on some well-defined premises of the behavior of the consumers and the managers. Constructing a theoretical explanation (behavioral economics is one dimension) based on empirically observed behavior would enrich the understanding of the functioning of the modern corporation. This remains an agenda in relation to many activities of the firm. The existing classification of analytical and/or empirical studies emphasizes only one aspect of behavior, such as its impact on consumer welfare, profits distributed to shareholders, and so on. The primary purpose of this book is in defining the discretion available to the management of a firm as observed in practice. Thus, the chapters of this book present a holistic view cutting across many conventionally defined areas of study. Consider the following to make the details more specific. (a) Microeconomic theory concerns itself with how the functioning of firms in different market structures has an impact on the welfare of consumers. Some modifications have been brought about to indicate how different firms operating in the same market may have different effects on consumer welfare. Differences between welfare maximization and profit maximization emanating from the discretionary choices of the management of firms are at the center of almost all such analytical studies. (b) Studies of industrial economics have an exclusive emphasis on the maximization of profit or market value of assets of the firm and how differences in market structures and/or the organizational arrangements within the firm create a deviation from such objectives. The basic emphasis is once again on how different market structures affect the discretion that management exercises. The difference between firms is in the quantitative magnitude of the discretion. These studies do not consider consumer welfare maximization as a concern. (c) The existing literature on industrial organization attempts a design of mechanisms to conduct transactions within a firm and with agents outside the firm. The differences, if any, created by external market conditions have been underestimated. The emphasis is on how the coordination of activities of the managers at different levels should be structured to minimize managerial discretion. The

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markets vs. hierarchies argument was expected to apply to all forms of market structures related to product markets. (d) Managerial economics is primarily concerned with how the managements make decisions. The general contention is that externally determined markets are not much of a concern. Instead, the functioning within the firm is portrayed as the basic source of managerial discretion. (e) Management science once again assumes that the nature of products, the technology of production, and organizational arrangements are given. The emphasis has been on the strategic choices with respect to products, financial arrangements, and the tradeoff between profits and control. The interest of the management, when contrasted with enterprise level profit or value maximization, assumes significance. Similarly, a great deal of effort is devoted to the identification of the channels through which managerial decisions affect the performance of the firm and create managerial discretion. The implied belief is that several decisions of the management have a unique structure and explanation that theory should capture. Such a group of decisions was expected to be fairly large and requires priority over a few others that vary over time with no apparent regularity. The more recent position is that the decisions that were considered as sporadic earlier have become dominant. The focus shifted to a study of such areas of concern and how the management adapts to them. The emphasis on trying to disentangle some regularities and common features of such decisions remains. Several empirical results relating to the choice of an organizational structure are pertinent. First, the cost of obtaining finances is not significant. In the short run, the interest cost of financing is an insignificant part of the costs of holding inventories. It was generally noted that the availability of the requisite quantum of finances alone matters. In the context of long-term financing of fixed assets, it was noted that (a) the interest costs are a small portion of the investment, (b) the shareholders, in the context of equity financing, are more concerned with the dividends they receive and the capital gains from shareholding, and (c) diffused shareholding does not provide the control of the corporation and its investment activities as was generally postulated.4 Thus, a low debt–equity ratio per se does not indicate control by outside shareholders. It was also noted that the managers tend to hold a fairly large share of equity so as not to dilute control. Second, turn to the possibility that shareholders have control on dividend decisions. The empirical evidence suggests that the managers determine this so as not to lose their positions and prestige. Third, in addition, the difficulties of the general manager, in obtaining and processing the requisite information to maintain control, deter the possibility of resorting to a governance mechanism. On the whole, the efficacy of the governance mechanism, as an organizational structure, is undermined. For all practical purposes, implicit contracts turn out to be the dominant choice. Fourth, the M-form literature also suggests that the interest rate on 4

Williamson (1988) contends that a low debt–equity ratio is an indication of the control by the shareholders. However, in empirical practice, the volume of financing matters. A low debt–equity ratio per se has no such effect.

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finances, determined by the internal capital market, ensures efficient allocation of capital between product divisions. This does not hold empirically for two reasons. (a) The demand for finances must be announced by the managers of the individual divisions. They will distort it so as not to lose their supremacy. (b) A high interest rate per se does not deter larger capital allocation to a division essentially because the overall profit-generating potential matters. In general, empirical evidence indicates that organizational details per se have no effect on profit. Adding appropriate control measures and their interaction with the organizational structure explain the profit achieved. Fifth, empirical evidence on capital investments in the Indian context indicates that internal sources of finance are predominant. Financing through long-term debt or capital market did not have a major role. Two reasons can be suggested. (a) Saving of individuals is too small for them to find it worthwhile to enter the equity market. Instead, they divert saving to institutional investors who in turn provide longterm debt to corporations. (b) Some saving of individuals is diverted to the capital market simply because many other avenues for generating profit from their saving are not available. Two distinct features of analysis are discernible. First, a theory or hypothesis about the behavior of the management is conceptualized through intuition based on some empirical observations that are common to all firms and irrespective of the market structure of the industry. This is in congruence with the belief that data generated through empirically observed outcomes cannot be sufficient to infer the managerial processes that generated it. Usually, the emphasis was on the effect of a unit change in the choice of the management, how many units of change have been contemplated, and the length of time over which the decision of the management is expected to have an influence on the performance of a firm. Such studies are portrayed as valid (relevant) if (a) the premises of the theory are drawn from empirical observation and follow accepted logical processes of deduction (irrespective of the empirical validity of conclusions), (b) the theory can explain observed outcomes (without having to empirically justify the premises), or (c) the logical procedures are valid irrespective of the premises on which they are built and the empirical validity of their conclusions. Second, some of this variation is attributable to the inadequacies of theories to account for the empirical reality. In particular, the proposed theories do not adequately reflect the changes (in either the sources of choice across different firms and/or the effects of any of these on the observed outcome) both across firms and temporally for the same firm. The following observations regarding the construction of machine learning algorithms are in order. First, the machine learning algorithms are based on three premises. (a) A large amount of data (big data) on managerial decisions is available. It can be conveniently stored in computers and managed. (b) The regularity and stability of decisions are far more than the uncertain changes caused by environmental conditions. (c) Several regularities can be made explicit by using statistical methods. However, machine learning algorithms can effectively deal with stable market environments. They may do adequately well even when the market conditions can be specified with some probability. Entirely unexpected and uncertain events will have

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to be dealt with as and when they arise. In particular, discrete and uncertain motivations—of the managers, the consumers, and other stakeholders—that are purely a reflection of behavior should be studied for their causes as well as the decisions made in response. The major burden in this endeavor will be on behavioral economics. Note further that the observed data contains all the inefficiencies inherent in the managerial decisions that explain managerial discretion. It would be necessary to clear the data before the algorithms can suggest appropriate decisions. Irrespective of the efficiency of the statistical procedures, a manager cannot be convinced about the suggested action without a behavioral basis. Therefore, this study is directed to examine the aspects related to major managerial decisions. Four basic issues appear to hinder the progress. First, the theoretically defined concepts do not correspond to empirical reality. In particular, the terminology adopted by the studies in industrial organization is not as yet standardized. Second, the theoretical expectations, even if they appear to be fundamental, do not portray empirical relevance. Many modeling structures are difficult to justify. Third, obtaining empirical data corresponding to theoretical concepts (e.g., transaction costs) has been very problematic. Essentially, as Williamson (1988, p.65) pointed out, this is “largely attributable to the failure … to operationalize this important concept.” More pertinently, Chung (1969) noted the necessity to develop a well-behaved function of transaction costs. Though Ben-Porath (1980, p.5) detailed the possible approaches to the specification of transaction costs, Williamson (1981, p.1538) pointed out that “the main reason (for the difficulties) is that the origins of transaction costs must often be sought in influences and motives that lie outside the normal domain of economics.” They depend mostly on the psychological traits of the shareholders, managers, workers, and other individuals associated with different aspects of the functioning of the firm. Fourth, the econometric techniques, for all the sophistication achieved over the years, do not take empirical reality into account. This resulted in extensive misuse of the big data available and econometric software. It would be useful to offer some details of these aspects. The very notion that a single theory—be it in economics or management science— can encompass the mostly divergent empirical reality is elusive. In the final analysis, it is necessary to acknowledge that each modern corporation provides a unique experience and any generalizations, however useful as a guidance to understand future behavior, would be hazardous. The author examined many dimensions of several properties of modern corporations in empirical contexts. The details presented in the book pertain to the experiences of the author as they are related to Indian industries. The incongruity of the empirical experiences with received theory was noted. Alternative justifications have been suggested. An attempt to comprehensively present empirical evidence in a wider context has not been attempted. The reader should consult the original papers listed in the references since they have not been reproduced in any extensive form. Against this backdrop, this book presents a systematic analysis of some experiences over the years. The basic expectation is that it points to several pitfalls of conventional conceptualization and the alternative routes that analysts should pursue. The studies here, though they form a miniscule part of the landscape, have important

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implications for commercial transactions in other settings. In general, a comprehensive classification of the issues involved and their proposed solutions is unlikely to emerge any time soon. Fundamentally, the different chapters in this book deal with the tendency for too much generalization, insufficient attempts to identify different patterns of behavior and the sources thereof, and inadequate choice and application of analytical methods. The pious hope is that analytical research in this area will eventually overcome at least some of these limitations. In this endeavor over several years, I had the benefit of learning from all my coauthors. I sincerely thank all of them for educating me. However, I do not hold any of them responsible for the integrated view that I attempted to offer here. As it turned out, I was motivated to work on this project during the nine days of Lord Venkateswara’s Brahmotsavams. I acknowledge the requisite peace of mind due to the Lord’s encouragement at every subsequent stage. I had the opportunity to complete it despite many obstacles. I therefore present this book at his lotus feet. I sincerely thank the editorial team of the publishers for making the presentation readable and accessible to the readers. Hyderabad, India December 2022

T. V. S. Ramamohan Rao

References Ben-Porath, Y. (1980). The F-connection: Families, friends, and firms and the organization of exchange. Population and Development Review, 6, 1–30. Cheung, S. (1969). Transaction costs, risk aversion, and the choice of contractual arrangements. The Journal of Law and Economics, 12, 23–42. Heath, J. (2010). Economics without illusions. Broadway Books. Hoenack, S. (1983). Economic behavior within organizations. Cambridge University Press. Mueller, D. (1992). The corporation and the economist. International Journal of Industrial Organization, 10, 147–170. Williamson, O. (1981). The modern corporation: Origins, evolution and attributes. Journal of Economic Literature, 19, 1537–1568. Williamson, O. (1984). The economics of governance: Framework and implications. Journal of Institutional and Theoretical Economics, 140, 195–223. Williamson, O. (1988). Corporate finance and corporate control. The Journal of Finance, 43, 567– 591.

About This Book

This book deals with behavioral responses of management of firms that make several decisions with respect to production, marketing, finance, organization of activities within divisions, and interrelations between divisions (including synergies between them and constraints placed on each other in the attainment of overall goals of the firm). The market conditions, that constitute the basis of such decisions, may be stable, random but predictable, or uncertain. It can be expected that the objectives attained by the firm, as a result of decisions of management, may be different from the maximum which can be achieved. A generic conceptualization of such managerial discretion and operationally useful methods of measurement have been presented. It is possible to develop machine learning algorithms on this basis to minimize managerial discretion and assist managers in arriving at strategic decisions, thereby leaving more resources to deal with uncertain events as they arise. The volume is a great resource not only for researchers, but also for decision-makers in corporates.

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Contents

1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.1 The Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3 Agency Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4 Some Hybrids . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5 Non-price Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.6 Financial Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.7 Managerial Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.8 Purpose of Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.9 Designing a Machine Learning Algorithm . . . . . . . . . . . . . . . . . . . 1.10 A Look Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 1 6 7 8 10 11 12 15 16 18 19

2

Managerial Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.1 The Genesis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Measuring Managerial Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Choice of Materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Choice of Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 Organizational Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Financial Mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.7 Summing Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8 Lessons for Machine Learning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21 21 25 27 30 32 34 34 35 36

3

Specification and Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1 The Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 The Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 The Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Price Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 General Forms of Tradeoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.6 Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.7 Switching and Threshold Effects . . . . . . . . . . . . . . . . . . . . . . . . . . .

39 39 40 41 44 45 46 51 xv

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3.8 Estimation Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.9 Uncertainty Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.10 Tradeoff Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.11 Estimating Thresholds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.12 Contract Parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.13 Further Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

52 53 55 56 61 68 69

4

Production Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Some Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2 Imperfect Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Related Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Small Scale Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 Public Sector Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 Service Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.7 Price Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.8 Summing Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

73 73 75 77 78 79 81 82 83 84

5

Multi-product Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 The Nature of Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Economies of Scale and Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3 Tradeoff Between Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.4 Organizational Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.5 Franchises and Subsidiaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.6 Non-Price Strategies and Value Generation . . . . . . . . . . . . . . . . . . . 5.7 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.8 Anomalies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

85 85 87 88 90 92 93 94 96 96

6

Advertising and Warranties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1 Focus on Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Advertising and Selling Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3 Modeling the Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.4 Empirical Experiences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.5 Warranties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.6 Further Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

99 99 102 104 105 105 106 107

7

Inventory Behavior . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1 Sources of Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Pertinent Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.3 Determinants of Inventory Holding . . . . . . . . . . . . . . . . . . . . . . . . . 7.4 Blinder Paradox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Fazzari and Peterson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.6 Composition of Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.7 Empirical Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

109 109 110 111 112 114 115 117

Contents

xvii

7.8 Adjustments to Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 7.9 Some Issues Remain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 8

Capital Stock and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.1 The Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.2 Why Invest? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.3 Acceleration Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.4 User Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.5 Tobin’s q . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.6 Market Imperfection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.7 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

123 123 124 125 127 131 133 136 139

9

Financial Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.1 Product and Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.2 Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.3 Locus of Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.4 Focus Versus Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.5 Debt–Equity Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.6 Dividend Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.7 Empirical Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.8 The Imponderables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

141 141 143 144 146 147 149 151 153 153

10 Carveouts and Spinoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.1 Empirical Setting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.2 Elasticity of Substitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.3 Organizational Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.4 Specification of Synergies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.5 Basic Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

155 155 156 158 160 165 170 171

11 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.1 Overall Pattern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.2 Specific Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.3 Organizational Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.4 Concept of Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.5 Managerial Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.6 What Then? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

173 173 175 178 179 180 180 183

About the Author

Dr. T. V. S. Ramamohan Rao is an emeritus professor and an institute fellow of the Indian Institute of Technology, Kanpur. His research and publications are in the areas of industrial organization, microeconomic theory, and econometrics. e-mail: [email protected]

xix

Chapter 1

Introduction

The concept of the firm, as it evolved over the years, encompasses the technology of production, the economies of scale and scope that enabled a multi-product structure, the organizational arrangements, including implicit contracts and governance relation, necessitated by information asymmetry, transaction and agency costs that it entails, and the financial arrangements. The information requirement and the costs of arriving at the optimum arrangements (defined by the maximization of the market value of the firm, profits generated, dividend paid to shareholders, etc.) necessitated delegating several decisions to the managers at the divisional level. The autonomy they have in decision-making, despite the constraints imposed by higher level managers, leaves some discretion to the management. The uncertainties of market environment, even if the management utilizes non-price strategies to reduce its impact, also results in managerial discretion. It can be surmised that the resulting reduction in the market value of the firm (or any other objective) can be eliminated if managerial decisions are monitored and controlled. The primary objective of this study is to identify the sources, measuring the extent of managerial discretion, and outlining strategies that can reduce it. Though creating synergies between different divisions and different groups of individuals is important it is not possible to prove or presume that managerial discretion in imperfect markets can be eliminated altogether. It is expected that machine learning algorithms can be developed on a behavioral basis to reduce the burden on the management except in cases of unexpected and uncertain events. Organizations are like water drops, or snow-balls or stones, or any other large mass; the larger they are the more easily they are broken into pieces; the larger in proportion is the amount of energy that must be consumed in holding them together.—Knight (1933, p. 22).

1.1 The Firm Neoclassical microeconomic theory defines the firm as an input output relationship. It is assumed that inputs are bought on a market and that the output is also sold on © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_1

1

2

1 Introduction

the market.1 That is, the basic function of the firm is to produce specific quantities of output of well-defined goods and services using inputs that should be combined as described by the technology inherent in the production function. Hence, the firm is characterized as a production function that embodies the technology of converting inputs to outputs.2 The other fundamental assumption is that all individuals act independently and that they accept the market determined prices as parametric. Further, as Ben-Porath (1980, p. 4) observed, the basic premise is that “the value in exchange is independent of the identity of parties; sufficient information is contained in the price-quantity offers, and nothing else about the transacting parties matters.” There are three advantages of market procurement. First, if the needs of the firm are small in relation to the market, static scale economies can be more fully exhausted by buying rather than making. Second, markets can aggregate unrelated demand while realizing the risk pooling benefits. Third, the firm may require one raw material which is costly to produce in isolation. Instead, markets may internalize economies of scope if all the related inputs are produced. In general, as Cheung (1983, p. 6) noted, “the cost of organizing production through the price mechanism is that of discovering what the relevant prices are. The costs of discovering prices is higher in the absence of a firm since significantly more transactions are required, each calling for a separate price.” The markets, for the inputs as well as the output, were assumed to have a large number of competitive firms. For all practical purposes, the assumption was that the inputs bought by a firm and the output that it sells are small relative to the total market. This is the essential premise of the conclusion about market transactions being perfectly replicable. When more than one input is involved in production, it is unlikely that there will be fixed input combinations per unit of output.3 There is a need to know the quantity of each resource needed. Further, it is necessary to know the sequence in which the inputs should be made available to the technological process since production cannot be instantaneous. That is, some organization is necessary. This has led Coase (1937, p. 387) to observe that coordination by a price mechanism “does not mean that there is no planning by individuals. (They) exercise foresight

1

Recent trends in the development of the modern corporations suggest that markets do not precede the emergence of transactions. Instead, markets are created by entrepreneurs. The following examples are typical: (1) Facebook and Airbnb are the result of the felt needs of the prospective customers, (2) Murphy (2010) documented entrepreneurs creating particular types of products with consumer needs in focus, (3) Lubetsky (2015)’s concept of the KIND thing to sell chocolates and cookies in transparent packages and prominent displays in stores. 2 Note that this does not specify the quantity of output that the firm produces even if it is presumed that it can sell whatever it produces. Thus, the decision regarding the quantity of output is deemed to be of no consequence. 3 Assuming that a fixed combination will be needed per unit of output necessitates a further assumption that the firm chooses output to maximize profits since it can be defined only when the cost of production is known.

1.1 The Firm

3

and choose between alternatives.” Each individual may be considered as a manager though acting independently of each other.4 In general, internal organization within a firm can be expected to be advantageous in the following contexts: (a) high asset specificity, (b) costly adjudication is necessary to resolve differences between traders, and (c) it can provide complete access to the relevant information necessary to maintain efficient operations.5 Refer to Williamson (1984, pp. 1548–9). Under these conditions, the firm may be viewed as an institution which directs activities within the firm. One further aspect of the behavior of such firms was brought to attention. The assumption that individuals who own and operate such firms make their own decisions acknowledged their greed to maximize profits. However, the other cornerstone in specifying the functioning of markets was the acknowledgement that consumer preferences should guide the markets.6 Hence, the maximization of consumer welfare was considered as an important dimension.7 The assumption of identical firms implied that the price per unit of output (p) is the same across firms. Under the assumptions regarding the nature of the markets stated so far the condition p = MC (marginal cost) defines the quantity of output that maximizes both the welfare and profit (indeed, they are identical). This appears to be the primary reason why the neoclassical theory of the firm postulated that individuals acting independently in such markets maximize profits. Thus, as Boudreaux and Holcombe (1989, p. 148) remarked, the neoclassical firm was designed to illuminate the way markets work rather than the functioning of the firms. The existence of economies of scale in production created a limit on the efficient level of production of a firm. Even when the firm can sell all that it decides to produce there is a possibility that the total market for the product is much larger. Some other entrepreneur will find it worthwhile to enter the market. Since the number of successful firms is likely to be small, the market is no longer competitive but becomes an oligopoly. All the firms that remain in the market need not be of the same size, and some excess capacities are likely to be built in to take advantage of the economies of scale that technology provides. Firms tend to compete by creating strategies that do 4

Note that if different individuals are responsible for each of the inputs it is not necessary that every one of them considers input prices as the only cost. Such search costs as well as subjective costs of acquiring inputs are important. 5 Generally contracts can be efficiently structured if the contribution of each individual within the firm is independent of those of others. However, team production has the following characteristics: (a) the inputs are not owned by a single individual, (b) individuals, who act independently from one another, cannot produce the output expected from a team. That is, synergies can be expected from working together. Such team production perforce requires contractual agreements between the members of the team that accounts for such interrelationships. Team production may also be necessitated by the nature of technology. For example, in steel ingot production and steel products based on that input the ingots must be reheated to make products if they are produced in separate firms. However, there is no such problem if they form a team under a common ownership. 6 Clearly, this was brought to the limelight since the prices that the firms charge the consumers are supposed to be determined by the market. 7 The basic objective of firms could have been stated as maximizing welfare that includes profit as a component. It was necessary to argue that these two objectives do not contradict each other.

4

1 Introduction

not depend on price alone. The emergence of differentiated oligopoly changes the organizational culture. The management of such firms may attempt to consolidate market advantages instead of (or in addition to) pursuing profit maximization as an objective.8 Faced with excess capacities, firms made attempts to introduce other products that require minor modifications to the existing technology. In other words, they attempted to diversify into related products. Several products offered by a firm (or, on the market by several firms) may be related. Thus, the existence of economies of scope may signal the emergence of multi-product firms. These aspects have been extensively documented by Chandler (1990). This had led Williamson (1981, p. 1537) to observe that “the study of the modern corporation should actively concern itself with and provide consistent explanations for the following features of economic activity: what are the factors that determine the degree to which firms integrate in backward, forward, and lateral aspects.” The ramifications of these dimensions can be assessed accurately only by augmenting the concept of a firm as a production function. Cost minimization was considered as the primary target of such diversification because the prices of the products were in the realm of the markets.9 See, for instance, Baumol (1982). Diversification was considered as the answer since shortrun profits are not required to defend the existing market position. The alternative of vertical integration was considered as a distinct possibility because the firm may be in a position to convince the customers that it is a reliable supplier in addition to the possible cost reduction. To an extent pursuing profit maximization in the choice of each of the products in the firm’s portfolio became impractical since the management cannot distribute the fixed costs and the transaction costs of organization within the firm in any objective manner. See, for instance, Hexter (1975). For all practical purposes, as Burton and Obel (1984, p. 4) pointed out, there was a need for an internal structure to determine mechanisms of cooperation between agents to further the formal goals of the organization and control mechanisms to ensure that the performance of the agents is within tolerable limits.10 The U-form vs. M-form debate ensued. Note that a firm facing excess capacity when catering to a local market had another option of catering to a related market. This was also the case with multi-product firms. Several other variants of the theory of the firm emerged.11 First, consider a market with few firms offering differentiated products. Each firm found it necessary to control some features not related to the firm itself. For instance, every firm found it necessary to consider its interface with consumers on the market and its interaction with rival firms. The firm made attempts to achieve these through non-price 8

Detailing the interrelationships between such firms and their decision making is as yet contested. Ideally, the increase in the revenues or profits will direct such horizontal or lateral integration. Cost minimization is not an essential prerequisite. 10 Walmart, Indigo bookstores, and virtually all other large stores, allow firms to display their products (instead of purchasing them at market prices) and pay them (after deducting their share) only after the products were sold. 11 Kay (1991, 1995) has details of the nature of the firm and the sources of corporate success. 9

1.1 The Firm

5

decisions. Manipulating the market demand for the products of the firm is the main emphasis of such theories. Second, some theories portray the firm as a nexus of contracts. In these theories, the contracts may be with agents outside the firm as well as those inside the firm. Third, the shift to functioning within the firm emphasized the organizational arrangements within the firm. Many details were studied in the work of Williamson (1975, 1981, 1984). The M-form organization, its efficacy, and limitations required attention. Fourth, starting from Cyert and March (1963) attention was diverted to behavioral aspects and their effect on economic decisions and their consequences. The behavioral dimensions include psychological, social, and political aspects.12 Alvarez et al (2020) and Ingro and Sardoni (2020) suggested extensions to this line of argument though the major emphasis was on the market structure and organizational arrangements for the coordination of activities within the firm. They exclude psychological and social attributes that may be important sources of managerial discretion. The impact of the structure of ownership and control of the organization were considered to impact decision-making within the firm and the corresponding implications for the performance of the firm. Despite these extensions, several aspects of decisions, their control of corporate affairs, and consequences for the performance and market value of the firm are still being debated. However, the most important relation between the behavioral aspects and their economic consequences are not clear. Fifth, financial markets and their impact on real aspects of firm performance received attention in Jensen and Meckling (1976), Williamson (1988), and related developments. The assumption that all inputs are bought on the market may be violated. First, some inputs (capital goods) may be in use for a longer period of time.13 Second, there may be productivity advantages in continuing purchase from the same firm. That is, firms may develop loyalty to some suppliers. Several other dimensions of products and market operation have been sighted. With the advancement of technology some firms offer larger output at lower average cost. The economies of scale that distort the market prices of established products are easy to ascertain. However, when a new product is introduced in the market consumers may need some time (or, on use) to assess the value of the product and decide the price that they are willing to pay (the market demand generally). Hence, the firm may not have adequate clues about the price it can charge for a new product and the quantity they can sell. These aspects indicate that the objectives and welfare of all the parties in exchange have been efficiently taken into account.14 For all practical purposes, the essential workings within the firm remained a black box. As a result, the initial theories of the 12

Cyert and March (1963) noted four aspects that need attention: focusing on a few key economic decisions, developing process-oriented models of the firm, linking empirical reality to the models of the firm, and constructing a theory going beyond the details of specific firms. In fact, a behavioral model should be in a position to explain how, and by how much, behavioral aspects bear on the economic factors that impinge on the firm and the consequences thereof. 13 The durability of capital goods necessarily implies that the frequency of purchases is low. This is not in agreement with the competitive market assumption. 14 This was clearly articulated in Barnard (1966).

6

1 Introduction

firm offered relatively little information about the decision-making process within the firm.

1.2 Transaction Costs Conceptually, all materials that a firm needs for production can be acquired on the market. These transactions will be of the nature of short term contracts executed at the prices fixed by the market. Thus, as Coase (1937, p. 388) noted, “outside the firm, price movements direct production, which is coordinated through a series of exchange transactions on the market.” However, as noted in Sect. 1.1, there are several instances where the market functioning involves costs in addition to the market price.15 The firm must incur these additional transaction costs. The possible reduction in the costs, of organizing production within the firm (thereby supplanting the market), was at the apex of the transaction cost argument. Conducting such transactions can be usually described as contractual agreements.16 In most of the subsequent work, the Coasian transaction costs are attributed to market imperfection. Generally, the firm has to identify the correct supplier (whether it is an outside firm or an agent inside the firm), negotiate a contract, and implement it. The supplier (even if chosen to be efficient ex ante) may renege on agreements. This results in transaction costs of adverse selection ex ante and moral hazard ex post. The cost of writing the most efficient contracts (eliminating all transaction costs) may far exceed the advantages due to internalization.17 It is important to note that Coase (1972, p. 63) acknowledged that his 1937 paper was “much quoted but little used.” Similarly, Williamson (1988, p. 65) noted that “the state of transaction cost economics in 1972 was approximately where Coase left it in 1937 largely attributable to the failure, for thirty five years, to operationalize this important concept.” Thus, there has been little empirical progress though the concepts, and their ramifications have been debated extensively. Fundamentally, as Cheung (1983, p. 4) noted, “how the costs are to be specified is a matter of choice 15 Cheung (1983, p. 6) observed that “the cost of organizing production through the price mechanism is that of discovering what the relevant prices are. The costs of discovering prices is higher in the absence of a firm since significantly more transactions are required, each calling for a separate price.”. 16 Paradoxically, Coase (1937) considered vertical integration as the only efficient agreement. As Coase (1937, p. 388) put it, “within a firm, these transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur coordinator, who directs production.” However, contracts can be viewed as another form to conduct such transactions efficiently. 17 Suppose the activities performed by an input supplier change frequently, they vary significantly, or some of the activities cannot be stipulated in advance. Under these conditions the transaction costs of market exchange may be lower than the costs of opportunism and control in a contract. A similar situation may arise even when the quantities bought are rather small. The assumption that an entrepreneur coordinating within the firm will have all the information necessary to direct production may be an exaggeration.

1.3 Agency Costs

7

(not technology alone), depending on the problem at hand.” Further, as Williamson (1981, p. 1538) pointed out, “the main reason is that the origins of transaction costs must often be sought in influences and motives that lie outside the normal domain of economics.” Cheung (1969) noted the necessity to develop a well behaved function of transaction costs. Ben-Porath (1980, p. 5) contains a description of some ways of conceptualizing the measurement of transaction costs. The issue of measurement remains unresolved.

1.3 Agency Costs The agency theory, as elaborated by Jensen and Meckling (1976), maintains the assumption that individuals, be they principals or agents, are free to make their own decisions. Jensen and Meckling (1976, p. 908) “define an agency relationship as a contract under which one or more persons (the principals) engage another person (the agent) to perform some service which involves delegation of the decision making authority to the agent.” Thus, the essence of the agency relationship is that transactions can take the form of contracts between different individuals within the firm. Typically, a principal (may be the owner of a specific asset) engages an agent in the production process through a contract. Second, the principal would also anticipate some reneging on the part of the agent since the agents are expected to act at their own volition once they enter into a contract.18 As such, the principal will make attempts to specify the monitoring and control mechanisms. They will involve some costs in addition to the technologically determined costs. In other words, the principal negotiates a change in the form and dimensions of monitoring and control. Independent actions of the agents may exhibit some reneging even when a new level of contract execution is indicated. This results in some additional cost and a lowering of the gains (welfare) of the principal. This is generally designated as the residual loss.19 There is a fundamental difference with the transaction costs outlined in Sect. 1.2. In the Coasian firm, the contracts are with agents outside the firm, whereas the

18

The presumption here is that the contribution of the agent can be measured and monitored independently. This is rarely possible in practice. In other words, even if moral hazard prevails, it is difficult to attribute it to a specific individual. 19 Jensen and Meckling (1976, p. 308) noted that “there will be some divergence between the agents’ decisions and those which would maximize the welfare of the principals (the expected profits or gains in general). The dollar equivalent of the reduction in welfare experienced by the principal due to this divergence is also a cost of the agency relationship, and we refer to this later cost as ‘residual loss’.” Similarly, Williamson (1988, p. 572) observed that the “residual loss is the reduction in the value of the firm that obtains when the entrepreneur dilutes his ownership (presumably by taking agents to execute production). This shift out of profits and into managerial discretion induced by the dilution of ownership is responsible for this loss.” This refers to financial arrangements though Jensen’s conceptualization can be interpreted more generally.

8

1 Introduction

agency theory attributes them to contracts within the firm.20 Confusions pertaining to this distinction arose due to the following observation of Coase (1937, p. 388) who argued that market related “transactions are eliminated and in place of the complicated market structure with exchange transactions is substituted the entrepreneur coordinator, who directs production.” Coase considered the firm as producing the relevant inputs whereas most of the current literature on transaction costs considers the production activities.

1.4 Some Hybrids Cheung (1983, p. 19) suggested that “we can clearly identify what a firm is if (a) producers or agents sell directly to consumers, (b) agents hold only wage or rental contracts with input owners, and (c) there is no contractual relationship with agents.” However, every one of these conditions has been violated in the development and progress of firms in the real world. It was noted earlier that the nature of technology and the scale and scope effects determine vertical or horizontal integration. However, given the limits on the market for a single product, firms considered expansion into a multi-product portfolio as an alternative. In general, as Wrigley (1970) pointed out, the extent of diversification was not random but was related to the company’s core skills, its basic production technology, and the knowledge about the product markets. Several new activities have been added to the modern corporations. The businessmen in charge of the firms found new ways of organizing the production and distribution of their goods and services. In general, a variety of other forms of organizing the modern corporation emerged. In most cases, more than one organizational form or a hybrid was considered as the superior alternative. Consider the stages of product development that Chandler detailed: local involvement in a single market, sales to geographically distinct but similar markets, and involvement in different (related or unrelated) product markets. In general, the new firms exhibit differences in technological and cost relationships, product market conditions, and distinctive competence of the management. Four possible scenarios have been identified. First, economies of scale may be exhausted while catering to the production center. The original firm may not have the capabilities (capital and/or management) to set up a new plant in a different location. Second, the firm may find it expensive, relative to expected gains, to collect all the information about demand, resource availability, etc. from the new location. Third, the firm may feel that the new agent it takes can replicate its technology and eventually start a new firm on its own. Franchising would be inefficient in such cases. 20

The other difference between the two approaches should be noted. For Coase the coordination within the firm is entrusted to a single principal. The agency cost approach envisages the possibility of many principals and multiple agents. The independent decision-making ability attributed to agents is distinctly different.

1.4 Some Hybrids

9

Fourth, the parent firm may find the production or demand conditions to be uncertain to bear the entire burden. As a result, the firm may agree to create a subsidiary (rather than a franchise). The parent firm may continue to control production, finance, and scale of the subsidiary. However, the relative fit of a subsidiary may be positively correlated with size, since the cost of control of effecting turnarounds of smaller subsidiaries may outweigh the expected returns. The ownership of capital assets by a subsidiary may also indicate that it may spinoff as an independent competitor over time.21 In general, it appears that enterprises develop innovative strategies when confronted with unexpected circumstances. The theories of organizational control and economics perforce lag behind. Part of the reason is that neither group can foresee all possible external circumstances. Two other hybrids have been brought to light. First, the functioning of a firm must be viewed in a dynamic context partly because a corporation plans for a longer life span and secondly due to present decisions affecting its future and conversely the recognition of the firm about the necessity to make current decisions with the future of the corporation in perspective. One of the features that the firm acknowledges is the greater variability of demand over time compared to the costs of altering production at short notice. As a result, the firm should plan production and inventory levels simultaneously. This would also necessitate organizational arrangements that will have a bearing on the cost of goods that the consumers demand. Second, the large corporation has to perforce find appropriate instruments of finance corresponding to the capital investments that are necessary for its growth. Clearly, both debt and equity receive prominence. Though the organizational imperatives of these modes of finance are significant, and received proper emphasis, the primary focus was on the cost and control aspects of the optimal mix. Debt would make the cost of financing higher but does not provide any control rights to the debt holders. On the other hand, the payments to equity holders are at the discretion of the management. However, equity holders will have control rights. Over time the range of instruments, both in the forms of debt and equity, have been increasing.22 The cost vs. control balancing has become very intricate and needs deeper study. For all practical purposes, the hybrid forms of corporate organization received emphasis of its effects on production, cost, and control and the implied tradeoffs. To treat production and organizational choices on different economic reasoning is not tenable any longer. The details available as of now are at best sketchy and the dynamic adjustments and their consequences are rather imponderable.

21

Making franchises and subsidiaries appear on the balance sheet of the parent firm may mitigate some of these effects. 22 An increase in debt may also signal to the shareholders that the management will bond with their objectives. The bonding aspect should also be factored in while conceptualizing the optimal debt–equity ratio.

10

1 Introduction

1.5 Non-price Strategies Two possible scenarios have been identified. First, economies of scale may be exhausted while catering to the production center. Second, in some cases the local market may limit production below capacity levels. The firm has to conceptualize an alternative. Catering to the demand at another location requires additional managerial and financial resources. The existence of excess capacity when catering to a local market suggested that the firm can explore selling its products in another geographically separated market. The available demand for its products may prompt it to set up another firm. However, the firm may not have the capabilities (capital and/or management) to set up a new plant in a different location. Similarly, the locally available information cannot be efficiently transmitted to the headquarters of the firm to assist in its decision-making. Decisions, based on such localized information, should be taken at local levels. Creating franchises was considered appropriate. Thompson and Wright (1988) identified two contexts in which franchising may be efficient. First, contexts like automobiles indicate that the economies are significant in production but not in their distribution. Hence, dealers to sell the automobiles can be assigned franchises while production is centralized. Second, both production and distribution may not have significant economies of scale as in the case of fast-food chains and soft drinks. In such cases, the original producer must preserve the brand name (by appropriate arrangements to share fixed costs) while offering a franchisee an exclusive right to produce and distribute their product over a specified geographic area and for a predefined time. In other words, the role of centralized production and decentralized distribution is not necessary for franchising to be efficient.23 Two sources of difficulties have been noted. First, the firm may find it expensive, relative to expected gains, to collect all the information about demand, resource availability, etc., from the new location. Second, the firm may feel that the new agent it takes can replicate its technology and eventually start a new firm on its own. Franchising would be inefficient in such cases. The parent firm may find the production or demand conditions to be uncertain to bear the entire burden. As a result, the firm may agree to create a subsidiary (rather than a franchise). The parent firm may continue to control production, of finance, and scale of the subsidiary. However, the relative fit of a subsidiary may be positively correlated with size, since the cost of control of effecting turnarounds of smaller subsidiaries may outweigh the expected returns. The ownership of capital assets by a subsidiary may also indicate that it may spinoff as an independent competitor over time.24 In general, it appears that enterprises develop innovative strategies when confronted with unexpected circumstances. The theories of organizational control 23

Note that inventory may accumulate beyond reasonable limits unless controls like those specified in footnote 16 are in place. 24 Making franchises and subsidiaries appear in the balance sheet of the parent firm may mitigate some of these effects.

1.6 Financial Issues

11

and economics perforce lag behind. Part of the reason is that neither group can foresee all possible external circumstances. It can be generally observed that several strategic choices are available to the management while resolving a problem and/or attempting a consequence. The number of choices available, to resolve a problem, multiplies as a result. The question then arises as to which is the most efficient. It is difficult to categorically specify a criterion on which a judgment can be reached.

1.6 Financial Issues A further aspect about the choice of a financial mix was often pointed out. When the firm increases equity, there is a gain in terms of payments made (the declaration of dividends is at the discretion of the management) but is subject to loss of control. On the other hand, increasing a preference for debt increases the cost (interest payments) while diluting control. Clearly, there is some combination that minimizes the total cost. However, the management may choose more debt in the interest of maintaining their control over the activities of the corporation. Many details of this phenomenon have been elucidated in Jensen and Meckling (1976) and Williamson (1988). In particular, Williamson (1988, p. 1538) defines managerial discretion thus: It is “the shift out of profits and into managerial discretion induced by the dilution of ownership and is responsible for this loss.” The large corporation has to perforce find appropriate instruments of finance corresponding to the capital investments that are necessary for its growth. Clearly, both debt and equity receive prominence. Though organizational imperatives of these modes of finance are significant, and received proper emphasis, the primary focus was on the cost and control aspects of the optimal mix. Debt would make the cost of financing higher but does not provide any control rights to the debt holder. On the other hand, the payments to equity holders are at the discretion of the management. However, equity holders will have control rights. Over time the range of instruments, both in the form of debt and equity, have been increasing. Individuals receive a certain interest rate if they put their money in a bank account (supposed to be a safe asset with high liquidity). So long as bond holding provides a larger return they are satisfied. Similarly, the shareholder is only bothered about the returns and never really cares to know or control the decisions of the management, or the overall efficiency of the firm. Hence, maximizing profit or maximizing the market value of assets is not their concern directly. Only the ease of acquiring and selling shares matter. As Leech and Leahy (1991, p. 1438) noted, frequent changes in the market environment may necessitate periodic adjustments in the various decisions of the firm. An outsider, like a shareholder, would find it difficult to maintain control on managerial decisions. The cost versus control balancing has become very intricate and needs deeper study.

12

1 Introduction

1.7 Managerial Discretion25 The management of every corporation decides the products to produce, the quantities of each product, the methods of organizing production, the composition of the necessary finances, the outlets through which the outputs will be sold, and several others. The concept of managerial discretion takes different forms in each of these contexts. Consider the transactions on the market. The management has a choice with respect to the quantities of various inputs acquired on the market. The management may develop loyalty with respect to a particular supplier over time due to its reliability of supply and prices offered. They use their discretion to continue with that supplier.26 A similar situation arises even when the input is obtained through a contract. The only difference is that contracted prices are considered instead of market prices. In addition to the costs of writing the contract, there can be reneging after the contract. The management uses its discretion in weighing the alternatives. The actual choice may involve a cost in excess of the minimum possible so long as it is less than that implied by the market transactions. This is the essence of managerial discretion. The large size of a firm (basically due to economies of scale and scope) and the limit on the total market for products limit the number of firms in the market. This gives rise to the possibility that each firm makes an attempt to convey the value of their products to the consumer and/or capture as large a market share as possible utilizing non-price strategies. This, in itself, is a dimension of managerial discretion. Rao and Bhattacharyya (2021) provided empirical evidence to support the view that firms give preference to revealing the value of their products. However, market competition may induce them to utilize such strategies to augment market shares as well. Consider the context of team production. It is difficult to separate the contribution of each individual. Instead, the output of the team alone is of value to the owners of the firm.27 The resulting information asymmetry and delegation of responsibility is 25

An exclusively capitalist minded observer would take the position that individual freedom in decision making should be honored and that every decision that managers make is the best they can do and perforce efficient (as they view it). This does not leave any room for the notion of managerial discretion. Such value judgments cannot be avoided. The argument of the present book is that due to information asymmetry (a) a divisional manager may not have the best information about the market environment, (b) it would be possible to modify the constraints, that a higher level manager sets for a lower level manager to follow, taking into account the objectives of the divisional managers, and so on. That is, an overall improvement in the performance of the firm can be achieved without necessarily restricting the decision-making independence of the managers at any level. 26 Conceptually, there may be another firm offering lower prices for the quantities the firm needs. They may find the transaction costs of searching for a different supplier too high relative to this supplier. Assume that the pe of the current supplier is ≤ pa + transaction cost, where pa = price charged by the alternative supplier. Then, the firm maintains its loyalty. Only when pe ≥ pa + transaction cost will the management replace the current supplier. 27 Alchian (1950, p. 219) noted that individual behavior in a team may be random. However, other members of the team make up the deficiency since the management is worried about the output of the team alone.

1.7 Managerial Discretion

13

at the apex of the resulting managerial discretion. The output is somewhere between these two limits because the organization would gain some increase in output. This may persist even if the management exercises some control.28 Managerial discretion arises due to the ability to recognize that the management will not be displaced so long as the output achieved is greater than the sum of output that each member of the team can contribute if they act independently of each other. The problem may persist in the context of organizational choice as well. It was generally conceptualized that an internal market, especially in a M-form, will be efficient. However, as Chandler (1962, p. 87) pointed out, capital (common resource) allocation to product divisions is based on the information divisional managers reveal (or the general manager can obtain). This information gathering is costly and weighing the benefits leads to managerial discretion. The discretion may also be due to the fact that the profit attributable to each of the product divisions cannot be measured independently.29 In actual practice, managerial discretion does not vanish in the M-form. From the above description, it is obvious that managerial discretion30 may arise due to the behavior of the workers in the production and distribution process, the mangers themselves, the holders of equity who are the ultimate owners of the firm, the consumers of the products of the firm whose valuation ultimately depends on the prices and quantities of the products offered, and on occasions the government controllers who act on behalf of the consumes and/or the shareholders. For all practical purposes, the decision-making process, that is related to decisions within the firm as well as those that have an influence on rival firms,31 can be designated as managerial discretion though it may take a variety of manifestations in different firms. Thus, as Knight (1957, p. 22) put it, “managerial discretion is the opportunity for individuals to secure private gain by dislocating the organizational machinery.” Consequently, it was recognized that managerial discretion is an inevitable consequence as the size and scope of the firm increases irrespective of the organizational arrangements chosen. Conceptually, there may be two alternative choices in any given context. One of them is to lower cost (or maximize gains) to the firm. However, the management may feel that the costs to themselves, or the reduction in the value that they associate, is high. Their actual choice may involve a choice between the two extremes.32 Rubin

28

Leech and Leahy (1991, p. 1418) observed that control is itself the power to exercise discretion over decision making. 29 The profit maximizing quantities of output of each of the product divisions should account for possible interdependence of the divisions. However, to define product divisions without the necessity for such interdependence has been assumed rather than proven empirically. 30 The concepts of residual loss (Jensen and Meckling (1976)) and X-inefficiency (Leibenstein (1980)) are fundamentally describing the same phenomenon. 31 Note that there is a possibility of shirking by retailers in the distribution of products as well. 32 Note that the minimum cost or the maximum value may be from the viewpoint of the consumers of products or the shareholders of the corporation. The ambiguity about whose viewpoint should prevail persists.

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1 Introduction

(1980) contains some other related aspects of this phenomenon. This is the essence of managerial discretion. If the inputs are acquired on a contractual basis, the very notion of an efficient price acquires an altogether different connotation. Cost minimizing combination of input prices and their quantities is relegated to the background in preference to efficient contracts relative to the contracting parties, loyalty of suppliers, and the dynamic stability of contracts. A similar problem arises with respect to subsidiaries, franchises, and similar organizational arrangements. The alternative of an administrator (manager) setting the transfer prices in an internal capital market gains preeminence in hierarchical organizations that supplant the external markets altogether. The design of the internal capital markets is generally expected to maintain the notion of cost efficiency. However, as will be described in ch.5, the efficiency of operation of an M-form has been questioned. Uncertainty in the procurement of resources and/or the distribution of outputs can potentially disturb the often stated assumptions of the neoclassical theory. Consider the determination of the output produced (or demanded) on the market. Its relation to price is at best tenuous. Consider examples like theaters, large super markets, and for that matter any durable goods. It is generally observed empirically that these quantities are fixed (through learned experience), the desire of the managers to achieve a predetermined market share, the need for a predefined utilization of fixed assets, as well as minimum scale considerations stipulated by the embodied technology, etc. In practice, neither the price nor the quantity is determined by impersonal markets and the efficient cost minimizing choice is more by assumption than a practical reality. Even when prices and quantities purchased in a unit of time are fixed outside the market mechanism, there is a need for the management to decide several other related factors. For instance, the management of the firm must decide the total stock offered on the market and hence the number of units of time over which the inventories are carried. In the context of movie theaters, for instance, they have to decide the number of days over which a movie or a show should be continued. For all practical purposes, the notion of the quantity of output takes on a variety of dimensions. In practice, none of them may be related to the prices that the consumer pays. In the context of theaters and movie houses, this will generally depend on the price at which a contract is negotiated. Thus, price, in itself, has become multi-dimensional in modern empirical settings. There can be variations on the theme as well. A notable example occurs in freight transportation. Generally, freight is consolidated at a truck terminal or a railway yard so as to reduce the extent of demand variability and/or uncertainty. There may be adaptive attempts in other contexts to elicit information about endogenous randomness with a view to reducing it over time to the extent possible.

1.8 Purpose of Study

15

1.8 Purpose of Study The ultimate purpose of any analysis of corporate behavior is to provide guidelines to the management to define a course of action when confronted with a new situation. As of now, it is difficult to depend on the existing theories to offer any such guidelines in many contexts.33 Therefore, it is important to examine the different theories and their empirical implications. The analysis of any phenomenon, either in economic theory or in management science, proceeds along these lines: (a) it is based on certain premises, presumably based on empirical observation about reality, (b) elaborates a theory, usually an if– then relationship, that links the premises to some observable consequences, and (c) sets up a method of validating the conclusions by referring to practical reality. A theory is justifiable only if it satisfies all the three requirements stated above. There, is, of course, an ambiguity regarding what constitutes premises and consequences. Note that a majority of studies assumed that markets are the most efficient coordinating mechanism. They thought that the nature of the market alone defines the behavior of the management of firms. However, the existence of economies of scale allowed the emergence of large firms, but the transaction costs in catering to large markets limited the geographic spread of a firm and gave rise to a number of competing firms in an industrial market. Similarly, the economies of scope enabled firms to diversify into several products. A market could not be conceptualized and operationalized to achieve efficient coordination within a firm. Though the M-form was adopted, its limitations necessitated the search for alternative organizational mechanisms. Contracts, hierarchies and several other mechanisms of control for the inside activities of the firm and the behavior of couplings determine the behavior of firms. Attempts have been made to disentangle the factors that explain the choice of the organizational form: frequency of operations, the time taken to complete a transaction once initiated, and the specificity of assets have been taken as desiderata. Similar explanatory forces operate on the demand side as well. Contracts, with individuals inside a firm and those outside it, exhibited similar behavior. In particular, it was recognized that making every component of the organizational structure function efficiently will not ensure the efficient function of the entire system. The behavior of the system can be understood only when suitable couplings are added. While devising a strategy the management seeks answers to three questions: (a) what advantage does the firm have per unit of change being advocated, (b) what is the extent of change that should be managed, and (c) what is the time horizon over which the implementation of the strategy (say, investment in capital assets) provides the expected benefits? Further, these advantages will be calibrated against the cost of utilizing the strategy. 33

Three different stands appeared in practice: (a) a theory is valid if the premises can be verified and the logic of deduction of consequences follows an accepted procedure, (b) a theory is acceptable if the consequences can be empirically validated, and (c) accepted logic of deduction is sufficient to validate a theory. All three strands of thought can be found in the context of economic theory and management science.

16

1 Introduction

The strategic choices of the firm in imperfect markets are necessarily oriented toward the consumers as well as rival firms. As a result, the objectives of the firm can be stated as (a) maximizing profit (short-term view), maximize market share, or maximize the market value of the firm (a long-run perspective), (c) cater to the goals of divisional managers of a decentralized organization (ranging from perks, stability, and so on). Some combination of these objectives of a higher level manager may constrain a lower level manager. After choosing a theory, it is as yet necessary to estimate the model for it to be suitable to define management strategy. There is a proliferation of the number of models and estimation techniques. However, they are based on different assumptions that do not appear to correspond to plausible managerial practices. Most of the studies of industrial organization started with a hypothesis about the behavior of the management and tested it against empirical data. The more recent recognition is that it is necessary to start with empirical facts to build theories and tests of hypothesis.34 In other words, empirical information about who is making the decisions, what decisions they made and what are the constraints and motivations to make the specific choices they made must be the primary concern of theories and their tests. Theories based on apriori intuition do not provide enough credibility even if they stood the econometric test. In particular when theory and data are in conflict it is necessary to authenticate the theories as well as the methods of empirical analysis. Recognition that natural experiments are a rich source of knowledge has been changing the way economists use data to generate theories.

1.9 Designing a Machine Learning Algorithm In recent practice, machine learning algorithms have been set up for specific functions of firms and several applications generally. The feature common to all of them is their reliance on statistical regularities, and no attention has been paid to the underlying behavior of the units that are studied. This is unsatisfactory since they assume that the prevailing behavior is optimal and acceptable. There is hardly any recognition that current behavior involves managerial discretion and hence not optimal necessarily. Machine learning algorithms should not perpetuate the infirmities of the management in the way they make their decisions currently. Ideally, it should direct them to better decisions consistent with the behavior of various constituents. The ultimate purpose in studying the emergence and extent of managerial discretion is to provide guidelines for decisions so as to minimize it and provide the maximum possible advantage to the firm. The information available may be deterministic, varying periodically with a certain degree of regularity, or entirely uncertain. Several aspects should be considered.

34

Data, in itself, cannot reveal anything unless we are looking for something. Some apriori theorizing appears to be inevitable. How to strike a correct balance is an issue in itself.

1.9 Designing a Machine Learning Algorithm

17

(a) In general, the information asymmetry and the costs of centralized coordination suggest that the decision-making will be decentralized. For all practical purposes, three functional divisions should be considered, viz. production, marketing, and finance. The interaction between them is of critical importance given the autonomy of decision-making delegated to the divisional managers. Though the organizational structure is important, it was suggested earlier that it does not have any independent effect once the other strategic decisions are in place. In other words, organizational arrangements affect the performance of the firm only through the decisions made. (b) The decisions of the firm will depend on the market environment outside the firm as well as the specific details within the firm. Porter’s (1980, 1985) paradigm of competitive advantage, viz. that activities that can be sustained over time (e.g., capitalizing on consumer relationships involved in selling every day consumer needs, making highly complicated machines such as airplanes and operating a mine) was considered as the essence of strategic choice. By way of contrast, recent arguments of McGrarth (2013) indicate that markets are dynamic arenas where firms tend to position themselves in other segments within the industry and cater to transient requirements. This necessitates changes to be frequent and well managed. In either case, it would be easy to incorporate these nuances in machine learning algorithms. Some studies suggest that the environment within the firm may become binding before outside factors prevail. Thus, Prahlad and Hamel (1990) argued that the resource base of the firm has an effect. Similarly, Wernerfelt (1985, 1995) contends that the core competence of the management team will be binding. For purposes of machine learning algorithms, any of these features may be constraints whether or they are binding or not. (c) Some attention should be directed to the objectives of the firm and the divisional managers. The firm may have several goals, viz. maximizing the market value of the firm, maximizing profits, the market share, dividend payments if the shareholders express such a preference, and so on. In practice, some of them may be maximized subject to some constraints on the others. The actual choice in the design of a machine learning algorithm will depend on the information that can be elicited from the general manager. The goals of the divisional managers may or may not correspond to the objectives of the firm. In such a case, it would be necessary to place constraints to elicit compliance. (d) Some decisions, especially regarding the capital stock of the firm and product portfolio, may be of a long-term nature and would be best assigned to the general management. Decisions regarding the execution of production, inventories, and so on would be best left to divisional managers. (e) Note that the performance of the firm depends on the quantum of resources, including finances available. As such it would be necessary to investigate whether certain objectives and constraints or resource availability explain the measured managerial discretion. The measurement of managerial discretion will itself be a subordinate goal when these features can be identified. (f) The structuring of machine learning algorithms would be roughly along the following lines: specify the major decisions of each division, define and estimate

18

1 Introduction

the relationships between them and their effect on the goals of the division, identify the interactions of the decisions of other divisions with its own, and the goals of the division and the constraints imposed by a higher level manager. Clearly, it would be necessary to specify a problem of decision-making by a division and the maximization process in its interaction with the other divisions. Further, periodic updating may be necessary when new information becomes available. In the final analysis, it must be acknowledged that a single algorithm will not be useful to all firms within an industry and less so across industries.

1.10 A Look Ahead Against this backdrop the organization of the rest of the chapters in the book is as follows. Chapter 2 will outline the concept of managerial discretion and its sources. Specification of models and their empirical estimation will receive attention in Chap. 3. Chapter 4 outlines the theories, modeling, and empirical results concerning the production decisions of the firm. In the context of multi-product firms, the primary concern of the existing studies is on the internal organizational details and how they affect the performance of firms. In general, Chap. 5 examines the interaction between corporate strategies and organizational structure as they affect the objectives of firms. The modern corporation has to interact with rivals in addition to their interface with the consumers in imperfect markets. They utilize several nonprice strategies to achieve their goals. Some of the major choices will be considered in Chap. 6. Chapter 7 is devoted to issues related to inventory management of firms. To an extent, inventories are a managerial response to uncertainties they confront in imperfect markets. But the sources of uncertainties and the strategic responses of the management need a deeper analysis. It is obvious that the short-run decisions of the firm considered so far depend on the available capital stock and the investment decisions in dynamic context. Chapter 8 deals with these aspects and provides a link between real and financial choices of a firm. Financial considerations have not been ignored while the emphasis of most studies has been on product markets and organizational details of corporations. The financial aspects pose a different set of problems in the efficient functioning of firms. Chapter 9 is devoted to some of the major issues involved. A major change observed in corporate structures has been the emergence of startups, spinoffs, and carveouts. Chapter 10 deals with the lack of organizational synergies as a major source of such outcomes. This analysis provides an idea about the shortcomings in conceptualization, modeling, and methods of estimation. Chapter 11 outlines some of the issues that can offer guidance about the direction that future research should take so that more practically usable information becomes available.

References

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References Alchian, A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58, 211–221. Alvarez, S., Zander, U., Barney, J., & Afuah, A. (2020). Developing a theory of the firm for the 21st century. Academy of Management Review, 45, 711–716. Barnard, C. (1966). Functions of the executive. Harvard University Press. Baumol, W. (1982). Contestable markets: An uprising in the theory of industrial structure. The American Economic Review, 72, 1–15. Ben-Porath, Y. (1980). The F-connection: Families friends, and firms and the organization of exchange. Population and Development Review, 6, 1–30. Boudreaux, D., & Holcombe, R. (1989). The Coasian and Kightian theories of the firm. Managerial and Decision Economics, 10, 147–154. Burton, R., & Obel, B. (1984). Designing efficient organizations. North Holland. Chandler, A. (1990). Scale and scope: The dynamics of industrial capitalism: Advances in economic and econometric theory and applications. Cambridge University Press. Chandler A. (1962). Organizational capabilities and the economic history of the industrial enterprise. Journal of Economic Perspectives, 6, 79–100. Cheung, S. (1969). Transaction costs, risk aversion, and the choice of contractual arrangements. The Journal of Law and Economics, 12, 23–42. Cheung, S. (1983). The contractual nature of the firm. The Journal of Law and Economics, 26, 1–21. Coase, R. (1937). The nature of the firm. Economica, 4, 386–405. Coase, R. (1972). Industrial organization: A proposal for research. In V. Fuchs (Ed.), Policy issues and research opportunities in industrial organization, pp. 58–73. National Bureau of Economic Research. Cyert, R. & March, J. (1963). A behavioral theory of the firm. Prentice Hall, Englewood Cliffs. Hexter, J. (1975). Entropy, diversification, and information loss barrier to entry. Industrial Organization Review, 3, 130–137. Ingro, B., & Sardoni, C. (2020). Images of competition and their impact on modern macroeconomics. The European Journal of the History of Economic Thought, 27, 500–522. Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3, 305–360. Kay, J. (1991). Economics and business. The Economic Journal, 101, 57–63. Kay, J. (1995). Foundations of corporate success. Oxford University Press. Knight, F. (1933). The economic organization. Harper Torch Books. Knight, F. (1957). Risk, uncertainty and profit. Harper Torch Books. Leech, D., & Leahy, J. (1991). Ownership structure, control type classifications and the performance of large British companies. The Economic Journal, 101, 1418–1437. Leibenstein, H. (1980). Beyond economic man. Harvard University Press. McGrath, R. (2013). The end of competitive advantage: How to keep your strategy as fast as your business. Harvard University Press. Murphy, B. (2010). The intelligent entrepreneur. Holt and Company Porter, M. (1980). Competitive Strategy. Free Press. Porter, M. (1985). Competitive advantage. Free Press. Prahlad, C., & Hammel, G. (1990). The core competence of the corporation. Harvard Business Review, 68, 79–91. Rao, T. V. S. R., & Bhattacharyya, S. (2021). Transient market power of firms. Cambridge Scholars Publishing. Rubin, P. (1980). Managing business transactions. Free Press. Thompson, S., & Wright, M. (1988). Internal organization, efficiency and profit. Philip Allen. Wernerfelt, B. (1985). A resource-based view of the firm. Strategic Management Journal, 5, 171– 180.

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Wernerfelt, B. (1995). The resource-based view of the firm: Ten years later. Strategic Management Journal, 16, 171–174. Williamson, O. (1975). Markets and hierarchies. Free Press. Williamson, O. (1981). The modern corporation: Origins, evolution and attributes. Journal of Economic Literature, 19, 1537–1568. Williamson, O. (1984). The economics of governance: Framework and implications. Journal of Theoretical and Institutional Economics, 140, 195–223. Williamson, O. (1988). Corporate finance and corporate control. The Journal of Finance, 43, 567– 591. Wrigley, L. (1970). Divisional autonomy and diversification, Ph.D Dissertation, Harvard Business School.

Chapter 2

Managerial Discretion

Every decision of the management involves some choice. Managerial discretion cannot be described by saying that the management made one choice rather than another. In general, there will be one choice that provides the maximum gain (to the division or the market value of the firm whichever is applicable) and another choice that results in the least gain. If the choice of the management results in a gain between these limits the difference between the maximum and the realized gain constitutes the appropriate measure of managerial discretion. It would generally be useful to identify the motive for the actual decision made. Several measures of managerial discretion are a result of the variety of possible motives. The possibilities are outlined. Some changes in organizational culture and control have been suggested to reign in managerial discretion. However, it is unrealistic to expect that managerial discretion can be eliminated altogether. Making sense of a constantly changing environment is less a matter of systematic analysis than of being alive to alternative ways of seeing the world; opening minds to new possibilities, abandoning long held convictions, and resisting the temptation to seek comfort in facile explanations.—Levis (2009, p. 354).

2.1 The Genesis Managers at different levels of a corporation encounter a variety of problems regularly. In the short run, the market conditions and organizational arrangements cannot be changed significantly to adapt to the changing requirements. Similarly, the received theories cannot offer sufficient guidelines to the management about the changes that they should bring about periodically. However, managers do come up with innovative solutions that may be at variance with what is expected. A manager, any decision-maker, is conditioned by the environment in which decisions ought to be made. That would involve the objectives that should be pursued within stipulated constraints. It would still leave some choices in practice. The © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_2

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2 Managerial Discretion

manager chooses one of the alternatives at his discretion. The basis of such a decision may have some logic that is not necessarily quantitative. When a human mind is contemplating a decision it takes some considerations into account: (a) the individual’s psychological predisposition, (b) the implications of belonging to a social group (sociological aspects), (c) the political environment and how they will be affected in such an atmosphere, and (d) economic considerations. Any of these factors may operate alone or in some complex combination. Similarly, when confronted with a situation the individual does not necessarily analyze (a) the sources of the problem, (b) the decisions made in a similar context earlier, and (c) the quantitative economic impact.1 Such a phenomenon has led Williamson (2000, p. 200) to suggest that “the organization man is given to opportunism because he is cognitively less competent (subject to bounded rationality) and motivationally more complex (subject to moral hazard).” Stated differently, human behavior always finds ways of overcoming any shackles imposed on them by the organizational arrangement in use. Going a step further, Knight (1933, p. 22) pointed out much earlier that managerial discretion is “the opportunity for individuals to secure private gains by dislocating the organizational machinery.” Williamson (1981, p. 1538) expressed this in concrete economic terms by noting that managerial discretion represents “the shift out of profits … induced by the dilution of ownership.” However, Barnard (1966, p. 5) contends that managerial discretion may have more to do with psychology rather than economics. Managerial discretion may take several forms depending on the context. In general, it may extend to the choice of which products to produce, the quantities of each of the products, the methods of organizing production, the outlets through which the products are sold, the composition of the necessary finance, and several others.2 However, the existence of such a choice or the basis on which a decision is made does not specify managerial discretion. Managerial discretion will reveal itself only when such differences in goals achieved, or violation of the constraints placed on an individual, manifest in actual functioning. Some inferences can be drawn based on the consequences observed in practice. The intensity of managerial discretion may be identified along any of these dimensions: a lack of expected outcomes per unit of action, the volume of action over which the infraction occurred, and the amount of time over which the consequences of action are expected to persist.

1

The way logical analysis proceeds is however somewhat different and structured. It looks for stable patterns observed earlier and solutions adopted in similar contexts. The analyst conceptualizes a pattern and a solution and tests it against empirical observation. Instead, it would be best if the psychological and other environmental factors that give rise to a decision are decoded and built into the analysis before testing the proposed model. Behavioral economics may be moving closer to portray such patterns of behavior and decision-making. 2 As Knight (1957, p. xxxi) pointed out, there is a need “for some grasp of the infinitely complex, intangible and downright contradictory character of men’s interests, conscious and unconscious, and their interaction with equally intricate mechanical, biological, neural and mental processes in forming the pattern of behavior.”.

2.1 The Genesis

23

Consider the following. Suppose the decision-maker has two choices with respect to a decision. Let maximum expected gains be m1 and m2 . Assume that m2 > m1 .Clearly, it can be expected that the second alternative will be chosen. However, the decision-maker knows that the first alternative available defines a limit to which slacking off will not lead to displacement. Consequently, the unit may deliver m such that m1 < m < m2 . Strictly speaking, the difference (m2 − m) should be designated as managerial discretion.3 Ideally, it should be expected that every individual in the organization will be dedicated to the overall objectives of the firm, is technically and motivationally competent to execute the given job, and the management provides sufficient incentives to extract the best effort expected. It is unlikely that managerial discretion can be totally eliminated. At best, organizations may attempt to minimize such losses. Managerial discretion should only refer to actions of individuals that deviate from such limits.4 To this point in the analysis losses due to managerial discretion have been attributed to the psychological predisposition of individuals. In practice, economic analysis also made attempts to explain it by utilizing more than one objective that they may be pursuing. In such a case, the maximum of one of them, if the higher level manager targets it, may not be achieved. The reduction in the goal of the higher level manager would then qualify as a measure of managerial discretion.5 However, it cannot be so designated if the higher level manager concurs with the chosen tradeoff and its quantitative magnitude. The important observation from this description is that managerial discretion can only be measured by the deviation from the potential maximum of the chosen objective. It is not necessary to identify the lower limit. From a practical standpoint, it would be difficult and expensive to monitor every activity of all the individuals within an organization. At best some inferences can be drawn based on the consequences observed in practice. Managerial discretion will reveal itself only when such differences in goals achieved or violation of the constraints placed on an individual manifest in actual functioning. Two extreme forms of decision-making can be conceptualized. First, centralize all decisions in the hands of the shareholders or the general manager as their proxy. Second, decentralize decisions to the level of individuals or, at least, to smaller divisions of the firm. Centralized control in the hands of the general manager is not practical since there will be an overload of information processing and control. Further, there will be difficulties in enforcing the decisions made. Centralized control 3

Suppose two individuals constitute a team. Let the higher level manager expect an output y from them. If one of them reneges, the other member of the team may compensate the reduction since the higher level manager only monitors the performance of the two together. The reneging may not be traceable and it should not be designated as managerial discretion. On the other hand, suppose the group produces a < m. In such a case, (m−a) represents the result of managerial discretion. 4 It appears that psychological traits of individual behavior determine the economic consequences like managerial discretion. Attempts to utilize economic measures to control such distortions will perforce have a limited effect. 5 Rao and Rastogi (1997a, 1997b) reported both theoretical and empirical details of such managerial discretion with respect to several corporate decisions.

24

2 Managerial Discretion

will be inefficient on both the counts. Similarly, from a practical standpoint, it would be difficult and expensive to monitor the activities of every individual within an organization. Somewhat more pragmatically it may be suggested that some decisions can be in the realm of the shareholders while others would be best delegated to lower level managers who possess the best information to make appropriate decisions. In the context of decentralized decisions, it would be realistic to suggest that divisional managers pursue a variety of goals. For example, the production manager may be concerned only with the cost of delivering the expected level of output. Such a manager does not know the contribution of the division to the overall profits of the firm (and, consequently, it would be unrealistic to expect the pursuit of such a goal). Managerial discretion then refers to the possibility that cost minimization is not attained. Similarly, a manager coordinating the production activities of various divisions may be capable of calibrating the revenue potential of each division. However, the information about the minimum possible cost of production may not be available. As such profit-maximizing objective cannot be attributed.6 A further complicating feature of such actions must be noted. A certain type and intensity of a decision of every individual is necessary in order for the firm to achieve the stated objectives. However, observe that irrespective of the organization under consideration it is never possible to specify the results expected from the existing group of individuals within an organization. What constitutes the optimal performance expected may itself be subject to managerial discretion. In general, it is not economical to monitor and control the activities of every divisional manager let alone all the workers individually. Some amount of flexibility is built into the description of the work process, the constraints on their activities, and the objectives that they are expected to fulfill. The organizational specifications, however detailed and clearly defined, leave some room for choice at the micro level. The managers at every level must depend on conformity of goals and the actual performance of workers at the next lower level. However, both approaches have drawbacks in obtaining the most efficient performance expected. This description makes the notion of managerial discretion subjective. Even so it would be useful to offer some contours of the phenomenon. Reducing it over time in

6

Suppose the management of a firm trades off profit to achieve a larger market share. Higher level management may yet utilize the realized profit to set goals so that there is no further erosion of profit. Consider the context of a principal negotiating a contract with an agent to complete a stipulated job. The agent may offer to do the job for an amount keeping the potential discretion he expects from the workers and input suppliers in perspective. The agent has to absorb the losses if he cannot contain the discretion to the anticipated level. In general, the management at every level can be expected to define the constraints and the objectives for a lower level manager keeping the possibility of managerial discretion in perspective. It is possible to claim that managerial discretion arises only when such limits are not adhered to. Even if such a phenomenon is anticipated managers can be expected to minimize losses incurred. Generally, economic analysis attributes managerial discretion to imperfection of markets. Leibenstein’s (1980) X-inefficiency notions alerted economists to think more broadly. The residual loss concept in Jensen and Meckling (1976) and organizational slack conceptualization in Williamson (1964) are similar.

2.2 Measuring Managerial Discretion

25

a specified manner may turn out to be the most practical objective.7 The details that will be listed below should be viewed from such a perspective.

2.2 Measuring Managerial Discretion Two different approaches to measuring managerial discretion have been observed: either in absolute quantitative terms and expressed in the form of a tradeoff between choices and consequences or among the consequences themselves. Consider the first approach. (a) Theories based on the market structure focus on the inelasticity of demand as the source of managerial discretion. They utilize price– cost margins as the measure of managerial discretion. Acknowledging the market as differentiated oligopoly necessitated accepting changes in market shares as an additional dimension of managerial discretion. Rao and Bhattacharyya (2021) documented empirical evidence about these aspects of managerial discretion. (b) In the context of vertical integration, it was necessary to conceptualize the minimum achievable cost and compare it with the actual costs of operation. Clearly, the difference between the two is a measure of managerial discretion. (c) When considering horizontal integration, the difference between the maximum value that can be achieved and the actual value reported becomes a measure of managerial discretion. However, the value may itself be measured variously as revenue, profits of the firm, market value of the assets of the firm and so on. (d) While appraising the performance of their organizational forms the difference between the actual and potential minimum (maximum) will still be the measure of managerial discretion though the measurement of minimum cost is dicey. (e) Similar problems arise in the context of the value of alternative financial choices of the firm. It is obvious that there are limitations of measurement if this approach is followed. The alternative is to recognize that while choosing the instruments and/or their consequences in the control of the management they will exhibit a tradeoff which is the source of managerial discretion. The actual specification has not yet stabilized. Instead, a variety of alternatives have been proposed and empirical evidences provided. Prominent among them are the following: (a) Sales maximization hypothesis (Baumol, 1959). This is presented in two different forms: (i) the maximization of sales revenue subject to a minimum profit constraint and (ii) the tradeoff between profit and sales. (b) Marris (1964) model. Profits have been replaced by the market value of the firm. Hence, the sales volume or sales revenue is one of the dimensions. The other is the tradeoff between profits and market value of the firm. Clearly, the market value of the firm depends on its capital stock, reputation of the products on the 7

It is almost impossible to say what global maximum a firm can achieve. What is observed in real life is that every one of them is trying to pursue proximate and localized objectives in the hope that they will constitute an invariant embedding to the global maximum.

26

2 Managerial Discretion

market, dependence on inventories, composition of financial resources, and so on. Empirical evidence does not as yet specify the relevant combination. (c) The tradeoff may be between the quantity of output of the products of the firm, the non-price and promotional strategies, and so on. This remains open ended as evident from the studies of management strategy such as stable market shares as in Porter (1980, 1981) or transient markets as in McGrath (2013) which depend on external market conditions, and the U-form vs. M-form that consider the organization within the firm. On the other hand, some studies focus on the internal aspects of the firm as the determinants. For example, Wernerfelt (1985, 1995) suggests that the resource base of the firm has a crucial role. On the other hand, Prahlad and Hamel (1990) concentrate on the core competence of the management. The currently available theoretical and empirical evidence is, as yet, insufficient to isolate relevant patterns applicable to clearly identifiable industries. (d) It is equally important to recognize that the decisions of every manager are subject to certain constraints placed on them by either the management at higher levels or the consumers and equity holders. The relationship between objectives and constraints remains nebulous. Consider the neoclassical standard where the market determined prices and exogenously defined technology determined the combination of inputs utilized to produce a given quantity of output. This does not completely determine the choice since many combinations of inputs give rise to the same level of production. Economic theory therefore imposes the concept of cost minimization as efficient. However, the marginal products of each input cannot be readily determined and hence the possibility of cost minimization can be questioned. The management of the firm has some discretion. Similarly, profit maximization as the overall objective can be called into question. This is valid even in imperfect product markets where each firm will be in search of as large a market as it can achieve. The possibility that firm prefers a larger market share and its dynamic stability in preference to maximization of profits at every unit of time has now been documented very well. If the inputs are acquired on a contractual basis the very notion of an efficient price acquires an altogether different connotation. Cost minimizing combination of input prices and their quantities is delegated to the background in preference to efficient contracts relative to the contracting parties, loyalty of suppliers, and the dynamic stability of contracts. A similar problem arises with respect to subsidiaries, franchises, and similar organizational arrangements. The alternative of an administrator (manager) setting the transfer prices in an internal capital market gained prominence in hierarchical organizations that supplant the external markets altogether. The design of the internal capital markets is generally expected to maintain the notion of cost efficiency. However, as will be described in Chap. 5, the efficiency of operation of an M-form has been questioned. Managerial discretion is a result of information asymmetry and the inability or unwillingness of individuals to cooperate. Detailing various aspects of managerial discretion in imperfect markets is extensive. However, there are several explanations

2.3 Choice of Materials

27

and sources of managerial discretion. There is every chance that none of the existing theories can explain the observed patterns of behavior. Perforce it becomes essential to look at more intuitively plausible explanations. Making the models operational and providing empirical evidence is scanty. In particular, the sources and measurement of transaction costs, that form the core of the reasons for managerial discretion, have not been amenable to anything resembling a satisfactory resolution. Some constraints are placed on the management, and they are expected to pursue certain objectives to ensure efficient performance of the firm. Such efforts proved to be inadequate to obtain the desired behavior and prevent opportunistic behavior. Despite such efforts, there was some leeway to the managers to behave opportunistically. Managerial discretion may take several manifestations. (1) All the activities of a firm must be taken up with a specific objective in mind. More pertinent is the argument that each individual should be allowed to pursue distinct objectives depending on their predisposition. This gives rise to constraints imposed by other functional groups on the pursuit of activity by every one of them. It should therefore be acknowledged that there may be conflicts of interest in goal pursuit, recognition, and adherence to continuity that others impose and so on. (2) The competence of individuals in articulating and responding to the needs of other groups is limited. Managerial discretion is a result of information asymmetry and the inability or unwillingness of individuals to cooperate. They may not find it possible to accommodate the desires of all others even if they perceive them adequately. This is inevitable even if each manager designs and implements policies to elicit the requisite information and design control mechanisms to rein in moral hazard. It is difficult to conceptualize a situation where all the conflicting interests can be accommodated in the interest of the organization. (3) Managerial discretion may take the form of a tradeoff between objectives; e.g., profit and market share, profits, and stability of the market value of the firm over time, etc. (4) Managerial discretion may be moving a firm toward exhibiting the intrinsic value of products to the consumer. To that extent, it may not result in any reduction in profits. However, it may result in diverting market share from others to the gain of the firm.

2.3 Choice of Materials Let the quantity of output that the firm wishes to produce be fixed apriori. The management has a choice of the quantities of the various inputs acquired on the market. Assume that the price of each of these materials is also fixed. Several possibilities of managerial discretion can be expected. (a) Economic theory generally postulates that the efficient choice of the combination of inputs should minimize the cost of production given the technology and the production function. However, several constraints appear in their procurement. (i) Acquisition, installation, and operational use of fixed assets (capital) require time. Also they are durable in nature. Hence, they cannot be easily

28

2 Managerial Discretion

replaced after the initial installation. The optimality of other inputs must be defined keeping this constraint in perspective. (ii) In imperfect markets, there will be many firms offering the same input. There may be another firm offering lower prices for the quantities the firm needs. However, it will be expensive to switch between suppliers. The firm may find the transaction costs of searching for a different supplier too high relative to this supplier. For instance, assume that pc of the current supplier ≤ pa + transaction cost, where pa = price charged by the alternative supplier. (iii) The firm may be satisfied with the original supplier after using the materials supplied. This may also be due to the promptness of delivery, the quality of materials, and so on. The firm develops loyalty to the original supplier. It is entirely possible that the costs to the firm, greater than the conceptual minimum, will be the measure of managerial discretion. (b) When brand loyalty emerges the firm may try to avoid the possibility of the supplier reneging, or not offering the desired quantity and quality, in practice. The management of the firm has the choice of a contract. This involves costs of negotiation and monitoring the danger of reneging. The management can be expected to use its discretion while weighing alternatives. The actual choice may involve a cost in excess of the minimum possible. But the management may choose it so long as the cost is less than what can be achieved through market transactions (the next best alternative). (c) In general, the management has the choice of the quantities of inputs as well. Hence, the choice of input combinations will depend on profit maximization. This may not correspond to the cost minimum conceptualized above. The problem of the inability of the divisional managers to calibrate the contribution of their divisions to the overall profit of the firm compounds problems. (d) Observe that the firm has the alternative of producing the necessary inputs. Such vertical integration saves search and transaction costs. Let the output produced be y. When it is low, the input requirements are low and it would be advantageous for the firm to acquire the inputs on the market. Similarly, when the output level is in excess of some y and the input requirements are high the firm would do well to revert to the market mode. Note that this occurs for two reasons: (i) given the economies of scale in the capital stock of the firm such increases in input production may result in a higher average cost of producing the level of output. (ii) Procuring larger volumes of inputs may save on transaction costs if the firm can obtain brand loyalty from the input supplier. In Fig. 2.1, let AC m be the average cost of producing y if the materials are purchased from the market. Similarly, let AC i be the average cost if the firm is vertically integrated. The firm producing the required materials will be beneficial between output levels market as i. At the level of output A, the average cost of producing y will be AC if the inputs are procured from the market. On the other hand, it will be AB if the firm is vertically integrated. Clearly, the difference BC motivates the management to internalize production of materials.

2.3 Choice of Materials Fig. 2.1 Vertical integration

29

AC ACi i

C

i

ACm

B* B O

A

y

However, note that the actual level of costs AB* will generally exceed the minimum AB conceptualized.8 Three reasons can be offered. (a) The determination of the price per unit of the input necessitates apportioning the fixed costs of the integrated firm between output y and the input i. The management may not have any objective way of apportioning it. (b) The shareholders cannot calibrate the transfer price that the management imputes. In general, they will be interested in the overall profit of the firm instead of bothering about the contribution of each of the products. (c) Bates and Parkinson (1982, pp. 304 ff) also suggested that neither the firm nor the rivals have an accurate method of calculating the profitability of the product market when the firm is vertically integrated. This may result in a barrier to entry, decrease the elasticity of demand, and increase profits of the firm. As Williamson (1964, p.11) pointed out, the management attempts to approximate B when BC is small and survival of the firm is narrowly bounded. However, a large value of BC will not compel the management to initiate decisions to reduce the average cost. (d) Rubin (1990) suggested another reason. When the firm is vertically integrated, the management attributes a cost to organizing production in addition to the technologically determined cost mentioned earlier. They may not be adequately compensated. They will not be motivated to reach AB. In fact, they will be satisfied if AB* < AC because they are doing better than what is possible by reverting to the market mode.

8

Observe that BB* is considered as the measure of managerial discretion. The psychological factors or some other source of motivation causing it will not be pertinent to the measurement at hand. Measures designed to reduce managerial discretion need not depend on the sources that gave rise to it in the first place.

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2 Managerial Discretion

2.4 Choice of Products9 Consider a firm producing only one product. The large size of the firm is due to economies of scale and scope. Managerial preference to orient such choices to augment market share are discernible only in cases where the products of different firms are substitutable and the limit on the total market for the product define the number of firms on the market. This gives rise to the possibility that each firm makes an attempt to convey the value of its product to the consumer (through an appropriate choice of non-price strategies) or capture as large a market share as possible. This, in itself, is a dimension of managerial discretion. Rao and Bhattacharyya (2021) provided empirical evidence to support the view that firms give preference to revealing the value of their products to the consumers.10 Managerial preferences to orient such choices to augment market share are discernible only in cases where the products of different firms are substitutable. There is no doubt that most modern corporations are multi-product firms. The longstanding debate is whether the consumer (who decides the range of substitutable products) or the firms (that tend to prefer products related in production) determine the range of production. Assume that either (a) the prices and quantities demanded are fixed by the consumers on the market, or (b) production constraints (defined by technology and organizational arrangements) place a limit on the product range. In such cases, cost considerations dominate the choice of products. The general contention is that economies of scale, inherent in the capital stock of the firm, define a limit on the production of the primary product. In addition, learningby-doing within the firm over time may identify products that can be produced within the firm utilizing the excess capacity. Hence, it can be argued that the basic motivation for diversification is the desire on the part of the management to utilize excess capacity. Baumol (1982) and Sharkey (1982) extended this argument to take the variable factors into account. The suggestion was that the existing capital stock and

9

Consider the choice of the output produced and sold on the market. Its relation to price is at best tenuous. Consider examples like movie theaters, large super markets, and for that matter any durable goods. It is generally documented empirically that the quantities are fixed (through accumulated experience), depend on the desire of managers to achieve a predetermined market share, the need to utilize fixed assets, as well as the minimum scale considerations stipulated by the embodied technology. Suppose the prices and quantities of output produced are fixed outside the market mechanism. Several other factors need attention: (a) the total retail stock offered on the market and hence the number of units of time over which the inventories are carried, (b) generally, freight is consolidated at a truck terminal or railway yard so as to reduce the extent of demand variability over space, (c) movie theaters must decide the number of days over which a movie should be continued. It would not be surprising if it depends on when the next movie is received even if the quality of the current movie screened is an important determinant. 10 Note that Knight (1957, p. xv) is of the following view. “Commodities and services are in a limited degree wanted for their intrinsic properties; in the main they are symbolic of ends the substance of which is a social relation or ideal value. But he goes on to say that “in the great bulk of wants satisfied through the market, a desire for ‘goods and services’ because of intrinsic quality is a minimal element”.

2.4 Choice of Products Fig. 2.2 Horizontal integration

31

AC ACd i

C

i

ACa

B* B O

A

y

embodied technology may offer significant economies of scope. Also see Chandler (1990). Consider the following. Let two products y1 and y2 be produced by two different firms under the same ownership. Then, for any given y1 the average cost of producing y2 will be AC a as in Fig. 2.2. However, the average cost changes to AC d if the firm diversifies into the production of y1 . When the output is low, the production cost advantages, if any, will be neutralized by the excessive costs of information that the management is expected to incur. A similar situation arises when y2 is large due to the economies of scope being exhausted. At the level of output represented by A, the firm experiences a minimum cost AB if it is diversified and AC in the contrary case. However, the management of the diversified firm may feel that its position remains secure so long as the actual cost AB* < AC. This is the essence of managerial discretion.11 An alternative argument emerged. Note that the capital assets of the firm are specific to the production of its primary product. Even if excess capacity emerges it cannot be traded on the market. Further, the possibility of an outsider imitating the technology of the primary product, while purchasing the excess capacity, was noted as a deterrent. In either case, the implied transaction costs may be sufficiently large so as to induce the management to prefer diversification. Further, as Teece (1980, p. 232) noted, internal trading changes the incentives of the parties and enables the firm to bring managerial devices to bear on the transaction. A further argument emerged when an oligopoly market for the outputs is acknowledged. The actions and reactions of rival firms will render the demand curves for the products to be random. As a consequence, the firm cannot be definite about how much capacity should be utilized in the production of the diversified product range. The diversification decision may stabilize the total revenue of the firm.12 In fact, as 11

Leibestein (1980) describes this phenomenon as arising out of X-inefficiency. The differences in the argument relate to the sources of managerial discretion and not necessarily the quantity of it. 12 Note that when confronted with demand uncertainty, the management of the firm may adopt several short run policies in addition to the long run strategy of diversification. Prominent among

32 Fig. 2.3 Product diversification

2 Managerial Discretion

π B B* C O

πd A

πa y2

Penrose (1959) noted much earlier, horizontal integration can occur in the short run even if there is excess utilization of the existing capacity and average costs are rising. Fundamentally, the product line choice of the firm may be justified on the grounds that diversification, by spreading the risks over a variety of products, will provide long run market stability. Observe that in Fig. 2.3 π a represents profits generated by y2 given y1 and π d the expected profit if the firm is diversified. An optimal choice of ya is A. However, the management may be satisfied even if they can generate AB* of profits per unit of y2 simply because it is better than returning to independent production. BB* will then be a representation of managerial discretion. In sum, it appears that the notion of cost reduction per se cannot explain horizontal integration. The management may prefer to introduce a new product line and operate at a point where the average costs increase sharply. Thus, the management may tradeoff short run advantages to explore new opportunities and hope that greater long run returns can be generated. There are several sources of managerial discretion and the quantitative inputs are equally varied.

2.5 Organizational Arrangements The emergence of multi-product firms signals the necessity for detailed organizational arrangements for several reasons. (a) There is an increase in the information overload on the general manager often compounded by the uncertainty that the firm experiences. (b) Autonomy of the management of product divisions necessitates attempts to achieve cognizance of objectives, allocation of fixed assets to divisions, and (c) acquiring and controlling the organizational capabilities required, and ensuring that the activities are in line with the requirements of the firm in general. them may be rice fixation, inventory policy, and advertising. These issues and the managerial discretion that they entail will be considered in the subsequent chapters.

2.5 Organizational Arrangements

33

The M-form organization is the most popular. The managers of each product division can be expected to provide the general manager the information about the markets for their products and the cost of operating the division. Based on the information about the profit-generating potential of different products, the general manager can define the transfer prices of the fixed resources so that most of the strategic decisions can be delegated to the divisional managers.13 In other words, an internal capital market may enable the general manager to allocate resources efficiently by using a mechanism that replicates the properties of a market. However, several disadvantages in implementation have been recorded. First, each of the divisional managers has goals (e.g., ease of satisfying workers so that their workload is reduced) which can be at variance with the overall objective of profit maximization. Achieving cooperation and subgroup compliance will be possible only when the aspirations of the divisional managers and their workers can be accommodated. Second, there is a possibility of moral hazard in the pursuit of divisional goals. In particular, delegation of decision-making can lead to shirking. This is compounded by the inability of the general manager to measure performance of the different divisions in isolation. This applies to difficulties in monitoring costs as well as the revenue generated by each of the divisions separately.14 Third, there is a general difficulty with team production. The divisional manager can be made accountable to the profit of the division alone and not to the contribution of each individual in achieving it. Every member of the team has an incentive to shirk in the knowledge that other members of the team will make up for their negligence since the overall profit generated by the division alone can be monitored. Managerial discretion arises due to the ability to recognize that the management will not be displaced so long as the profit achieved is greater than the sum of profit each member of the division can contribute if they act independently of each other. In general, divisional managers may be influenced by their ability to generate and consolidate their positions even if it involves compromising on profit generated. In the initial stages, the markets for new products do not provide adequate information to conceptualize and structure an efficient organization. Thus, organizational improvements alone cannot sustain the profitability of the multi-product firm. This section can be summed up as follows. From the above description it is obvious that managerial discretion may arise due to the behavior of the workers in the production and distribution process, the managers themselves, the consumers of the products of the firm whose valuation ultimately determines the quantities and prices of the products offered. Irrespective of the organizational form chosen, the goals of each division will have to be defined taking into account the aspirations and motivations of the constituents of the subdivisions. When they recognize this, there 13

Chandler (1962, p. 87) pointed out that information gathering is costly and weighing the benefits leads to managerial discretion. This discretion may also be due to the fact that the profit attributable to each of the product divisions cannot be measured independently. 14 Monitoring the non-price decisions, costs of production, the level of sales and several other features will be burdensome to the general manager. Merely allocating fixed assets on the basis of reported profit potential may be inadequate and lead to managerial discretion at lower levels.

34

2 Managerial Discretion

is a possibility that they understate their potential. This is a fundamental difficulty in controlling managerial discretion.

2.6 Financial Mix The financial requirements of a firm relate to the short run as well as the long run. There will be some choices for the management regarding the nature of short run assets: raw materials inventory, inventory of goods-in-process, and final goods inventory while dealing with the physical quantities. They also have choices of dividend declaration, sundry creditors, and so on in the context of long-term financing. These issues will be considered in a later chapter. Referring to the long run, the firm should perforce find instruments of finance corresponding to the capital investments that are necessary for its growth. Debt and equity receive prominence as instruments of finance. However, the declaration of dividends versus retained earnings has also received attention. This issue will be considered in another chapter. Two aspects of debt and equity require attention: the cost aspect and the control of the activities of the organization through the market mode (debt) or by contracts with individuals outside the firm (equity). Debt would make the cost of financing higher but does not provide any control rights to the debt holders. On the other hand, payments to equity holders are at the discretion of the management. However, as owners of the assets of the firm equity holders will have control rights (including how much dividends they receive). There is some combination that minimizes the total cost. However, the management may choose more debt in the interest of maintaining control. Details of this phenomenon have been elucidated in Jensen and Meckling (1976) and Williamson (1988). Over time, the range of instruments, both in the forms of debt and equity, have been increasing. Managerial discretion with respect to balancing cost versus control has become very intricate and needs deeper study.

2.7 Summing Up For all practical purposes, hybrid forms of corporate organization received emphasis while explaining the effects of the firm’s production, cost, control, and the resulting tradeoffs. To treat production, organizational choices, and finance on different economic reasoning is not tenable any longer. From the description in the preceding section, it is obvious that managerial discretion may arise due to the behavior of the workers in the production and distribution process, the objectives of the managers of the firm, the consumers of the products of the firm whose valuation ultimately determines the prices and quantities of the products offered, and on occasions, the government controllers who act on behalf of the consumers and the shareholders who are the ultimate owners.

2.8 Lessons for Machine Learning

35

The decision-making process, that is related to decisions affecting consumers, the individuals within the firm as well as those that have an influence on rival firms, can result in managerial discretion though it may take several manifestations in different firms. Managerial discretion is a result of information asymmetry and the inability or lack of willingness of individuals to cooperate. Further, note that the sources and measurement of transaction costs, that form the core of the reasons for managerial discretion, have not been amenable to anything resembling a satisfactory solution. Detailing various aspects of managerial discretion in imperfect markets is extensive. There may be several patterns of managerial discretion, and any of them may be applicable to one or a few firms. Managerial discretion may also take the form of a tradeoff between objectives; e.g., profit and market share, profit and stability of the market value of the firm over time, and so on. However, no significant efforts have been made to examine the tradeoff between them or to examine whether one hypothesis is superior to others. Resolving the dichotomy between constraints and objectives has been risky. Some constraints are placed on the management, and they are expected to pursue certain objectives to ensure efficient performance of the firm. Such efforts proved to be inadequate to obtain the desired behavior and prevent opportunism. In particular, each individual should be allowed to pursue distinct objectives depending on their predilections. This gives rise to constraints imposed on the unit by other functional groups in pursuit of the activity by every one of them. It should therefore be acknowledged that there may be conflicts in goal pursuit, recognition, and adherence to continuity that others impose and so on. Similarly, the competence of individuals in articulating and responding to the needs of the other groups is limited. Indeed, they may not find it possible to accommodate the desires of all others even if they can perceive them adequately. In general, managerial discretion can be eliminated only if individual goals and willingness to adhere to organizational goals are the same. This is rarely the case.15

2.8 Lessons for Machine Learning It is obvious from the above presentation that autonomy of managers in the decentralized decision-making of the firm can result in various forms of managerial discretion. The following examples are merely illustrative. (a) The divisional manager may choose the profit maximizing level of output in compliance with the constraint defined by the general manager. However, the division may not generate the expected profit. (b) The choice of output level may be higher signaling a deviation from the objectives of the firm. This will also result in a lower level of profit. (c) The division may have achieved a lower level of profit partly because it increased costs when 15

In general, managers may develop reputations that are valuable (to them) in the market place. See, for instance, Parker et al. (2019). Such managers will indulge in shirking and threaten to leave if disciplined.

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the management finds the compliance to worker goals, or taking the expected future market conditions, as important for the stability of the division. (d) The diversification decision may not correspond to efficient utilization of capital assets suggested by the technologically defined economies of scale and scope. (e) The organizational arrangements may not have cost minimization or efficient allocation of capital to divisions as an objective. In short, the observed data contains all the infirmities of managerial discretion. The current practice, while developing machine learning algorithms, is to utilize this data without any attention to the behavioral deviations that they embody. The argument of the present study is that the data should be modified, taking the inadequacies mentioned above into account, before utilizing it to develop machine learning guidelines to the management in their decision-making process. The following example is merely meant to illustrate the nature of the modification necessary. Assume, to begin with, that the demand curve and the cost curve for the product of the firm are not affected by managerial discretion. The profit for the firm may be represented by π = a0 + a1 S − a2 S 2 where π = profit and S = volume of sales The profit maximizing level of production and the resulting profit will be Sm = a1 /2a2 , and πm = a0 + a12 / 4a2 Now, suppose the actual level of profit attained is π a < π m . This can happen if the higher level manager sets a target on the level of production alone. The difference may be simply the gain (may be psychological) to the manager as long as the division meets the production target. The difference π m – π a is a measure of the managerial discretion. But more importantly, there is a signal to the general manager to set an appropriate profit constraint such as π a ≥ π m as well. The crux of the argument is that defining the constraints should ensure that managerial discretion is minimized to the extent possible. This should apply to all the decisions at the divisional levels. The next chapter will describe some of the appropriate conceptualizations and estimation procedures.

References Barnard, C. (1966). Functions of the executive. Harvard University Press. Bates, I., & Parkinson, J. (1982). Business economics. Basil Blackwell. Baumol, W. (1982). Contestable markets: An uprising in the theory of industrial structure. The American Economic Review, 72, 1–15. Baumol, W. (1959). Business behavior: Value and growth. McMillan. Chandler, A. (1962). Organizational capablities and the economic history of the industrial enterprise. Journal of Economic Perspectives, 6, 79–100.

References

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Chandler, A. (1990). Scale and scope: The dynamics of industrial capitalism: Advances in economic and econometric theory and applications. Cambridge University Press. Jensen, M., & Meckling, W. (1976). Theory of the firm: managerial behavior agency costs, and ownership structure. Journal of Financial Economics, 3, 305–360. Knight, F. (1933). The economic organization. Harper Torch Books. Knight, F. (1957). Risk, uncertainty and profit. Harper Torch Books. Leibenstein, H. (1980). Beyond economic man. Harvard University Press. Levis, K. (2009). Winners and losers. Atlantic Books. Marris, R. (1964). The theory of managerial capitalism. Free Press. McGrath, R. (2013). The end of competitive advantage: How to keep your strategy as fast as your business. Harvard University Press. Parker, O., Krause, R. & Devers, C. (2019). How firm reputation shapes managerial discretion. Academy of Management Review, 44, 254–278. Penrose, E. (1959). The theory of the growth of the firm. Wiley. Porter, M. (1980). Competitive strategy. Free Press. Porter, M. (1981). The contributions of industrial organization to strategic management. Academy of Management Review, 6, 609–620. Prahlad, C., & Hammel, G. (1990). The core competence of the corporation. Harvard Business Review, 68, 79–91. Rao, T. V. S. R., & Bhattacharyya, S. (2021). Transient market power of firms. Cambridge Scholars Publishing. Rao, T. V. S. R., & Rastogi, R. (1997a). Discretionary managerial behavior. Kluwer Academic Publishers. Rao, T. V. S. R., & Rastogi, R. (1997b). Identification of managerial preferences. Indian Journal of Applied Economics, 6, 113–124. Rubin, P. (1990). Managing business transactions. Free Press. Sharky, W. (1982). The theory of natural monopoly. Cambridge University Press. Teece, D. (1980). Economies of scope and the scope of the enterprise. Journal of Economic Behavior and Organization, 1, 223–247. Wernerfelt, B. (1985). A resource-based view of the firm. Strategic Management Journal, 5, 171– 180. Wernerfelt, B. (1995). The resource-based view of the firm: ten years later. Strategic Management Journal, 16, 171–174. Williamson, O. (1964). The economics of discretionary behavior: Managerial objectives in the theory of the firm. Prentice-Hall. Williamson, O. (1981). The modern corporation: Origins, evolution and attributes. Journal of Economic lietrature,19, 1537–1568. Williamson, O. (1988). Corporate finance and corporate control. The Journal of Finance, 43, 567– 591. Williamson, O. (2000). The new institutional economics: taking stock looking ahead. Journal of Economic Literature, 38, 595–613.

Chapter 3

Specification and Estimation

Managerial discretion reveals itself only after the consequences of every decision can be estimated. This will consist of the range of relevant decisions, how and the extent to which decisions interact with others, the threshold values of the decisions that offer the maximum effect, the tradeoff between objectives and decisions, and several other features. Some of these effects pose formidable estimation problems due to lack of data, the inability to account for the constraints on the parameters posed by the decision-making process, and others. Some of these inverse optimal problems can be approached successfully. Some decisions have long-term effects on the firm, and in others cumulative use of decisions (not necessarily in a distributed lag sense) offers an explanation for the market value of the firm. Identifying such influences does pose difficult estimation problems. In addition, estimating the separate average cost curves resulting from one decision rather than another is as yet intractable however elegantly the theoretical model visualizes it. Modern work demands knowledge transfer: the ability to apply knowledge to new situations and different domains. Our most fundamental thought processes have changed to accommodate increasing complexity and the need to derive new patterns rather than rely on familiar ones. Our conceptual classification schemes provide scaffolding for connecting knowledge, making it accessible and flexible.—Epstein (2019, p. 48)

3.1 The Purpose In large corporations, the general manager experiences information overload while making decisions and inability to control lower level managers if decision-making is centralized. It was generally considered prudent to allow independence to divisional managers and decentralize the decision-making process. The general manager and perhaps even divisional managers experience information asymmetry since most of the consequences of their decisions are interrelated. Consequently, there is a need to identify the behavioral attributes of the divisional managers and the constraints © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_3

39

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that should be placed on them to ensure that the overall objectives of the firm are achieved. In recent times there has been a proliferation of big data regarding the corporations, significant storage capacity of the internet on the cloud, and the emergence of a plethora of developments in the software that can be used, presumably more efficiently, to lighten the burden of the management and providing them more resources and time to concentrate on important strategic decisions. This is the fundamental premise of the machine learning algorithms. Some aspects of this development need recognition. First, it is necessary to identify critical decisions of every division and the interactions between divisions. They may be specified as objectives or constraints. Second, even if some decisions are dependent on stable information about the market environment and the internal structure of the divisions, it would be necessary to acknowledge the existence of managerial discretion which is embedded in the information about the past decisions of the firm. Generally, the randomness or uncertainty in the environment makes this more significant. The computer scientists and statisticians consider the big data available as sufficient to develop machine learning algorithms and provide guidance to the management. Their objective is to ensure that their algorithms can reproduce observed decisions notwithstanding their impurities. They pay scant attention to the behavioral aspects of the decision-making process and the infirmities in the data. This is hardly satisfactory if the aim is to ensure efficient decision making. Two course corrections are indicated. First, identify and estimate managerial discretion in all the major decisions and purge the data of the impurities. Second, structure the decision-making process as a set of interrelated optimization problems that appropriately account for the behavioral, organizational, and other constraints. This can be designed to minimize managerial discretion by providing appropriate resources, constraints, and incentives to the divisional managers so as to attain the overall objectives of the firm. Machine learning algorithms based on the latter approach appear to be more promising. However, a single generic specification is unlikely to be satisfactory. Many detailed empirical experiences would be necessary to improve managerial decisions iteratively.

3.2 The Issues Studies of industrial organization and management are perforce empirical. Any theory regarding the behavior of the management of a firm must be supported by empirical facts. Sometimes it is even suggested that the patterns exhibited by empirical data should form the basis of theoretical explanations and suggestions for the management regarding the desirable and/or efficient changes in their strategies and functioning. However, there have been deficiencies in the specification, the methods of estimation, and the resulting process of inference. Each of these aspects will be taken up sequentially.

3.3 The Variables

41

The basic purpose of this chapter is to examine the patterns of change in the decisions of the management and the resulting consequences over time. This approach attempts to explain how the choices are made and changes over time brought about. Usually, the machine learning algorithms use stable patterns of behavior to provide guidance to strategic management. Variations around stable trends can be incorporated to the extent possible. The general understanding is that a very large proportion of strategic decisions are oriented to such stable patterns and that even infrequent changes exhibit patterns that can be replicated. The specification and estimation of managerial discretion centers around three aspects: (a) how much effect does a unit of a decision have on the overall objective of the firm? (b) how many units of a decision would constitute the optimum? and (c) how long will the effects of a decision persist over time? It has also been recognized that consumers, through the effect of their decisions on the market and the interaction of rival firms on the market, ultimately constrain and define the extent of managerial discretion. Consequently, a reduction in managerial discretion can be brought about only by controlling and altering the activities of these agents.

3.3 The Variables The first fundamental problem is in the specification of how a variable of interest should be measured. Consider the following. (a) It is generally believed that the management is oriented to design the activities of their unit so as to contribute to profits of the enterprise. However, the management of decentralized decision units rarely knows how the activities of their unit contribute to profits of the enterprise. Instead, they will be guided by the production constraints placed on them (since they will be rewarded for fulfilling them) and the stability and fulfillment of the desires of the workers of their unit. (b) Consumers are expected to accept the prices set by the firm and signal their choices for as low a price as possible for the quantities they desire. (c) The theories generally postulate that the shareholders of a firm are quite conscious of the control they exercise while evaluating the dividend and investment choices of the firm. However, the majority of shareholders only pay attention to the dividends they receive as compared to the interest they can earn via the debt route. That is, short-term and visible measures are preferred over conceptually elegant aggregates.1 However, such microlevel measures are difficult to obtain in practice. For example, it would be difficult to obtain information about organizational structures and control of corporations. A similar problem arises in giving operational expression to the bonding effects. See Rao and Raja (1999, p. 389, note 7). Studies of Rao and Saha (1994a, 1994b) illustrated this by constructing proxies based on annual statements of the chairmen of companies. Similar conceptual difficulties associated with focus and 1

It would be fair to say that ex post outcomes of a decision can be measured while the ex ante motives for making a specific decision are difficult to decode.

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flexibility in choosing product and financial portfolios of firms have been resolved in Rao and Raja (1999) utilizing the conventionally defined diversification indices. The extensive empirical work of Rao and Bhattacharyya (2021) also documented the difficulties in obtaining measurable notions of non-price choices of firms. The predicament can be stated succinctly. Suppose the management of the firm seeks to receive detailed information about the work performance of every worker. They will have an excessive information overload to a point where they cannot monitor and control enterprise level achievements. The converse is also true. To arrive at the optimum level of managerial discretion may well be idiosyncratic. In general, paucity of relevant data has been a basic hurdle in proceeding with any analysis. Perforce empirical work on managerial discretion is confined to some level of aggregation and obtaining microlevel inferences is as yet a distant objective. Much of the empirical analysis begins by specifying the cause effect relationship y = f (x), where x includes a number of strategic, organizational, and environmental variables. If the data relates to either a time series or to a cross section of firms, it is generally postulated that each of the variables x has the same quantitative influence on y. That is, the estimated coefficients associated with each of the x variables is a constant for all the firms. This is rarely the case especially in a cross section. Similarly, it cannot be taken for granted that every one of the causative factors account for the observed variation in y. In the context of a time series specification, it is equally important to identify the reasons for the changes in the x variables and whether all of them have a bearing on the resulting y at every point of time. The hypotheses, such as stating that the market functioning is efficient, leaves much room for choice. In general, the same set of variables will simultaneously influence more than one outcome. This also creates a problem in identifying the interdependence between the y variables themselves. Some of these issues have already been addressed in the existing studies. Hence, only an approach that has not been presented so far will be outlined. In sum, it is necessary to address the following questions: (a) how can the estimated coefficients of a variable be explained? (b) can the differences in the coefficients of several variables be explained? (c) is it possible that the coefficients vary over time? in such a case is it necessary to explain the sources of these variations? (d) is it possible that different variables explain observed variations in outcomes at different points of time. If yes, how can the analysis identify the sources? The difficulties are both in the theoretical specification and the availability of data. On occasions, it was noted that the influence of a managerial decision and its effect on the performance of the firm may change over time. That is, the value of b in the specification y = a + bx may vary. Such structural breaks have been examined independently. However, it must be acknowledged that the structural break may be a result of some changes in the managerial choices. When two or more variables explain an observed outcome, the usual assumption is that they have independent and additive effects. Instead, it can be claimed that the desired results can be achieved only by suitably defining the interaction between them. See, for example, Williamson (1971, p. 179). In particular, Varadarajan and Ramanujam (1990, p. 475) suggested that “pursuing a philosophy of decentralization may be a necessary response to

3.3 The Variables

43

the relatively high level of product line breadth and geographic diversification in many of the firms. The concomitant use of tight financial controls and reporting systems appear to indicate a conscious effort by these firms to manage the structural complexity entailed by a strategy of product and market diversification.” Rao and Saha (1994a, 1994b, p. 295) proposed a specification Profit = a + (α + β I C) SO where IC = a measure of organizational control, and SC measures an organizational structure variable as an alternative. The understanding is that the effect of structural variables will be contingent upon the controls built in. Rao and Rastogi (1997a, 1997b, p. 50 ff) proposed more detailed alternatives. Let C represents a managerial decision which is necessitated by the change in an exogenous variable X. Let G be the market value expected by the use of C. Then, X will have no effect if C adjusts completely to the variations in X. However, this adjustment will be generally partial due to various constraints. The contribution of a unit change in C can be written as a1∗ = a1 + a2 X Hence, G can be specified as G = a0 + a1∗ C = a0 + a1 C + a2 C X Rao and Rastogi (1997a, p. 52) indicated a similar specification in the context of the objective function pursued by the management. Let the management place a cost on utilizing C while achieving G. Then, the preference function will be U = G + λ∗ C However, λ* is conditioned by (a) the incentives provided for the mangers to willingly cooperate with the higher level management and (b) the controls placed on them by the higher level management. In general, it is expected that λ∗ = λ0 + λ1 Y where Y is an incentive or control. Then, U = G + λ0 C+ λ1 CY is an appropriate specification. Consider Fig. 3.1 AB represents the maximum achievable G. If the managerial preference function is U then the management will choose C*. That is, BB* represents the result of managerial discretion. The management is willing to forego BB* of G in order to obtain an increase B*C* in C.

44 Fig. 3.1 Tradeoff profit for sales

3 Specification and Estimation

G

B B*

C* U G

O

A

y2

On occasions, a systems model is specified indicating deeper interactions. However, the actual choice of the analyst depends on the information about the causative relations and the available data.2

3.4 Price Determination The idea that the demand curve p = f (y) is known apriori or that it can be estimated is only notional in practice. Both the price and quantities are set on an entirely different reasoning. Consider price setting. In general, a firm will not set a price p < AC + notional markup, where AC = average cost. Similarly, in a market that is oligopolistic, firms will strive to be at or close to the capacity level of output.3 They can do so and utilize inventory and non-price strategies, as opposed to price policies, to sustain their market share. Minor variations in prices are mostly due to unexpected changes in non-price strategies. Similarly, significant reductions in demand and quantity sold should be explained primarily by the emergence of new technologies and the quality of products. The decline, of film processing by Kodak and the near annihilation of digital camera once the smart phones took over, is sufficient to illustrate this phenomenon. Note the following. (a) The textbook assumption is that the price and output choice will be in the increasing portion of the MC curve. (b) The resulting π < 0 if p < AC . In general, in the presence of the network effect, the firm will, most likely, operate in the decreasing portion of the AC. It can obtain π = 0 only by expanding subscriptions to the threshold limit. (c) Suppose the price p is set apriori on the expectation that the firm can expand to a level in excess of K. This will not materialize in practice since the congestion effects will deter consumers to purchase beyond K. The saturation price pk will correspond to the minimum average cost. The firm will set this price apriori. 2 3

Note that the quantum BB* of managerial discretion may arise even if A is chosen. Becker (1991) and Shy (1995, pp. 438–9) contains such a specification.

3.5 General Forms of Tradeoff

45

This tendency reduces the market power of firms because the price cost margins will be lower. This effect has nothing to do with competition among rival firms. If they adopt a markup over MC (low elasticity may be the basis for this), market power remains.4 Σ A caveat is in order. Let Y = yi and note that π (Y ) = pk Y − C(Y ) so that dπ/dY = pk − MC But for Y < Y k we have MC < pk . That is, π is monotonic increasing in pk . Incidentally, if (pk – MC)/pk is the market power of the firm it will be positive for low values of Y and it will tend to zero as Y approaches Y k . The firm’s desire to take advantage of the network effect reduces the market power to zero. In practice, this may not occur. The firm may wish to maintain a minimum rate of profit, and hence a price cost margin, say r. Then, pk = (1 + r) minimum AC. Clearly, the choice of r will depend on the inelasticity of demand. The above argument can be extended to the other cases considered earlier with suitable modifications.

3.5 General Forms of Tradeoff Another specification of managerial discretion is plausible. Let S be the volume of sales and π be the profit generated through the sale on the market. Given the demand curve p = f (S); f 1 < 0, where f 1 is the derivative of f with respect to S, it can be inferred that π = π (S) has an inverted U-shape as in Fig. 3.2. The firm will choose S* if it maximizes profit. However, in oligopolistic markets the firm may prefer a larger, but probably more stable, S. That is, the management can be expected to have a preference function U(π , S); U 1 , U 2 > 0. The actual choice of the firm may be S u > S* as in Fig. 3.2. Similar preference functions with respect to several other non-price strategies can be visualized in the efforts of the firm to attain a high and stable market share. While describing managerial behavior, it is possible to visualize many other forms of tradeoff. For example, it may be between the market value of the firm and control of the firm that management chooses to hold and so on. As Young (1928, p. 536) suggested, “the search for markets is not a matter of disposing of a surplus product,

4

In general, the total cost of a firm may be calculated by including production cost, cost of selling the output, and a fair return on capital. That is, the r postulated below may be a part of the marginal cost.

46 Fig. 3.2 General tradeoff

3 Specification and Estimation

π U π

O

S*

Su

y2

… but of multiplying profits by multiplying sales; it is partly a matter of augmenting profits by reducing costs.” In an oligopoly market, the actions and reactions of rival firms tend to be unpredictable and uncertain. The firm may also experience various other sources of uncertainty regarding the profits that it can achieve. A risk-averse manger may strive to reduce the variability of profit even if it results in a reduction in the expected profit. Assume, for illustrative purposes, that the demand curve is p = f (S) + u, where u is a random variable with mean E(u) = 0 and Variance V (U) = σ 2 . As noted earlier, E(π ) increases with an increase in S initially but can be expected to decrease after the maximum is attained at S*. However, it would be expected that V (π ) increases monotonically with S. The locus of (E, V ) combinations can be represented as LL in Fig. 3.3. Given the assumption that the management of the firm is risk averse their preference function can be written as U = U(E, V ); U 1 > 0, U 2 < 0. Maximization of U results in the choice (π a , V a ). Managerial discretion then implies that the management will target a lower E(π ) to achieve a lower V (π ). It is recognized that uncertainties may arise due to various sources. Turnovsky (1970, p. 1064) and Vickers (1987, pp. 162–3) distinguish between business risk and financial risk. The uncertainty in the demand for the product of the firm is the source of the business risk. Similarly, financial risk can be represented by the interest payments and repayment capabilities of utilizing debt, or the dividend obligations that the shareholders impose on the management.

3.6 Contracts As noted in Chap. 1, there are several occasions where the market functioning is inefficient. The firm may find contracting as a more efficient mechanism. For instance,

3.6 Contracts Fig. 3.3 Tradeoff profit for variance of profit

47

V(π) L

Va A O

πa

S*

E(π)

this is noted in the context of warranties for its products, the relationship with various workers and managers, and so on. Contracts are a major mechanism for conducting transactions. They occur more often than market relations even in what is generally considered as a predominantly market-oriented economy. The basic justification for the choice of contracts to conduct transactions was set out in Coase (1937). Fundamentally, contracts can facilitate greater specialization and division of labor. Consequently, costs of contracting are lower relative to those incurred in conducting transactions on the market. Specificity of the agent in repeated exchange over time also facilitates reduction in transaction costs. This is the crux of the transaction cost argument. On the downside, every contract necessarily generates an agency relationship. Information asymmetry is at the apex of this relationship. Some adverse selection and moral hazard are bound to occur. Agency costs capture the effect of this problem quite naturally.5 The primary concern of contract theory6 is in devising mechanisms to minimize this contractual hazard while preserving the advantages alluded to by Coase (1972). The principal agent models essentially contain a formal characterization of this aspect. However, both the principals and the agents can have very different objectives depending on the contracting context. This is also true with respect to the instruments available to them. Consequently, a rather rich theoretical literature has been built under the rubric of principal agent models. 5

Jensen and Meckling (1976), Barney and Ouchi (1986, pp. 208–210) represent the most influential specifications of agency costs. On the other hand, Williamson (1988) contains a succinct exposition of the distinctions between transaction costs and agency costs. 6 Note that vertical integration and circumventing the market lead to contracts within the firm. The labor market literature predominantly deals with this. Contracts with agents outside the firm, e.g., subcontractors, franchisees etc., is equally dominant. The first set of studies is closer to the transaction cost argument of Coase while the latter are more concerned about agency costs. They also differ with respect to the duration of contracts. The present study concentrates mostly on the second type of contracts. The reader may refer to Masten and Saussier (2002) for a review of econometric studies dealing with the choice of market versus contracts.

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Seminal theoretical developments are at least thirty years old and can be traced to Mirrlees (1974) and Holmstrom (1979).7 However, empirical and econometric work lagged far behind mainly due to the unavailability of data. Nevertheless, the specification and resolution of econometric problems has been a continuing process. Generally, as Datta and Radner (1994, p. 483) observed, “a notable feature of many real life principal agent contracts is that they specify simple compensation rules, i.e., they identify only a small set of contingencies on which a reward is conditioned.” Basically, such a choice is a result of three types of costs of implementing contracts: costs of communicating with the agents, costs of obtaining information about output, profit, etc., and the costs of computation (and the convenience of the principals) while implementing complex payment schemes stipulated in the contract. See, for instance, Ferrall and Shearer (1999). The most common contract in many practical contexts is a fixed upfront payment plus a share of output. In practice, the choice of contract parameters and their quantitative determination has been conditioned by two other features. First, starting with the work of Yun (1999, p. 105), and Okamuro (2001, p. 377), it was noted that the principals may actually incur some costs in their efforts to choose the most efficient agent and/or monitor them appropriately. This endogeneity problem has also been highlighted in Ackerberg and Botticini (2002) and Chiappori and Salanie (2003). Second, Masten and Saussier (2002, p. 283) suggested that “the more uncertain the environment and the harder it is to accommodate changing circumstances within the contract, the more likely it will be that parties will sacrifice the precision and ease of implementation of definite contract terms for more cumbersome but flexible ‘relational’ contract terms that define performance obligations less precisely or establish procedures for negotiating adjustments in the terms of trade within the contract.” Both these features create formidable econometric problems. Consider the context of a firm, e.g., an automobile assembly plant, which subcontracts the production of various parts. Here, conventionally, the subcontractor is the agent and the automobile assembler is the principal. Assume that the contract is for an output y. For simplicity, it will be assumed that y is revenue as well. The agent spends an amount y2 /2δ while planning production. In this formulation δ is the efficiency of the agent. The actual output achieved, say ya , depends on the agent’s actions and/or external production conditions that the agent cannot control. Hence, it can be postulated that ya = y + u where u is a random variable8 with expected value E(u) = 0 and variance V (u) = σ2 . 7

Though somewhat dated, the early exposition by Rees (1985a, 1985b) contains very useful insights about the principal agent models. 8 Strictly speaking there will be two types of randomness. First, there will be fluctuations in external market conditions. Neither the principal nor the agent can do much to neutralize this effect. Second, there can be moral hazard on the part of the agent. This may be quite unpredictable ex ante. A part of this randomness can be controlled if the principal exercises necessary control. In much of what follows u contains the effect of randomness of both types. Unfortunately, neither the economic

3.6 Contracts

49

The basic form of the contract is a payment p(y + u) to the agent. That is, he is made to share the risk. A larger p provides him greater motivation to do better. The profit of the agent is then written as πa = p(y + u) − y 2 /2δ Normally, the agent is expected to be risk averse. That is, his valuation of π a will be va = py − y 2 /2δ − λ p 2 σ 2 where λ is a measure of his degree of risk aversion. The agent’s first priority is not about what fraction of output he should be paid. Instead, if he increases y he must incur a larger cost. But, he is not sure about the ya that can be recovered. Consequently, the agent would be more worried about how much y he can realize.9 Such a choice of y is clearly10 y = pδ Consider the return to the principal next. It is given by π p = (1 − p) (y + u)

theory underlying the principal agent models nor the econometric methods have been able to deal with these two types of randomness separately. 9 For the sake of analytical curiosity consider the case where the agent chooses both y and p. This results in. y = pδ, and p = y/2λσ 2 These two equations can be satisfied simultaneously if and only if. δ = 2λσ 2 It may not be realistic to expect this apriori in any practical contracting situation. It is also unrealistic to believe that the principal does not keep any controls under his discretion. For, this is the only way he can safeguard his interest. 10 In this formulation u may be purely exogenous. In such a case, an agent that is made to share risk feels that he is being punished for something he did not do. There is then a possibility that he will reduce y if σ2 increases. This was noted in Borenstein et al. (2007). Alternatively, Baker (2006) suggested the following. The agent may use more resources and incur greater costs, given his risk aversion, in order to be sure that he may deliver the promised output. This can also give rise to the possibility that y depends on λ and/or σ 2 . However, note that in this formulation it is independent of σ 2 ex ante given p. Ex post p will depend on σ 2 and hence the observed y is not independent of σ 2 . By way of contrast, based on some experimental evidence, Sloof and vanPragg (2008) noted that y does not depend on σ 2 even ex post. It is difficult to replicate this result in principal agent models of this vintage.

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In the simplest version of the model it is assumed that the principal need not incur any costs. Further, the firm will be dealing with many such contracts. Hence, it can balance the losses in any one transaction against gains from another. It can be surmised that the firm will be risk neutral. Hence, the value to the principal is v p = (1 − p)y Note that, for all practical purposes, y2 /2δ + λp2 σ 2 is the cost, to the principal, of entrusting production to the agent. The principal reckons that the costs would be higher if he produces y on his own. It is this transaction cost argument that prompts him to assign the production to the agent in the first place. Hence, from the perspective of the firm, the net value of the contract is N = va + v p Surely, the firm must take the incentive constraint of the agent into account. Hence, it follows that N = pδ − p 2 δ/2 −λp 2 σ 2 Note that the output and revenue generated are beyond the control of the firm since it does not wish to interfere directly in the production activities of the agent. Consequently, the only choice available to it is p. Maximizing N with respect to p it follows that11 ) ( p = δ/ δ + 2λσ 2 This is the basic structure of the KM model. Observe that the KM model postulates that the agent, that considers the realized output to be random, prefers to choose a level of output he could possibly commit to and leaves the choice of the fraction of output that will be paid to the discretion of the principal. It is equally plausible that the agent wishes to make sure that a predefined share of the realized output is offered. In this conceptualization the decisions regarding the output to be produced are left entirely to the principal. Since the agent incurs the costs of production the concern would be with respect to recovering the costs whatever the market conditions may be. This depends on the choice of p.

11 Sloof and vanPraag (2008) and Aggarwal (2007) pointed out that the choice of p need not depend on δ and/or λσ 2 . A similar argument can be found in Nichols (1983) and Svejnar and Smith (1984). The implications of such choices in franchise contracts have been explored in Lafontaine (1992) and Kaufman and Lafontaine (1994). However, it is rather difficult to develop satisfactory economic theory to justify such a choice by the principal in principal agent models of any vintage. Sharma and Rao (2007) reported one such attempt. Some aspects of this and other implications for econometric estimation will be considered in Sect. 3.5.

3.7 Switching and Threshold Effects

51

3.7 Switching and Threshold Effects Note that several managerial decisions lose their efficiency over time. On occasions they are replaced by alternative strategies. From the viewpoint of specification, the first possibility is expressed as y = ax for x ≤ x ∗ , and y = bx for x > x ∗ ; b < a In the second case the specification is of the form y = ax for x ≤ x ∗ , and y = bz for x > x ∗ where z is an alternative strategic variable. In practice, the switch may be caused by another related strategy and both branches will have information about the parameters a and b. In general, the firm may experience various switch points, and they need to be estimated based on observed data. It is equally important to identify the reasons for switching so that some suggestions for possible changes in the future can be offered. However, this is rarely attempted. Every firm in an industry consisting of n firms offers a product that has a unique intrinsic value that may be multi-dimensional. In general, both the firms and consumers experience asymmetry w.r. to such a value. Consequently, every firm utilizes s, e.g., its advertising intensity (ratio of advertising expenditure to total sales), to convey the value of its product to consumers. When s is small the consumers do not get to know the intrinsic value v* until it reaches a threshold s*. However, the consumers begin to ignore its sales promotion activities once it exceeds the threshold. The firm may however find the cost of advertising to be low enough compared to the value of its product so that it may utilize s > s*. More than one dimension of service may reach a threshold in some contexts like the use of a car or a machine. The number of hours of use (or the no. of km of driving) per day and the number of years of service provide examples of such characteristics. The threshold levels in such cases may be interrelated. Clearly, the relative use involves a cost that must be viewed against the value derived while determining the optimum utilization of such durables. Consider the following decision problem. A decision-maker chooses the quantum s of a variable in search of the value v that can be achieved by its use. However, there is threshold s* beyond which increases in s will not provide any further increase in v. That is, v attains a threshold v* thereafter. Further, implementing the quantum of s can only be at a cost c. In general, the cost also depends on another exogenous variable x in addition to s. Assume that c increases with x. A value x* exists such that c(s*) = v(s*). The most efficient quantity of x is x* corresponding to s* but it may not be achieved in practice primarily due to the information asymmetry that the decision-maker experiences. In Fig. 3.4, the choice of s is represented by s1 > s*corresponding to cost c and a value s1x < s* as the cost function moves to cx .

52 Fig. 3.4 Cost effect on the choice of s

3 Specification and Estimation V

Cx

V C

O

S1x

S*

S1

S

It should be obvious that conventional threshold regression procedures cannot be utilized since V is not observed in practice. Further, the interaction of the value with the cost associated with such expenditures critically determines the s chosen in practice. The specification issues outlined so far have been encountered quite frequently. Several other problems may arise in practice. It would be necessary to deal with them separately.

3.8 Estimation Problems In almost all problems of this nature, the data generated will be of the form (yi , x i ); i = 1, 2,…,n which form the basis of estimation. The statistical methods proposed in such contexts make one of two plausible assumptions. (a) The effects of x on y are fixed. The fixed effects must be estimated in such a way that they come out satisfactory when the sampling is repeated. The expected value and the variance of the estimators are taken as the deciding criteria. (b) The sample is given. The estimation should be based on this without reference to repeated sampling. The effect of x on y is the only unknown. Two alternative methods of estimation have been proposed. (i) The effects are random with either a postulated probability distribution or left open to be determined by the sample. (ii) Start with some apriori postulate about the probability distribution and seek improvements based on the sample. However, note that in practice, the switch points are not random. They occur systematically either because the consumers change their valuation of management strategies or because the firms find it necessary to make the changes based on the reactions of rival firms. The first approach is more in line with the way managers react. Similarly, the management changes (y, x) over time based on a variety of considerations. Analytically, it would be

3.9 Uncertainty Considerations

53

prudent to seek constant effects based on repeated sampling. Note that even changes in the effects can be traced to specific choices of the consumers or the management of firms. The effects of x on y are by no means random. More often than not they are chosen by the management on the expectation that they result in well-defined outcomes. One further observation is in order. The neural networks approach to estimation adopts the first assumption. However, the attempt is to train the network (use piecewise continuous functions) to fit the observed sample in the best possible way. The procedures are statistical and do not offer any information about why the switches or thresholds occur. As a result, they will not be useful in providing any guidance to the management regarding the useful course correction they should conceptualize. The methods proposed below are perforce heuristic and much of their use in practice depends on how well managerial strategies can be understood.

3.9 Uncertainty Considerations In markets characterized as differentiated oligopoly the demand curve for the product of any firm tends to be uncertain both due to consumer interface as well as their interaction with rival firms. The management of such firms has several alternative ways of incorporating the uncertainty in their decision process. Leland (1972) noted three possibilities: the firm fixes (a) p apriori, (b) y apriori, or (c) both p and y apriori allowing inventories as a buffer. The study of Rao and Rastogi (1997b) also indicated that the management of the firm may maximize a preference function U = E(π ) + λ V (π ) while choosing the volume of sales. Both these approaches indicate that the observed choices of p and S will be subject to some constraints. The procedures of estimation must account for this process by which the data is generated. Several variations of constrained regression estimates and maximum likelihood procedures have been outlined in Rao (1988a, 1988b, 1988c), Rao and Singh (1990a, 1990b), Rao et al. (1991a, 1991b). An outline of these methods is presented here. Assume that at the beginning of time period i the firm has S −1 of inventory stock, produces X i * of output during the time period and ends with S i of inventory. Clearly, the sales X i during the time period will be X i = S−1 + X i∗ − Si Let the demand curve for the firm be pi = price per unit of sales = − X i β + Yi γ + u i ; i = 1, 2, . . . , n where Y i is a l × k vector of k exogenous variables that affect x i and n indicates the number of observations available for estimation. Assume that the random variables ui are independent and identically distributed with E(u) = 0 and V (u) = σ 2 . Let the cost curve of the firm be

54

3 Specification and Estimation

Ci = cost of production = X i m + X i2 q + Z i δ where Z i is a vector of exogenous variables. Obviously, the parameters m, q, and δ can be estimated using the cost equation. To present the simplest case for estimating the other parameters assume that the firm is risk neutral and maximizes expected profit. If the firm fixes a price pi * apriori in its endeavor to maximize profits it can be verified that it satisfies the equation 2 pi∗ = Yi γ + m + 2q X i∗ + 2u i The n observations on pi can be written in the form (

) p ∗ − 0.5lm − q X ∗ = 0.5Y γ + u

where l is a n × 1 vector of unit values. Clearly, for given values of m and q the best linear unbiased estimator of the parameter γ can be defined. Similarly, the first order condition for the maximization of expected profit can be written as Xβ = 0.5Y γ − 0.5lm − X ∗ q Hence, β can be estimated from the equation ( ) X ' Xβ = X ' 0.5Y γ − 0.5lm − X ∗ q The crucial step in the analysis is the estimation of the parameter β utilizing the constraint indicted by the first-order condition for maximization. However, note that this constraint will have information about the parameters m and q. This can be utilized by modifying the above constrained regression estimators. Similar methods of estimation can be developed if the firm fixes the quantity apriori or fixes both the price and quantity initially. Based on such estimates, the actual choice of the management can be inferred. Consider the possibility that managerial discretion consists of maximizing12 U = E(π ) + λ V (π ) indicating a valuation of the implied randomness. To reduce the presentation to its essential detail, assume that the demand and cost curves are p = a0 + a1 S + a2 X + u, and C = c0 + c1 S + c2 Y 12

This approach is ad hoc and does not have any logical basis.

3.10 Tradeoff Estimation

55

Maximizing U with respect to S yields S = α0 + α1 X,

) ) ( ( where α0 = − (a0 − c1 )/ a2 + λσ 2 , and α1 = a2 / a2 + λσ 2

The locus of the expected value of the profit will be π = A0 + A1 X + A2 X 2 −A3 Y, where A0 = − c0 + α0 ( a0 − c1 ) + a1 α02 , A1 = α1 (a0 − c1 ) + 2a1 α0 α1 + a2 α0 , and A2 = a1 α12 + a2 α1 Clearly, the parameters c0 , c1 , and c2 can be estimated using the cost equation. Similarly, the parameters a0 , a1 , and a2 can be obtained after estimating the π relationship indicted by the optimization process. Once again, utilizing the information contained in the process of generating the observations provides the proper basis to estimate all the parameters. A more general approach to dealing with uncertainty can be suggested. Environmental conditions, both in the market outside the firm and the behavior of individuals and machines within the firm, are four types: they are steady and predictable, they experience cyclical fluctuations though it is possible to reasonably predict the point on the cycle where they can be expected, they can be predicted only with some probability, or they cannot be predicted. Strategic decisions in the first case are obvious. In the second, they are quite manageable without much error. In the third, decisions are made using the available information about the probability and update it when new information is available. This is like the Bayesian learning methods utilized by machine learning algorithms. In the fourth, strategic decisions are made on the basis of the best information available. If the realized events are contrary the decisions will be changed if possible or else the losses and other consequences absorbed or internalized.

3.10 Tradeoff Estimation Consider maximizing U = G + λ1 C + λ2 CY, where G = objective of the general manager like the market value of the firm, C = a decision of the management, and Y = any variable which the management values either because it is an incentive or a constraint placed on them subject to G = a0 + a1 C 2 + a2 C X,

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3 Specification and Estimation

where X = a market related variable or a characteristic representing the distinctive competence of the management. The general expectation is that a1 < 0 and a2 > 0. The maximum of U is attained for C = b0 + b1 X + b2 Y, where b0 = − (λ1 /2a1 ) , b1 = − (a2 /2a1 ), and b2 = − (λ2 /2a1 ) the locus of the values of C and G (also called the expansion path) will then be ( ) G = a0 + a1 Y ∗ 2 − X ∗ 2 , where Y ∗ = b0 + b1 Y, and X ∗ = b2 X Hence, the b0 , b1 , and b2 can be estimated from the C equation and a0 and a1 can be obtained by estimating the expansion path. In the general problem encountered in managerial practice, the C, X, and Y will be vector valued. Rao and Rastogi (1997a) demonstrated that the above estimation problem can be generalized to include that as well.

3.11 Estimating Thresholds The simplest form of a threshold regression model is v = as for s ≤ s ∗ = as∗ for s > s ∗ and c = c0 + c1 s + c2 x where v = a measure of value that cannot be observed directly, s = an observable variable that determines v, c = cost of maintaining s, x = exogenous variable that affects costs of operation, and s* = unknown threshold that must be estimated from the available data. The econometric problem is one of estimating the parameters a, s*, c0 , c1 , and c2 given the data regarding s, x, and c. Though several methods have already been proposed each of them depends on a specific assumption regarding how the observations on v and s are generated. Assume that each observation is (s + u) where u is a random variable that is normally distributed with mean 0 and variance σ 2 . That is, each observed value of s is the mean of the distribution of (s + u). Clearly, the same assumption holds for s* as well. This is Tobin’s (1958) approach. On the other hand, the method proposed in this section

3.11 Estimating Thresholds

57

postulates that the values of s are chosen randomly from a distribution with mean x m and variance σ 2 calculated from the observed sample. The assumption that s is normally distributed is not necessary for purposes of estimation. Only the test of a hypothesis depends on it. In practice, once the value of x is fixed apriori there is a value of s such that v = c. Hence, s will be chosen such that as = c0 + c1 s + c2 x. That is, s = (c0 + c2 x)/ (a − c1 ) = A∗ + B ∗ x where A* = c0 /(a−c1 ), and B* = c2 /(a−c1 ) Observe that x* exists such that v = c. as∗ = c0 + c1 s ∗ + c2 x ∗ That is, ) ( s ∗ = c0 + c2 x ∗ /(a − c1 ) Suppose c2 > 0. Then, an increase in x will necessitate a reduction in s. Hence, s ≤ s* will materialize when x ≥ x*. Further, when x < x* the choice of s will be such that as* = c0 + c1 s + c2 x. Hence, s = Ax ∗ + Bx + C where A = ac2 /c1 (a−c1 ), B = − c2 /c1 , and C = c0 /(a−c1 ) The threshold regression problem will then be s = A∗ + B ∗ x for x ≥ x ∗ = Ax ∗ + B x + C for x < x ∗ The essential observation is that the parameters of the model are related. Define R = a/c1 . Then, A∗ = c0 /(R − 1)c1 = C, B ∗ = c2 /(R − 1)c1 , and A = c2 R/(a − c1 ) For all practical purposes, it is necessary to estimate the parameters R and x*. Further, note that the threshold model involving the unobservable v has been converted into one involving observable s and x.13 13 Another variant of the above model is also relevant. Instead of, or in addition to, x having an influence on c it may affect v as well. For example, the advertising intensity of a firm improves the valuation of the products of the firm because it has an influence on the consumer loyalty to its products. The model may then be structured as

v = as∗ for s > s ∗

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3 Specification and Estimation

The method of estimation presented below is unique. As such comparisons with the existing methods of estimating threshold regressions will not be attempted since they have a more restricted purpose. Step 1: Estimate the cost function. This provides estimates of the parameters c0 , c1 , and c2 . Step 2: Note, further, that all the parameters of the model are estimable since ( ) s ∗ = c0 + c2 x ∗ /c1 (R − 1) That is, the value of v can also be estimated even if it is not observable. A constraint c0 + c1 x ∗ < c1 (R − 1) may be included in the estimation process if s* < 1 should be taken into consideration. Clearly, the case where c2 < 0 would be analogous. Step 3: The other assumption is that each of the samples of n observations is chosen in such a way that every sample has a mean x m and variance σ 2 . Each observation in the sample will then satisfy the inequality x ≤ x* with a probability p. This probability will be the same for each independently chosen observation. Consider the prob (x ≤ x*). It will be high if x* is high and conversely for low values of x*. An appropriate specification of the probability for s ≥ s* will therefore be αx*. This is the crucial aspect of the specification of the threshold regression model. The model stated in Sect. 2 above can now be written in its complete form as s = Ax ∗ + Bx + C with prob αx ∗ = C + B ∗ x with prob 1 − αx ∗ Therefore, the expected value of s is ) ( E(s) = [Rc2 /c1 (R − 1)] x ∗ − x αx ∗ + (c0 + c2 x)/c1 (R − 1) This fundamental transformation provides the basis for the estimation problem. The parameters α, x*, and Σ R can be estimated by minimizing. Σ Q= [s – E(s)]2 , where is the summation over the n observed values. The following results can be verified. X* can be estimated from the equation = as + bx for s ≤ s ∗ c = c 0 + c1 s + c2 x The change in the specification to one involving s and x would be analogous.

3.11 Estimating Thresholds

59

Q 1 x ∗ 3 + Q 2 x ∗ 2 + Q 3 x ∗ + Q 1 = 0, where Q 1 = − 2nα Rc2 Σ Q 2 = − 3α Rc2 x, Σ Σ Σ s − 2c0 n − 2c1 x − Rc2 α x 2 , and Q 3 = 2c1 (R − 1) Σ Σ Σ Q 4 = c0 sx x + c1 x 2 − c1 (R − 1) α can be estimated from the equation [ [ Σ ] Σ Σ ] α = c1 (R − 1) x s − nc0 − c2 x / Rc2 x ∗ nx ∗ − Similarly, the estimate of R is given by (Σ )] [ Σ Σ ]/ [ s + c2 x c1 Σ s + c2 αx ∗ x − nx ∗ R = nc0 + c1 Utilizing the initial values x ∗ = − Q 4 /Q 3 , α = c1

Σ

s/c2

Σ

x, and R =

Σ

s/

Σ

x

an iterative procedure will converge to the desired parameter values. It is necessary to recognize that (a) α < 0 in which case α may be set to 0 since only the second branch is valid. (b) Similarly, if α > 1 the value of α may be set to 1 and only the first branch is valid. The threshold cannot be achieved since it is large. On the other hand, if it is too low relative to the cost of generating s the threshold is exceeded in almost all cases. (c) R < 0 is unlikely. However, if the estimated value is negative, it must be inferred that a < 0. The model cannot represent the reality that it attempts to depict. The following alternative should be considered. The assumption that c2 > 0 may not be valid in the specific application under consideration. The estimation process must be restructured to account for c2 < 0. The variance of each of the estimated parameters can be obtained in the following manner. Suppose s = s(α) It can be approximated by s = s0 + αs1 , where s1 = ds/dα Hence,

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3 Specification and Estimation

E(s) = s0 + E(α) s1 , where E(α) is the expected value of α. The variance of α will then be given by V (s) = V (α) s12 where s1 and V (s) are estimated from the sample. Consequently, V (α) = V (s)/s12 The tests of significance of the estimated parameters will then be based on asymptotic normality. Further, the estimated error sum of squares can provide a measure of the goodness of fit of the threshold regression. An alternative method of estimation suggests itself. The value of s* is unknown, and it must be estimated from the observed sample. It depends on the process that generates the values of s. The other important feature of the method of generating s is the following. Consider s* to be large. Then, it can be argued that s ≤ s* holds with a large probability. Similarly, the probability will be low if s* is small. A convenient specification of the probability will them be prob (s ≤ s*) = αs*. The threshold regression can then be rewritten as v = as with prob αs ∗ = as ∗ with prob 1 − αs ∗ The model, specified with this in view, necessitates the estimation of another parameter α. This is the additional burden on the estimation process though the specification offers a simpler method of estimation that does not require the assumption of normality. Note that each randomly generated observation s satisfies this probability specification. Hence, the expected value of s will be ( ) E = aαs ∗ s − s ∗ + as∗ Define the observed error as Q = v−E The method of estimation of the parameters will then be to minimize Σ

Q2

3.12 Contract Parameters

61

This results in the three equations Σ

( ) Q as∗ s − s ∗ = 0 Σ [ ( )] Q s ∗ + αs ∗ s − s ∗ = 0, and Σ [ ] Q a + aαs − 2aαs ∗ = 0

However, these equations can be reduced to Σ Σ

Q = 0, and Qs = 0

Effectively, only two parameters of the model can be estimated through this method. It can be readily verified that ] [ ( ) ) [ (1) aα = vm + vm − (vs)m / s ∗ sm − s ∗ sm − s ∗ + {sm2 − s ∗2 ] [( ) ] [ ( ) ( ) (2) as ∗ = vm − sm − s ∗ (vm + vm sm − (vs)m / sm − s ∗ s − s ∗ + sm2 − s ∗2 ] That is, a and α are estimable. It is necessary to investigate the source that contains the information regarding s*. Observe that the variance of v can be shown to be ( )( )2 V (v) = a 2 αs ∗ 1 − αs ∗ s − s ∗ Consequently, s* can be estimated from this equation by replacing V (v) by the estimated variance in the sample.

3.12 Contract Parameters Seminal theoretical developments are at least thirty years old and can be traced to Mirrlees (1974) and Holmstrom (1979). However, empirical and econometric work lagged far behind mainly due to the unavailability of data. Nevertheless, the specification and resolution of econometric problems has been a continuing process. Given this empirical reality, the linear quadratic models provide the most satisfactory theoretical basis. Perhaps the most influential work has been Kawasaki and McMillan (1987) (KM hereafter). Many recent developments of the state of econometric practices and empirical evidence, based on this and related models, have been surveyed in Masten and Saussier (2002) and Chiappori and Salanie (2003). Significant work is still in progress. However, as of today, many econometric problems remain unresolved. Availability of data has also been a constraint. Masten and Saussier (2002, p. 289) pointed out the following. “As the number of provisions (objectives of the principals

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and agents as well as the instruments available to them) analyzed increases, the number of explanatory variables and the size of the dataset needed for statistical identification multiply. Often, sufficient numbers of observations to analyze more than two or three provisions at a time simply do not exist.” Further, as Aggarwal (2007, p. 476) reiterated recently, “most of the theoretically (defined) variables are either not observed or only partially observed. Given this problem, the empirical methodology used most often is to regress control choice on a range of proxies relating to the characteristics of the contracting parties (and other variables conditioning the environment in which the contracts are defined and implemented).” This gives rise to the question about how such econometric practices can be justified on the basis of economic theory. The most basic difficulties in the state of econometric methods based on the simple version of the principal agent models originated by KM can be outlined as follows. We also offer a more satisfactory method of estimating all the parameters of such models and several more realistic versions of it. It should be noted that meaningful changes to econometric techniques require that we must modify the models and their economic content first. Suitable econometric techniques, to incorporate greater degrees of practical reality and complexity, can be conceptualized only in an interactive fashion. In a nutshell, these are the issues around which an attempt will be made to develop econometric estimates of the parameters of principal agent models. To begin with the basic approach adopted by KM and related studies14 will be outlined. This enables us to specify the econometric issues clearly before searching for more satisfactory and/or efficient methods. Consider the time series data that would be available with respect to all contracts of a given firm. Usually, this consists of the observed output ya and the profits of the agent from each contract, viz., π a . Estimation of the necessary parameters of the models necessitates the assumption that the null hypothesis, i.e., that the data is indeed generated by the optimization process implied by the principal agent model, is valid. They begin estimation by observing that V (ya ) = variance of ya = σ 2 Hence, this can be used to estimate σ2 . Secondly, note that V (πa ) = s 2 = p 2 σ 2 as implied by the specification of the principal agent model. Consequently, they propose to estimate p as

14

Prominent studies include Asanuma (1989), Asanuma and Kikutani (1992), Yun (1999), and Okamuro (2001). Their studies differ mostly with respect to the proxies used. The econometric methodology is essentially the same. Related studies also include Allen and Lueck (1999), GonzalesDiaz et al. (2000), Brickley (2002), Aggarwal (2007), Haubrich (1994) and Hernandez (2003).

3.12 Contract Parameters

63

p = s/σ The other two parameters of interest are λ and δ. KM then observe that va = E(πa ) − λs 2 so that we can write πa = constant + λs 2 + ε where ε is a random variable. Now, suppose the data is for a panel of several firms over some years for each of them. Then, π a and s2 can be computed as averages for each firm over time. A cross section regression will then estimate λ. Note that λ need not be the same across all firms. However, even a random coefficient regression approach has not been utilized.15 KM then test the hypothesis that their principal agent model is a true theoretical explanation of the observed data. To achieve this, they start with the equation ( ) p = δ/ δ + 2λσ 2 Hence, it follows that ] [ ln {(1/ p) − 1}/2σ 2 = ln λ − ln δ where ln is the natural logarithm. The general approach adopted is to identify proxies for λ and δ and estimate a cross section regression ] [ ln {(1/ p) − 1}/2σ 2 = a0 + a1 ln x1 + a2 ln x2 where x 1 and x 2 are the proxies chosen. Statistical significance of a1 , a2 and a high R2 are then interpreted as a test of the validity of their model.16 There are many difficulties with this method of approach to estimation. First, there is no clear definition of the parameters that need to be estimated. In particular, the specification of the KM model postulates that p, δ, λ, σ 2 will be unobservable parameters. Hence, all of them must be estimated using the same dataset. As Masten and Saussier (2002, p. 289) observed, “ given that contract provisions will have been chosen simultaneously and are likely to interact with one another … in subtle and unexpected ways … empirical contracting studies should, ideally, estimate the full

15

To the extent I could understand these papers it is quite clear that they did not really make any attempt to estimate δ from the observed data. 16 Almost all subsequent empirical work on the principal agent models utilizes proxies. These studies did offer various useful insights into the economic mechanisms underlying such contracts. However, the estimation process rarely follows from the theoretical model specification.

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set of contract provisions simultaneously.”17 This has not been attempted so far. Second, the dataset that can be made available is never fully specified. Suppose a time series of only one firm is available. According to the KM approach only p and σ 2 can be estimated. Third, using panel data to estimate λ by regression assumes that λ is the same for all the firms. This is rarely satisfied in any dataset. Hence, they make an ad hoc specification of other intervening variables. Clearly, this is not satisfactory. Fourth, the observable data is generally the actual output or sales revenue and the realized profit from the firm’s profit and loss account. Kawasaki and McMillan utilized this information to estimate p. Do they not contain any information about other parameters? They did not explore this aspect at all. Fifth, suppose we make an attempt to use the specification πa = py − y 2 /2δ + pu to estimate p and δ. We need information about y. This is not available. Instead, the above equation can be written as πa = pya − ya2 /2δ + u a ( ) where u a = u 2 + 2ya u /2δε Estimation may then be possible. However, this leaves λ undetermined. Sixth, the reader may also easily verify that a maximum likelihood method to estimate all the parameters fails18 if the data available is only with respect to ya and π a . In general, despite many interesting econometric inferences reported in the estimation of principal agent models, there is an uneasy feeling that the methods that form the basis of their inferences are most unreliable. The pertinent question would be that of estimating all the parameters using a single firm time series. Other extensions will be meaningful after this basic task is accomplished. Assume that the data available is a time series for the same principal firm contracting with the same agent. More specifically, let the available data consists of 17 18

Ferrall and Shearer (1999) also voiced a similar concern. Note that ya = pδ + u ) ( = δ 2 / δ + 2λσ 2 + u

Assume that u is normally distributed. Write the likelihood function. Since u is almost never identically zero the first order conditions with respect to δ and λ cannot be solved to obtain the corresponding estimators. Similarly, we may write ( ) ) ( πa δ + 2λσ 2 / δ = δ 2 /2 δ + 2λσ 2 + u Once again it is very easy to show that the first-order conditions for the maximization of the likelihood function cannot be solved for δ and λ.

3.12 Contract Parameters

65

(a) ya , the actual or realized output or revenue, and (b) π a , the profit of the agent. The parameters that must be estimated from this dataset are p, σ 2 , δ, and λ. Recall that p will be exactly determined if δ, λ, and σ 2 are known. However, it is listed as a parameter to be estimated because it is unlikely that any data on this will be available. Two important observations should be kept in perspective before proceeding further. First, note that if δ, λ, and σ 2 are fixed over time, as the model postulates, the data for any one firm should have the same values of y and π a . However, the observed data regarding ya and π a do vary over time. The exogenously determined randomness is the only source of these variations. All the estimates that we can develop essentially reflect the effect of this randomness instead of any other systematic economic behavior. Second, note that ya is known. If p can be estimated from π a then we also know (1 − p) (y + u). Hence, π p does not contain any additional information about the parameters. Similarly, E(π a ) = py – y2 /2δ does not contain any useful information. For, p and δ must always be chosen to satisfy this equation.19 With this background in perspective, estimation can proceed as follows. (a) Since ya = y + u, y can be estimated from E(ya ). From an operational point of view this will be the sample average. (b) Similarly, σ 2 can be estimated from V (ya ). (c) Note that π a = p(y + u) – y2 /2δ Hence, V (π a ) = p2 σ 2 = s2 Therefore, as in KM, p can be estimated as20 p = s/σ (d) Observe that y = pδ given the incentive constraint of the agent. Hence, it is possible to estimate δ as δ = y/ p

19

Strictly speaking this is valid only when the data generation process corresponds to the optimization implicit in the KM formulation of the principal agent model. In practice, this may not be true. In such a case, aχ 2 test based on the deviations of π a from its estimated value can be utilized to test the validity of the model. 20 Okamuro (2001, p. 364) pointed out that this is not a good estimate. For, suppose π = 0.1(y + a u). That is, profit is about 10% of the sales revenue. Then, it follows that V (π a ) = s2 = 0.01 σ 2 . Consequently, p = 0.1. This indicates that there is some risk absorption. However, the following scenario is plausible. Suppose output and cost increase by α percent. Let the price of output remain invariant. Then, profit will also increase by α percent. But, clearly, there is no risk absorption. It is much more important to model systematic fluctuations in demand to get a reliable estimator of p. In other words, as Masten and Saussier (2002, p. 284) pointed out, risk sharing is not the major determinant of output sharing contract choice.

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(e) Recall that p = δ/(δ + 2λσ 2 ). Hence, λ can be estimated as21 λ = δ[(1/ p) − 1]/2σ 2 This simple approach, utilizing the data pertaining to ya and π a , can therefore retrieve all the parameters of the model. Another approach to the problem starts with the following observation. The actual output or revenue that can be generated by the actions of the agent does not depend only on the randomness determined by external market conditions or the moral hazard inherent in the actions of the agent. Instead, it also depends on systematic market trends, the ability of the agent to absorb the new technology, designs and so on that the principal expects him to use. Perhaps, the principal takes the expected values of these variables into account while determining y. However, the variation of these external factors, around their expected values, is unlikely to be captured while determining y. In other words, the actual output ya = y + ax + u where x = X – E(X) with X denoting an exogenous variable, and u = random error similar to the original formulation. Consider model 1. The expressions for va and vp will now contain ax linearly and independent of y. Hence, none of the decisions will be affected. That is, p cannot be a linear function of x. The only difference is in the estimation of σ 2 based on the regression ya = y + ax + u Note that this regression offers an estimator of the additional parameter in the model as well. However, the model cannot provide a justification for the observed econometric practices. Assume, on the other hand, that the agent may choose p and the principal chooses y. This possibility was indicated earlier even in the context of model 1. In this case, Estimation of λ crucially depends on the choice of p as recorded in the basic model. This can be contested on two counts. First, suppose σ 2 is very high. A risk-averse agent may ask for an even higher fixed upfront payment and a lower p compared to what the model signals. Similarly, when σ 2 is fairly low, he may be emboldened to take the risk. He may then accept a higher p and a lower upfront payment. That is, there may be incongruence between the observed data and the predictions of the model at both extremes of market uncertainty. Second, the principals may have a tendency to underpay agents by substantial amounts. For, the principal may suspect that the agent is not revealing correct information on three counts. (a) The agent may reveal a lower probability of success hoping that a low output target will be set. (b) The agent may be more risk averse than what he is willing to reveal. (c) The agent exaggerates his level of skill in contract negotiations. Further, the principal, not being fully aware of how δ and λ contribute to his profit may prefer to reduce p. This possibility implies that the estimated value of δ may be an underestimate and that of λ an overestimate. It is necessary to free the model from its excessive dependence on σ 2 as the key to the entire decision process. Borenstein et al. (2007) also voiced similar concerns. 21

3.12 Contract Parameters

67

maximizing va with respect to p results in p = (y + ax)/2λσ 2 and the choice of y that maximizes N is given by ) ( ) ( y = δ 2λσ 2 − ax / δ + 2λσ 2 Simple rearrangement yields22 ( ) p = (δ + ax)/ δ + 2λσ 2 It is now obvious that running a regression23 p = a0 + a1 x + ε will be justified.24 Clearly, the u, which represents randomness in market conditions specific to the products transacted under the contract, can be expected to be independent of ε. It is now important to note that δ and λ can also be estimated with the available information. For, δ = aa0 /a1 , and λ = a(1 − a0 )/ 2a1 σ 2 Standard tests of significance can also be conceptualized since a, a0 , a1 , and σ 2 are all estimators in the usual sense. See, for instance, Rao (1965, Sect. 6.2, especially p. 322). Three important inferences emerge from this analysis. First, all the parameters of the model can be estimated by using the information contained in ya and x. It was not necessary to resort to the observations regarding π a . The economic rationale underlying this result is not easy to disentangle. Second, the appropriate proxies for the x variables are not those representing δ and λ. Instead, they should represent variables that can capture systematic productivity and market demand related influences. Third, model 1, with the choice of y left to the agent, cannot justify using the proxy regressions that predominate the empirical literature. Though no independent proof 22 Observe that the p so defined is not a constant independent of x. Instead, it is somewhat similar to a bonus (or, incentive) scheme. 23 This approach to the estimation problem requires data on p. But this is not available. However, it is clear that pλ is estimable. Hence, this can be used in the regression without loss of any other information. 24 Note that the random variable ε introduced here is in no way related to the ε in the KM estimation of λ. Further, it can be argued that ya and p equations constitute a pair of seemingly uncorrelated regressions. This is a matter of detail and not fundamental to the issue of identification being considered here.

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for p being the agent’s choice is available, the success of the regression approaches suggests that this is the dominant form in the principal agent model. For all practical purposes, this is a far superior approach to the estimation of all the parameters of the principal agent model.25 The most important finding is that even limited time series information, about the output (revenue) and profit of the agent, will be adequate to estimate all the parameters of the model. It was also shown that the econometric practices currently in vogue would be valid only under very limited assumptions. The attempt here, however, represents the tip of an iceberg. In practice, there are many unresolved theoretical issues, and lack of appropriate econometric techniques. The principal agent models, if considered logically in an econometric framework, as yet leave several questions unanswered. It would be fair to say that at this stage it is not possible to speculate about the nature of econometric tools that will adequately resolve the many problems that analysis of contracts presents.

3.13 Further Observations Direct estimation of the ex ante postulated model is not possible. However, empirical information about managerial discretion can be obtained by combining the observed choices, their consequences, and the constraints emerging from the implementation of the decision process that defines them. The methods are quite varied and depend on the empirical situation that is being studied. It is difficult to claim that there is unified framework to deal with the specification or the estimation of managerial discretion that form the basis of all such inverse optimum problems. In the final analysis, as Pinker (2018, p. 404) put it, “human beings will always be in the loop to decide which data to gather and how to analyze and interpret them. The first attempts to quantify a concept are always crude, and even the best ones allow probabilistic rather than perfect understanding. Nonetheless, quantitative social scientists have laid out criteria for evaluation and improving measurement, and the comparison is not whether a measure is perfect but whether it is better than the judgment of an expert or a critic.”

25

The practical difficulty is the following. Much of the empirical literature suggests that the principal’s choice of p will not be a function of δ, λ, or any other exogenous variation of x over time for any contract for a specific product type. The variations in p would only be over a cross section of different products handled by the same principal and/or agents. Even empirical studies utilizing panel data could not come to grips with this issue so far. Consequently, there is a great deal of ambiguity about the appropriate economic model and the corresponding econometric methods of estimation. Given the paucity of data the best empirical studies should depend on panel data. Economic theory must be developed with this constraint in perspective. For example, the x variables may refer to contracts for different products instead of a time series for the same product. The estimation of δ, λ, and σ 2 should be modified accordingly.

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References Ackerberg, D., & Botticini, M. (2002). Endogenous matching and the empirical determinants of contract form. Journal of Political Economy, 110, 564–591. Agarwal, R. (2007). Role of risk sharing and transaction costs in contract choice: Theory and evidence from ground water contracts. Journal of Economic Behavior and Organization, 63, 475–496. Allen, D., & Lucek, D. (1999). The role of risk in contract choice. Journal of Law, Economics, and Organization, 15, 704–736. Asanuma, B. (1989). Manufacturer supplier relationships in Japan and the concept of relation specific skills. Journal of the Japanese and International Economies, 3, 1–30. Asanuma, B., & Kikutani, T. (1992). Risk absorption in Japanese subcontracting: A microeconometric study of automobile industry. Journal of the Japanese and International Economies, 6, 1–29. Baker, R. (2006). Risk Aversion in Maintenance: Overmaintenance and the principal agent problem, IMA Journal of Management Mathematics, 17, 99–113. Barney, J., Ouchi, W. (1986). Organizational economics. Jossey-Bass. Becker, G. (1991). A note on restaurant pricing and other examples of social influences on price. Journal of Political Economy, 99, 1109–1116. Borenstein, S., Busse, M., & Kellogg, R. (2007). Principal agent incentives, excess caution, and market inefficiency: Evidence from utility regulation, NBER Working Paper 13679, available at nber.org/papers/w13679. Brickley, J. (2002). Royalty rates and upfront fees in share contracts: Evidence from franchising. Journal of Law, Economics, and Organization, 18, 511–535. Chiappori, P., & Salanie, B. (2003). Testing contract theory: A survey of some recent work. In M. Dewatripont, L. Hansen, & S. Turnovsky (Eds.), Advances in economic and econometric theory and applications. Cambridge University Press. Coase, R. (1937). The nature of the firm. Economica, 4, 386–405. Coase, R. (1972), Industrial organization: A proposal for research. In V. Fuchs (Ed.), Policy issues and research opportunities in industrial organization, pp. 58–73. National Bureau of Economic Research. Datta, P., & Radner, R. (1994). Optimal principal agent contracts for a class of incentive schemes: A characterization and the rate of approach to efficiency. Economic Theory, 4, 483–503. Epstein, D. (2019). Range. River Bend. Ferrall, C., & Schearer, R. (1999). Incentives and transaction costs within the firm: Estimating an agency model using payroll records. The Review of Economic Studies, 66, 309–338. Gonzales-Dias, M., Arrunada, B., & Fernandez, A. (2000). Cause of subcontracting: Evidence from panel data on construction firms. Journal of Economic Behavior and Organization, 42, 167–187. Haubrich, J. (1994). Risk aversion, performance pay and the principal agent problem. Journal of Political Economy, 102, 258–276. Hernandez, M. (2003). Structural estimation of principal agent models: Moral hazard in medical insurance. RAND Journal of Economics, 34, 670–693. Holmstrom, B. (1979). Moral hazard and observability. The Bell Journal of Economics, 10, 74–91. Jensen, M., & Meckling, W. (1976). Theory of the firm: managerial behavior agency costs, and ownership structure. Journal of Financial Economics, 3, 305–360. Kaufman, P., & Lafontaine, F. (1994). Costs and control: The sources of economic rents for McDonalds franchises. The Journal of Law and Economics, 37, 417–453. Kawasaki, S., & McMillan, J. (1987). The design of contracts: Evidence from Japanese subcontracting. Journal of the Japanese and International Economies, 3, 1–3. Lafontaine, F. (1992). Agency theory and franchising: Some empirical results. The Rand Journal of Economics, 23, 263–283. Leland, H. (1972). The theory of the firm facing uncertain demand. The American Economic Review, 62, 278–291.

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Masten, S., & Saussier, S. (2002). Econometrics of contracts: An assessment of developments in the empirical literature on contracting. In E. Brousseau & M. Glachant (Eds.), The economics of contracts. Cambridge University Press. Mirrlees J. (1974). Notes on welfare economics, information and uncertainty. In M. Blach, D. McFadden & S. Wu (Eds.), Essays in economic behavior under uncertainty. North Holland, Amsterdam. Nichols, S. (1983). Agency contracts, institutional mode, and the transition to foreign direct investment by British manufacturing multinationals before 1939. The Journal of Economic History, 43, 675–686. Okamuro, H. (2001). Risk sharing in supplier relationships: New evidence from the Japanese automotive industry. Journal of Economic Behavior and Organization, 45, 361–381. Pinker, S. (2018). Enlightenment now. Viking. Rao, C. (1965). Linear statistical inference and its applications. Wiley. Rao, T. V. S. R. (1988a). Demand uncertainty decision models of the firm, and parameter estimation. Journal of Quantitative Economics, 4, 45–58. Rao, T. V. S. R. (1988b). Transaction Costs, Vertical Integration, and x-efficiency. International Review of Economics and Business, 35, 1173–1190. Rao T. V. S. R. (1988c). Econometric estimation of decision models under uncertainty. In J. Sengupta & G. Kadekodi (Eds.), Econometrics of planning and efficiency. Martinus Nijhoff. Rao, T. V. S. R., & Bhattacharyya, S. (2021). Transient market power of firms. Cambridge Scholars Publishing. Rao, T. V. S. R., & Raja, A. (1999). Flexibility in the choice of financial instruments and corporate performance. Indian Journal of Economics, 79, 387–403. Rao, T. V. S. R., & Rastogi, R. (1997a). Discretionary managerial behavior. Kluwer Academic Publishers. Rao, T. V. S. R., & Rastogi, R. (1997b). Identification of managerial preferences. Indian Journal of Applied Economics, 6, 113–124. Rao, T. V. S. R., & Saha, S. (1994a). Interactive effects of organizational structure and control on corporate performance. Journal of Quantitative Economics, 10, 293–308. Rao, T. V. S. R., & Saha, S. (1994b). Business policy and corporate performance. Indian Economic Journal, 42, 39–53. Rao, T. V. S. R., & Singh, S. (1990a). CORE: For decision models under uncertainty. Economics Letters, 34, 43–48. Rao, T. V. S. R., & Singh, S. (1990b). CORE vs MLE for decision models under uncertainty. Z Fur N, 51, 145–158. Rao, T. V. S. R., Singh, S., & Talwar, P. (1991a). Decisions of the firm under uncertainty: Estimation and structure of price-cost margins. International Review of Economics and Business, 38, 355– 368. Rao, T. V. S. R., Singh, S., & Talwar, P. (1991b). Estimation and structure of price-cost margins under demand uncertainty. Advances in Econometrics, 9, 61–86. Rees, R. (1985a). The theory of the principal and the agent: Part 1. Bulletin of Economic Research, 37, 2–26. Rees, R. (1985b). The theory of the principal and the agent: Part 2. Bulletin of Economic Research, 37, 75–95. Sharma, R., & Rao, T. V. S. R. (2007). Technology transfer in international joint ventures. Indian Journal of Economics, 87, 663–678. Shy, C. (1995). Industrial organization. M.I.T. Press. Sloopf, R., & vanPragg, C. (2008). Performance measurement expectancy, and agency theory: An experimental study. Journal of Economic Behavior and Organization, 67, 794–809. Svejnar, J., Smith, S. (1984). The economics of joint ventures in less developed countries. The Quarterly Journal of Economics, 99(1), 149–67. Turnovsky, S. (1970). Financial structure and theory of production. The Journal of Finance, 25, 1061–1189.

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Varadarajan, P., & Ramanujam, V. (1990). The corporate performance conundrum: A synthesis of contemporary views and extension. Journal of Management Studies, 27, 463–484. Vickers, D. (1987). Money capital in the theory of the firm. Cambridge University Press. Williamson, O. (1971). Managerial Discretion, Organizational Form, and the Multi-Division Hypothesis, in Maris, R., & Wood, A. (eds. (The Corporate Economy (London: Macmillan))). Williamson, O. (1988). The logic of economic organization. The Journal of Law, Economics, and Organization, 4, 65–93. Young, A. (1928). Increasing returns and business progress. The Economic Journal, 38, 527–542. Yun, M. (1999). Subcontracting relations in the Korean automotive industry: Risk sharing and technological capability. International Journal of Industrial Organization, 17, 81–108.

Chapter 4

Production Decisions

One of the significant decisions of the management relates to the level of production. The concept of what constitutes the production level depends on the context. Similarly, the stock of capital of the firm or the expected market demand may be important in different situations. When a firm sells its products in geographically dispersed markets it would be prudent for them to fix prices apriori instead of allowing the prices to fluctuate on the basis of the market conditions that obtain. The possibility that the firm sells differentiated products necessitates that a firm structures non-price strategies to influence its market share. It is necessary to define managerial discretion in each of these contexts. None of the proposed measures can be considered as perfect. A system – any system, economic or otherwise – that at any point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no point of time, because the latter’s failure to do so may be a precondition for the level or speed of long-run performance—Schumpeter (1950, p. 83).

4.1 Some Basics1 One of the major choices of the management relates to the quantity of output produced. It will be determined by minimum cost considerations if there is no limit on the quantity demanded. Similarly, the constraints on demand may overshadow cost considerations if they are binding. In either context, the assumption that production adjusts instantaneously to a market determined price is unrealistic. Instead, the operation of imperfect markets suggests that firms fix the prices of their products apriori and adjust other decisions as the market conditions change. The acquisition 1

The primary emphasis of this chapter is on actual choices of a firm in an empirical setting. As such the possible patterns may not correspond to a predefined theoretical model. However, it would be possible to assess the impact, on different firms, of market information, and the relative valuation of choices available to the firm.

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_4

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of capital stock and the time necessary to have the orders fulfilled are also subject to managerial discretion. The time lag between the time inputs is provided to the technologically determined production process and the receipt of output also necessitates some advance planning. The logic underlying price fixation, planning production, and the factors that determine such managerial choices need analysis. There is also a need to examine whether steady trends alone matter or managerial discretion extends to unexpected and discrete changes in the environment. Firms will operate at or close to long-run efficiency if the product and factor markets are competitive. For all practical purposes, the variable costs can be assumed to be parametric and independent of the levels of production. Further, the output of any one firm is small relative to the total market for the product. Under these conditions, the firm can sell all that it wants to. In its simplest form, the production decision is depicted in the following model. Let p = f (Y ), where p = price per unit of output, and Y = volume of production, represent the demand curve. In general, C = C(Y, K), where C = cost of production and K = stock of capital, will be the cost curve. The assumption that the firm maximizes profit results in the choice of production Y = Y (K), dY /dK > 0. However, this specification is unsatisfactory. The specification p = f (Y ) can also be interpreted to mean that Y is defined if the firm sets a price p ex ante. In most practical situations, this may well be the case. The price may be set by the firm keeping the valuation of its products by the consumer and the competitive interaction among rival firms. The issue regarding how price is set apriori remains an empirical question though several theories have been put forward. Y = Y (K) may still be a realistic description if the firm sets a price based on the minimum average cost. The ex ante assumptions that form the basis of the production decision of the firm will therefore involve managerial discretion. It is also necessary to acknowledge that the assumption of competitive markets where production adjusts automatically to market demand does not hold in practice. It cannot be assumed that firms can adjust supply to orders at every point of time effortlessly and without incurring any additional cost. In addition, there is a possibility that the firm receives more orders than it plans to satisfy. The orders will be lost if the firm cannot alter production schedules. All these aspects require attention in describing the choice of the production level by the management. It is necessary to specify the economic motivation for forward planning of the production level.2 It should be noted that production activity involves a lag between the time at which inputs are provided to the production process and the time at which outputs are available. As a result, it is usually difficult and costly to change the commitment of raw materials and orders for machines as the demand fluctuates. The cost of adjusting production level from one unit of time to the next is significant since the cost of being out of equilibrium is ruled out. Eisner and Strotz (1963) postulated that such a cost of adjustment will be a (Y t – Y t −1 )2 . The resulting profit maximization yields 2

It may be noted that holding inventory to smooth production is a feasible alternative. However, a comparison of the relative costs may indicate that changing the production level is more efficient.

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Yt = α0 + α1 Yte + αYt−1 The quantity of α 2 will depend on the parameter a in addition to others. It can be expected that α 2 < 1 if some changes in K t can be conceptualized.

4.2 Imperfect Markets3 Virtually, all decisions of a firm are a consequence of the planned level of production. It depends on the market demand, capital stock, finances, and many other related choices and influences external to the firm. Normally, an efficient plan for production is based on certain assumptions and future market conditions.4 It should also be noted that the production activity involves a lag between the time at which inputs are provided to the production process and the time at which outputs are available. As a result, it is usually difficult and costly to change the commitment of raw materials and orders for machines as the demand fluctuates over time. This gives rise to the costs of adjustment alluded to earlier. The following argument indicates the possibility that there will be costs of being out of equilibrium. Very often, all the plant and machinery cannot be planned, acquired, and installed simultaneously. There will be wastages and transitory costs associated with the resulting idle time in the process of phasing the installation to the ultimate desired level of production. This was demonstrated in Somayajulu (1971). This argument points to the existence of the costs of being out of equilibrium. It may be represented by b(Y t – Yt∗ )2 , where Yt∗ is the planned level of production. Consequently, there will be costs of being out of equilibrium in addition to the costs of adjusting the level of production. Maximizing profit results in the decision rule Y t = α 0 + α 1 Yte + αY t −1 . Yt∗ may be determined in one of the following ways: (a) A large firm may have to attain a high rate of capacity utilization in its efforts to stabilize its market share at a high level. The planned level of production will depend on the stock of capital.5 That is, Yt∗ = αK t . (b) The firm’s attempt to maintain a high market share may be represented 3

In general, there is significant uncertainty in the demand for the products of a firm. The arguments of Ingro and Sardoni (2020) and Levis (2009) can be summarized as follows. (a) Much of the business, like much of life, is inherently unpredictable, untidy, and uncertain. (b) Incumbents firms find that new opportunities are at best hazy and competitive threats may come from unexpected quarters. They may involve new technologies, new competitors, and business models. (c) Market imperfections, other than those related to information, may be eliminated, or at least, significantly reduced by managerial discretion. However, issues related to this can never be answered by rigorous quantitative analysis. Managerial decisions reflect adjustments to the many factors that cannot be predicted. 4 Small firms do not generally have any control on prices. They accept the price offered by the buyer and offer the quantity demanded. Large firms maintain a high level of capacity utilization, and consequently production level, and sell at a price that they determine. They use non-price strategies to make the quantity demanded to correspond to their level of production. 5 The firm will choose the price and non-price decisions to correspond to the target level of production. Hence, planned or anticipated sales level is not exogenously given.

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by St * , where St * is the expected level of sales. Hence, Yt∗ = αSt∗ may be more appropriate. In general, these expectations can be specified by utilizing the adaptive expectations formulation   ∗ St∗ − St∗ = a St∗ − St−1 (c) Since production is normally ahead of demand the mismatch can be buffered by holding inventory. Hence, the level of production may be reduced if the initial level of inventory is high. In an oligopolistic environment, where the market demand may be random, the firm may utilize inventories as a buffer to avoid outages. In some practical contexts, it may also represent a planned level. In such a case an adaptive expectations specification is relevant. In either case, the production decision rule will be6 Yt∗ = β Ft−1 , and Yt = α0 + α1 Ft−1 + α2 Yt−1 (d) The uncertainty in demand may induce the firm to extend credit to buyers beyond the normal trading conventions thereby increasing the value of its receivables.7 (e) Variability in the prices of raw materials and frequent changes in Y t necessitated by the randomness in the demand for the products in the market may be indicated by the variability of the average cost (AVCt ). That is, ACt /AVCt −1 may an adequate measure of risk. Yt∗ = δ(AVCt /AVCt−1 ) May be necessary while specifying Yt∗ . (f) Financial constraints are important in the choice of production levels though they have no effect on sales. Small firms, that do not have adequate sources of external finance, may be constrained by the availability of internally generated sources.8

6

Each of the descriptions of the motives for inventory will suggest that the magnitude of the coefficients in their estimated equations will be different. However, it is not possible to identify the choice made by the management from the estimated decision rule. 7 It may be conjectured that an increase in the interest rate decreases production via the cost effect. However, the interest payment is a small portion of the total cost. Further, in oligopolistic markets firms may receive the additional cost by increasing prices. Hence, the effect of the interest rate on the production decision will be negligible. 8 Let the optimization problem be postulated as Max pP subject to cP + a(P – P 2 t t t t−1 ) = F (fixed financial resources). The resulting decision rule Pt = α 0 + α 1 Pt−1 + α 2 Pt∗ must satisfy the constraint. Consequently, Pt will be a function of Pt−1 and F, and Pt∗ will depend on F.

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A comprehensive specification of all the variables that affect the production decision and identifying the conditions under which one or more of these influences are significant in the firm’s choice of Y t is a task that should be addressed.9 Two caveats are in order. First, most firms maintain excess capacity under conditions of oligopolistic competition. This allows firms to increase production at a lower average cost whenever they experience demand shocks. That is, firms deviate from planned level if circumstances warrant it. Second, suppose production and/or sales are dispersed geographically. In such a case, output available at each location must be sufficient to meet the demand as it arises because stockout is costly. That is, some excessive production may be indicated. Every one of these patterns is valid in different empirical context. However, there is no information about why the other patterns are not valid in the case of a firm.

4.3 Related Products10 Consider the market for sugarcane. Usually, the organized sector, consisting of sugar mills, must pay a minimum stipulated price. On the other hand, the relatively unorganized gur manufactures buy sugarcane in the open market. Given the prevailing market conditions there will be a well defined (normal demand) for sugarcane from the manufacturers of sugar and gur. Suppose, to begin with, that there is an excess supply of sugarcane after taking the normal demand into account. The sugar manufacturers will not increase production since the market price of sugar will go down. That is the off take of sugarcane by sugar manufacturers does not increase. As a result, the excess supply must result in an increase in the production of gur. The price of gur in the open market will be reduced. By way of contrast, assume that there is a shortage of sugarcane. The price may go up. This induces the sugar manufacturers to reduce production. The production decision can be formalized in the following manner. Let X t = production of sugar at time t Gt = production of gur at time t. 9

Clearly, it is as yet necessary to specify the measures of managerial discretion. Three approaches can be suggested. (a) Use the estimated regression to calculate the expected maximum. Managerial discretion is discernible if the actual observation is lower. However, the possible negative values are difficult to explain. Conceptually, this may indicate that the firm underestimated the potential initially or that the management increased production beyond the stipulated level to gain some perks. (b) Find the maximum output from the observations. The deviation of the expected level of production will then indicate the extent of managerial discretion. (c) Construct an envelope using the data envelopment methods. Managerial discretion may be measured by the amount of deviation from the envelope. None of these measures is perfect. However, to define and estimate the maximum expected output remains an issue. 10 The production of these products depends on a common resource. The context of vertical integration and horizontal diversification will be considered in Chap. 5.

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The demand for sugarcane from these two sectors will then be C xt = a0 + a1 X t , and C gt = b0 + b1 G t Suppose C xt + C gt < C t (total production of sugarcane). X t will not increase. However, C t – C xt will be available to produce gur. That is, Gt will be such that b0 + b1 Gt = C t − C xt and Gt will increase. Let C xt + C gt > C t instead. Then, X t may be reduced to X 1t and Gt will satisfy the equation b0 + b1 G x1t = Ct −C x1t The basic difference in this formulation, based on the empirically observed behavior, consists of accommodating the additional constraints imposed by the specific context. A formulation of this nature was reported in Joshi (1973).

4.4 Small Scale Firms Four observations are significant in the context of small-scale firms. (a) As Singh (1970, p. 75) pointed out, production planning in a majority of units is “based on low utilization of production machinery and equipment. It was often considered economical to have plenty of spare capacity available, to save on machine ‘setting time’.” (b) The cost of acquisition of most of the variable factors of production has been increasing over time. The increase in average variable cost will make it infeasible to conceptualize a commitment for higher levels of production. Hence, an increase in the average variable cost over time indicates a risk that constrains production. (c) Small firms may find it expedient to adjust production to order. (d) The external sources of finance available to these firms are limited and uncertain. The consequent limited repaying capacity makes it imperative on the part of such firms to depend on internal sources of finance while planning production. It should also be noted that the operating cycle of these firms is not more than three or four months. Hence, the most appropriate measure, to determine the extent to which current production operations can be carried out, will be an average of past and current profits. Empirical evidence can be viewed against this backdrop. It was found that firms of the smallest size generally respond to orders and base much of their production on internal funds. They are not significantly affected by market competition.11 That is, they can sell whatever they produce and market demand is not a constraint in itself. However, firms of the largest size are virtually competing with large scale firms in the organized sector. When prices rise and the demand for their products is lowered firms tend to reduce production and sell what they can. Further, they tend to be risk 11

Small firms do not generally have any control on price. They accept the price offered by the buyer and offer the quantity demanded.

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averters since they do not have the strategic flexibility of large-scale units. Such firms also experience marketing problems and consequent difficulties of working capital management. This explains why the largest firms are not able to adjust quickly to the desired equilibrium targets. In generally, the planned production level of large firms depends on a certain high level of utilization of the stock of capital.12 However, their costs of adjustment will be high if production is at or close to the capacity level. Rao and Acharya (1975, 1978) documented these patterns in empirical practice. As stated in the previous section, there is enough evidence that internal availability of resources and the competence of the management constrain production. External conditions like the market demand for the products take over as the size of the firm increases. More recent experiences indicate that the financial constraints imposed by monetary and credit policies have a significant role in the production decisions of such firms.

4.5 Public Sector Firms Several features of public sector firms have been documented. (a) Conceptually, public sector enterprises may be catering to government agencies or private markets. However, the general observation is that their sales related more to interenterprise transfers and enterprise-government exchange rather than to open market transactions. (b) Public sector enterprises suffered from a lack of demand for their products on account of the non-availability of finances for investment projects for which these enterprises were supposed to supply equipment and materials. (c) Public sector enterprises have problems in the collection of receivables because the government departments, which account for almost 50% of their sales, are notoriously poor in making payments on time. As a result of the above three features, most of the public sector enterprises incurred significant losses at one time or the other. In a few cases, the problems have been cumulative for quite some time. (d) Production losses have also been caused by technical problems. In some cases, the indivisibility of equipment contributed to unavoidable capacity imbalances in different sections of the firm. (e) Some cost problems are a direct consequence of the difficulties in the production organization itself. (f) Production also suffered on account of the delays in releasing foreign exchange required to certain essential spare parts. Thus, though the capacity utilization has been improving over time, there is substantial excess capacity in most enterprises. The upshot of these observations is that in most cases, the overheads are so large that it will not be possible to reduce production without incurring a substantial cost disadvantage. Similarly, if, for some reason, the demand is not commensurate with planned production, the firm may keep sales up by using a suitable credit policy. There would be no necessity to increase production if this can be done in the desired 12

The requirement to maintain a high and fixed market share may be the primary reason for such a choice.

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quantum successfully.13 Therefore, it may be hypothesized that, at least in the short run, firms will try to maintain planned levels of production. Empirically, it was observed that K t has a positive sign for all the firms in the estimated equation for production decisions. This provides a strong support for the hypothesis that there is a desire on the part of firms to maintain a steady rate of capacity utilization. Further, another feature is specific to the public sector enterprises. Usually, over fulfillment of production targets is looked upon as a virtue and the management is rewarded. The profit of the enterprise does not receive priority that is expected of private corporations. On the other hand, the management comes under severe criticism if planned targets are not fulfilled. Hence, there is a tendency to understate their production capabilities.14 The following modification of the production decision rule is indicated. Let the initial planned level of production be Pt∗ = αK t . However, if the actual level of production is higher due to unforeseen reasons, the firm will reduce the planned level to avoid penalties in the future. That is, the proposed production target will be   ∗ Yt∗ = α K t − β Yt −Yt−1 ;β > 0 As before, the costs of adjustment suggest   Yt −Yt−1 = λ Yt∗ − Yt−1 Hence, Yt = α0 + α1 K t + α2 Yt−1 , where α 0 = βλY t −1 which is a constant for the reference period t, α 1 = λα, and α 2 = 1 – λ(1 + β). Note that α 2 can be negative. For instance, α 2 = − 0.2 if λ = 0.8 and β = 0.5. That is, when α 2 , the coefficient of Y t −1 is negative there is an indication that firms set lower targets so that over fulfillment is the general rule. Rao and Dua (1980) provided empirical support for this hypothesis in the context of some public sector firms. Public sector firms generally target lower levels of production partly due to the incentives provided for over fulfillment of targets.15

13

However, public sector enterprises have excessive debt burden and are unable to extend much credit. 14 This may occur even if the planned targets for the current year are over fulfilled. 15 Note that this can only be a short-run choice. Over a sufficiently long horizon, the higher level managers may fix output targets rather than rely on the management to do so. They may also alter the incentive schemes.

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4.6 Service Organizations16 The context of service organizations offers a very different perspective on the production decision. The following presentation regarding movie theaters is based on Shrivastava and Mittal (1985). Movie theaters invariably have fixed capacity limits based on their geographic location. For all practical purposes they offer that level of production irrespective of the actual demand. It is generally necessary for such firms to fix a price as well in the hope of stabilizing their demand over time at the predetermined level of production. Indeed it is impractical to think that they can charge different prices depending on the actual number of visitors for a given show of a movie. Hence, the choice of theaters can be represented by the quality of movies they exhibit. The level of occupancy, or demand, is purely dependent on the quality of the movie and is exogenous to the decision making of the firm. The only choice for the management of the theater is with respect to the days over which the movie is exhibited. The simplest formulation presented in Shrivastava and Mittal (1985) is as follows.17 Assume that the demand for seats reduces over time. Let it be represented by S t = C—at, where C is the capacity limit and t is the number of days for which the movie has been in exhibition. Then, the total demand over (0, T ) can be represented by D = C T − 0.5 aT (T + 1) Assume that the contracted price per day of exhibition is α. For simplicity of exposition, this will be assumed to include the other fixed overhead costs of the theater. The net profit for the theater over (0, T ) will then be π = (C – α)T − 0.5aT (T + 1). Consequently, it can be expected that the optimal T over which the movie will be exhibited is T = (C – α −0.5a)/a. Their empirical evidence indicated that this is generally a good approximation. However, they noted the actual choice of the management is generally in excess of the optimal. This may occur due to two reasons: (a) the theater expects demand, though at a low level, to continue for a longer duration, and (b) there is a delay in receiving the next movie that they intend to exhibit. In the context of production processes of the above kind, and of retail outlets generally, there is an option of reducing the price by the amount rt (say).18 Clearly, 16

Price quantity fixation is common in the context of airlines and many others. Can there be a model of product to formulate them? In the context of power generation (a), it must be supplied as the demand arises, (b) power generation is not instantaneous, and (c) output cannot be normally stored. Hence, some advanced planning is necessary. The power plants generally choose fixed operational levels and fix tariffs accordingly. 17 Their study presented many further extensions based on empirically observed variations. However, the basic conclusions will not be affected qualitatively. 18 In the context of retail stores, this is the essence of offering discounts. The strategy of extending credit and increasing the quantum of receivables may be equally efficient.

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r = a/t will induce full capacity utilization. However, this may be infeasible based on profit considerations. It is important to recognize that the definition of production level may vary depending on the service being offered. Note that in the above specification, the price per ticket (though fixed in advance) must be defined by a mechanism other than maximizing profit. This remains an open question.19

4.7 Price Determination Economic theory of imperfect markets suggests that each firm sets the price of its product based on consumer demand and the reactions of rival firms. That is, the demand for the product of a firm is assumed to be exogenous to the decision making of the firm and determined primarily by the market mechanism. However, empirical observation suggests that firms fix these prices apriori and (a) adjust the production level to the demand at the specified price, or (b) fix production also in advance, based primarily on cost considerations, and attempt to sell the output at the price fixed in advance by utilizing non-price strategies. Let the average cost of production of the firm be AC = c0 −c1 K Y + c2 Y 2 This may be a result of the economies of scale and scope made possible by the technology of production and organizational constraints of the firm. The efficient level of production will be Y = (c0 /2c2 )K and the corresponding average cost of production is AC = c0 + c12 (1 − 2c2 )/ 4c2 K 2 The firm may add a margin based on the elasticity of demand and fix the price. This approach is feasible if the firm can influence demand using non-price strategies to correspond to the optimum level of production at fixed price. Consider the possibility that the firm acknowledges a threshold demand curve based on network effects or the limits of using non-price strategies either due to cost considerations or the actions and reactions of rival firms. Let such a threshold be represented by 19 Becker (1991) noted that the demand for tickets on day t may not be (C – at) when network effects are present. That is, a positive feedback from individuals that visited earlier may make more people view a movie. Similarly, full occupancy on successive days may induce some individuals to refrain from a visit. Shy (1995, pp. 438–439) provided a pricing model for services on the basis of such information.

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Ym = T −aY For the cost curve defined above, the profit maximizing production level will be such that T −2cY = c0 −2c1 K Y + 2c2 Y 2 Let Y * be a solution to this equation. Then, p* = T – aY * will be the price set by the firm. Other similar pricing schemes can be conceptualized if holding inventories is possible. Threshold pricing, reference pricing, peak load pricing, and other approaches have been suggested in other contexts.

4.8 Summing Up The primary observation from this chapter is that price determination as usually described in economic theory is rarely applicable. The time lags in the production process, acquisition of capital and other resources, organizational arrangements including the cost of holding inventories do have an influence on the actions and reactions of rival firms. The pricing schemes of airlines also depend on the alternative routing arrangements, the time involved in the travel, and the timing of different flights. It is quite obvious that the production decisions of a firm depend on the external market conditions and internal factors that reflect the resources available and the constraints on the management in directing them to the production targets. Among the external factors, the primary attention was on the expected level of sales and the stock of inventories. It is often acknowledged that the available quantum of finances creates a constraint on the level of production. However, there is no empirical evidence on the conditions under which finances dominate the decision making process. There has been an acknowledgement that some decisions of the management can alter the external market conditions. Chief among them are the non-price strategies that alter the consumer viewpoint or change the interaction with rival firms. Empirical evidences are difficult to discern. Several internal factors may not affect the external market conditions but may have a significant effect on production decisions. Their influence on the stock of capital and internal sources of finance has been attempted. However, when it comes to managerial resources and the competence of such resources to alter production, there is no information available. The primary difficulty is not only in conceptualization but also on the availability of data. The interaction between external and internal factors appears to alter the production decisions. Codifying managerial resources and obtaining the necessary data has been the major constraint in such an endeavor. Every production decision contains some elements of managerial discretion when alternatives are available. General rules about the constraints they experience and

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the objectives they pursue are not readily discernible. The quantitative methods of analysis have not been able to fix the factors that affect the decisions and suggest which of the two or more alternatives that give rise to the same decision rule are operating in any specific context.

References Becker, G. (1991). A note on restaurant pricing and other examples of social influences on price. Journal of Political Economy, 99, 1109–1116. Eisner, R., & Strotz, R. (1963). Determinants of business investment, in commission on money and credit: impact of monetary policy. Prentice Hall. Ingro, B., & Sardoni, C. (2020). Images of competition and their impact on modern macroeconomics. European Journal of the History of Economic Thought, 27, 500–522. Joshi P. (1973), The Sugar Cycle: A Diagnosis, Sankhya. Series B, 427–450. Levis, K. (2009). Winners and losers. Atlantic Books. Rao, T. V. S. R., & Acharya, S. (1975). Structure of Production Decisions of Small Scale Firms. Indian Economic Review, 10, 127–135. Rao, T V S R and S Acharya (1978), Managerial Decisions of Small Scale Firms. Jaico, Bombay). Rao, T. V. S. R., & Dua, A. K. (1980). Inventory decisions of public sector enterprises. Industrial India, 1–6. Schumpeter, J. (1950). Capitalism. Harper Torch Books, NewYork. Shrivastava, D., & Mittal, A. (1985). On the economics of entertainment: optimal length of movie runs. Indian Economic Journal, 35, 66–82. Shy, C. (1995). Industrial organization. M.I.T. Press. Singh, N. (1970). Scientific management of small scale industries. Lalwani. Somayajulu, V. (1971). Production planning in steel forgings industry in India. Productivity

Chapter 5

Multi-product Firms

Most corporations produce a variety of related products. They also utilize an appropriate geographic spread of their production and retail outlets for the sale of their products. Economies of scale and scope, embodied in the technology of the available capital stock, determine the portfolio of the choices. The interrelationships between the demands for the products will also have an effect on such choices. Most of the studies consider the efficiency of organizing production of the multiplicity of products as the more important determinant of the portfolio of the products. The emphasis was on the internal capital market for the efficient determination of the product mix. However, managerial discretion regarding the group of products that are independent of the others affects the performance of the firm. Similarly, an efficient allocation of the fixed resources of the firm is inadequate for the efficient performance. Several dimensions of managerial discretion have been noted. The issue of an efficient mechanisms design remains intractable. That a whole machine should be built of parts of given behavior is not sufficient to determine its behavior as a whole: only when the details of coupling are added does the whole’s behavior become deterministic—Ashby (1960, p. 53).

5.1 The Nature of Products Most corporations, in practice, are multi-product firms. They may be (a) vertically integrated, i.e., produce inputs necessary in the production of their primary product, (b) produce substitutable (by consumers) products or complementary products (the joint use of which consumers value), or (c) conglomerate, indicating that the products are unrelated in consumption. Generally, there will be an excess capacity as a result of competition from rival firms (as the group equilibrium of Chamberlin suggests) and also due to the nature of technology embodied in the capital stock. The firm’s quest to utilize this excess capacity by taking advantage of the demand for related products is one of the reasons for diversification. © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_5

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Fundamentally, if there is near saturation of market opportunities, the management of the firm may find it possible to achieve cost reduction1 by altering the range of products as well as their quantities. It is eminently plausible to argue that much of the time management may find any of the above types of product range to be efficient so long as the technology embodied in their stock of capital and the excess capacity that the firm has can be utilized to improve (and/or consolidate) their market position.2 Both market demand and cost considerations guide the firm in its choice of the range and quantities of the many products that they offer. However, the observed range of product diversification may well be a result of uncertainties in demand for any one (or many) products of the firm. See, for instance, Baumol and Fischer (1978, p. 441), Chandler (1990), and Mueller (1992) The context of vertical integration may be primarily for cost reduction whereas the other two types are closely related to the demand conditions3 though economies of scale and scope (and their relation to the costs of production) are equally important.4 Three broad questions are pertinent: what determines the range of products and the quantities of each product?,5 how best can the production be coordinated?, and what are the sources of managerial discretion and what is the extent of deviation from efficient choices? In general, it is expected that organizational structures can be devised to reduce (or eliminate) the control loss intrinsic to decentralized decisionmaking within the firm. That is, they can be devised in such a way as to optimize the information flows between different echelons of the firm. Thus, the market structure can only define the profit potential whereas the management can help the firm to realize it in practice. The pattern of diversification achieved in practice is therefore determined by the resource base (and the technological and cost relationships that it embodies), the core (distinctive) competencies of the management, and the product market conditions.6 1

This may be one of the reasons adding to the demand for related products. There can be several other reasons for diversification as evident from Chaudhuri et al. (1982), Datta et al. (1991), and Rao (1991). 2 Chandler (1962) and Woodward (1980) contend that the nature of technology determined the scope and extent of diversification as well as the organizational structure that integrates them in the firm. 3 Forward integration into distribution of products may take the form of franchising and/or subsidiaries instead of creating a multi-product firm. 4 If each product is produced in a separate firm costs will increase. Producing more than one product in a firm may create cost advantages related to technology. This may also be related to better management of production. 5 Some intermediate products are specific to a firm. In such a case, the firm may do well to undertake their production. Cost considerations may be secondary. On the other hand, some of these products may be used in the production of a variety of products of other firms. A single firm offering such products may be more efficient due to the cost reduction that can be achieved. Possible holdup issues may till force each of the firms to produce such intermediate products. The costs and prices are insufficient indicators of such choice. Managerial discretion will take the center stage in such contexts. 6 Clearly, the market-determined diversification takes factors outside the production organization of the firm into account. Technological, capacity, and organizational constraints will not themselves

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Recall, from the previous chapter, that it is necessary to identify the strategic and structural features of firms that determine the amounts of each of the products that it produces. However, perusal of the existing studies indicates that this does not receive the required attention. Instead, the primary emphasis of studies dealing with multi-product firms is on the choice of the organizational structure and control as they affect the performance of the firm. In general, the following issues become important. (a) Will firms prefer the longrun market value of the assets of the firm over short-run profits?, (b) can it be demonstrated that firms choose the composition of capital stock and the technology embodied therein ahead of the diversification decision or conversely?, (c) what are the factors that explain the nature and extent of diversification that a firm chooses?, (d) can it be said that the choice of an appropriate organizational structure or control has an independent role compared to the diversification decision, or can it be taken for granted that an appropriate choice will be made to strictly suit the pattern of diversification so that it will not have any further effect?, and (e) will the control measures of the organizational structure have any independent effects? Or, as noted in Cable (1988), Hill (1988), and Varadarajan and Ramanujam (1990), the structural choice and its interaction with control measures become significant? These and related issues need to be examined extensively.7

5.2 Economies of Scale and Scope Given the technology and availability of the minimum size of capital assets embodying it, there is a certain volume of production of the primary product that minimizes cost. However, the externally determined market for the product may result in excess capacity. Following Chandler (1990), it was generally suggested that the technology embodied in the capital assets of the firm and its choice of organizational form will have a distinct bearing on the costs of production. It can be claimed that cost minimization can be an important determinant of the products chosen by the firm.

create binding limits on the extent and quantum of diversification. On the contrary, factors specific (inside) to the firm will gain precedence if the markets themselves are not binding constraints. 7 Deriving market power may be one of the objectives of firms in imperfect markets. The multiproduct structure of firms provides them a market advantage that cannot be achieved by firms producing each product in separate firms. Three features of monopoly power require attention: (a) each of the products may have different monopoly power (measured by the conventional Lerner measure, (b) the monopoly power will now be per unit sales revenue of the firm (instead of the sales of any one product), and (c) it also depends on the influence of the non-price strategies of the firm that would either attempt to identify the value of its products to the firm and/or make attempts to increase the market share of any one or all of the products of the firm. Conceptualizing such a make-power index may well be an additional dimension of objectives in the context of such firms. It is critical that both the aspects of managerial discretion may be operating in imperfect markets of this nature.

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Excess capacity in the production of the primary product leads to diversification. More generally, asset specificity—physical capital goods, location specific, human assets specificity, dedicated assets for a specific consumer—may encourage diversification. It can be suggested that the firm has the option of allowing producers of other products to utilize such excess capacity. However, apart from the scheduling difficulties the firm should consider the possibility of rivals getting to know its business models and technology that they may eventually imitate. The synergies among products may be technological, market related, or organizational. Irrespective of their source such synergies will be expected to encourage diversification. However, the observed range of product diversification may well be a result of uncertainties in demand for any one (or many) products of the firm. See, for instance, Baumol and Fischer (1978, p. 441), Chandler (1990), and Mueller (1992) As Rao and Singh (2000) noted, the firm can make cost-minimizing changes in production if it can anticipate changes in market demand. However, greater changes in production may be necessitated if unexpected changes in demand occur since other adjustment mechanisms are not available in the short run. Great care is required in deciding which activities are related since there may be important spillover benefits from one part to another. Varying management styles required to control different activities may mean that the problem is not solved. Two possible decisions are the size of capital assets and the degree of diversification. Life cycle effects mean that older firms exhibit greater diversification. Firms which encouraged centralized decision-making are more likely to diversify. Managerial wisdom is reflected in withdrawing some products and sometimes in adding new products. The choice of product portfolio depends on four aspects of management decisions, viz. flexibility, ability to focus, the management’s control on corporate affairs, and the cost of transacting a given volume of business. However, in several contexts, technological considerations may precede others. For instance, vertical integration is explained by technological factors—steel milling and steel production. The metal has to be reheated to make plates if they are separate. But there is no problem if both are under the same roof. Thus, as Rubin (1980, p. 155) noted, common ownership is required by the transaction structure of the deal.

5.3 Tradeoff Between Objectives The previous section considered the factors that explain why a firm considers product diversification to be important. It is necessary to identify the objectives that a firm endeavors to achieve in its choice of the exact combinations of diversification that it wishes to pursue. The following possibilities should be considered. (a) The management may maximize profits in the short run. This is the conventional objective attributed to managers. It may be due to the profits that they should retain in order to offer what the shareholders expect. It may also be due to the necessity to attract new capital investments.

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(b) The managers of the firm may be interested in their continuity in the organization over the long run. This can be achieved by maximizing the market value of the firm. (c) The management would be interested in satisfying the consumers and maximizing the market value of the firm. This may be one of the avenues for their long-term survival. In an M-form organization, the divisional managers have the autonomy to make decisions. They will have the independence to devise strategies for their divisions. The basic decisions in their purview are the generation of assets, through the allocation offered by the CEO, and their use. Further, they may endeavor to minimize outside interference and preserve the autonomy of their team. However, the autonomy of divisional managers may lead to several unexpected consequences. Note that the objectives of the management may not be in one dimension alone. For instance, the management may forego short-term profits to achieve higher market value or market share in the long run. Second, increased size may be an aspect that gives them prestige and control. Baumol (1959) considers the volume of sales as one dimension. Williamson (1970) argued that the ability to have adequate financial resources and spend them on the expenses associated with the division is important. Third, when a product division is sufficiently large the administrative load on the management increases. They will try to reduce the output of the firm if returns are considered inadequate to compensate the workload. Similarly, when the market for their product is uncertain they may either try to stabilize its market share or choose a level in excess of that which maximizes the market value of the firm. Consider the tradeoff between the efficiency in the allocation of capital to different divisions and the control that managers have. In the centralized U-form, the management may gain control while they experience a greater workload and inability to influence the capital allocation to the division. On the other hand, in an M-form there is an increase in the efficiency of capital allocation but the general manager experiences a loss of control. Clearly, there can be other aspects of tradeoff that are specific to a firm. Tradeoffs occur due to difficulties to overcome free riding, the lack of observability of effort or the lack thereof, individual performance, lack of congruence of goals between central and divisional management, and so on. Monitors themselves must be satisfactorily motivated. Otherwise, they may divert gains away from shareholders to themselves. Hill (1984, p. 65), and Williamson and Bhargava (1972) contend that the goals of the CEO may not be to maximize profits, and the divisional managers may not share the same objective. The behavior of practicing managers is to look for possible improvements within the accepted constraints. Uncertainty is therefore the lack of recognition of constraints that can be overcome and in ways that do not strictly go against stated objectives. Increased job security and opportunism may lead to decreased responsibility and free riding. The management may endeavor to maintain diversification to a level where they can minimize outside interference and preserve the autonomy of the management team. Similarly, when the market for the primary product is uncertain, diversification may stabilize the market share. Managers choose in excess of that maximizes the market value of the firm.

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5.4 Organizational Forms8 When the firm is specializing in a single product, the CEO creates functional divisions, delegates responsibilities to divisional managers, and coordinates their activities. In the context of a multi-product firm, Hill (1988, p. 79ff), and Naylor and Thomas (1983, p. 130) noted that extensive relationships among products may necessitate the U-form. Rubin (1980, p. 9) pointed out that vertical integration is beneficial when assets are specific. It will save haggling costs since efficient contracts may not emerge. The assets of both input and output streams are worth more if one person owns both. That is, a U-form will be more efficient. However, Chandler (1962, pp. 382–383) argued that “the inherent weakness (Uform) in the centralized, functional organization is the administrative load on their executives. They are not able to handle any entrepreneurial activities efficiently. In addition, operations of the enterprise become too complex, and problems of coordination, appraisal, and policy formulation become too intricate.” U-form allowed opportunism because the top management was in charge of too many day-to-day operational details. A firm which diversifies into technologically unrelated products will choose an M-form consistent with the requirements of an internal capital market. In the M-form, the general office can be created as an internal capital market and strategic resource allocation is delegated to it. Market opportunities drive the diversification decision when the products are distinct. Hence, distinct product lines enable an organizational structure along Mform lines. Williamson (1970, p. 134) holds that “the organization and operation of the large scale enterprise along the lines of the M-form favors goal pursuit and least cost behavior more nearly associated with the neoclassical profit maximization hypothesis than does the U-form alternative.” In the M-form, the general office can be treated as an internal market since strategic resource allocation is delegated to it. Chandler (1962, 1990) argued that most of the firms derive market advantages by exploiting the economies of scale inherent in the production of their primary product. However, the market limits the degree to which size advantages can be exploited. Further, as Mueller (1992) pointed out, the demand for the primary product of the firm will be subject to life cycle effects. Over time the management would find it necessary to utilize the fixed assets of the firm to produce a variety of goods. The alternative viewpoint is the following. The managers of the firm take signals from the market about profitable production opportunities, choose the optimal level of diversification, and acquire capital assets of the firm accordingly. Teece (1980) pointed out that “internal trading changes the incentives of the parties and enable the firm to bring certain managerial control devices to bear on the transaction, thereby attenuating costly haggling and disruptions and other manifestations of non-cooperative behavior.” When this kind of an organizational structure 8

Efficient allocation of resources to the product divisions and controlling managerial discretion have been the main emphases in choosing the organizational arrangements. Some pertinent issues have been presented in Fulghieri and Hodrick (2004), Rao (1989, 2011), Thompson and Wright (1988), and Willamson (1971)

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is adopted, the management develops distinctive competencies in terms of (a) the ability to design the organizational structures to accommodate a given diversification strategy even if it is into related products and (b) the exercise to control diversified business through the internal capital market. Leach and Leahy (1991, p. 1418) pointed out that control is the power to exercise discretion over major decision-making. In that sense, the U-form has control advantages though efficiency considerations may be called into question. On the other hand, loss of control can be expected for a variety of reasons while the M-form suggests an increase in efficiency. The inability to bring about cost control and/or adapting organizational control to unexpected market fluctuations makes the M-form vulnerable. The following observations are pertinent. (a) M-form divisions may not be subject to capital reallocation by corporate management. Power relations between divisions heavily influence the allocation of investment funds. With capital rationing, some units may be designated as “cash cows” and deliberately starved of investment funds while milking them to finance developments elsewhere. The need to monitor an increasing diversity of operating divisions may also hinder an internal capital market. (b) The inability to write watertight contracts allows management to engage in opportunism and shirking. Monitors themselves must be satisfactorily motivated, or they may divert gains away from shareholders to themselves. Central management has incentives to develop the firm beyond the optimal size because of the rewards that occur with it. Thus, M-form may not reduce the pursuit of sub-goals by the management. Similarly, as salaried employees, the divisional managers may not be profit oriented. (c) The experiences of Markides () indicate that there have been miscalculations and over-optimistic over reaching of managerial competence in diversification. In other words, the M-form organizational culture encourages excessive diversification. This results in a tendency on the part of the management to seek control since the management may endeavor to maintain the operations of the firm at a level where they can minimize outside interference and preserve the autonomy of the management team. The desire to diversify production also arises from the need to stabilize the market share of the firm when the market for the primary product is uncertain. Similarly, there can be potential control problems if unions press for wage parity across different products or geographical markets. It is doubtful whether the M-form prevented the spread of remuneration systems across divisions based on the notions of parity rather than marginal productivity. A risk-averse management may therefore choose a level of diversification in excess of that which maximizes the market value of the firm. (d) The difficulties are to overcome free riding, observing effort and individual performance, the lack of goal congruence between central and divisional management, and the danger of encouraging short-term performance due to the existence of asymmetric information. Managerial discretion does not vanish in M-form.

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Williamson (1986, p. 179) argued that the efficiency of decentralized organizational structures depends on a combination of structural and control properties. However, Hill (1988, p. 71) and Varadarajan and Ramanujam (1990, p. 475) indicate that the lack of an appropriate control may reduce the effectiveness of the organizational structure. Nayyar and Kananjian (1993) observed that organizational synergies can only be in related lines of production based on organizational competence. Cable (1988, p. 20) noted that “profit maximizing behavior at the top level remains only an assumption underlying the M-form hypothesis, and perhaps its strongest assumption. The desirable properties of the M-form in constraining lower level behavior toward an overall objective, and avoiding organizational chaos after rapid and diversified expansion cannot be taken for granted.”

5.5 Franchises and Subsidiaries To this point in the analysis, the emphasis was on M-form organizational gains obtained from independent product divisions. The demand for the products was assumed to be at one location. It may be the same as that of production. A similar approach to product divisions and delegation of responsibility can be discerned in two other contexts. Assume that the demand for the product of the firm is spread geographically. (a) There may be economies from centralized production but not distribution or sales (e.g., automobiles). In such a case, the franchise may be for distribution and sales. (b) In the context such as soft drinks, decentralized production is not only feasible but it will be economical. The parent company may create a franchise while retaining control on production and quality standards so that there is no erosion of the brand name of the parent company.9 Both the franchisor and the franchisee want the joint profit to be as high as possible though the ownership remains independent. In some franchise operations, there may be economies from centralized production and decentralized distribution (automobiles). In others, centralization of image creation may be combined with decentralized production (soft drinks). Two forms of franchising are discernible: (a) an organization (the franchisor) with a business centered on a product or service entering into a continuing relationship with selffinanced and independently owned small firms operating under the franchisor’s trade name to produce and/or market goods according to agreed-upon rules and (b) exclusive right to produce a particular product or service for a given period. Franchising is viable if (i) the contract is complete and clearly specified (to be enforceable), and (ii) there are incentives for the franchisee to perform (residual claimant). No problems of risk-bearing will occur when the franchisee has a large portion of wealth tied-up in an undiversified portfolio. Parent companies may monitor quality standards and cost minimization. 9

Many aspects of organization related to franchising and subsidiaries have been considered in Kasufman and Lafontaine (1994), Kindstrom (2010), Lafontaine (1992), and Pyo (2007).

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The vertical separation provided by franchising can make commitment to a transaction more observable and harder to reverse. The residual claimant status of the franchisee reduces the need for monitoring and enables a single supervisor to oversee a large number of franchisees. Contracting out transactions to a specialist may enable the firm to achieve economies of scale and scope and avoid transaction cost problems. On the other hand, a subsidiary implies a controlling shareholding of the parent company. Given the legal rights, the accounts of the subsidiary appear in the parent company’s balance sheet. Subsidiaries also have implications for taxation and legal claims. Franchising may be important in the early stages but a return to integration occurs in a mature phase. A firm may switch to dealing with a newly created firm as a subsidiary. On the other hand, a small, perhaps newly developed (may be sales or production), part of a group is separated out into a new legal entity (subsidiary) when there is a recurring relationship between the firms with low asset specificity, scarcity of resources, and small markets so that firms can act independently and efficiently. The firm may switch to dealing with a newly created firm as a subsidiary. For purposes of the present analysis, franchising is important because it has the nature of an M-form organizational structure. For all practical purposes, it is expected that franchising improves the operations of the parent company. However, the problems of M-form organizational structures prevail.

5.6 Non-Price Strategies and Value Generation Each product has a distinct value to the consumers. However, due to information symmetry and cost of evaluating the value consumers may not respond (create demand) adequately. Firms may utilize non-price strategies to reveal value to the consumers. When several firms in the market offer substitutable products, these strategies may be utilized to improve their market share beyond that implied by the intrinsic value. Note that different products offered by the firm require distinct resources (materials, management, finances). The management of the firm, while allocating its resources among the different products, may wish to economize on the use of a specific resource. Consider the returns management obtains and/or profit that can be generated. The actual mix of outputs chosen will depend on the perception about markets, resource requirements and costs of production, managerial compensation, and organizational details of production. The choice need not be in line with the intrinsic value of the products. The distortions may be due to the non-price choices as well. Strategies of the firm may be such as to enable the consumers to infer the true value of the products. Intangible loyalties, viz. those of consumers, suppliers of inputs, the workers towards organizational goals, and of marketing agents, cannot reduce once they have taken root. The actual market power of a firm consists of not only the difference between price and marginal cost but also the economic activity over which the deviation

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occurs. The ex post market share achieved through the use of non-price strategies is a consequence of the consumer valuation, firm’s efforts to influence the consumers, and the presence of competitive firms. The convergence of consumer valuation, the firms realizing that these choices must be a part of their strategies, and the recognition by rival firms that the ultimate equilibrium over the long run emerges only when every party in the exchange modifies its strategies accordingly is unlikely.

5.7 Empirical Evidence Technological features of the primary product and economies of scale and scope are the basis of the capital stock of a firm. Generally, older firms, whose products are in the declining phase of the life cycle, are more likely to diversify. The efficient use of capital assets necessitates the diversification decision. That is, firms do have a preference for a large size of capital assets as a priority over the extent of diversification. There will be greater diversification whenever the organizational culture supports product-wise divisions and decentralization. Related or unrelated product choice is not a major consideration in the diversification decision because the existing assets should be used according to market conditions. As Khanna (1994) pointed out, diversification may be due to market euphoria, technological and cost relationships, flexibility of the organizational structure and culture, possibility of breaking out of MRTP regulation, willingness of MNCs to enter into technological collaborations, availability of finances through direct foreign investment, and optimism on the part of large firms about developing their distinctive competencies in a dynamic environment. Williamson (1986, p. 179) argued that the efficiency of decentralized operations depends on a combination of structural and control properties. Similarly, Cable (1988), Hill (1988, p. 71), and Varadarajan and Ramanujam (1990, p. 475) indicated that the lack of an appropriate control mechanism may reduce the effectiveness of the organizational structure. The organizational structure and control variables interact in producing the desired optimization. In the case of general engineering, the existing divisions are along product lines and/or based on common facilities. This reflects technological synergies. At the other extreme, in the electrical goods industry divisions are mostly along the lines of market expansion. In the case of chemicals and cotton textiles, it was observed that horizontal diversification along product lines as well as geographic expansion of markets is important. The range of consumer tastes for variety necessitates expansion into a wide spectrum of products and catering to as many markets as possible in order to stabilize market share. The variability in the product markets justifies spreading the risks rather than concentrating it in the hands of a few. This necessitates a reduction in the shareholding of the directors and owners. As Leech and Leahy (1991, p. 1433) put it, frequent changes in the environment require frequent adjustments to the deployment of productive assets and shareholders have a greater incentive to exercise control.

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The chemical industry, which is primarily a process industry, requires more working capital since it tends to increase inventory when confronted with product market fluctuations. However, the ability to diversify into different markets enabled it to successfully reduce the pressure on high liquidity requirements. For general engineering, product-based diversification necessitates the divisions maintaining specialized inventories of raw materials and goods in process that tend to increase working capital requirements. Textiles and electrical goods are affected by market fluctuations. Inventories and working capital are high. Caves (1980, p. 75), Kinnie (1987, p. 467), and Marginson (1985, p. 141ff) noted that the operation management may be compelled to pay higher wages due to unionization and generate a higher wages-to-sales ratio. The expected controls are operating both at the level of the general management and at the divisional levels. However, they are mostly determined by the instability of product markets and the need to maintain harmonious relations at the divisional level. Aggressive profit maximization is subservient to this overall trend. As Ouchi (1984, p. 6ff) put it, the balance between individual effort and teamwork explains the success of the M-form. Interaction is crucial, not structure and control. The inability to bring about cost control and/or adapt organizational functioning to the unexpected fluctuations in the market makes the control aspect crucial. Several issues of managerial discretion appear to be relevant. (a) Do firms prefer to maximize profits rather than the market value of the firm? (b) Is it possible that managements will trade off some market value to achieve higher diversification or greater capital stock and assets? Rao and Rastogi (1994) developed methods of resolving these issues. They offered several empirical evidences on these issues. Rao and Acharya (1995) offered some empirical evidence with respect to the choice of organizational forms as well. The salient findings can be summarized as follows. (a) Most firms concentrate on diversification decision and the necessary capital stock acquisition and tradeoff market value of the firm. (b) Firms prefer to trade off short-run profits in preference to achieving greater market value of the firm. (c) In addition, they trade off market value to achieve the desired diversification into products. (d) They trade off market value to achieve greater stock of capital. (e) While it is expected that an organizational structure like the M-form would be a significant aspect of management strategy it did not appear to be empirically significant. Stated differently, firms perhaps find appropriate organizational arrangement based on their diversification attempt and they cannot be of separate and significant influence in determining the market value of the firm. The nature of the market for the diversified products seems to determine the diversification decisions. These findings are at variance with the findings presented earlier. It is possible that they apply to the chemical industry more so than others.

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5.8 Anomalies This chapter presented details about the emergence of multi-product firms and the need to seek an organizational structure to stay efficient. In particular, the M-form and the associated internal market were designed to cater to the needs of products that have independent markets so that the economies of scale and scope embodied in the technology can be used efficiently. However, empirical evidence indicates that (a) to identify independent product groups is an uphill task, (b) the independence of the management of each product division leads to their discretion to pursue policies that perpetuate their interests instead of those of the firm (such as minimizing profit or the market value of the firm), (c) the differences between cost-minimizing choices of the product mix will be at variance with profit maximization resulting in managerial discretion, (d) there is a need to find ways to allow the interaction between organizational structure and control mechanisms to deliver the desired efficiency. The tradeoff between these goals in empirical practice remains unexplored, and (e) the expectation that the capital asset choice follows the multi-product decision does not appear to hold empirically. Future work should focus at least on the following issues: (a) How can a firm decide the combination of interrelated products if the markets are not an adequate guideline? What is the objective of the management if profit maximization is not dominant? (b) What is the efficient choice of organizational structure and control if all the products of the firm are complements of each other? Can U-form be modified in such a context? (c) Differences in the composition of excess capacities in different types of product lines lead to managerial discretion and firms respond to this need by aligning the output combinations? (d) Note that the capital structure of the firm and the influence that shareholders have on the product mix of the firm also remain unexplored. Isolated examples and case material do not offer adequate information about the outcome of the decisions and offer inadequate information about the factors that lead the management to make the choices they have. As a result, they cannot provide guidance to the management. Even machine learning algorithms that have the objective of guiding the management in making a choice with future consequences require more information than what is available currently. Similarly, the basic motivation for the use of specific combinations of non-price strategies remains unexplored. It would be worthwhile to investigate the economic forces behind such decisions and contrast them with those emerging from managerial discretion. Such an exercise is necessary to provide guidelines to the management in their choices. The availability of the requisite data and analytical tools to utilize it even if it is available continues to be insurmountable obstacles for further progress.

References Ashby, W. (1960). Design for a brain. Wiley. Baumol, W. (1959). Business behavior: Value and growth. McMillan.

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Baumol, W., & Fischer, D. (1978). Cost minimizing number of firms and determination of industry structure. Quarterly Journal of Economics, 92, 439–467. Cable, J. (1988). Organizational form and economic performance. In S. Thompson & M. Wright (Eds.), Internal organization, efficiency, and profit. Philip Allen. Caves, R. (1980). Industrial organization corporate strategy and structure. Journal of Economic Literature, 18, 64–92. Chandler, A. (1962). Organizational capabilities and the economic history of the industrial enterprise. Journal of Economic Perspectives, 6, 79–100. Chandler, A. (1990). Scale and scope: The dynamics of industrial capitalism: Advances in economic and econometric theory and applications. Cambridge University Press. Fulghieri, P., & Hodrick, L. (2004). Synergies and internal agency conflicts: The double edged sword of mergers. Journal of Economics & Management Strategy, 15, 549–576. Hill, C. (1984). Organizational structure in the development of the firm and business behavior. In J. Pickering & T. Cockerill (Eds.), The economic management of the firm. Philip Allen. Hill, C. (1988). Internal capital market controls and financial performance in multidivisional firms. Journal of Industrial Economics, 37, 67–83. Kaufman, P., & Lafontaine, F. (1994). Costs and control: The sources of economic rents for McDonalds franchises. Journal of Law and Economics, 37, 417–453. Khanna, S. (1994). Core versus anti-core (pp. 68–77). Business Today, August 7–21. Kindstrom, D. (2010). Towards a science based business model—Key aspects for future competitive advantage. European Management Journal, 28, 479–490. Kinnie, N. (1987). Bargaining within the enterprise: Centralized or decentralized? Journal of Management Studies, 24, 463–477. Kumar, C. S. K., Prahlad, C., & Vastala, S. (1982). Patterns of diversification in larger Indian enterprises. Vikalpa, 7, 23–39. Lafontaine, F. (1992). Agency theory and franchising: Some empirical results. Rand Journal of Economics, 23, 263–283. Leech, D., & Leahy, J. (1991). Ownership structure control type classifications and the performance of large British companies. Economic Journal, 101, 1418–1437. Marginson, P. (1985). The multidivisional firm and control over the work process. International Journal of Industrial Organization, 3, 37–56. Markides, C. (1992). The consequences of corporate restructuring: Ex ante evidence. Academy of Management Journal, 35, 398–412. Markides, C. (1995). Diversification restructuring and economic performance. Strategic Management Journal, 16, 101–118. Mueller, D. (1992). The corporation and the economist. International Journal of Industrial Organization, 10, 147–170. Naylor, T., & Thomas, C. (1983). Microeconomic foundations of corporate strategy. Managerial and Decision Economics, 4, 127–135. Nayyar, P., & Kananjian, R. (1993). Organizing to attain potential benefits from information asymmetries and economies of scope in related diversified firms. Academy of Management Review, 18, 735–759. Ouchi, W. (1984). The M-form society. Addison Wesley. Pyo, U. (2007). Enhancing managerial incentives and value creation: evidence from corporate spinoffs. Journal of Economics and Finance, 31, 341–358. Rajagopalan, D. D. N., & Rasheed, A. (1991). Diversification and performance: Critical review and future directions. Journal of Management Studies, 28, 529–538. Rao, T. V. S. R. (1989). Inefficiency in the organizational decisions of the firm. Arhavijnana, 31, 176–195. Rao, T. V. S. R. (1991). Economic efficiency of the horizontal integration decisions of the firm. Indian Economic Journal, 39, 14–49. Rao, T. V. S. R. (2011). CES as an organizational production function. International Journal of Economics and Business Research, 46, 69–81.

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Rao, T. V. S. R., & Acharya, S. (1995). Product diversification and market value of the firm. Decision, 22, 229–245. Rao, T. V. S. R., & Rastogi, R. (1994). Estimating attitudes towards risk in a volatile environment. Indian Journal of Applied Economics, 3, 253–270. Rao, T. V. S. R., & Singh, A. (2000). Market imperfections, financial constraints, and the volatility of production. Indian Journal of Economics, 81, 61–80 Rubin, P. (1980). Managing business transactions. Free Press. Teece, D. (1980). Economies of scope and the scope of the enterprise. Journal of Economic Behavior & Organization, 1, 223–247. Thompson, S., & Wright, M. (1988). Internal organization, efficiency and profit. Philip Allen. Varadarajan, P., & Ramanujam, V. (1990). The corporate performance conundrum: A synthesis of contemporary views and extension. Journal of Management Studies, 27, 463–484. Williamson, O. (1970). Corporate control and business behavior. Prentice Hall. Williamson, O. (1971). Managerial discretion, organizational form, and the multi-division hypothesis. In R. Maris & A. Wood (Eds.), The corporate economy. Macmillan. Williamson, O. (1986). The multidivisional structure. In J. Barney& W. Ouchi (Eds.), Organizational economics. Jossey Bass. Williamson, O., & Bhargava, N. (1972). Assessing and classifying the internal structure and control apparatus of the modern corporation. In K. Cowling (Ed.), Market Structure and Corporate Behavior. Grey Mills. Woodward, J. (1980). Industrial organization. Oxford University Press.

Chapter 6

Advertising and Warranties

Very often the emergence of new products, embodying new technologies and creating new ways of catering to consumer needs, has been a recurrent theme. The success of such products on the market depends on the knowledge of consumers regarding the value of such products to them. Firms adopt broad general strategies of advertising. Consumers tend to ignore a large part of such impersonal information. Managerial discretion may indicate that firms spend on advertising even if the sales revenues do not increase simply because such costs can be written off against profit and reduce corporate taxes. Similarly, the recall value and stabilizing demand over time may provide adequate information. The managements also utilize more direct methods of persuasion in the form of warranties. The quantitative choices are also a form of managerial discretion. Many related issues have been addressed though the optimal mix that minimizes managerial discretion remains elusive. The management is always looking for “more efficient ways of operating, for a smarter way to price their products – anything that will win them more customers and give them an advantage over competition.”—Beattie (2019, p. 10)

6.1 Focus on Consumer Increasingly, most firms operate in markets characterized as differentiated oligopoly. As a rule, they resort to advertising and other sales strategies, to convey the value of their product to the consumer, so that they can increase and/or stabilize their market share. Advertising and selling strategies of firms are highly impersonal. They target consumers generally. As a result, they may not be in a position to convince specific consumers, about the quality of their products and their commitment to satisfy consumers, regarding the use of their products. Consequently, they find it necessary to convince the consumers of their desire to satisfy their wants by protecting them with warranties. Warranties apply mostly in the context of durable goods though both strategies are applicable generally. These approaches endeavor to obtain consumer loyalty to the products of the firm and to ensure stability of their market share. Two © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_6

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further observations are relevant. (a) It is not altogether clear if the management considers these two types of strategies as substitutable. (b) If they do, it is necessary to explore the managerial discretion in favor of one over the other. Many other details of managerial choices are relevant. First, advertising should not refer to the amount of money spent alone. It is equally important to examine the managerial discretion regarding the choice of content, the frequency of advertising, and the various media (television, billboards, personal visits, etc.) employed. Some of these aspects did not receive the analytical attention they deserve. Second, in many contexts, pricing strategies, such as discounts and sales, choice of outlets to sell their products, and associated strategies overlap with other strategies. There is a possibility of far-reaching substitution and managerial discretion. The existing empirical studies barely scratch the surface. Analytical attempts focus on different aspects of these choices. Consider the motivation to undertake advertising. First, studies on advertising generally tend to focus on the changes in market demand and the elasticity of demand as the major consequences. That is, the nature of the market structure is postulated as the major determinant. Second, in more recent studies dealing with decentralized organizational structures, it is recognized that the marketing manager has the best information regarding the market condition for the products of the firm. Consequently, the marketing manager is held responsible for the sales of the firm. As a result, they have the responsibility to define the market share strategies. The general manager allows them to utilize advertising and the associated selling costs1 to achieve the target they set.2 One of the consequences of advertising is to deter entry of rivals into the industry. Secondly, they increase sales and market share of the firm and reduce the elasticity of demand. These features enable the firm to maximize profit. Observe that a firm derives advantages regarding market share either in its interface with the consumers or its interaction with rival firms. Advertising strategies may operate at either level. Some strategies target one rather than the other but it is difficult to maintain such a distinction. Rao and Bhattacharyya (2021) outlined several of these distinctions and offered empirical evidence. In general, most firms utilize a majority of strategies to attract consumers. When the products of different firms are highly substitutable firms tend to use some of these strategies to lure consumers away from rival firms. This can be observed even when new materials (lighter and durable) displace steel (say) and electronic communication devices replace conventional paper trail. Further, it should be noted that consumers neglect several advertising strategies. The possible inference is that they are directed to divert consumer attention from the products of rivals. Such selling costs tend to be unfavorable to the consumers (increase prices) and to shareholders (by reducing the profit of the firm). Several individuals are affected by the advertising decisions of the firm and the far-reaching tradeoffs signal managerial discretion.

1

Selling costs include discounts, payments to selling agents, and so on. On some occasions, it was claimed that firms indulge in advertising merely as a means of writing them off as costs and avoid profit taxes. To obtain empirical evidence is almost impossible.

2

6.1 Focus on Consumer

101

Firms consider warranties as another strategy to convey the value of their products to the consumer. In general, warranties may also be motivated due to the durability of some products. In such cases, the consumer demands that the firm should assure continuity of the quality of service from the product. However, such continuity also depends on the manner in which the product is used. Hence, the firms tend to expect some preventive maintenance on the part of the consumer so as to provide continuous service over the stipulated life span of the product. Such caveats, that warranties stipulate, do provide an incentive effect since the consumers must adhere to them to be entitled to warranties. Despite the best efforts of the firm, it is possible that the consumers find the product unsatisfactory. The consumers then demand an adequate compensation. The warranty also specifies the liability of the firm in such contexts. This provision offers a control to the firm over the consumer misusing rights. That is, warranties offer an integrity effect, an incentive effect, and a control effect. Note that warranties are generally contracts between the firm and consumers. As yet, it is difficult to conceptualize the effect of warranties on the demand for the products of the firm. Note that warranties may be observed on several low-valued products. It can be quickly judged that consumers will not be able to utilize it fearing legal costs that will not be commensurate with the claim for compensation. Warranties do not cover all aspects of the quality of service, and the firms can claim that they are not responsible for certain observed infractions. There is thus a significant doubt about the efficacy of warranties and associated contracts. Studies on advertising, while focusing on market demand, consider the tradeoff between profit and market share as significant. They also concentrate on managerial discretion that does not make attempts to minimize costs to maximize profits. There have been many difficulties in conceptualizing efficient advertising and measuring managerial discretion. The possibility of managerial discretion can be illustrated by the following. In Fig. 6.1, S 0 represents the market share of the firm in the absence of advertising or warranties. Non-price strategies may not be useful when the volume of advertising intensity (measured as the volume of advertising per unit of sales) is low (point Am ) essentially due to the costs involved. Similarly, beyond the point Am these strategies lose their efficiency since the consumers have a good idea about the use of products. That is, advertising is useful between pints Am Am . Their effect will be the maximum at A*. The efficiency gains may be represented by XY. However, the management of the firm may be content with obtaining Y * that offers an assurance that they will not be displaced. As a result, YY * can be designated as the result of managerial discretion. The rest of this chapter will focus on the discretion that management exercises in pursuit of objectives, other than those expected initially. Essentially, there is a recognition that the observed performance of the firm may be less than that which is expected while designing strategies. The reasons for the deviation will be investigated. They will be offered as basic dimensions of organizational slack as in Williamson (1970) and X-inefficiency in the choices of the management.

102 Fig. 6.1 Limits on advertising

6 Advertising and Warranties

S Y Y* Am

Am X Sa O

AI*

S0 AI

6.2 Advertising and Selling Costs The effect of advertising on the demand for the products of a firm can be considered to arise from the following channels: (a) selling costs provide the consumer information about the product and thereby alter their preferences and the demand for the products of a firm, (b) a firm gains customers by altering the demand curves of firms that offer related products, (c) in this endeavor the level of advertising chosen by a firm will not be necessary that which maximizes the demand for its products, and (d) as a corollary, the choice of the nature and quantum of expenses may not minimize the cost of achieving a given level of sales. The definition of the costs at which the consumer obtains the requisite information about the products has another dimension. Fundamentally, the consumers need to choose from a variety of products on offer. The collection of the requisite information may necessitate searching beyond the messages conveyed by advertising by the firm. Based on such search, the consumer may express a preference for a certain level of advertising and thereby exhibit a ceiling demand curve.3 Figure 6.2 illustrates this viewpoint. As the level of advertising intensity on the horizontal axis increases, the consumer is in a position to evaluate the value of the product and the willingness to pay the price that is represented on the vertical axis. Conceptually, the consumer would have received the necessary information about the intrinsic value of the product when Am is attained. However, the firm would consider the cost C(A) of using the advertising level A.4 The firm will tend to increase A to the level Aa . The consumers would be willing to 3

Dixit and Norman (1978) and other authors consider this ex post demand curve to measure the efficiency of the firm. 4 To make the comparison between the price on the vertical axis with cost that is now defined, it is necessary to view C as the cost per unit of output. This cost evaluation is from the consumer perspective.

6.2 Advertising and Selling Costs Fig. 6.2 Advertising in excess of threshold

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V C(AI) V(AI)

O

Am

Aa

AI

accept Aa > Am since they will experience a search cost of switching to a product of a rival firm. Consumer loyalty may be of this nature as well. The realized demand and market share will not be commensurate with the intrinsic value of the product. Note that a method of isolating Am would still be necessary. Turn to the choice of the management of the firm. Their attention will be focused on the attainable market share. Thus, market share will replace price on the vertical axis.5 However, there is a maximum level of advertising at which the market share, commensurate with the intrinsic value of the product, will be attained. Note that the firm may be motivated to choose Aa > Am even if it has a transitory gain in the market share. The consumers can be expected to eliminate it over the long haul. This indicates one source of managerial discretion. Turn to the actual choice of Aa by the firm. If the firm considers the basic effect to be on the market for the product, it can be expected that they wish to maximize profit. However, if the firm is orienting advertisements to attain the maximum possible market share the corresponding Aa will be different. This is another source of managerial discretion. It may be more realistic to postulate that the firm would be willing to forego some profit to attain a higher market share. That is, the management would be prone to maximize U(π, s), where π = profit, and s = market share. The determination of the tradeoff is yet another dimension of managerial discretion. In general, managerial discretion will be a result of (a) information asymmetry, (b) managerial preference for profit, and (c) managerial attitude toward risk. A preference for a high and stable market share over the short-run profit may well be in the interest of long-run gains for the firm. Reconsider the viewpoint that the management of the firm considers advertisements as a means of convincing the consumer. The changes in demand will be the

5

The cost should be interpreted as the cost of achieving a unit of market share.

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primary factor affecting the choice of the level of advertising. If excessive advertising is observed in practice the general manager may place some constraints on the marketing manager or provide some incentives to ensure compliance. On the other hand, suppose excessive advertising results even when the marketing manager has the authority to choose its level. For instance, assume that the marketing manager is rewarded for attaining or exceeding the stipulated target of the market share. There will be a motivation to understate market share targets and overstate the requirements of advertising. This may convince the general manager that higher levels of market share can be attempted. Competition from rival firms would be necessary to make the two levels correspond. In practice, excessive advertisement may be due to managerial discretion.6 The market structure itself will not have any significant effect.

6.3 Modeling the Effects Consider the effect of advertising on the consumer valuation of a product and the resulting shift in the market share of the firm. The following modeling approaches may be recorded. (a) MS = market share = f (AI), where AI = advertising expenditure per unit of sales. It is important to recognize that AI may itself have various components. Further, the effect of a unit change in AI will also be due to several factors. One such is the availability of warranty. After all, a money-back guarantee announced through advertising is not legally binding on the firm. (b) Recall that AI may have threshold effects. Surely, there will be a limit on consumer expenditure on any particular item. Similarly, consumer valuation of the products may not enable the firm to achieve a market share implicit in such a valuation. (c) Turning to the influence of rival firms, it is clear that in imperfect markets rival firms utilize their own strategies to reduce the market share of a firm. The advertising expenditure of a firm relative to the total advertising expenditure of all the firms in the industry may be a better proxy. The interconnection between advertising campaigns of rival firms may turn out to be intractable. (d) Several intervening variables require attention. For instance, either the availability of working capital financing or the cost at which it can be obtained will have a crucial role. (e) The more difficult modeling issue relates to the tradeoff between instruments and objectives and among objectives themselves. It is possible to argue that the marketing manager will trade off a portion of market share to assure the stability of the division in the overall management structure of the firm. Similarly, there may be a tradeoff between profits and market share. 6

In some contexts, selling expenses may not yield proportional benefits. That is, the costs may be steeply increasing and the resulting Aa < Am .

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In general, to approach the issue at a more microlevel may not be possible due to difficulties in obtaining the cause-effect relationships and the availability of data. The methods of estimation suggested in Chap. 3 may be adequate only if the necessary data is available.

6.4 Empirical Experiences The empirical evidence available in Rao and Rastogi (1997, pp. 140–142) suggests the following: (a) marketing managers set a target rate of capacity utilization and (b) marketing managers are risk averse and are sensitive to cost changes. As such, they are not likely to set high targets for market shares that necessitate high selling costs. Instead, it was observed that they set a low market share target and defend it by excessive advertising. One reason may well be that they are rewarded for fulfilling market share targets but face punishment in the contrary case. Second, as Drucker (1986, p. 303) noted, incentive and compensation mechanisms are notoriously ineffective. Instead, dividend requirements that set limits on the availability of working capital finances provide a constraint to effectively reduce managerial discretion. (c) As of now, there is no evidence on the relationship between advertising and warranties as complementary strategies to defend a stipulated market share.

6.5 Warranties Measurements regarding warranties are beset with many conceptual issues. First, observe that warranties may be with respect to the intensity of use, a level of cumulative use over time, and so on. Second, the pertinent question may be about the process of aggregating the component effects. Third, empirical data about the various aspects of warranties, when the consumers normally utilize warranty terms, and the extent to which firms honored their commitments are difficult to obtain. Much of the empirical evidence is piecemeal, and case-related studies utilize intuitive methods of analysis. Generally, as Emons (1989) pointed out, the insurance motive, the signaling motive, and the incentive motive have been utilized to explain the nature of warranty contract. The firm may be tempted to pass on low-quality products without any warranty. On the other hand, consumers may not exercise due diligence in the use of the product if warranty is high. The warranty offered by a firm will never fully cover the entire loss to the consumer in case the product fails. There is also ambiguity with respect to the relationship between product quality and warranty. Warranties generally consist of a payment covering the cost of repairs of some specific components and excluding those attributable to wear and tear in the usage of the product. Shavell (2004, p. 220) suggested that “the type of warranty that a firm would offer is the one that would maximize the full price of its product as perceived by the consumers. A firm that is not offering that warranty would lose its customers to

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competitors. This means that if the consumers do not misperceive risks, the warranty that will be sold will be the one that results in the lowest full price.” The firm fixes a warranty ex ante, and the consumers will choose a product from among the many on offer. It was generally noted that the use of the product by a consumer cannot be observed or verified in practice. The consumer may use the product intensely and invoke warranty requirements in case of failure ahead of the stated lifetime of the product. The firm may consider protecting the less intense user. The extended warranty may apply until a certain length of time or until usage exceeds a predefined number (e.g., km of driving in the case of automobiles). Clearly, the low intensity users will prefer warranties of a limited duration. When a durable good breaks down, one option available to the consumer is to approach someone, other than the firm, for repairs. These firms may imitate the production of such products when they acquire the requisite technical knowledge. Hence, warranties are one method of protecting their property rights. Similarly, when a product breaks down firms are not in a position to ascertain the due diligence exercised by the consumer. Limited warranties may be justified on the basis of this information asymmetry. However, ex post, verification of due diligence may indicate that the failure is due to the production process itself. The firm may then offer an extended warranty. Extended warranties are offered if the product does not fail in the time stipulated by the original warranty. Such contracts may increase the quantity of output or the time period beyond which the original contract is in vogue. Extended warranties may be offered at an additional cost to the consumer. Firms tend to direct their strategies to indicate the value of the product to the consumer. When there is significant competition among firms, they tend to use advertising to obtain a greater market share even if temporarily. The adjustments made by consumers, and not necessarily by rival firms, tend to reduce the advantages of such non-price strategies. The management of decentralized divisions does not appear to have any significant effect on managerial discretion. The control dimension, offered by capital markets, appears to be the important dimension for doing so.

6.6 Further Observations Rao and Bhattacharyya (2021) offered extensive empirical evidence regarding a wide range of non-price activities including advertising. Two conclusions are significant: (a) firms generally utilize non-price strategies to signal value of the products to the consumers and (b) firms use non-price choices to gain an advantage over rivals especially when products of different firms are highly substitutable.

References

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References Beattie, A. (2019). False economy. Viking. Dixit, A., & Norman, V. (1978). Advertising and welfare. Bell Journal of Economics, 9, 1–17. Drucker, P. (1986). The practice of management. Harper and Row. Emons, W. (1989). The theory of warranty contracts. Journal of Economic Surveys, 3, 43–57. Rao, T. V. S. R., & Bhattacharyya, S. (2021). Transient market power of firms. Cambridge Scholars Publishing. Rao, T. V. S. R., & Rastogi, R. (1997). Discretionary managerial behavior. Kluwer Academic Publishers. Shavell, S. (2004). Foundations of economic analysis of law. Balkanap Press of the Harvard University. Williamson, O. (1970). Corporate control and business behavior. Prentice Hall.

Chapter 7

Inventory Behavior

Inventories play an important role in stabilizing production as well as demand. Uncertainties in demand and availability of finances may also induce firms to hold different forms of inventories. The geographic spread of demand necessitated the spread of retail inventories and production. These sources give rise to managerial discretion. Defining optimal inventory holding to minimize managerial discretion has not been achieved as yet. Since production should be ahead of demand a firm may have a monopoly in anticipating future market requirements and making plans to fulfill them. After all, “men differ in their capacity to perception and inferences to form correct judgments as to the future course of action in the environment—Knight (1957, p. 241).

7.1 Sources of Inventory Virtually, every production process involves time lag. This is valid even in the context of a large store acquiring products that it expects to sell. A similar phenomenon may occur even when some raw materials are acquired on a contractual basis. As a result, large stores tend to procure products in advance anticipating sales, the firm attempts to acquire raw materials and finances well ahead of the demand for its products, and hold some goods-in-progress given the time required for production. In general, the inventories of a firm may be raw materials, goods-in-progress, or finished goods. A firm may experience a loss in sales if output is not available when the demand arises. This can be expected if the firm does not have the requisite brand loyalty which alone can assure the firm that the consumers will wait when there is a stock out. The precautionary motive may determine the quantity of inventory when the firm expects demand to be random. In markets characterized as differentiated oligopoly, the firms tend to speculate about the increases in demand based on their non-price strategies and the possible reactions of rival firms. The speculative motive may also indicate the emergence of inventories. © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_7

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Inventories are primarily financed by utilizing short-term sources such as bank borrowing, trade credit, and so on. If the firm expects some fluctuations in any of these sources, they resort to holding inventory when there is an ample credit suspecting that a credit crunch will not allow it to maintain its sales profile. Financial sources therefore become another factor determining inventory holding. Uncertainty in the availability of finances, raw materials, and demand conditions may also lead to some inventory holding if the firm is not able to cushion the shocks when they arise. Note that different forms of inventory may be subject to constraints specific to them partly due to the cost of holding inventory. There will be substitution between inventories of various kinds depending on such cost considerations and the degree of difficulty in converting them to final products when the demand materializes.

7.2 Pertinent Issues It is generally noted that increasing production at short notice involves some cost. This may depend on the extent of expansion sought by a firm at a point of time. The firm can then be expected to hold inventory to avoid such cost increases. But this creates some cost. Hence, an increase in inventories can be expected if there is a net cost advantage. The production smoothing argument therefore suggests that production will be less volatile than sales over time. This could not be validated empirically. This is the basic argument of the Blinder paradox. See Blinder (1981, 1986). It was necessary to investigate the reasons for production experiencing greater volatility compared to sales. Firms in mature capitalist economies place a greater emphasis on their long-term growth and profit prospects even if there is a reduction in profits in the short run. Problems of availability and/or costs of credit were often expected to have a significant impact on the investment in fixed assets as well. Fazzari and Peterson (1993) argued that this is generally not the case. Essentially, firms in mature capitalist economies place a greater emphasis on their long-run growth and profit prospects even if there is a reduction in profits in the short run. However, in some economies, especially where the financial intermediation is weak or not sought given the propensity to obtain profits in the short run and liquidate capital investments before conceptualizing further expansion, this may be a consequence of the nature of product markets as much as it is an aspect of the behavioral psychology of the management of enterprises.1 Capital markets are generally imperfect. This results in differential credit ratings of firms. Hence, both the interest rate and the quantum of credit available will be affected. It can be expected that an increase in interest rate will decrease inventory via the cost effect. However, interest payment is a small portion of the total cost for it to have a significant effect on the choice of production and inventory. Further, interest 1

Note that the more recent strategic management literature holds the view that firms choose investment strategies to provide them hit-and-run market advantages and shift to other product lines whenever it is necessary. See McGrath (2013).

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costs should not matter since firms can recover it by a suitable pricing policy. Hence, quantitative limits on credit, rather than interest rate alone, are a determinant of inventory investment. The lower costs of holding inventory in relation to the changes in the cost of production provided one of the basic reasons for holding inventory. However, the changes in the cost of materials, processing them to final products, and the cost implication of different methods of delivering products to consumers should also be taken into account. There is a possibility that changes in the level of production would be cheaper than catering to demand from inventory. Similarly, technological changes and the emergence of new competitive products suggested to the management that the firm should dilute the inventories of current products before they lose their value. Relative cost differentials received emphasis as a consequence.2 When the firm experiences a credit crunch, it may employ subcontractors or utilize franchising. They will take the burden of the credit squeeze. If this can be achieved, there is no need to reduce inventory as such. Darbha (2000) and Fafchamps et al. (2000) argued that the inability to conduct sales reduces the flow of finances. Even in that case, firms may be forced to extend credit to conduct sales. There may be a reduction in inventories. In empirical practice, it was noted that the costs and quantum of credit available for different forms of inventory may vary. In general, it was observed that there was an increase in the inventories of goods-in-progress consequent upon a credit squeeze (either a reduction in the quantum or an increase in interest rates). Similarly, when there is an abundance of credit, firms may try to dilute inventories by providing credit to the consumer. Clearly, there was a necessity to establish the degree of substitution between the components of inventory.

7.3 Determinants of Inventory Holding Observe that some studies suggest that firms make the production decision first. The reasoning is along the following lines. (a) Imperfection in product markets enables firms to choose the optimal level of capacity utilization based on the average cost of production. In general, there is excess capacity and adjusting production can be achieved at lower cost. (b) The production managers will be penalized if targets are not achieved. They are likely to fulfill production targets. This may also induce them to understate production possibilities. (c) Sales decisions are not exogenous. Instead, firms make them endogenous by adjusting prices and non-price decisions. (d) Consumers develop loyalty toward products of some firms. This enables firms to focus on production decisions. They need not consider the demand for the products to be exogenous. Instead, they can backlog orders if the current production level is 2

Rao and Rastogi (1997a. 1997b) demonstrated empirically that minimum cost considerations are not important in managerial decision-making. They may accept a higher cost instead of foregoing sales. Similarly, they may be willing to accept a higher cost of holding inventory in preference to increasing sales. As a consequence, some of the following results may need modification in empirical practice.

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inadequate. (e) Contrary to the above, it was suggested that there may be a loss of goodwill if sales are backlogged. In such cases, the firm will try to maintain a steady production level even if financial problems are discernible. (f) If there is a transitory component of increased demand firms will not cater to it if it is not possible. For any given level of output, the decision to sell depends on a comparison between current marginal revenue and the discounted value of selling from inventory. (g) Inventories can be used as a buffer if demand conditions vary. However, sudden changes in production will be expensive. Hence, it is necessary to plan production ahead of sales. Some studies tend to suggest that firms concentrate on the information regarding the sales they can achieve and plan production accordingly. (a) The marketing manager may set sales targets that the production divisions must adhere to. The management would wish to keep its position secure by fulfilling targets. (b) The loss of goodwill if firms cannot cater to demand as it arises may compel them to define a level of sales and make adjustments in production accordingly. (c) The cost of inventory holding may be significantly high. This compels firms to obtain information about the anticipated level of sales before planning production. There is a necessity to conceptualize an inventory policy irrespective of which of the above decisions prevails. It would be necessary to conceptualize a target level of inventory. Two considerations predominate. (a) The cost of holding inventory in relation to the changes in the cost of production determines the optimal level. (b) Changes in the cost of materials, processing materials to final products, and the cost implications of different methods of delivering the products to consumers have a bearing on the choice. On the whole, the availability of inventory as a buffer reduces the need for sudden and unanticipated changes in production. Holding a given stock of final goods depends on the sales level. When the actual inventories exceed this there may be a reduction in desired inventories. However, the desired stock tends to be high if the management can convince the CEO that demand will increase. (d) A large inventory may be a barrier to entry and thereby stabilize the demand for a firm. This will also require attention in determining the optimal level of inventory stock.3

7.4 Blinder Paradox Assume that a firm experiences an increase in demand at a point of time. The management has two options: (a) increase production and (b) utilize inventory. If the firm is operating on the increasing portion of its average cost curve, it would be likely that utilizing inventory is the better option. In a similar vein, whatever may be the production cost, the time required to increase production may be such that the demand is lost and there will be a loss of consumer goodwill for the future as well. The relative advantage may indicate that the firm will smooth production and cater to sales from inventory. Similarly, Singh and Rao (2000) reported that aluminum, paper, and tea 3

Several other theoretical considerations have been outlined in Rao (1981, 1991).

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plantations experienced volatility in the availability of raw materials. This created cost shocks making it difficult to adjust production ex post. These industries had to carry inventories to accommodate the fluctuations in sales. However, in empirical practice, production is found to be more volatile than sales. This is the essence of the Binder (1981) paradox. Several considerations have been brought to attention to explain this paradox. The following are pertinent.4 (a) In imperfect markets, firms may be operating on the decreasing portion of the average cost curve. As a result, increasing production may be at a lower total cost and the firm prefers this alternative. Production levels are not entirely planned. (b) The cost of holding inventory may be excessive if the products are perishable. Increasing production may turn out to be less expensive. (c) Even a small expected increase in sales may induce the management to increase production even more if the management expects such increases in demand to persist. That is, even if production smoothing is the basic aim, production may be more volatile than sales. (d) There is an upward pressure in the increasing phase of the business cycle. However, the cost of production increases even faster. The profitability of holding inventory decreases. Firms will reduce output since the current levels of inventory are already high. (e) Access to external finance becomes less expensive and easier when balance sheet conditions improve in the upturn of the business cycle. This will increase production at a time when the desired inventory/sales ratio is lower. (f) Assume that there is accredit crunch. Firms may have to extend consumer credit to maintain sales for fear that there will be a loss of goodwill otherwise. They utilize available credit to finance sales. This reduces production. That is, production is rendered more volatile than sales. (g) When the demand for output is increasing due to technological advances, firms will need to make constant adjustments in production in excess of the variation in the level of demand. (h) Unanticipated or large and sudden shocks make adjustments in production very expensive. Even so, firms need to increase production fearing that consumer loyalty will decrease. (i) Note that production equals the sales plus the change in inventories. In general, it will be expected that inventories will increase with an increase in sales and possible expectation that the trend will continue. That is, the covariance is positive. This renders production more volatile than sales. Even when the covariance is negative, the variance in sales exceeding the covariance implies that production is more volatile than sales. In general, the extent to which production or sales take the brunt of adjustment will depend on the profit that the production and/or marketing managers are willing to trade off to maintain their position stable.

4

Refer to Rao (1995, 1988), and Singh and Rao (1998).

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7.5 Fazzari and Peterson Consider the managerial discretion to trade off the long-run benefits of capital investments for the short-run profits from inventory investment. The central argument of Fazzari and Peterson (1993) is that firms must utilize any long-run investment opportunities they can identify on a priority basis for two reasons. First, the management expects the possibility of decreasing the market value of the firm if they do not utilize the opportunities or capital investments. Second, it may also be due to their priority for investment opportunities in the interest of maintaining a stable market share and thereby achieving long-term stability of their own position. It is unrealistic to expect a firm to forego opportunities for investment and divert long-term finances to inventory and working capital. Firms tend to reduce inventory investment and forego short-term profits to maintain their market share. The flip side of the argument is that in many contexts the firm prefers to use the existing capital stock to increase sales revenue and recover the fixed investments already made. It is equally plausible to argue that when confronted with cashflow and financial constraints myopic firms will assign a priority to utilize the existing capital stock to augment cashflows. In general, the firm may reduce the volume of inventories by either increasing sales (that augment the availability of short-term finances) or by reducing production (thereby reducing the demand for such finances). The priority to fixed capital equipment is neither necessary nor sufficient to observe a reduction in inventory investment. This can also happen if the gains from a startup are expected to be of a short-term nature and there is a necessity to explore related arenas to generate profit. The management of a firm may be myopic and prefer to generate profits from the existing capital assets as soon as possible. In other words, short-term benefits taking precedence over long-run stability may invalidate the Fazzari and Peterson proposition. The firm may increase inventory investment by financing it through the use of a larger fraction of reserves and surpluses that reduce fixed investment. A higher cost of inventory holding alone explains the reduction in inventories. Similarly, a large adjustment cost compels the firm to smooth the stock of capital. The output market has little effect. The possibility of achieving cost reduction, rather than the improvement in market shares, leads the firm to increase market share. Similarly, the firm may have to extend credit to increase sales. In such a case, under a financial constraint, it may not be possible to increase investments in fixed capital. Financial constraints may also have a role in determining the tradeoff. It must be noted that the financial resources for short-term and long-term capital are not the same. The terms, regarding the interest rate as well as the quantum and restrictions on the use for which the finances can be utilized, are different. Consider a reduction in financial resources. This may be either long-term sources or short-term finances. The decisions of the management may depend on several considerations. (a) There can be several institutional and structural rigidities that prevent the firm from canceling orders for machinery at short notice. (b) Suppose the management attempts to increase internal sources of finance (retained earnings) by reducing dividends. This

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will have a negative effect on the market value that may be disproportionate to the value generation expected from capital investments.5 (c) Fazzari and Peterson (1993) argue that the firm may divert short-term finances to long-term capital investments. However, three aspects need attention. (i) The rate of interest on short-term finances is generally higher. (ii) There is a strict control by banking authorities on such rerolling of short-term finances. (iii) The expected present value from the proposed investments may be lower than the profitability of current production and sales operations. (d) Firms utilize signals like dividend payments and announcements of fixed capital investments to indicate the well-being of the firm. Consequently, the management may increase investments in fixed capital even if product markets are not favorable. Some inventories have a long-term nature. They must be financed by long-term sources. However, if the plans for fixed capital are rigid the volume of inventories must be reduced either by increasing sales (generate more short-term finances) or reduce production (reducing the demand for such finances). Neither of these may constitute an efficient choice. Further, in imperfect capital markets quantitative limits on credit, rather than interest rates affect inventory investment. Interest cost is a small fraction of the total cost of inventory holding. Hence, the effect of interest rates will be negligible. The firm can pass on most of the increased cost to the consumer given the imperfection in product markets. Hence, inventory holding is not affected. On the whole, financial constraints can have wider implications for inventory investment as evident from the empirical evidence in Rao (2005), Rao and Singh (2000, 2001, 2005), and Singh and Rao (2000) indicate that the Fazzari and Peterson argument is not valid.

7.6 Composition of Inventories In general, inventories may consist of raw materials, works in progress, or final goods. Inventories of final goods have been emphasized to this point in this chapter. It is necessary to consider the composition since managerial discretion consists of adjusting the composition depending on the external market conditions and organizational rigidities within the firm. The operating cycle concept provides a unifying framework. It consists of four phases: (a) the acquisition of raw materials and other inputs, (b) the desired level of output in the production process, (c) marketing and selling goods, and (d) the recovery of working capital committed to the process of production. The following concepts have been developed to operationalize these phases. See Rao and Dua (1977a, 1977b, 1978). (a) t 1 = average stock of raw materials and stores/average daily consumption of materials 5

When there is a credit crunch, the firm may employ subcontractors and franchising that will take the burden off the credit crunch. There is no need to reduce inventory as such.

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This number represents the number of days over which inventories of raw materials and components wait. (b) t 2 = average value of inventory of goods-in-progress/average cost of production per day Clearly, t 2 represents the time over which raw materials are locked up before the final product emerges. (c) t 3 = average daily stock of finished goods/average daily sales This quantity represents the time over which final goods are held in the form of inventory. (d) t 4 = receivables outstanding/average daily sales Note that t 4 represents the time that the firm takes in recovering the sales in the form of cash  In general, the finances required to complete the operating cycle, viz. t = t i , indicate the working capital finances required to complete the operating cycle. However, the length of the operating cycle is not a constant over time since the firm has to adjust to external influences. Further, the computed operating cycle will not be adequate to compute the desirable composition of inventories. Consider the current asset requirement. The minimum quantity of raw materials required to maintain continuity of the production process will be defined by t2 . Clearly, t 1 > t 2 would indicate excess inventory of raw materials. Similarly, sales operations can be carried out on a continuous basis if the inventory of final goods is sufficient to cover one production run. Ideally, t 3 = t 2 . Inventories of final goods may be deemed to be excessive if t 3 > t 2 . Note that working capital requirements should ideally represent the finances necessary to keep both production and sales continuous. In most practical situations there will be certain minimum time lags in the collection of receivables even if production and sales can be synchronized. Hence, the norm t 1 = t 2 renders the pipeline empty after t2 days and further credit is necessary to obtain raw materials to carry on production. A similar contingency arises while considering t 4 . Hence, ideally, t 1 = t 2 + t 3 + t 4 is desirable. These and related issues have been reported in Rao (1978a, 1978b). Empirical estimates reported in Rao (1978b) and Rao and Dua (1978) revealed the following patterns. (a) The inventories of raw materials were close to optimum in the case of agriculture and allied activities, and electricity generation and supply. (b) Inventories of raw materials were excessive for some time for cotton textiles, ferrous and nonferrous metals, foundries and engineering workshops, medical and pharmaceutical preparations, and rubber products. (c) Raw material inventories were excessive throughout for silk and rayon products, transport equipment, basic industrial chemicals, pottery and clay products, as well as paper and paper products. More detailed estimates at the firm level have been reported in Rao and Dua (1977a, 1977b). Turn to the managerial practices of utilizing different components of inventories in a dynamic context. The changes could be traced empirically when firms experienced

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a reduction in bank credit. Rao (1978a) reported the following. (a) There was a significant upward trend in raw materials consumed per day and the production rate. (b) Sales increased in tandem and final goods inventories did not change by very much. The brunt of the adjustment was in the inventories of goods-in-progress. One of the reasons is that strict credit limits were not imposed on this component of inventories. Similarly, firms financed the purchase of materials by increasing sundry creditors probably because there were no similar limits on the credit available to them. Good managerial discretion therefore consists of increasing components of inventory for which credit is available. Similarly, smaller firms that provide the raw materials have easier access to credit. Larger firms piggy back on them using the credit in the form of postponing payments to them. Consider a situation in which the economic activity is reduced due to environmental conditions. More recently, the central bank increased liquidity hoping that it would be possible to induce greater investments to revive the economy. However, the managements found it convenient to utilize the excess credit to offer short-term loans to consumers so that the accumulated inventories of firms can be liquidated. There was an experience of inflation along with a zero growth revival of the economy. Economic policy should have anticipated such reactions from the managers using their discretion. Capital investments depend more on the economic environment than on the availability of credit.

7.7 Empirical Patterns Imperfection in product markets enables the firm to choose the optimal level of capacity utilization (based on the size of the capital assets) and the average cost of production (Chamberlin’s group equilibrium). Large firms, to the extent they have a greater diversity of products, are more vulnerable to business cycle effects. The goodwill loss induced by the inability to cater to the demand for one of the products may reduce the demand for other products. Consequently, large firms maintain excess capacity and production is flexible. The significant changes in the level of production depend on the availability of raw materials and costs of production. The availability of internal finances, the amount of credit available, and the interest rate determine the level of production. In general, production volatility is due to cost shocks. Financing constraints are the other major explanation for the observed volatility of production over time. Greater volatility of production is induced by the interest rate and credit policies of the central bank. It is generally expected that the market demand is exogenous to the decisionmaking process of the firm. However, in imperfect product markets the firm will choose price and non-price decisions to make demand correspond to the target level of production. Planned, or anticipated sales, is not given exogenously. Instead, it is endogenous to the decision-making process of the firm. However, empirically it was noted that technological changes may induce changes in demand. In general, it

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would be realistic to conclude that the demand for the products of a firm has both exogenous and endogenous determinants. Expected changes in demand can be smoothed by production. Not so the unanticipated or large sudden shocks. Note further that it may be necessary to make constant adjustments in production capacity (may be in excess of that needed for the sales since capital investments are lumpy). Thus, the changes in production adjustments exceed the variations in demand levels. The availability of inventory as a buffer reduces the need for sudden and unanticipated adjustments. Holding a given stock of inventory depends mostly on the expected profitability instead of production costs per se. Firms may hold a desired level of inventory commensurate with the anticipated demand since production adjustment at short notice can be expensive. Thus, persistent variations in sales are more likely to induce inventory. Further, backlogging orders may not be an efficient choice if subsequent cost increases are expected to be high. An increase in interest rate will decrease inventory via the cost effect. However, interest payment is a small portion of the total cost for it to have a significant effect on the choice of production and inventory. Interest costs should not matter since firms can recover it by suitable policy. Quantitative limits on credit rather than interest rates matter. There is an upward pressure on prices in the increasing phase of the business cycle. However, costs of production increase even faster. The profitability of holding inventory decreases. Three other roles of inventory should be noted. First, a large inventory may stabilize demand since it may act as a barrier to entry by rival firms. The quantum or composition of inventory cannot explain stabilization of business cycle effects. Second, the management may wish to keep their position secure by fulfilling the sales target set by the marketing manager. They will draw down inventories if necessary. Third, desired inventory of final goods depends on sales level. When the actual inventories exceed this, there may be a reduction in desired inventories. However, if the management can convince the CEO that demand will increase the desired stock tends to be high. Production targets also imply targets for raw material inventory. In addition, the inventory of materials tends to be high when there is speculation about raw material availability or prices. Firms try to build brand loyalty and regular customers. If there is a transitory component of increased demand, they will not cater to it if it is not possible. For any given level of output, the decision to sell depends on the comparison between current marginal revenue and the discounted value of selling from inventory. If cost conditions are pertinent, some part of the sales is conducted by adjusting output ex post. Financial constraints do not affect sales. Production increases when credit is abundant and is reduced in the contrary case. Production is more volatile than sales. Note that empirical information about the optimal quantity of inventory, its composition, and the methods of finance is scanty despite the voluminous theoretical literature.

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7.8 Adjustments to Uncertainty Randomness can be of two generic types: (a) from sources external to the firm and (b) forces within the organization of the firm. Consider the external sources. They can be of five types. (i) Consumers cannot calibrate the value of a product to them except through the experience of using it. At what price they will buy and how much they will buy remain random apriori. (ii) When a new and novel product is introduced, or when it involves a new technology, consumers will not be aware of the service that it can offer. In general, consumers would be unlikely to make these assessments in advance. (iii) In markets, characterized as differentiated oligopoly, the products of a firm are also influenced by the offerings of rival firms and their selling strategies. It may be possible to obtain a part of the information about the quantity demanded but there may be significant randomness in the observed outcome. (iv) Randomness may be typical of contracts and agency relationships. In general, neither the calibration of the availability of agents ex ante nor the correspondence of their actions with the promises made ex ante can be known in advance. For all practical purposes, the discretionary behavior of every party within a firm may be intrinsically random. (v) In large corporations, these decisions will be centralized and a top-level manager makes the decisions. The actual execution is left to individuals who perforce act independently though the decisions at the top level act as constraints. The lack of communication and opportunism exhibited by individuals are the sources of randomness. As Alchian (1950) noted, randomness arises from at least two sources: imperfect foresight and human inability to solve complex problems involving a host of variables. Turn to randomness generated by the workings within the firm. They can be due to two generic sources. (i) In general, a higher-level manager makes the decisions and leaves the implementation to lower-level individuals. These individuals are allowed to operate independently subject to the constraints set up by the higher-level managers. There may be difficulties in articulating and communicating individual responsibilities and monitoring their performance. (ii) Organizational structures are generally fixed, and it will be difficult to change them at short notice. This creates the possibility of imperfect adjustments when individual goals are at variance with organizational goals. Randomness in the outcomes may therefore be due to the lack of recognition and inability to make swift readjustments when there is incongruity of objectives and behavior at different levels. Thus, as Levis (2009, p. 329) pointed out, “incumbents have to cover an indefinitely broad landscape: new opportunities are at best hazy and threats could be lurking anywhere. It is not just technologies, new competitors and business models that could change everything, but so many things that don’t seem to make sense.” Two aspects of this characterization are significant. (a) The sources of randomness may be known apriori though the probabilities of their occurrence remain random. (b) Both the sources and probabilities may be difficult to specify apriori. This is the distinction between risk and uncertainty advocated by Knight (1957).

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In a more general sense, randomness may also be with respect to the availability of finances and the costs of production related to the deployment of technology. Turn to the methods adopted by the management in response to the randomness. The following observations are pertinent. (a) The game theoretic approach assumes that the likely values of demand are known apriori, the likely strategies of the management can be enumerated apriori, and that the outcomes of the interaction between the two can be specified in advance. Generally, this would require too much information that is unlikely to be available. Further, this approach postulates a well-defined method to decision-making (for instance, minmax). Clearly, there is no procedure specified to identify the strategies of a firm at a point of time, and so on. Despite the theoretical elegance, this tool is not useful from a managerial viewpoint. (b) Leland (1972) suggested a different approach. The possibility that the management fixes the price apriori, a quantity, both apriori and explores the location of the demand curve ex post has been considered. However, note that the ex post data cannot identify which of these strategies the firm adopted. In practice, the management may try to obtain the information not through these channels but by utilizing non-price strategies. Thus, this offers only limited information about managerial discretion. (c) Pragmatically, it would be feasible to assume that the management targets a stable component of demand, develops strategies accordingly, and adjusts to randomness when the occasion arises. Intuition and heuristic approaches seem to be essential. As of now, it is difficult to say more about managerial choices and their discretion. Note that the diversity of individual choices and randomness of their actions will leave a mark on the observed outcomes of the firm. However, diversity among many of these aspects has been left out while developing economic analysis based on broad aggregates. As a result, such an analysis may not be useful in assisting the management of individual firms even when adjusting to such random changes may be more important.

7.9 Some Issues Remain At a pragmatic level, inventories of most commodities (including those of the FMCG sector) are at the retail level. For many of the manufactured goods, production is centralized despite the geographic spread of demand and the necessity to cater to it through several franchises. The pertinent questions are as follows. (a) What is the expected demand at a given location? Note that the demand may not be the same or continuous over time. This necessitates an investigation of the time profile before inventories can be arranged. (b) How many retail outlets would be optimal? What should their location be? In fact, the greater the geographic spread of the outlets the more the inventory stock. Similarly, the possibility of catering to demand from a nearby store must be kept in perspective while approaching franchises. (c) How often should inventories at a given retail outlet be replenished? From where should the replenishment be managed? (d) The entire process has implications for logistic costs. Clearly, this also implies the necessary finances. It is also clear that either the

References

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manufacturer or the franchise should be responsible for the financing. Detailing the best combination for a given level of inventory, the timing of replenishments, and the profile of financing to the manufacturing level should be defined to make it usable for the firm. Such information alone can provide guidance for the production levels over time at a centralized location. The currently available theories and empirical data are unequal to the task. The obvious retort may be that these decisions are in fact made by the managers on a continuous basis. The difficulty is to investigate the basis of their intuitive and pragmatic decisions. Only such efforts can bring the theorizing and empirical tests to bear on the direction and extent of managerial discretion and make analytical attempts move closer to practical reality.

References Alchian, A. (1950). Uncertainty, evolution, and economic theory. Journal of Political Economy, 58, 211–221. Blinder, A. (1981). Retail inventory behavior and business fluctuations. Brookings Papers on Economic Activity, 2, 443–505. Blinder, A. (1986). Can production smoothing model of inventories be saved?. Quarterly Journal of Econmics, 101, 431–453. Darbha, G. (2000). Financial factors, inventory investment and economic activity. Journal of Quantitative Economics, 15, 229–256. Fafchamps, M., Gunning, J. W., & Osetndorp, R. (2000). Inventories and risk in African manufacturing. Economic Journal, 110, 861–893. Fazzari, S., & Peterson, B. (1993). Working capital investment: Evidence on financial constraints. RAND Journal of Economics, 24, 328–342. Knight, F. (1957). Risk. Harper Torch Books. Leland, H. (1972). The theory of the firm facing uncertain demand. American Economic Review, 62, 278–291. Levis, K. (2009). Winners and losers Atlantic books. McGrath, R. (2013). The end of competitive advantage: How to keep your strategy as fast as your business. Harvard University Press. Rao, T. V. S. R. (1978a). Corporate response to credit policy during the seventies. Indian Economic Journal, Conference volume, 51–58. Rao, T. V. S. R. (1978b). A normative approach to working capital management. Management Review of DMA 5, 25–30. Rao, T. V. S. R. (1981). Economic theory of inventory behavior. Indian Journal of Economics, 62, 247–257. Rao, T. V. S. R. (1988). Inventory decisions of public sector enterprises. Industrial India, 1–6. Rao, T. V. S. R. (1991). Inventories and welfare. International Review of Economics and Business, 38, 267–287. Rao, T. V. S. R. (1995). Managerial preferences for holding inventory. Indian Journal of Applied Economics, 4, 27–53. Rao, T. V. S. R. (2005). Financial constraints, inventory investment and fixed capital. Indian Journal of Economics, 85, 489–514. Rao,T. V. S. R., & Dua, A. (1977a). Working capital and the operating cycle: The micro-level norms. ASCI Journal of Management, 6, 188–195. Rao, T. V. S. R., & Dua, A. (1977b). Input uncertainty and the structure of production inventory decisions. Industrial Engineering and Management, 1–10.

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Rao, T. V. S. R., & Dua, A. (1978). Normative aspects of the dynamics of the operating cycle. Decision, 5, 225–234. Rao, T. V. S. R., & Rastogi, R. (1997a). Discretionary managerial behavior. Kluwer Academic Publishers. Rao, T. V. S. R., & Rastogi, R. (1997b). Identification of managerial preferences. Indian Journal of Applied Econmics, 6, 113–124. Rao, T. V. S. R., & Singh, A. (2000). Market imperfections, financial constraints, and the volatility of production. Indian Journal of Economics, 81, 61–90. Rao, T. V. S. R., & Singh, A. (2001). Effect of financial constraints on inventory investment. Indian Development Review, 1, 1–25. Rao, T. V. S. R., & Singh, A. (2005). Financial constraints, inventory investment, and fixed capital. Indian Journal of Economics, 85, 484–514. Singh, A., & Rao, T. V. S. R. (1998). Precautionary Inventories and Volatility of Production. Indian Journal of Economics, 78, 37–44. Singh, A., & Rao, T. V. S. R. (2000). Market Imperfection, Financial Constraints, and the Volatility of Production. Indian Journal of Economics, 81, 61–90.

Chapter 8

Capital Stock and Investment

Almost all the short-run managerial decisions studied in the earlier chapters depend on the stock of capital available to the firm. The decision to increase the stock of capital crucially depends on the growth in the sales of the firm, availability of finances, the cost at which different financial instruments are available, and the technological changes in the process of production. Earlier studies on the capital stock decision emphasized only one of these aspects and excluded others. An attempt is therefore made to trace the path of transition based on available empirical results. Similarly, the resulting notion of managerial discretion pertains to many other dimensions not hitherto mentioned. Thus, this chapter offers a logical transition to a study of financial decisions considered in the chapters that follow. The actual economic injury caused to society is a function of not only the deviation between price and marginal cost but also the amount of economic activity over which the deviation occurs—Landes and Posner (1951, p. 953).

8.1 The Setting The stock of capital available to a firm, the resources available to it, and the distinctive competencies available within the firm have been the basic factors determining the short-run choices of the firm. These issues have been considered in detail in the earlier chapters. The aspects related to the physical side of decisions have been addressed to the exclusion of the financial factors underlying them. The only exception was the role of short-run financing of inventories and working capital. However, finances have a crucial role in the functioning of every corporation. Hence, it is necessary to focus on the relevant factors associated with it. One upshot is the recognition of several other dimensions of managerial discretion—choice of capital structure, riskiness of investment project, etc. This chapter is written jointly with Surajit Bhattacharyya of IIT, Bombay. I am grateful to him for providing all the relevant references. © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_8

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Crucially, the capital stock decision is a long-run choice. First, there is a necessity for forward planning because it takes time to conceptualize the need for it, place orders and receive the required equipment, and obtain the resources necessary to put the stock of capital in operation. Second, the capital stock installed at any time will have a reasonably long lifetime and the consequences over that span of time should be taken into account at the outset. Third, one of the drivers of capital formation is the changes in the expected or actual change in the sales of the firm and the inadequacy of the existing machinery to cater to the increasing demand. Fourth, the firm will be driven to non-price strategic choices to utilize the excess capital (the capital equipment and machinery tend to be lumpy and not malleable) when the market demand fluctuates. Fifth, the internal sources of finances, even if they are the preferred choice, will not be adequate to finance the requisite capital formation. As a result, the search for alternative sources of finance and their consequences should be kept in perspective. Sixth, there have been several interventions by the government, both enabling and controlling, that have an impact on the capital stock decisions. These and related aspects will be considered in this chapter.

8.2 Why Invest? Assume that the firm bought some resources and converted them into output. Suppose when the output is sold on the market the firm finds that the market value of output is greater than the market value of resources that have gone into production. It would be worthwhile for the firm to invest the surplus in more capital and seek growth. The economies of scale and scope generally place limits on the extent to which a firm can increase output commensurate with the changes in demand. It may also involve some organizational difficulties. It is possible that the firm will also experience some problems in its ability to attract the requisite finances. Suppose the firm finds its internal resources to be inadequate so that it is necessary to seek external finance (debt or equity). It will do so only if the returns expected from capital formation are better than those expected by trading on the financial market (e.g., the interest rate). In other words, the expected real rate of return from production being in excess of the cost of obtaining external finances may well be a basic motivation to increase the capital stock of the firm. On certain occasions, it is suggested that the market value of the existing assets may far exceed the replacement value of the same assets. In such contexts, it would be wiser to make the change. (This argument is somewhat analogous to the logic of Tobin’s q which will be taken up in what follows.) Much of the earlier literature focused on a competitive financial market, thereby assuming that all the necessary finances are available at the market-determined interest rate. The only thing that mattered was the expected real rate of return. As a result, the entire decision regarding investments in capital stock was expected to be

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contingent on the cost of finances to the neglect of the quantity available (presumably, it is infinitely elastic). Subsequent work, that acknowledged market imperfection, sought to modify the measurement of the cost of capital while still neglecting the availability of the quantum of finances. Some earlier work maintained that (a) sales volume instead of price per unit of output, quantity of financing, and not the cost of capital are crucial in the choice of capital stock. It was acknowledged that in non-competitive markets there will be increasing costs of acquiring and integrating the machinery into the production process. Nonetheless, the emphasis on the cost of capital as the basic determinant of investment persists. Further, it was acknowledged that costs of being out of equilibrium may be as significant as adjustment costs. It is necessary to focus on these aspects as well.

8.3 Acceleration Principle Assume that the technology of production is such that K = aY, where, K = stock of capital, and Y = volume of output Therefore, the capital output ratio, a, is determined by the technology.1 The other necessary assumption is that the firm can vary its production level at each point of time to cater to the market demand that arises. That is, Y can be replaced by S so that K = aS. Suppose now that S t − S t −1 is the increase in sales from (t − 1) to t. The corresponding K t −K t−1 = It = a(St − St−1 ), where, I t = gross investment at time t Unfortunately, in practice, (a) a cannot be assumed to be a constant, and (b) though not acknowledged, sales may be conducted by utilizing inventories,2 (c) production cannot adjust to sales instantly even if machinery can be acquired and installed, and (d) it is necessary to account for the depreciation of capital. The specification can be modified as3 This is the neoclassical dogma where in equilibrium x = K/L = capital intensity, L = labor employed, and the corresponding K/Y is a constant. 2 Note that a high inventory to sales ratio signals that product markets are not sufficiently encouraging to make investments. It may be argued that limited financial availability implies that increases in inventory results in reduced investment in fixed assets. Krishnamurty and Sastry (1975) consider these two types of investment to be competitive. 3 The costs of adjustment in organization and production may be reflected by introducing bI t − 1 in the equation. 1

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It = a(St − St−1 ) + δ K t However, δ is only an accounting convention devoid of any economic rationale and assuming that it is a constant is untenable. As a matter of practical reality, it should be made to depend on the cumulative output produced.4 So far the accelerator principle is depicted as reflecting the embodied technology. An alternative interpretation based on adjustment to market demand is possible. Given the change (S t − S t −1 ), the management of the firm may discount it. The reasoning will be that this change may not persist over time and that capital stock once installed cannot be reduced at will. If the lumpiness of machinery is acknowledged the discounting may well depend on this feature. Consequently, a in the above investment equation is subject to managerial discretion. Clearly, assuming that a is a constant over time is untenable. Instead, it would be necessary to specify the economic reasoning leading to its choice.5 Four further observations are in order. (a) So far, it was assumed that the finances required to implement the investment will be available. The costs of doing so, when introduced, will modify the demand for machinery. (b) It is apparent that the acceleration principle assumes that the demand for machinery can be satisfied without any friction. In practice, the supply of machinery need not be so simple. Accounting for this may alter the actual investment of the firm. In particular, the interest variable should be included in the specification. (c) Note that in practice inventories are utilized to cushion the difference between production and sales. As a result, the actual level of investment may also depend on inventory policy. This adds a further dimension of managerial discretion. (d) The acceleration principle rarely acknowledges the cost of capital as a determinant. The market for machinery may, however, be imperfect in practice. Let the investment equation be specified as It = a0 + a1 (St − St−1 ) + a2 r in its simplest form. If a1 = 0, it can be inferred that the supply of finances has the dominant influence. The acceleration principle is irrelevant. However, in the technology interpretation the possibility that the variations in S t − S t−1 are far too significant cannot be ruled out. Clearly, the converse is also possible and a2 = 0, thereby indicating that capital markets are perfect and that there is relatively insignificant variation in the cost of capital. In sum, it must be acknowledged that acceleration models (a) require an economic basis, (b) should acknowledge that capital output ratios vary over time, (c) should note that investment decisions also depend on the financial arrangements and not merely technological factors and the rate at which finances can be obtained, and (d) cannot reflect the many behavioral attributes of managerial choice. As will be noted 4

Clearly, this is one aspect of managerial discretion. The following observation is pertinent. It is not possible to identify which of these interpretations is valid in practice even if the acceleration principle is significant empirically.

5

8.4 User Cost of Capital

127

later, that it has done well in empirical practice is mostly a coincidence and not a confirmation of the validity of the underlying logic.6

8.4 User Cost of Capital7 Note that the level of investment may depend on (a) the technology of production, (b) the market conditions for the sale of the products of the firm, and/or (c) the market imperfection in financial markets represented either by the cost of obtaining finances or the limits on the quantity available. Jorgenson’s (1963) cost of capital approach emphasizes the importance of the price mechanism and several other related aspects. The existence of imperfect product markets does not negate the operation of the price mechanism which forms the core of the ensuing analysis. Ignore depreciation as a cost of using the existing stock of capital to simplify the exposition. Let I be the quantity of investment goods purchased, installed, and utilized in production. Assume that pi is the price per unit of investment goods. Similarly, let the entire output be sold at a price p per unit. The cashflow from the production and sale will then be cashflow generated = pY −wL − pi I if L units of labor are employed at wages w per unit. Let K 0 be the stock of usable capital goods at the beginning of a unit of time.8 Then, the capital stock available for production is K = (K 0 + I). Postulate that the output produced can be represented by Y = Lα K β and that the management of the firm chooses I to maximize the cashflow. This results in the equation9 pi = p(∂Y/∂ I ) = pβY/K Hence, the desired capital stock of capital is10 6

Of course, to a Friedmanite this is enough confirmation of the theory. As a practical matter, a manager obtains an expected market valuation for the proposed investment from a chartered accountant. To what extent, it will correspond to the objectives postulated in economic theory is a moot question. 8 Usable capital, in this definition, accounts for the depreciation of machinery. Hence, it will not be considered explicitly again. 9 The implicit assumption is that investment is financed by internal sources and that they will be fully utilized. 10 It is not altogether clear if specifying 7

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K = pβY / pi Hence, the implied capital output ratio is a = pβ/pi . The following observations are in order. (a) The accelerator principle considered a as a technologically determined constant. (b) In this framework, it is determined by the market prices of the output and capital goods in addition to that of β that depicts a property of the technology. Investment at time t is then postulated to be It = K t −K t−1 = a ∗ (St − St−1 ), where, sales = S t = pY t , and a* = β/pi . It is assumed that it will be implemented in practice without any delay. However, the lumpiness of investment in machinery and several other relevant factors make the realized investment different from the desired level. Hence, the choice of the equilibrium cost of capital should be distinguished from the investment in machinery at a point of time. For all practical purposes, investment in new machinery at any point of time cannot be fixed from the equilibrium stock itself since the time profile over which it can be achieved will depend on the lumpiness of machinery, the urgency to acquire and install it, and other considerations. Consider a firm investing an amount pi in machinery. This, along with the rest of the available capital stock, results in production that has a market value S. Let S i be the amount of S accruing to capital. The share S i in S is = S i /S. The firm will consider investment to be optimal if pi = increase in S attributable to capital. The investment in new machinery will itself be considered worthwhile if the share s increases. That is, the firm considers the price that it has to pay to achieve a unit increase in s as an indicator of the advantage in the acquisition and use of the new machinery. Therefore, q = pi /s is the appropriate measure of the user cost of capital. The user cost of capital = pi /β in the context of the problem considered in the text. Note, however, that the equilibrium stock of capital, the equilibrium capital output ratio, and the corresponding investment function will depend on the change in the quantum of sales as well as the user cost of capital. The user cost will dominate the decision if it exceeds the increase in the sales revenue by a sufficient amount. In the contrary case changes in sales revenue will determine the decision to invest. However, it is difficult to define the optimum amount of investment in new machinery independent of the equilibrium capital stock notion. The best that can be done is to suggest that the lower the user cost of capital the more will be the inducement to investment in new machinery. A dynamic generalization arises if there is a possibility that cashflows may not be utilized fully at every point of time. It may be assumed that the management maximizes the discounted cashflows over (0, ∞) in its choice of the investment profile. Consider maximization of K = K 0 + I = pβY / pi , and I = pβY/ pi −K 0 Will not be an adequate characterization of the neoclassical theory.

8.4 User Cost of Capital

129

∫∞ V =

e−r t ( pY −wL− pi I )dt

0

Subject to I = dK/dt + δK. Assume further that p and pi are constant over time. Utilizing the Euler–Lagrange condition, it can be verified that maximization implies pi δ + r = pβY /K Consequently, K = [ pβ/(r + pi δ)]/Y Note the following: (a) The assumption regarding competitive product and capital goods market is untenable in practice. (b) The constancy of r in fragmented financial markets (the debt market is different from the equity market) needs a revision. (c) As noted above, the constancy of δ is also questionable. (d) The most important drawback is the assumption that all the output produced can be sold instantaneously. (e) As noted in the previous section, machinery supplied is lumpy and not as malleable as postulated. (f) The above static analysis postulates that the entire available cashflow will be utilized to finance investment. In the dynamic analysis, the cashflows remaining after investment are postulated to be held as retained earnings and used when the need arises in the future. There is no indication of the utilization of V if it is positive. (Clearly, it cannot be negative.) What happens if the product market cannot absorb the entire output produced? Return to the static model. Suppose S > Y. There is no provision for increasing I and Y instantaneously. The actual output sold will be Y. I = ( pY −wL)/ pi = I (Y ) if the entire cashflow is utilized for capital formation. This will indeed be the case since the firm would like to minimize its losses due to not fulfilling demand. Suppose, on the other hand, S < Y. It will not be feasible to produce more than S since there is no provision for inventory. There is no guarantee that the cashflows from producing S is zero. The demand for investment goods remains indeterminate. Several extensions of this concept have been reported. (a) Apart from the acquisition of machinery, the firm will incur costs of installation and operating the machines. The latter may be increasing with the volume of new investments.11 (b) The government may utilize several policies to encourage investment and exercise several controls to channel investments in desired directions. (c) The imperfection in the 11

The fact that machinery once installed cannot be changed at short notice may have implications for investment. This is rarely taken into account while formulating the model specifying the cost of capital.

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financial markets may result in some quantitative limits on the finances available for investment. The following analysis is germane to an understanding of the role of financing on investment. Let S t * be the expectation of the management regarding the level of sales on the basis of their calibration of the market for the products of the firm. In the expressions for K t and I t noted above, S t will be replaced by S t * to indicate the expectation of sales. That is, ) ( It = demand for investment = β St∗ − St−1 / pi The current cashflow based on the observed level of sales S t and other related financial arrangements would be inadequate. Consider debt financing as one of the alternatives chosen by the management. Let r d represent the interest rate of borrowing. The expression for cashflow becomes CF = pY −wL− pi I −rd D, Pi I = R + D wherein it can be assumed that K 0 is already paid for, say by R* of retained earnings. The rest of the available retained earnings is R. The cost of obtaining D is r d D and assume that the firm maximizes CF while choosing I. The optimal choice of K will be K = βpY /(1 + rd ) pi where pY = S*, and the corresponding investment is ) ( I = β St∗ − St−1 / pi (1 + rd ), and the quantum of debt is ( ) D = β St∗ − St−1 /(1 + rd )−R The following alternatives can arise. (a) R is insufficient to finance even the investment corresponding to S t . In such a case, the investment will be determined by retained earnings and (S t − S t−1 ) will not appear in the equation. (b) R + D is sufficient to finance the quantity of investment corresponding to S t . The actual level of investment will be I = β(St −St−1 )/ pi (1 + rd ) and the financial variables will have no further role. Note, parenthetically, that the user cost of capital, including r d , will not appear in the determination of

8.5 Tobin’s q

131

the desired stock of capital. These quantities12 do not enter the I t equation independently. (c) Suppose R + D is adequate to finance investment corresponding to S t * though R itself is insufficient. In such a case, in addition to (S t − S t−1 ) the amount of debt will appear in the investment equation. (d) Consider the possibility that the expectations S t * are too optimistic. The debt and equity markets, or some financial regulatory agency, may consider the demand for external finances to be out of tune with the efficient performance of the firm. In such cases, the finances provided will cater to only the portion of S t * that can contribute to the market value of the firm. To this extent, finances constrain investment. Even if this is taken into account the feasible S t * may exceed S t . The result will be modified to that in case (c) above. Introducing equity financing as a source will not materially alter the above analysis. The loss in the value of common stock will be an additional item of cost while defining CF. Empirical results generally indicate that financial variables appear in the investment equation along with (S t − S t−1 ). The usual interpretation that financial constraints are responsible will be erroneous. Instead, it must mean that investment opportunities over and above those indicated by current markets exist and that financial constraints, if any, are not binding. Firms do take advantage of the additional opportunities by increasing investment in capital stock. Financial variables will appear in the investment equation irrespective of whether or not financial constraints exist. It is not possible to infer the existence of financial constraints just because financial variables appear in the investment equation along with (S t − S t−1 ).

8.5 Tobin’s q Tobin’s (1958) q ratio was considered as an alternative to the concept of the cost of capital. It is presented in two different forms. (a) Tobin’s main focus was more prominently on the financial side of the transactions. As a result, the q ratio may be defined as q = market value of physical assets/book value at which they were bought. Clearly, a low value of q indicates that the investment climate is not encouraging. The quantum of investment in physical capital will fall. Note that the market value of physical assets may be low due to (i) their low productivity, (ii) a reduction in the price of output produced, or (iii) the resale prices for the existing machinery. The third factor is the basic departure from Jorgenson’s formulation of the cost of capital. (b) Tobin considered the firm as a financial unit rather than a production engine. Hence, the definition of q changes to 12

The rate of return r, the user cost of capital q, the interest rate on debt D, the rate of dividend on equity, and Tobin’s q that will be detailed in the next section will have a similar role.

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Fig. 8.1 Variation in Tobin’s q

q q2 q1 P1 P2 O

K1

K

q = market value of the financial assets/book value at which shares of common stock were floated initially Once again, a low value of q implies that the shareholders do not consider the profit prospects of the firm favorably (they may be expecting lower dividends or capital gains if they sell their shares). The implication here is that the shareholders rarely have any way of calibrating the physical productivity of the capital assets of the firm. Instead, they rely on observable proximate measures like the current market value of the shares of the firm.13 It is important to note that the cost of finances instead of the quantum of finances available (or required) is still at the center stage. In most empirical applications, Tobin’s q was not considered significant. This may be due to the lower shifts in profitability relative to the cost of capital. See Fig. 8.1 where P1 and P2 represent the profitability of the firm in its product markets. Clearly, an increase in q from q1 to q2 may not result in a decrease in K if there is a sufficient increase in the productivity of physical capital due to technological progress. The possibility that K remains at K 1 despite an increase in q1 to q2 due to greater availability of finances cannot be ruled out. In empirical practice, the book value of assets of the firm does not consider the present market value of the common stock. Instead, the depreciation of capital assets, developed as an accounting convention, is taken into account. The distinction between the valuation of the physical and financial assets of the firm remains blurred. It is perhaps realistic to assert, on the basis of the current empirical evidence, that the technological aspects of the capital stock have been more important than the financial aspects in the investment decisions of the firm.

13

q is not defined merely as the current market price of a unit of common stock/its value at the initial public offering because there will be several vintages of such flotation. Hence, aggregating all such financial assets is more appropriate.

8.6 Market Imperfection

133

8.6 Market Imperfection The fundamental difference due to market imperfection is the nature of market demand. Each firm will have a separate demand curve based exclusively on the intrinsic value that consumers assign to its product. Such a valuation determines the market share of a firm in the equilibrium steady state. However, both the consumers and firms experience information asymmetry with respect to such a valuation. As a result, every firm utilizes some non-price strategies (E) to convey the value of their product to the consumers. However, firms are risk-takers in their attempt to increase their market share beyond that indicated by the intrinsic value of its product. This is induced by the recognition that higher market shares cannot be reduced by rival firms due to the emergence of consumer loyalty resulting from repeated use. On the flip side, it is generally observed that consumers tend to ignore excessive advertising and other strategies once they recognize the value of the products of the firm. In other words, there is a threshold on the market share and price achievable by a firm. However, note that firms tend to utilize non-price strategies beyond the limit so long as they expect the gains to exceed the costs. The output produced and supplied generally exceeds the demand. It was noted empirically that the supply in supermarkets, for example, always exceeds demand by a significant margin. The primary reason may be the time lag involved in production and the expected losses if the demand cannot be fulfilled as it arises. A part of the excess production may be justified by the excess capacity available to a firm (due to the lumpiness of capital and the implied economies of scale and scope). The cost of holding inventory relative to the expected gains may also justify such managerial discretion. However, the possibility that the creation of excess capacity is induced by such decisions in imperfect markets cannot be ruled out. The following analysis considers all the decisions—investment in capital stock, capital stock, and output—in real (physical) terms. It will also assume that the managers making investment and production decisions are independent of each other. They will necessarily have different objectives. To begin with, it will be noted that decisions regarding investment I (a flow) and the utilization of the stock of capital K are entrusted to different managers. In this endeavor, the manager who chooses I will be expected to be concerned with the cashflow such investment can generate. It will be a result of the revenue obtained from the output produced after integrating the investment into the stock of capital and the cost of obtaining the investment goods.14 Let Y be the output of a firm, E represents the number of advertising campaigns, and p = p(Y, E) be its demand curve. Assume that pi is the price of obtaining each unit of the capital goods I, and pe is the cost of each unit of E. For simplicity of 14

Since the manager making this decision is independent and responsible only to his division, the only concern will be with the cost of procuring the investment goods. Further, note that this manager is taking the output Y as given and decided by the production manager. Hence, the choice of I taking the expected revenue from the output that will be eventually sold on the market is relevant.

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exposition, it will be assumed that these markets are competitive. The cashflow of the firm will then be15 CF(Y, E) = Y p(Y, E)− pi I − pe E The effect of market imperfection on investment can now be inferred by returning to the choice of I by maximizing CF (Y, E). Noting that K = K 0 + I, where K 0 is the initial stock of capital, the resulting choice of I will be such that p(Y, E)(1 − 1/ηe ) (∂Y /∂ K ) = pi where ηe is the elasticity of demand. As before, Y = L α K β implies that (∂Y /∂K) = βY /K. Hence, K = p(Y, E) (1 − 1/ηe ) βY /pi . Note that the resulting investment will be higher whenever the MR and/or Y increase. Consider the choice of Y. Clearly, there is a cost of using K to produce Y. It can be represented by C(Y, E) since K = K(Y ) and L = L(Y ) will be chosen to minimize the cost of producing Y. Invoking the assumption that the management responsible to this decision will maximize profit π = Y p(Y, E)−C(Y, E) π will increase with E if MR(Y, E) > MC(Y, E), the marginal cost of production. As noted earlier, there is threshold E* beyond which the consumers do not find any increase in the value of the product to them. The corresponding threshold demand curve is p(Y, E*). Assume that the firm has the information about E* and chooses E*. The cost curve for the firm will be C = C(Y, E*). The firm maximizing profit will choose Y * = Y (E*) and the corresponding p*. It can be claimed that (E*, Y *, p*) is in consonance with the consumer valuation of the product. The steady-state growth path of the firm will be determined by (p*, Y *). However, both the consumers and the firm experience information asymmetry. Assume that the firm has information about E* and p* but not the Y *. The firm will have a propensity to increase Y and profits whenever an opportunity presents itself. Suppose the firm chooses E e > E* instead. Profit maximization results in Y e > Y * at price p*. This yields an increase in revenue. However, this increases the cost as well. Profits will increase so long as p* exceeds the marginal cost MC(Y *, E*). This is represented in Fig. 8.2. Clearly, there is a limit to the increase in E if this result should hold. 15

Note that the wages paid, viz. wL, to the labor does not enter the consideration since it is independent of I and K.

8.6 Market Imperfection Fig. 8.2 Advertising and output

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p MC(Y,Ee) p* MC(Y,E*) p(Y,E*) MR(Y,E*) O

Fig. 8.3 Information asymmetry

Y*

Ye

Y

p MC(Em)

MC(E) MC(E*) MR(E)

MR(E*) O

Y* Ye

Y

Consider the alternative that the firm does not have the information about p(Y, E*). Suppose they choose E such that both the marginal revenue MR and MC will increase. As shown in Fig. 8.3, Y e > Y * until MC(E m ) is attained. The firm may increase MR by a suitable choice of E. For all practical purposes, a firm which is risk-taking in its interface with the consumers—in pursuit of a larger market share and profit—will choose a lager quantity of investment and capital stock.16 The above argument also indicates that firms may undertake investments to gain advantages, even if temporarily, over rival firms. It would be fair to expect significant variations in investments in physical capital across firms. Similarly, potential competitors have an incentive to enter such markets due to higher rates of profit. However, several reasons for lower investments can be sighted. (a) Imperfection in the product markets renders the marginal revenue product of capital lower. Further, 16

Observe that the increase in MC with E may be sufficiently steep in relation to what can be achieved in MR as the firm approaches E*. The price may stabilize at a higher level in comparison to competitive market. This will entice the firm to return to p*, Y *, E*. Convergence to E* is indicated.

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the interest rate will be higher due to the imperfection in financial markets. Both these features lower investment. (b) The competitive nature of markets makes their stability (and, by inference, that of their managers) over time uncertain. The management will place a lower value on capital investments and long-run growth. (c) The management would be inclined to increase spending on non-price strategies to consolidate their market power. Such strategies displace physical capital investments.17 On the whole, tracing the influence on market imperfection on capital investment has not been definitive.

8.7 Empirical Evidence The theoretical considerations regarding private corporate investment have been extensive. However, the availability of data to verify these theories leaves much to be desired. It can be speculated that the information not included in the available data may yet be more important to explain investment behavior. One result stands out as unanimous. The accelerator variable is significant in almost all the studies. The significance is that the growth of sales, either expected or observed, is the prime motivation for private corporate investment. This is hardly surprising or innovative. Given the fragmented capital markets, the interest rate variable cannot be expected to have any influence. Indeed, the prices of new capital goods or any other measure of the cost of financial capital (such as Tobin’s q) have no effect on investment. As in the studies of inventory investment, the cost of acquiring machinery or the chosen mix of finances is itself a small, and perhaps insignificant, part of the total costs involved. What the accelerator variable indicates is that the demand for the quantum of investment overtakes the cost of capital since in any case the latter must be less than the expected rate of profit ex post. Investment will not be forthcoming otherwise. Despite this, the user cost of capital conceptualization maintains that the productivity of new machines, the price at which they are acquired, and the expected market price of output matters. Even the studies of Bhattacharyya (2008, 2010) that attempted empirical test of this variation could not estimate and include this variable. Conceptually, the user cost of capital varies over time and between firms.18 Since these variations could not be estimated, it would have been useful to utilize the random coefficient regression approach.19 As of now, it is not clear if the cost of capital or the postulated steady-state capital stock is empirically significant. As a result, the empirical evidence does not favor the user cost of capital and related capital output ratio against the technologically determined characterization that prevailed earlier. 17

Many of these arguments can be traced to Akdogu and Macay (2012) and Rao (2021). Jorgenson (1963) considers fiscal policy measures as an equally important source of the user cost of capital. It would be necessary to accommodate this as well. 19 Gauba (2017, pp. 474, 476) mentioned that the random effects models did not perform as expected. Evidence regarding this has not been presented. 18

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Krishnamurty and Sastry (1975) postulated that there is a limit on the total finances available and that investment in capital and inventories compete for the same resources. However, this appears to be implausible because there is no evidence of any such financial constraint and more significantly the inventories are financed by short-term sources whereas long-term sources are involved in financing fixed capital. Turn to the financial variables. It was expected that the supply of finances will depend on the financial strength measured by the ratio of networth to total assets since the latter is expected to reflect the creditworthiness of a firm. This variable was not significant in empirical results. However, the supply of financing matching the demand for finances remains important. Ganesh-Kumar et al (2003) documented extensively that the debt finance institutions and the stock market provided a significant amount of external finance for investment after 1991. It does appear that the stock market sources were primarily utilized by term lending institutions like the Infrastructure Development Finance Corporation.20 Essentially, there is a need to develop reliable measures of debt and equity finance, out of the available total, that were allocated to private investments. It is necessary to verify the contention that investments in the public sector crowded out investments in the private sector. The evidence presented in Ganesh-Kumar et al (2003) however indicates that, in addition to the accelerator, both retained earnings and external finance have a significant role. However, the effect of retained earnings was distinctly lower.21 They also subdivided external finance into five components (p. 100) and examined their relative performance. On the whole, they observed that “some of the external sources of funds may be closely related to the current level of operations of the firm represented by sales.”—p. 103. That is, the ex post variables about which data is available can only represent values that equilibrate the supply and demand.22 They also suggested that “investment is not sensitive to the borrowings from the financial institutions.”— p. 112. In general, they found that the development financial institutions “which provide long-term finance to Indian corporate firms seem to be a ‘weak link’ in allocating resources to arguably more dynamic firms in the Indian manufacturing sector.”23 —p. 114. Gauba (2017) obtained data from CMIE (Center for monitoring the Indian economy) and the office of the economic advisor, ministry of finance, and industry and found that all sources of finance—retained earnings, borrowing from term 20

In fact, the chairman of the corporation used to say that he has to convince his shareholders that his investments are worthwhile. 21 Cynically, it may be argued that stock market financing was more readily available to firms that have export obligations. 22 Two observations are indicated. First, the appearance of a financial variable may either represent the demand for it or it may suggest that supply restrictions prevailed. Unless this distinction can be resolved empirically, their usage of “financial constraint” is not consistent with this proposition. 23 They consider external finance to be more extensive due to transaction costs and enforcement problems. They also maintain that it is not as useful to know that financial constraints exist on the investment decisions of some firms as it is to know which markets or institutions are the cause of the constraints.”—p. 8.

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lending institutions, and equity financing—were significant in determining capital investments.24 However, debt (borrowings) was more important essentially because “the banks … are considered to be better off in terms of access to information than common investors in securities markets”—p. 476. In view of the reservations mentioned earlier, this result is not useful unless the external finances utilized for corporate investments are explicitly separated.25 The findings of Bhattacharyya (2008, 2010) provide a stark contrast. Retained earnings are introduced as a variable. It was found to be significant. It was more significant than the accelerator in some contexts. The following possibilities can be detailed. (a) Despite the enormous growth of the equity market, firms still tend to calibrate investment opportunities using (S t − S t−1 ). (b) Firms trust a few more market opportunities based entirely on the available retained earnings. (c) The enterprises were either not willing to acknowledge or take risks beyond those that can be financed by retained earnings or considered the external finance offered by the term lending institutions and financial markets to be a significant deterrent. Irrespective of these sources, Bhattacharyya’s findings would have been more robust if data regarding external finances was explicitly introduced into the analysis. In the early stages of economic and industrial development, the markets for manufactured goods were rather sluggish. As a result, I t = f (S t − S t−1 ). However, some firms found that their profits and retained earnings can support more investment and allow growth. Hence, I t = f [(S t − S t−1 ), profits retained]. Over time, more finances were available through external sources and government intervention. But the improvements in technology and product mix suggested that the cost of capital was in excess of the profit rates that firms can obtain on the market. Hence, the cost of capital, and not market demand, constrained investment decisions. Initially, the available external finances tended to be far in excess of perceived requirements for investment. There were sudden spurts of investment anticipating further profitability and decrease in the cost of capital. However, the improvements in production and productivity were below expectations and the supply of finances was limited partly due to pessimistic expectations and also due to government not being able to increase its component of financing. There was a feeling that there is a constraint on external finances limiting investment even if the cost of capital supported it. The costs of investment being low also added to this phenomenon. In general, the user cost of obtaining finances is the real characterization of Tobin’s q. It becomes important and binding if it exceeds the Jorgensonian user cost of capital. The cost of capital is itself not a binding constraint. In the Jorgensonian world, markets and finances are not constraints. Only the productivity of technology and the prices of output and 24

Krishnamurty and Sastry (1975, p. 172) noted earlier that “external finance is more supply determined than demand determined.” Perhaps due to this their investment equation (p. 47) has only internal sources (depreciation reserves + retained earnings) and the flow of net debt. Gauba (2017) reproduced a similar inference. This is probably the justifiable if there is an explicit characterization of credit constraints. If instead, as in most recent studies, they are demand determined the inference about credit constraints would not be meaningful. 25 On p. 472, Gauba (2017) notes that public enterprises run as commercial enterprises were included in the sample under study.

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investment goods matter. They determine the user cost of capital. However, as of now, perhaps we are reverting to accelerator-based investments but are constrained by retained earnings or external finances. In sum, it would be fair to conclude that much of the relevant information about the choice of the capital stock of firms is still missing. The relative importance of the product and financial markets can be ascertained only when such details are available.

References Akdogu, E., & Mackay, P. (2012). Product markets and corporate investment: Theory and evidence. Journal of Banking & Finance, 36, 439–453. Bhattacharyya, S. (2008). Determinants of private corporate investment: Evidence from Indian manufacturing firms. Journal of Quantitative Economics, 6, 151–172. Bhattacharyya, S. (2010). Determinants of private corporate investment: Panel data evidence from Indian manufacturing firms. In B. Bhattacharyya & M. Roy (Eds.), A collection of essays in finance. Allied Publishers. Ganesh-Kumar, A., Sen, K., & Vaidya, R. (2003). International competitiveness, investment, and finance. Routledge. Gauba, S. (2017). Financing of corporate investment: Panel data evidence from Indian manufacturing firms. Asian Journal of Management, 8, 471–478. Jorgenson, D. (1963). Capital theory and investment behavior. American Economic Review, 53, 366–378. Krishnamurty, K., & Sastry, D. (1975). Investment and financing in the corporate sector in India. Tata McGraw Hill. Landes, W., & Posner, R. (1951). Market power in antitrust cases. Harvard Law Review, 94, 937–996. Rao, T. V. S. R. (2021). Market imperfection and macroeconomic performance. Studies in Economics, 1, 61–71. Tobin, J. (1958). Estimation of relationships for limited dependent variables. Econometrica, 26, 24–36.

Chapter 9

Financial Arrangements

The relationship between production and financial decisions has been acknowledged for a long time. Recognizing the imperfections in the financial markets, the entire debate was whether the financial choices should be left to the management in an implicit contract or coordinated by the shareholders in a governance relationship. Managerial discretion in the choice of the debt–equity ratio has been at the center of the debate. Both the cost of capital and the quantum of finances have been subject to such discretion. Rapid changes in the market environment create a greater degree of managerial discretion. At the end of the day, delivering results should be a leader’s goal and in business, it’s shareholder’s value, brought about by profitability, market share growth, corporate reputation and long term outlook—Lutz (2019, p. 201).

9.1 Product and Financial Markets Every firm must utilize some factors of production in the manufacture and distribution of a predefined volume of output and sales. The time lag between production and sales will also generate some inventories. Similarly, the firm must undertake investment in the acquisition of fixed assets to support the production activity. The investment in the capital stock is a long-run commitment. More generally, even the growth of the market value of the firm depends on its capital stock. As noted in the previous chapter, a firm chooses a diversified product range, implements an appropriate organizational structure to achieve efficient monitoring and control, and chooses methods of finance that will minimize interest costs. The analysis of the foregoing chapter emphasized the product market conditions exclusively. Observe that the product market conditions alone will determine the output and inventory choices if the necessary finances are available at a market-determined

© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_9

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interest rate.1 However, if the financial markets provide only a limited amount of finances there will be some binding constraints on the market-related decisions.2 Note that firms must utilize, on a priority basis, any long-term investment opportunities that they can identify. There is a danger of decreasing their market value if there is delay. Further, from a practical standpoint, there can be several institutional and structural rigidities that prevent firms from canceling orders for machinery and equipment at short notice. In general, firms determine the optimal level of capital assets by taking into account the long-term opportunities and strength of the product markets. Capital markets will be efficient if competition among managers for the rights to manage finances is adequate. However, capital markets are generally inefficient. As a result, capital market imperfection results in differential credit ratings of firms based on the market value of their capital assets. Hence, both the interest rate and the quantum of finances available to the firm will be affected. Thus, it is necessary to acknowledge that quantitative limits on finance, in addition to the costs of capital, affect investment. For all practical purposes, the ability to raise the necessary finances is also a distinctive competence of the management. The following observation is pertinent. Notice that the financial requirements are determined by the product markets and the financial market considerations are mostly related to the supply of finances. The financial markets contain the money market that defines the availability of short-term working capital and the equity market for the availability of long-term finances for investment purposes. This chapter will focus exclusively on the long-term financial markets though some degree of substitutability between them exists.3 The long-term supply of finances can be classified in the following way: (a) internal sources of finance that consist of retained earnings from the firm’s profit and depreciation reserves, and (b) outside financing (essentially debt vs. equity), that relate to borrowings from the market and the public versus equity participation. Each of these instruments has a cost associated with it and the degree of control that the managers/owners of the firm have on the operational decisions of the firm. The problem for the management is to find the equilibrium between the demand for and supply of finances. In general, the financial decisions of the firm depend upon (a) the rate of growth of the capital stock and the quantum of financial requirements, (b) the cost of acquiring finances from different sources, and (c) the implications for the ownership and control rights.4 The third aspect is important because equity contracts contain the provision that rights regarding the decisions that affect the cashflows are in the realm of the 1

Suppose the firm must utilize more than one source of finances. Even in such a case this result will hold if the interest rates of different financial instruments are fixed apriori. 2 It is necessary to distinguish between finances available in the totality of financial market and those available to a firm. The present argument signals the possibility that profit expectations from the product market may not justify financial resources that require high interest rates. 3 Many relevant aspects have been considered in Chaps. 6 and 7. 4 It should be recognized that the supply available through the stock market has an excessive cost associated with it. This makes the existing shareholders captive because of the transaction cost of

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shareholders who bear all the business risk. In general, depending on the interest rates and constraints on the availability of finances from different sources, there will be a tradeoff between the market-determined and financially constrained choices of the management. Either of these sources may be binding as well. The availability of finances can have an influence on the demand curve for the products of the firm. (a) There will be a goodwill cost and a shift to the left if there is a quantitative limit on the ability to produce, hold inventory or extend credit to the consumers. (b) An increase in the costs of finance can limit the ability of firms to retain or attract new customers. (c) In some cases, the market demand crucially depends upon the ability of the firm to maintain the equipment that they supply and provide related services. Observe that, in general, the demand for finances depends upon (a) the rate of growth of the capital stock and the quantum of financial requirements, (b) the cost of acquiring finances from different sources, and (c) the implications for the ownership and control rights. The sources of supply of finances can be detailed as follows. Internal sources will be the first choice, followed by debt, and equity. An increase in equity dilutes the control of the management. As a result, the management tries to capture a large share of equity so that they do not lose control if the governance mechanism comes into effect. Note that unlike the decisions in the earlier chapters there are two parties in the decision-making with respect to finances: the managers and the shareholders even if the market environment is stable and relatively constant. The locus of control assumes significance.

9.2 Capital Structure Three long-term strategic decisions of the firm require attention while considering the demand for finances: (a) the extent and direction of capital requirements (in particular, the rate of growth of the capital stock), (b) the nature and extent of product diversification and the allocation of investment to different product lines, and (c) the efficient choice of financial instruments (that is, the capital structure represented by the debt–equity ratio). As noted above, both the managers and financial markets (that are represented by the shareholders and the board of directors) have the authority to determine the capital structure.5 The locus of control in specific instances can be detailed as follows. selling off their holding as also their inability to carry out a threat when their withdrawing does not make a significant impact on the supply of finances. 5 Perfect capital markets can fully evaluate the costs of utilizing different methods of financing rendering the choice of different financial instruments irrelevant. This was the argument of Modigliani and Miller (1958). However, capital markets are imperfect in the sense that the costs of financing from different sources are not equalized.

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There are limits on the availability of internal sources of finance; for instance, the nature of the product market and its profit-generating potential. Further, the actions and reactions of rival firms limit the quantum of internal finances available to the firm. Hence, firms that retain and invest most of their internal sources will be constrained by the fluctuations in cashflows over time. Most firms prefer internal sources to finance capital investments. They would prefer to return to them as soon as possible even if they deviate from them temporarily. The essential reason is that the greater the diversification of the financial mix the more difficult it will be to bring about necessary changes even if profitable opportunities are identified.6 Observe that debt financing increases the cost of financing while limiting the control of the decisions of the firm by equity holders. On the other hand, equity financing provides a degree of reduction in the cost of financing (the rate of dividend paid depends on the perception of the gains in the long-run market value of the firm) while providing the equity holders greater control on many decisions of the firm.7 The basic decisions of the firm can be detailed as follows. (a) Internal sources will be determined by the product market and the choices of dividend payments or retention of profit. (b) Debt financing will be determined by the time over which the capital stock remains stable. (c) Large volumes of capital stock necessitate equity financing. The management may try to gain some control rights by choosing the percentage of common stock that they hold.

9.3 Locus of Control Two competing theories regarding the locus of decision-making have been observed. (a) The relationship between the shareholders and managers is an implicit contract. This approach takes the position that the shareholders devise monitoring and incentive mechanisms to align managerial objectives with their own, require the management to share risks and thereby ensure bonding, and delegate strategic and operational decisions to the management. The shareholders invest in the capital assets of the firm and delegate their utilization to the managers. See Jensen and Meckling (1976). Williamson (1988, p. 580) argued that the shareholders are appraised of investment decisions before they are implemented. (b) The shareholders have a right to govern because they bear the risks associated with the net cashflows. The

6

That is, firms prefer focus in the choice of financial instruments. The shared holders will not, in general, know the efficiency of the operations of the firm. They utilize signals like the announcements about fixed capital and dividend payments as a reflection of the well-being of the firm. The shareholders are unlikely to actually scrutinize decisions regarding the capital stock and its allocation to the different products. They seek only a limited control of the corporation.

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9.3 Locus of Control

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shareholders retain control and decide various aspects, and the management would be expected to implement them (governance relation).8 The market environment has a high degree of business risk and frequent adjustments in the deployment of assets, marketing strategies, and so on are necessary. It would therefore be appropriate that decisions concerning product strategy and organizational arrangements are delegated to the management since they have the most relevant information. However, if the control by the shareholders is weak managers may pursue their own self-interest. Shareholders need to design and implement incentive arrangements to assure themselves of compliance. For instance, the common stock owned by the managers and directors is an incentive for them to operate in such a way as to take the interests of the shareholders into account. On the other hand, the governance mechanism delegates control to the board of directors as representatives of equity holders. They will examine the strategic alternatives of investment that are of a long-term nature and make decisions which the management is expected to implement.9 However, this may be insufficient: (a) there may be a large amount of information available at the headquarters and information overload makes it difficult to conceptualize and implement an efficient allocation to different product divisions. (b) The management does not receive all the returns associated with their decisions (they mostly receive wage payments). This leads to opportunism of the management at the level of execution which can be at variance with the goals of the shareholders. The information advantage that the management has can result in a high degree of moral hazard that is difficult to control. In sum, the choice of one of these organizational arrangements would be a result of the perception of the shareholders regarding the relative contribution to the costs of decision-making and enforcement vis-à-vis the contribution to the market value of the firm. Debt financing involves a fixed interest rate and a first charge for the repayment of the principal in case of default. On the other hand, increased equity participation means greater scrutiny by the shareholders of the decisions of the management. In general, financial markets can fully and unambiguously evaluate the position of the output markets and the implications of different methods of financing. In such a case, the output and financial decisions will be independent of each other. However, the information flows cannot be efficient and costless in practice.10 The management may make an attempt to reduce the impact of shareholding by share ownership in varying degrees, among themselves. In general, the greater the fraction of shares (especially voting rights) owned by the management the less the chance of a successful takeover threat and their likely profit potential.11 8

In particular, the governance mechanism implies that the shareholders make the decisions regarding the extent and composition of capital assets, choose organizational arrangement to control business risk, and share the residual risks that arise. 9 The advantages and drawbacks of the governance mechanism have been outlined in Ataay (2021), Foss et al. (2021), Falkinger and Habib (2021), and Korpoff (2021). 10 Several other considerations in the choice of the methods of finance have been detailed in Mehrotra et al. (2003), Rao (1991), Rao et al (1995), and Rastogi and Rao (1997). 11 The management may also design and implement complex organizational structures in such a way that outsiders do not have any effective control. However, the management cannot be expected

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9.4 Focus Versus Flexibility12 Some consequences of financing require attention irrespective of the locus of control. However, some differences due to the locus of control should also be investigated. This section considers the implications of focus versus flexibility in the financing of the firm. The choice of the financial mix has several consequences: (a) focus versus flexibility which defines adaptability over time, (b) the costs of obtaining finances, (c) the control of the operations of the firm reflected in implicit contracts and governance relations, and (d) the allocation of finances between different capital investments. The managerial team in charge of production and marketing will not bother to identify value-maximizing opportunities unless they have the assurance that the necessary financing will be provided. Hence, it can be expected that profitability is high if the financial mix is more focused. Such sources are more likely to develop loyalty toward a specific firm. The management of a firm generally prefers to focus on the internal sources to finance capital investments because (a) there will be no cost and there will be no loss of control, (b) when a single external source is utilized there will be an assurance to the owners that their interest will not be undermined, and (c) diversified choices create problems of adaptability when external conditions demand it. If a firm is constantly using external sources of finance due to the non-availability of internal sources (mostly due to product market conditions) the management has to be flexible. There is some flexibility in the use of internal sources of finance (reserves and surpluses). Under these conditions, the possibility of cost reduction, when confronted with financial constraints, is the basic motivation for the firm to engage in a rearrangement of its asset structure. Firms may need to alter their investment decisions and financial mix frequently given the uncertainties in oligopolistic product markets. Flexibility is the ability to cope with this requirement. In particular, when product market conditions favor large investments that cannot be financed by the existing sources it becomes necessary to depend on other sources. Similarly, if there is a restriction on the quantum of finances available from the existing sources it becomes necessary for the firm to look for an alternative. In such a case, the flexibility to make rapid changes will be necessary to take advantage of emerging market opportunities. Such flexibility was elucidated by Markides (1995) and McGrath et al. (1995). Generally, the flexibility to alter the financial mix toward cost-reducing diversification and investments may indicate managerial competence. In the short run, flexibility versus focus does not have a major impact. Instead, the short-run profitability is determined by the externally determined market conditions and the ability of the firm to utilize its capital assets in consonance with them. In general, the stock of capital is determined by technology rather than by how the to have such a high degree of control. Similarly, financial institutions, who own shares, are not under the influence of the management, and hence can only have a limited effect on the behavior of the management. 12 Many details of this aspect and the empirical implications are available in Rao and Raja (1999).

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capital is financed. For all practical purposes, the market value of the firm depends on product market conditions rather than the financial mix. Despite the oligopolistic nature of the product markets, firms do not have brand loyalty to a point where all the costs can be passed on to the consumers. Instead, cost control, including that in the choice of financial instruments, is important.

9.5 Debt–Equity Ratio The management or shareholders of a firm rarely know the maximum market value that the firm can achieve. What they try to do is to utilize short-term strategies that aim market value maximization partially and target a constantly shifting local maximum that they can conceptualize and achieve. The belief is that such strategies provide an invariant embedding to the attainment of the global maximum. This cannot be verified since the concept of the global maximum is never defined. What they can actually accomplish depends on their efforts and circumstances that explain opportunities and constraints. If there is only one source of finance, such as retained earnings, the firm experiences a limit on the supply of finances. However, given the countless financial innovations and sources of finance the cost of financing depends on the debt–equity ratio as well as the dividend payout ratio. While equity financing may reduce costs, it tends to generate risk in the form of a takeover threat. In general, both the management and the shareholders have their own valuation of the debt–equity ratio. Further, the greater the fraction of shares owned by the management the less the chance of takeover and greater the managerial discretion. The pertinent question is: who determines the debt–equity ratio and why? The relevant considerations can be detailed as follows. (a) A high dent equity ratio dilutes the control of the shareholders. Further, the high interest costs of debt make takeovers unprofitable. The managers gain control and alter the decisions of the firm. (b) By increasing the debt–equity ratio the managers may be signaling an assurance to the shareholders that the investments they propose would be profitable and they are willing to stake their prestige and jobs in case of a failure. (c) It is important to recognize that the management is fully accountable to the losses and costs associated with their decisions. However, they do not receive all the returns that their efforts generate. This creates the possibility of opportunistic behavior (pursuit of self-interest). It negates the proposition that competition among managers for the rights to govern would be adequate to limit such discretionary behavior. There may be an alternative to increasing debt. For instance, the managers may announce that they would forego all reward (resign in disgrace) if the firm’s market value does not correspond to the pre-specified minimum level. In general, the management refrains from seeking control if the costs are high. Such a bonding effect can be expected when product markets have such a disciplining possibility.

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Some bondholders understand the conflict of interest between themselves and equity holders, they demand covenants that restrict the behavior of managers, particularly with respect to new debt issues. As a result, such covenants typically target debt–equity ratios. On the other hand, the shareholders, as owners of the firm, will have to bear the risks. Consequently, they endeavor to control the decisions of the firm that affect the market value of the firm. Thus, increased equity participation will mean greater scrutiny of the decisions of the firm by outsiders. The threat of takeover and the risks associated with the loss of control define the boundaries within which the management seeks the participation of debt and equity. The resulting debt–equity ratio may therefore be looked upon as a tradeoff between cost and control. The equity holders are a diversified lot, and they cannot be expected to collectively work to bring about the necessary discipline. Similarly, they would be primarily interested in the return they receive (dividend and capital gains). However, this will not be sufficient to gain control of several important decisions of the firm. Further, they are unlikely to have the competence to manage day-to-day operations of the firm. They will indicate the behavioral constraints that should be imposed on the management. In other words, the control aspects of debt and equity can be achieved through more detailed organizational restrictions. One approach toward achieving this is by appointing a board of directors who act on behalf of the shareholders. As a result, strategic decisions of the firm emerge from the control exercised by the board of directors (governance mechanism) so as to maximize the market value of the firm. Concentrating governance in the hands of the shareholders (or a few directors appointed by them) provides an answer. Essentially, the argument is that equity holders bear the risks of net cashflows and therefore have the right to choose the decisions that contribute to it. They may also employ outside auditors on behalf of the shareholders. However, equity holders may take large risks knowing that the penalties accrue to the debt holders in the event of failure. Similarly, the board of directors, representing the shareholders, may develop reputations that are valuable in the marketplace. They may indulge in shirking and threaten to leave if disciplined. The governance relation will also have transaction costs. Thus, the directors (or managers) have goals of their own, such as enjoyment of perquisites or the maximization of their own income that may be at variance with the goals of the shareholders in general. That is, transaction costs describe the impediments to reaching and enforcing agreements. Laws regarding corporate governance may provide further safeguards. Rao (1988b) provided many relevant details. The implicit contracting approach implies that the management is made an agent of the shareholders who are designated as the principals. That is, the management may be delegated the responsibility of making strategic decisions. This will involve the choice of the correct agents and monitoring and control of their performance so that it is in consonance with the value maximization objective of the shareholders. The costs involved in these activities are designated as agency costs. Some residual loss is expected since the control aspects cannot fully ensure value maximization. The delegation of activities to the management may nevertheless make the shareholders cognizant of the emerging distortions and the need to realign incentives. That

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is, it may not be possible to resolve agency problems through contracts. See Hart (1995, pp. 678–9). Asset specificity and the entrenchment of the management may be the primary source of such problems. In sum, the efficient choice of the debt–equity ratio considers both the cost and control aspects and an appropriate tradeoff between them. There will be several sources of managerial discretion in the execution of the choice.

9.6 Dividend Decisions Dividend decisions are an important aspect of corporate financing policy since they have an effect on the availability as well as the cost of finances.13 The ex ante decisions of the management and shareholders depend on the nature of the product and financial markets. It is important to examine the locus of decision-making (shareholder vs. managers) and the motivations for the specific choice. If the management decides dividends as primary it indicates that the shareholders consider a constant dividend payout ratio primary from their perspective and the management is merely responding to it. In particular, the nature of financial requirements, the cost of acquiring finances from different sources, and the implications for ownership and control rights determine the dividend decisions. Note that both the management and the shareholders have concerns ex ante while determining the dividends paid. The actual execution will depend on whether a governance relation or an implicit contract is in operation. In the first, the ex ante choices of the shareholders predominate. In an implicit contract, the choices of the management will prevail so long as there is no threat to change the organizational structure. There are several pragmatic considerations that make the management choose stable dividends.14 Firstly, in the short-run finances obtained from the stock market cannot be repaid immediately. The management will try to reduce antagonism by paying a fixed dividend. Secondly, so long as internal finances are sufficient to finance new investments and build an adequate reserve base the management need not restrict dividends. Firms may feel that until they build an adequate reserve base they will do well to pay steady dividends rather than antagonize the shareholders even when they are not demanding it. In general, retentions may be primary from the management viewpoint. First, there is a significant divergence between ownership and control. When the managers do not have any property rights, they may not have any incentive to take risks with borrowed funds. Consequently, they may rely on internal funds at the expense of dividends. Second, the managers are increasingly compelled to raise 13

The cost of finance to the firm depends on the debt–equity ratio as well as the dividend payout ratio. The greater the debt–equity ratio the more conscious management would be of the need to generate adequate profits. However, given the innumerable financial innovations and sources of finance, the costs of finance rather than the availability is likely to be limiting. 14 See Rao and Sharma (1984) for a detailed consideration of ex ante dividend decisions of the management or the shareholders’ funds.

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internal sources and build a reserve base since finances from other sources dilute their control. Thus, dividend decisions may not be primary from the management perspective. Consider the credit rating and market valuation of common stock of the firm in secondary marks. The shareholders will not, in general, know the efficiency of the operations of the firm. They will utilize signals like the dividend payments and announcements regarding fixed capital investment to calibrate the financial wellbeing of the firm. The management may assign priority to such decisions even when the product markets are not favorable and cashflows are deficient. When debt is high and returns from investment are uncertain, the management may prefer to pay off higher dividends to indicate bonding. Higher dividends may also necessitate raising finances from the stock market, thus allowing shareholders to evaluate managerial performance. Assume that the shareholders seek an early resolution of the uncertainty of returns and consider dividend decisions as a signal in rearranging their portfolios. The management may then be compelled to truthfully reflect the future prospects of the firm in their dividend decisions. On the basis of the extent of dependence of the firm on the stock market, the management must be responsive to the demands of the shareholders to maintain a certain minimum dividend per share. Internal sources of finance and debt financing provide the management an opportunity to divert resources to their advantage. The shareholders therefore insist on regular dividend payment to reduce the need to monitor managerial discretion.15 The dissatisfaction of the shareholders regarding the long-run strategies of the management, and their perception that they are not in their long-term interest, can create a long-run primacy of dividend decisions from the shareholder perspective. Diffused shareholding and the absence of commitments to pay for the finances at a fixed rate have a tendency to dilute the necessity to maximize profits. Similarly, the management’s ownership of shares of the firm may be limited and the management may not emphasize profits as much as the perquisites they obtain or the job security. The shareholders may seek certain dividends to obtain adequate returns for their equity holding or to indicate the extent of control they seek. A large portion of shareholders are partly or fully dependent on dividends to meet their needs. They prefer dividends. De Alessi and Fische (1987, p. 41) observed that the shareholders may insist on dividend payments to reduce the need to monitor managerial decisions. In the governance framework, debt financing is motivated by the need to share risks. In the implicit contract, it is a mechanism to bond the managers with the shareholders. Share prices themselves are an insufficient signal to convey the well-being of the firm to the shareholders.

15

The shareholders would be willing to trade off short-run dividend payments in favor of long-term capital gains. Hence, even if there is a necessity to offer a minimum dividend payout rate it will be less than the market interest rate for long-term borrowing.

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The shareholders obtain a short-term dividend payment as well as capital gains in the long run. In their portfolio choice, they would be willing to tradeoff short-run dividend payments in favor of long-term capital gains. The currently available empirical evidence overwhelmingly indicates that the dividend decisions are made by the shareholders, or the board of directors. There is not enough evidence to the alternative argument that the management will decide this and use it as a bonding signal.

9.7 Empirical Observations Consider the measurement of focus and flexibility. To begin with, note that the sources of long term of finance can be: long-term loans, debentures, provisions for taxation, shareholder reserves, and equity capital. The numbers equivalent of several diversification indices based on the above sources capture the focusing effect. All these indices can be defined over the growth rates of the above financial instruments instead. Such indices reflect the extent to which the management has flexibility. Some studies utilize the variance of the financial mix as an index of flexibility. Similarly, the lack of flexibility can be indicated by the convertibility clauses or covenants (formally written contractual agreements) in bond financing. The less focused the choice of financial instruments the more difficult it will be to attract finances even if profitable investment opportunities exist. Similarly, an increase in focusing will induce the managerial teams to identify value-maximizing opportunities. The empirical evidence indicates that flexibility is more important than focus. The debt–equity ratio indicates both the cost and bonding effects. Whenever the management increases the debt–equity ratio they will attempt to increase their efficiency given the increased first charge on the firm’s cashflows. On the other hand, an increase in the debt–equity ratio signals a dilution of control of equity holders. Similarly, the negative effect of increases in the debt–equity ratio on short-run profits suggests that there is no bonding effect. There may be three possible reasons for the significance of the focusing effect. (a) The products may be such that adequate internal finances cannot be generated. (b) There are constraints on the availability to obtain adequate equity financing. (c) The management does not consider the dilution of control favorably. In general, the physical assets in production and distribution, instead of markets or methods of finance, appear to be significant in the short run. Similarly, the observed negative effect of the size of fixed assets indicates that underutilization of capacity and the associated costs are more important. See Rao and Raja (1999). In general, the choice between the governance mechanism and an implicit contract would be a result of the shareholder perception regarding the relative contribution to the costs of decision-making and enforcement. In a governance mechanism, the board of directors may be expected to trade off the market value of the firm to achieve goals like power, security, and prestige. On the other hand, in an implicit contract, the

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motivations of the management to make efficient decisions will be conditioned by the board of directors and/or constraints imposed on them. The governance mechanism may, however, eliminate the moral hazard possibilities of implicit contracting. Thus in an implicit contract approach, incentives like wage payments and constraints like the dividends per share determine the manager’s choice of the growth of capital assets and the capital structure. The incentives and constraints will be chosen by the board of directors keeping the business risk in perspective so as to achieve an appropriate sharing of risks and consequent alignment of objectives. Thus, the debt–equity ratio is chosen by the managers to indicate their bonding with the shareholder’s concerns. The management does not have any such role in the governance framework. On the other hand, in a governance framework, it should be expected that the strategic choices which the shareholders want to introduce would have an important role in determining the incentives offered to the management. The motivation for debt financing is determined by the preference for internal financing of capital assets and the associated fluctuations induced by the business risk. In sum, if capital structure decision is a governance relationship the choice of debt–equity ratio and the growth rate of capital assets will not be affected by the wages and dividend decisions. On the other hand, incentives like wages will be conditioned by the choice of the debt–equity ratio and growth of capital assets. By way of contrast, in an implicit contracting framework the debt–equity ratio and the growth of capital assets will be determined by wages and dividends. The latter will not be determined by the strategic choices. The empirical results suggest that, in general, a significant proportion of firms utilize implicit contract as the preferred organizational mechanism. For firms that utilize an implicit contract, the growth decision is mostly conditioned by the long-term fundamental strength of firms including the product market and internal sources of finance with medium- and short-term variations in the debt–equity ratio accounting for the contingencies arising from the business risk in product markets. On the other hand, in the context of the governance mechanism, the choice of higher debt–equity ratios and the associated costs induce the board of directors to offer appropriate wages and salaries to the management. The choice of dividends per share is not influenced by these considerations. More generally, the shareholders or the board of directors in the governance relationship may be conditioned by inadequate information with respect to market conditions external to the firm, and/or the distinctive competencies of individuals within the organization. They may also experience several constraints due to financial costs and loss of control in designing appropriate organizational structures. If these risks are sufficiently low, the board of directors will maintain control to ensure efficient functioning of the firm. On the other hand, when the risks increase the efficient organizational arrangement consists of delegating the decisions to the group that has the best information to make a specific decision. However, if information asymmetry and loss of control increase the board of directors prefers to regain control because the incentive mechanisms and dividend constraints have limitations in reducing moral hazard. This occurs whenever the shareholding by the managers and their relatives exceeds ten percent. Capital market imperfection does not appear to be sufficient

References

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explanation. For more details, the reader may refer to Rao et al. (1995) and Rastogi and Rao (1997).16 A more general approach to the estimation of the tradeoff between the market value of the firm and other controls of the management or the board of directors can be obtained from Rao and Rastogi (1994) and Rastogi and Rao (1995).

9.8 The Imponderables Observe that this chapter detailed several constraints on capital investments and the market value of the firm. Prominent among them are the following: (a) the market (both the quantities and prices) are binding on the investment opportunities,17 (b) the quantum and prices of the resources used in production and distribution and the competence of the management in discovering them, (c) the ability to raise the quantity of finances necessary and discern their costs, and (d) the capabilities of the organizational structure and management to reveal the worth of the investments. As of now, there is hardly any empirical evidence regarding which of these constraints, if any, operate in a given context. Further, there have been several references to the tradeoff between the different strategies of firms and between two or more of their objectives. It has been difficult to estimate the tradeoffs. Despite the significant progress observed in finding the basic organizational arrangements, it was observed that they tend to be insufficient as the size of the firm increases or more activities are added to the firm. Consequently, several other organizational forms, such as subsidiaries, franchising, spinoff, or carve out have been proposed as alternatives. The emergence of spin-offs and carveouts will be considered in the next chapter.

References Ataay, A. (2021). CEO outsiderness and firm performance in an emerging economy: The moderating role of managerial discretion. Journal of Management & Organization, 26, 798–814. de Alessi, L., & Fische, R. (1987). Why do corporations distribute assets?: An analysis of dividends and capital structure. Journal of Institutional and Theoretical Economics (JITE), 143, 34–51. Falkinger, J., & Habib, M. (2021). Managerial discretion and shareholder capital at risk. Journal of Business Finance & Accounting, 48, 1215–1245. Foss, N., Klein, P., Zellweger, T., & Zanger, T. (2021). Ownership competence. Strategic Management Journal, 4, 302–328. Hart, O. (1995). Corporate governance: Some theory and implications. Economic Journal, 105, 678–689. 16

Despite these empirical findings, it was generally suggested that the major effect on investment is through the quantitative limits on capital rather than the costs of finance. 17 It must be acknowledged that the competencies of the management and/or their commitment will be a constraint on the extent to which the potential market conditions are revealed.

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Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3, 305–360. Korpoff, J. (2021). On stakeholder model of corporate governance. Financial Management, 5, 321–343. Lutz, B. (2019). Icons and idiots. Penguin. Markides, C. (1995). Diversification, restructuring and economic performance. Strategic Management Journal, 16, 101–118. McGrath, R., Macmillan I., & Venkataraman S. (1995). Defining and developing competence: A strategic process paradigm. Strategic Management Journal, 16, 251–275. Modigliani, F., & Miller, M. (1958). The cost of capital, corporate finance, and the theory of investment. American Economic Review, 48, 25761–26297. Rao, T. V. S. R. (1991). Financial choices of the firm as organizational decisions. International Review of Economics and Business, 38, 753–778. Rao, T. V. S. R. (1988b). Transaction costs, vertical integration, and X-efficiency. International Review of Economics and Business, 35, 1173–1190. Rao, T. V. S. R., & Raja, A. (1999). Flexibility in the choice of financial instruments and corporate performance. Indian Journal of Economics, 79, 387–403. Rao, T. V. S. R., & Rastogi, R. (1994). Estimating attitudes towards risk in a volatile environment. Indian Journal of Applied Economics, 3, 253–270. Rao, T. V. S. R., & Sharma, R. (1984). Primacy of corporate dividend decisions. Indian Economic Journal, 32, 56–72. Rao, T. V. S. R., Rastogi, R., & Saha, S. (1995). Capital structure decision: An implicit contract or a governance relation. International Review of Economics and Business, 42, 145–162. Rastogi, R., & Rao, T. V. S. R. (1995). Towards formulation of a method of estimating managerial preferences: A case study of the Indian Chemical Industry. Journal of Financial Management and Analysis, 8, 26–37. Rastogi, R., & Rao, T. V. S. R. (1997). Corporate governance and capital structure. Finance India, 11, 951–977. Williamson, O. (1988). Corporate finance and corporate control. Journal of Finance, 43, 567–591.

Chapter 10

Carveouts and Spinoffs

Organizational synergy has been at the center of attention in explaining spinoff decisions. The lack of synergy may give rise to various forms of disagreement and managerial discretion to allow a spinoff. Even individuals who create an innovation will spin off if the incumbent management does not value it the same way. Finances have a crucial role in such spinoff decisions. The management of the firm may maintain a financial link even when production is strictly delinked leading to a carveout. This chapter elucidates the notion of synergy and the managerial choice between a carveout and spinoff. Clearly, the link between the real and financial consideration gives rise to new forms of managerial discretion. There is a strong undercurrent of dissent with loose and superficial thinking and a real desire, out of sheer intellectual self-respect, to reach clearer understanding of the meaning of terms and dogmas which pass current as representing ideas—Knight (1957, p. ix).

10.1 Empirical Setting In practically every context the important choices of the managers of a firm consist of the range of products that the firm should plan to produce and offer to consumers. Invariably as the size of the firm increases the management would encounter constraints inherent in the size and nature of markets, the technology embodied in the capital assets, and the limits of size indicated by the scale and scope they embody, the resources—including finances—available to the management, their competence in organizing production, and so on. The geographic spread of the markets for their products signals the need to diversify. This may result in the firm setting up subunits on its own (owing the physical and financial resources and control of organization), franchising production and/or distribution to other entrepreneurs (who may have advantages in production and sale) maintaining financial control (usually designated as a carveout), or leave production and distribution as well as financing to the entirely new firm (often called a spinoff). The choice, of one organizational form over the others and the circumstances that lead to a specific choice, has been the subject © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_10

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of intense debate. Empirical evidence in the form of case studies has been available. Several attempts have also been made to identify the prominent reasons for the observed choices. The rest of the chapter will present one such generalization that can go beyond the case study approach.

10.2 Elasticity of Substitution It may be surmised that the elasticity of substitution between products determines the extent of coordination necessary for the efficiency of the production organization. Suppose the products are not easily substitutable. The divisional managers of an integrated firm recognize that their contributions are unique and that coordination of their work from a higher level management is not necessary. However, the incumbent management may feel that they do not have the type of skills necessary to manage the new product. Suppose the elasticity of substitution is high instead. The managers of any one product division may feel that they can free ride on the efforts of others who will make up for the loss of revenue they create. Consequently, there will be a necessity to extensively coordinate the activities of the divisional managers, elicit commitment, and extract greater value by fostering team spirit.1 The extent of coordination necessary can be expected to increase with the elasticity of substitution. Hyytinen and Maliranta (2008) appear to be the only study that noted an increase in organizational requirements as the elasticity of substitution increases.2 Some studies considered the role of the elasticity of substitution as a determinant of the organizational capabilities necessary for the efficient performance of a firm.3 First, the vast majority of studies, including Hyytinen and Marilanta (2008), Erikkson and Kuhn (2006), Daley et al. (1997), Hellman and Perotti (2010), contend that the nature of organizational requirements, and not necessarily their quantum,

1

Klepper and Thompson (2010) suggested that information asymmetry leads to disagreements between the originators of the new product ideas and the incumbent management. They contend that this is the major reason for spinoffs. However, it appears more realistic to argue that information asymmetry induces strategic bargaining by incumbent management. Further, strategic choices of the incumbent management may be for reasons beyond information asymmetry. In either case, such strategic bargaining explains disagreements. 2 Klepper and Sleeper (2005) noted that some new products need greater marketing attention even when they are technologically similar to the existing products. If the elasticity of substitution is high and the products are similar, the firm will not have much strain on managerial resources. Hence, high elasticity products are not likely to spinoff. However, this argument may be confusing the availability of organizational capabilities with their requirement in an integrated firm. 3 Adams (2005) utilized a constant elasticity of substitution (CES) production function. However, the main emphasis is on disentangling the effect of synergies on the distribution of gains.

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will be different if the products have a low elasticity of substitution.4 Second, Elfenbein et al. (2008), Wagner (2004), and Klepper (2001) observed that spinoffs have superior managerial skills learned from the parent firm if spinoff products are closely substitutable to those of the parent firm. Somewhat more specifically, Klepper (2009, p. 163) pointed out that “initially spinoffs tend to produce types of products that were a substitute of those produced by their parent firms.” By implication, an increase in the elasticity of substitution may put a strain on the organizational capabilities of the firm and induce a spinoff.5 However, Pakes and Nitzan (1983) argued, on the contrary, that a specialist may find it more efficient to manage a new product in a spinoff if the product is distinct from the parent’s main line of business. That is, low elasticity products may require organizational capabilities that are at variance with those available with the firm.6 Third, Klepper and Sleeper (2005), and others suggested that new product introduction may cannibalize the demand for existing products if the elasticity of substitution is high. Fourth, McNeil and Moore (2005) and Klepper and Thompson (2010) noted that firms tend to develop organizational procedures and incentive payment mechanisms for organizing a diversified product portfolio. These institutional arrangements tend to be perpetuated even when new products are introduced. However, the possibility that new products may require different organizational mechanisms creates dissonance and reduction in synergies. A spinoff emerges. On the whole, it is obvious that the elasticity of substitution has an important bearing on the demand for organizational capabilities though the direction remains ambiguous.7

4

Daley et al. (1997) suggested that when a firm integrates a product with a low elasticity of substitution there will be a greater strain on managerial resources because more attention is necessary to ensure efficient operation. This may happen even when the organizational requirements are similar. Klepper and Thomson (2010), and several others before them, noted that when the elasticity of substitution is low the incumbent management will have limited competence to evaluate the new product idea. Hence, the absence of organizational capabilities induces spinoff of products with a low elasticity of substitution. 5 Actually, their general argument, in line with what has been suggested earlier, would be that the innovators of new products learn organizational skills necessary to produce a highly substitutable product while they are employed by a firm and use it to develop a spinoff firm. The general contention of spinoff studies is that the supply of organizational skill, in itself, would be sufficient for the emergence of a spinoff. While this is a sufficient condition it does not appear to be necessary. This is a limitation of studies that investigate the reasons why successful spinoffs chose to do so. 6 The following observation of Klepper and Sleeper (2005, p. 1293) suggests the same result. For, they observe that “spinoffs pursue ideas involving new niche markets or technologies their parents are unwilling or slow to pursue. Industry conditions favorable to the creation of niche markets are thus conducive to spinoffs, as are circumstances such as control changes that may cause firms to miss opportunities.” It would be difficult to identify the role of the elasticity of substitution on the spinoff decisions purely on the basis of the organizational requirements that they imply. However, the history of early industries, like automobiles and tires, suggests spinoff of highly substitutable products while the experience with Fairchildren offers a counter-example. See Klepper (2001, 2007). 7 Several types and sources of spinoff have been detailed. See, for instance, Buenstrof (2009), Pakes and Nitzan (1983), Slovin et al. (1995), Yang et al. (2010), and Rao (2015).

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10.3 Organizational Arrangements An equally large body of literature claims that financial arrangements and associated synergies often account for spinoffs. Of particular interest is the observation that innovators with new ideas often have the necessary technical expertise and that they can attract the necessary managerial talent from the market if they can attract the necessary finances. See, for instance, Erikkson and Kuhn (2006). In particular, Andrade and Kaplan (1998) argued that financial synergies alone, i.e., the reduction in the cost of capital and corporate governance, and not operating synergies, constitute the reasons for the spinoff. Note that financial considerations will not be important if managerial choices with respect to product divisions can be implemented without experiencing any financial constraints. On the other hand, differences in the perspectives of the managers and equity holders may lead to disagreements and financial synergies dominate the decision to spinoff.8 In general, production can be organized efficiently and operational synergies can be achieved if adequate financing is available, the capital structure minimizes the cost of capital, and efficient allocation to different products is made possible by the managerial process. Consider each of these in turn. First, Desai and Jain (1999) and Huson and McKinnon (2003) argued that financial synergies and market valuation of the assets of the firm depend on the information about the individual products of the firm available to the equity market. However, as Slovin et al. (1995), Chemmaneur and Liu (2010), and Chemmaneur and Yan (2014) noted, the stock market has limited information about the financial performance of each of the products when the firm is diversified. This information asymmetry results in a reduction in the finances available and/or an inefficient choice of the mix of financial instruments. Consider the possibility that the new product, which the firm is trying to assimilate, has a low elasticity of substitution with the existing products. In such a case, the agency cost argument suggests that the equity holders may find it difficult to ascertain the profitability of any one product if it is clubbed with many related products. See, for example, Chemmaneur and Liu (2010). Consequently, financial markets tend to underestimate the market potential of such products and therefore lower investment.9 It may be argued that it would be possible for market participants to assess the value of such products accurately and provide the requisite finances if it is organized in a spinoff. See, for instance, Chemmanur and Yan (2014). Similarly, suppose that the firm is using too many sources of finances and especially those that decrease outside ownership. It would then be difficult for equity markets to ascertain the efficiency with which they are used. This may result in a lower quantum of finances available to the firm. Second, the requirements of finances may indeed vary across products in the 8

Klepper and Sleeper (2005) suggested that a disagreement and spinoff of a new product will occur if its introduction is expected to lead to a reduction in the profits of the existing firm. 9 Chemmanur and Liu (2010) pointed out that financial institutions and equity holders are likely to be more familiar with the value of products that have a high elasticity of substitution. Distinct new products, with low elasticity, may find it more difficult to convince the equity markets. This was noted in Hellman and Perotti (2011), Klepper and Thompson (2010).

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product line of a firm. For instance, the markets for some products may be volatile. The assets utilized by such products cannot yield steady cashflows. Consequently, greater equity will be the optimal capital structure to finance such assets.10 More pertinent to the argument is the possibility that the optimal capital structure may not materialize if the capital market cannot calibrate the profitability of such products accurately.11 Andrade and Kaplan (1998), for instance, observed that better products may be developed in spinoff firms to protect them from possible erosion of value if they are left coupled with poor products for which profits are low, markets are highly volatile, assets have a low collateral value, and the leverage used to finance them is high. In general, two contradictory points of view about the relationship between the elasticity of substitution and financial synergies persist. First, for instance, Chemmaneur and Liu (2010), and others find that when the new product is highly specialized, i.e., the elasticity of substitution is low, the capital markets experience information asymmetry and find it difficult to ascertain the potential market value of the new product. In such a case the firm cannot attract adequate finances to integrate the new product efficiently.12 Second, if the elasticity of substitution is large equity holders will find it difficult to ascertain the true market value of the new product. That is, the possibility of cannibalization does not allow them to calibrate its true market potential. See, for example, Chemmaneur and Yan (2014).13 In retrospect, it has been difficult to specify the nature of products (in relation to the elasticity of substitution) which are spun off due to lack of financial synergies instead of difficulties associated with organizational capabilities.14

10

As Andrade and Kaplan (1998), Mehrotra et al. (2003), and Francoeur and Niyubahwe (2009) observed, better products may be developed in spinoff firms to protect them from possible erosion of value if they are coupled with poor products for which profits are low, markets are highly volatile, and the leverage used to finance them is high. Li and Li (1996), for instance, argued that products, whose cashflows are highly volatile, can be better managed as spinoffs. For, otherwise, they create problems of financial synergy for better products. 11 Assume that the firm already has a large product range. In such a case, some volatility and losses in one product can be compensated by profits in others. This will have a salutary effect on the finances available to the firm if equity markets calibrate only the overall profitability of the firm. 12 The firm may divest some existing products when a new product introduction is considered. The workers of that product division may still find it worthwhile to continue with it in a spinoff firm. As Thompson and Chen (2010) noted, history is replete with examples of spinoffs that were launched to continue with old product ideas that their parents were in the process of abandoning. It is possible to accommodate such a contingency as well. 13 On occasions, the incumbent management may cross-subsidize some loss-making products instead of allowing new product introduction. See, in particular, Chesbrough (2002). Francouver and Niyubawe (2009) suggest that spinoffs can overcome such biases in financial allocation and eventually dismantle cross-subsidies. However, McNeil and Moore (2005) found no empirical evidence to such behavior of internal capital markets. 14 Wruck and Wruck (2002) observed that a lack of financial synergies may occur while organizational capabilities still exist. In such a context, the top management of the incumbent firm may continue to manage the spinoff since the gains to them are personally large. Such interrelationship between financial synergies and organizational capabilities is far more difficult to disentangle.

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The rest of the chapter sets up a relationship between financial and organizational synergies and the effect of the elasticity of substitution on this nexus. It will be shown that the absence of financial synergies is the main reason for products of high elasticity of substitution to spinoff. In other words, equity markets find it difficult to calibrate the market value of a new product if it is integrated with highly substitutable products. On the other hand, low elasticity of substitution products spin off predominantly due to lack of organizational capabilities. For, it is not very difficult to attract external financial sources especially when the firm can use IPOs or tracking stock. The firm will find it far more difficult to internally generate the entirely different organizational capabilities that the new product necessitates. A few other variants will also be examined in detail. Of particular interest are the priorities of the incumbent management. Spinoff decisions will be predominantly influenced by disagreements in such a context.

10.4 Specification of Synergies15 As Fulghieri and Hodrick (2006) and Bernard et al. (2010) observed, firms do not make many adjustments in their capital stock or their organizational capabilities over a short time horizon. Primarily this is a result of their specificity and the expectation of losses on the downside.16 In other words, the management does not give much priority to capital labor substitution given the product lines. Instead, they tend to change the product choice given the capital stock.17 Four further observations are essential. First, irrespective of the nature of capital stock and capabilities of the firm, there will be diminishing returns to increases in revenue from any one product. This may be purely a result of reduced commitment of the management of the product divisions when the firm depends too much on them. It may also be a result of the limits on market demand. Second, given the nature of capital and other capabilities of the firm there will be a range of products 15

Note that the theoretical development of the revenue-sharing contracts assumes that the revenue generated is independent of the sharing of gains. However, it must be acknowledged that the commitment of the workers and managers to the overall revenue generation depends on efficient sharing. This is the basic departure in the following specification. 16 The possibility of dynamic changes as a source of synergies cannot be ruled out. See, for example, Chandler (1990). The basic insights from the approach adopted here will not be affected materially even if such dynamics is acknowledged. 17 The following adjustments may be envisaged if capital labor substitution is accounted for. Suppose the introduction of the new product is highly capital intensive relative to the existing products. The capital assets of the firm may not be sufficiently malleable to accommodate the new product. Similarly, it must be spun off if it requires a lot of capital to achieve the efficient scale of production. If, however, the new product is not capital intensive or requires very little to achieve efficient scale spinoff will be motivated by the relative ease with which this can be achieved. Further, products with very diverse capital intensities and capital requirements will form a cluster to complement each other. On the other hand, if capital intensity and capital requirements are low it will be very easy for many small firms to cluster together.

10.4 Specification of Synergies

161

that generate the maximum synergies. Similarly, changes in the market prices of products necessitate adjustments in the quantities of outputs produced so that revenue maximization can be pursued. Third, the workers and managers of product divisions generally prefer autonomy instead of constant supervision by the general manager. It can also be argued that such independence improves efficiency. Hence, as Garicano and Hubbard (2009) suggested, product divisions comply more readily and contribute to synergy if they participate in the decision-making or know why certain decisions are taken and why they are efficient from the viewpoint of the firm. Fourth, at least on some occasions, individual autonomy and pursuit of goals of self-interest may be at variance with organizational requirements. In particular, divisional managers may promote products which contribute to their stability rather than profit maximization of the firm. Managerial coordination and control may restore synergies. In essence, the realization of synergies depends on (a) the product range corresponding to the capital structure and capabilities of the firm, (b) the degree to which products can be substituted as market demand varies, (c) managerial coordination, and (d) an equitable sharing of revenue.18 The following specification of the revenue function incorporates these features. To begin with, assume that only one product is produced. Let y1 be the quantity of output. Postulate that the market price per unit of output is −1/η

p = Ay1

where η is the elasticity of demand. Hence, potential revenue from the product can be written as 1−1/η

r = Ay1

However, it may not be possible to realize this revenue given the nature of capital assets and organizational capabilities of the firm. Denote the revenue achievable by (1−1/η)

r = Ay1

γ ∗∗

where 0 < γ ** < 1 represents the organizational capabilities which determine the efficiency with which potential revenues can be achieved in practice. To simplify the notation write γ = (1 − 1/η)γ ∗ so that

18

The determination of payments to product divisions received a great deal of attention. See, for example, Adams (2005), Baccara and Razin (2007), and Schrafstein and Stein (2000). In general, an efficient contract must depend on the contribution of individuals as well as the synergies from coordination.

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10 Carveouts and Spinoffs γ

r = Ay1

In general, γ represents the effect of external market conditions and the organizational culture that the firm cannot change at short notice. Now, it may be argued that the workers and managers of the product division claim the marginal product for each unit of output they produce. Suppose y1 does not fully utilize the capital and/or capabilities of the firm. The firm may then encourage some of its employees to develop new product ideas. Assume that an employee of the firm discovers a new product. The firm will consider diversifying into this product as well. Following the logic of the CES function of Arrow et al. (1961) the expected revenue can be represented by 1/α  r = ay1α + by2α where r = potential revenue.19 (a) Assume, for the present, that the employees who produce y1 and y2 will be paid their marginal contributions. That is,  1/α − 1 r1 = ay1α−1 ay1α + by2α  1/α − 1 r2 = by2α −1 ay1α + by2α It is important to note that such marginal products are an amalgam of individual contributions to production of the respective outputs and the synergies due to the operation of the multi-product firm attributable to coordination of the respective output divisions.20 Hence, the share of the employees of the y1 division in r will be  1/α − 1 s1 = ay1α ay1α + by2α and, similarly,  1/α − 1 s2 = by2α ay1α + by2α 19

Observe that the value of r exceeds the sum of revenues achievable if y1 and y2 are produced in different firms. Hence, this specification captures the synergies that can be achieved by integration. Note that the sources of synergy can be any of the following. (a) The capital stock may be underutilized if y1 or y2 is produced exclusively. Hence, better utilization of capital is one source. (b) The experience of organizing production of y1 may be helpful in organizing y2 as well. (c) The nature of market demand may help the firm do better even if y1 and y2 are substitutable. For instance, a firm that produces many substitutable varieties of cosmetics or other consumer products may get to be better known to consumers and thereby capture a larger market share. 20 This is the efficient contract for sharing gains. However, it is possible that the incumbent management deviates from this since they have to give priority to the existing product divisions. Disagreements of this nature can be a source of the decision to spinoff.

10.4 Specification of Synergies

163

Consequently, s1 /s2 = (a/b)(y1 /y2 )α The externally determined market conditions specify the prices that these products can attract and the relative size of the market. Hence, a and b represent the relative market advantage of the employees of the two product divisions with respect to each other given the exogenously determined market demand for the two products. (b) Given r 1 and r 2 , that the workers of the yl and y2 divisions must be paid, the firm chooses y1 and y2 reflecting their capacity to generate revenue based on their production capabilities. The actual choice will be such that r1 /r2 = (a/b) (y1 /y2 )α − 1 Hence, the elasticity of substitution between y1 and y2 is σ = 1/(1 − α).21 Let σ < 1. That is, y1 and y2 are not easily substitutable. Both the product divisions have some specific capabilities to generate the market value of the firm. The divisional managers, who enjoy relative autonomy in decision-making, recognize that their contributions are unique and that they can get appropriate rewards and recognition if they cooperate. Potential maximum value may be achieved. Suppose σ > 1. Now, each of the managers of the two product divisions recognizes that capital assets of the firm are malleable and that their bargaining power will be eroded if they do not comply with the overall objectives of the firm. The divisional managers are therefore likely to comply for fear that they will lose their priority otherwise. Once again synergies are likely to materialize in practice. When σ = 1, such cooperation is unlikely since the products can be freely substituted. Some rudiments of this argument can be traced to Fulghieri and Hodrick (2004), Bellemare et al. (2009), and Nakamura (2009). There may be a downside to this argument in empirical practice. For, suppose σ < 1 and the divisions are special. The managers may try to derive advantages for their division instead of extending cooperation. Depending on the malleability of their talents and opportunities elsewhere, managers may find exit to be more efficient when σ > 1. Neither the general manager nor the divisional managers may find cooperation or monitoring to achieve efficient performance as the optimal decision when σ = 1. In general, though the elasticity of substitution is one of the determinants of synergy, it cannot be a reliable source in all practical contexts. The entrepreneur, or the general manager, finds it necessary to coordinate the activities of the divisional managers, elicit commitment, and extract greater value by fostering team spirit. However, they may not materialize automatically. 21

As Klepper and Sleeper (2005) and others noted, the market demand for y1 and y2 may also determine the degree to which y1 and y2 will be substituted. Suppose p1 and p2 represent the market prices of y1 and y2 respectively. Then, it may be claimed that the firm will choose y1 and y2 to maximize the profit generated. The degree of substitution will also be 1/(1 − α). Apriori it is difficult to separate these two effects. The only way to accommodate both the effects, as noted above, is to maintain the distinction between γ and γ ** in the foregoing analysis.

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10 Carveouts and Spinoffs

It may now be acknowledged that organizational capabilities of the firm may not enable it to achieve the most efficient choice of outputs of the two products implicit in the nature of capital assets. Then, the actual revenue may turn out to be γ /α  r = ay1α + by2α ;0 < γ < 1 Clearly, γ represents the organizational capabilities of the firm.22 Three possibilities can be visualized. (a) Organizational capabilities may be limited to achieving the synergies implicit in the elasticity of substitution. In such a case γ is equal to α. (b) Organizational capabilities may be fairly large irrespective of the elasticity of substitution. Such competence signals γ greater than α. (c) Organizational capabilities may be insufficient to ensure even the synergies implied by the elasticity of substitution. In such a case γ is less than α.23 This specification implies that (s1 + s2 ) = γ r so that the owners of capital24 obtain a profit π = (1 − γ )r. Recall that the incumbent management, who is coordinating the production and sale of y1 , may have reservations about the estimated market demand for y2 , its volatility, and the organizational requirements to achieve potential synergies. They may favor y1 disproportionately. The revenue achieved by the firm may then be γ /α  r = a β y1α + by2α

It is important to acknowledge that the elasticity of demand for y2 may not be η. Suppose it is η* instead. Then, the revenue from y2 , if produced in an independent firm, will be

22

(1−1/η)γ ∗∗

r = By2 This can be written as

r ∗ = By2α by rescaling the measurement of y2 . Arrow et al. (1961, p. 231) noted that such monotonic increasing functions of y2 can be utilized without altering the basic properties of the CES function. 23 Conventionally, γ is interpreted as a measure of returns to scale. However, Arrow et al. (1961, p. 247) acknowledged that “another loose end (of their analysis) has to do with the question of returns to scale.” The alternative interpretation of synergies applies for given y1 , y2 . If, ex post, y1 , and y2 have been found to vary proportionately the synergies are due to returns to scale. In all other cases, they represent organizational capabilities alone. This issue cannot be resolved ex ante. 24 In general, there will be two sources contributing to this financial synergy. First, the managers may argue that given the nature of products they are not able to raise adequate finances or maintain an efficient debt–equity ratio. γ may reflect this very well. Second, the equity holders may contend that the managers are not utilizing the finances efficiently and that the lack of financial synergy is essentially a result of their actions. γ may not reflect this effect. Instead, as will be noted below, their choice of y1 /y2 and the priorities they accord to y1 will capture this aspect more efficiently.

10.5 Basic Results

165

In this specification, β represents the preference which the management accords to y1 . For the sake of completeness observe that β = 1 when y2 = 0. Hence, γ

γ

r = a γ /α y1 = Ay1

as stated at the outset. Further, observe that a < 1. Clearly, β = 1 if managerial control is absent and/or both groups of talents have the same bargaining power. Similarly, β > 1 indicates a decrease in value ceteris paribus. It is a result of the priority management accords to product 2. β < 1 corresponds to the case where product 1 gets a favorable treatment by the general manager. It should also be noted that β tends to 1 as α tends to zero simply because managerial coordination is not the efficient choice.25

10.5 Basic Results Observe that the general specification of r embodies the organizational synergies as well as the strategic preferences of the incumbent management. Hence, as noted in the previous section, the marginal products efficiently capture the contributions of each of the divisions resulting from their own efforts to produce the output assigned to their division as well as their efforts to coordinate work with the other division. Consequently, marginal product payments to the divisions will be an efficient contract. The profit π, accruing to the holders of financial instruments utilized to finance the assets of the firm, will then be π = (1 − γ )r It can be readily verified that   ∂π/∂γ = 0 if α = (1 − γ ) ln a β y1α + by2α Hence, 1/α  γ = γ ∗ = 1−1/ ln a β y1α + by2α Note further that ∂ 2 π/∂γ 2 = −∂r/∂γ < 0 when γ = γ *. That is, γ * maximizes π.

25

Synergies may also be due to market imperfection. For, when markets are efficient, each of the products can be produced in independent firms and traded across the market interface.

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10 Carveouts and Spinoffs

It is pertinent to note that if the actual γ < γ * there is a shortage of organizational capabilities to achieve the maximum possible value. In general, an increase in γ to γ * enables the firm to organize production more efficiently and generate greater profit. On the other hand, if γ > γ * the reduction in value is due to an inefficient allocation of finances. This can be corrected when the management and/or the market recognizes it. Note that γ ∗ = 1−γ / ln r Hence, considering both r and γ * as functions of α for a given γ , it can be inferred that both of them have the same extreme points. Further, as noted above, r is u-shaped with its minimum at α = 0. The minimum value γ * is positive given the definition of γ . It may now be inferred that for any given value of α there will be a σ m such that γ * > α if and only if σ < σ m . The following relationships between γ , α, and γ * will therefore emerge. (a) Let σ > σ m . Three possible configurations arise. (i) γ > α > γ * (ii) α > γ > γ * (iii) α > γ * > γ (b) Let σ < σ m . Three patterns are possible even in this case. (iv) γ > γ * > α (v) γ * > γ > α (vi) γ * > α > γ Three groups of stakeholders and their interests have an important role in the firm’s decision to absorb the new innovation of an employee. These three groups are the management of the existing product division, the new management group that will organize the production based on the new innovation and its expectations, and the equity holders of the firm who own the firm’s capital. It will be expected that the firm can assimilate the new innovation if and only if the aspirations of all the stakeholders are fulfilled. As a consequence, the specification of the revenue generated, the mechanisms of sharing revenue specified ex ante by the marginal products, and the profits accruing to the equity holders can be viewed as the foundation to examine the conditions under which assimilation of the new product is efficient. Consider the influence of organizational capabilities to begin with. The firm will find it advantageous to sustain the integrated firm if and only if the (a) output generated after integration exceeds the sum of revenues from the two products if they operate independently and (b) both the product divisions gain from integration. Note that  β α γ /α γ γ a y1 + by2α > a γ /α y1 + bγ /α y2

10.5 Basic Results

167

if and only if aβ > x where  α/γ x = a γ /α + bγ /α (y2 /y1 ) −b(y2 /y1 )γ Let x* = ln x/ln a. Hence, β < x* must be satisfied. Observe that x* > 1 since x > a. The y2 division accepts integration if and only if  γ /α − 1 γ by2α a β y1α + by2α > bγ /α y2 However, note that this reduces to a β y1α + by2α > by2α if and only if γ > α. That is, the y2 division accepts integration whenever γ > α. Similarly, the y1 division gains from integration if and only if  γ /α − 1 γ a β y1α a β y1α + by2α > a γ /α y1 Assuming γ > α this condition requires a β y1α + by2α > a (1−αβ)/(1−α) y1α That is, by2α /a β y1α > a (1−αβ)/(1−α) −1 The expression on the right is positive if and only if β > 1. Hence, this inequality requires that 1 < β < x*, and (y2 /y1 ) > y* where    1/α y ∗ = a β a (1−β)/(1−α) −1 /b In other words, the firm will assimilate y2 into its product line if and only if it has (a) adequate organizational capabilities and (b) the y2 division gets adequate priority in resource allocation.26 There will be conditions under which the y1 division may gain by integration even when the y2 division does not. For, if γ < α, the y1 division may gain if β > 1 and (y2 /y1 ) < y*. Intuitively, though the firm lacks the capabilities to produce the efficient level of y2 it may gain by producing limited quantities of y2 commensurate with their organizational capabilities. Under these conditions when the employee decides to

26

Intuitively, the introduction of y2 reduces y1 . The loss in revenue due to this reduction can be recouped only if y2 is large enough.

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10 Carveouts and Spinoffs

produce y2 in a spinoff firm the original firm may initially lose but will reorganize itself and restore efficiency eventually. Klepper and Thompson (2010) suggested that the management of the firm may experience information asymmetry with respect to the revenue-generating potential of the product based on the new innovative idea.27 In such a case the priority that they will offer to y2 , viz. the parameter b, will be less than the optimal b. Since the originator will be aware of this he may benefit from a spinoff. This can be demonstrated as follows. Without any loss of generality assume that β = 1 = γ . Note that the gains to y2 from the spinoff will be higher compared to those derived from integration if and only if  1/α − 1 b∗1/α y2 > by2α ay1α + by2α Let b*1/α = b1/α + δ. It can be verified that the individual with the new idea will prefer a spinoff if and only if  1/α − 1 1/α δ > b a(y1 /y2 )α + b −b = x ∗ (say) The firm may yet pay the y2 division b1/α y2 and prevent the spinoff if the revenue generated is adequate without the y1 division suffering a loss. This necessitates  1/α − 1 1/α  ay1α ay1α + by2α + b1/α y2 < ay1α + by2α It can be readily verified that this inequality cannot be satisfied if δ > x*. Such contracts are not Pareto efficient. A spinoff is inevitable. The economic intuition underlying the condition δ > x* is the following. Suppose the firm faces information asymmetry with respect to y2 . Then, it allows a lower bargaining power to the y2 division. However, if it has a good marketing capability with respect to selling y1 , it can reduce some of the loss in revenue by better allocation of resources to y1 . This increase in synergy may enable the firm to offer a greater share of revenue to y2 . However, it may not be sufficient to prevent a spinoff if δ is rather large. Clearly, a larger (y1 /y2 ) will necessitate a larger value of δ to induce the individual who generated the new product idea to spin off.28 Consider the perspective of equity holders. The following patterns emerge. (i)

27

Let γ > α > γ *. In this case, the organizational capabilities would be adequate to integrate the new product within the firm. However, the lack of financial synergies will lead to a spinoff. Two observations are pertinent. (a) Wruck and Wruck (2002) observed that the top management of the incumbent firm

The following analysis holds even under conditions where information asymmetry is not dominant. In particular, the management of the firm may surmise that a new product has a good prospect only if it is developed in a spinoff firm. A spinoff may then be a result of the desire to avoid inefficient integration within the firm. 28 A rather opposite kind of a situation is sometimes visualized. δ < 0 is possible if the spinoff firm does not have adequate organizational capabilities. This may induce integration.

10.5 Basic Results

169

may continue to manage the new product introduction since they will gain personally. The financial markets, and equity holders in particular, will force the spinoff. (b) On occasions, when the financial markets find it difficult to assess the market value of high σ products, the firm may choose the option of tracking stock, IPOs, and structured finance. It may be possible to avoid a spinoff if they succeed. See, for example, Leland (2007). However, in general financial synergies are the primary source of spinoff in such a context.29 (ii) Let α > γ > γ *. Clearly, financial synergies bind even before the lack of organizational capabilities takes hold. Hence, as in the previous case, a spinoff is expected due to a lack of financial synergies. (iii) Let α > γ * > γ . This case suggests that the lack of organizational capabilities is the primary reason for a possible spinoff. However, since financial synergies exist the incumbent management may prefer a carveout and finance the new firm while allowing a new organizational arrangement to take hold. If the management of the new firm can attract adequate organizational capabilities it may yet prefer a spinoff. In general, a spinoff is due to the lack of financial synergies if the firm producing a new product can generate better financial synergies instead of restricting itself to the finances provided by the incumbent management. Note that these cases correspond to σ > σ m . Hence, in general, lack of financial synergies constitutes the major reason for products with high elasticity of substitution preferring a spinoff. This inference is contrary to the conventional wisdom that such products experience a spinoff due to the lack of organizational capabilities. Consider the possible patterns when σ < σ m . (iv) Let γ > γ * > α. This parameter configuration suggests that the new product will be integrated within the existing firm since both organizational capabilities and financial synergies are favorable. However, the following two contexts must be acknowledged. (a) Managerial preferences, as noted above, may yet result in disagreements and spinoff. (b) Yang et al. (2010) pointed out that some individuals may feel frustrated if the incumbent management does not allow integration. A spinoff emerges. However, note that financial synergies are not the primary source of such a decision. (v) Let γ * > γ > α. It should be expected that the new product will be integrated subject to the proviso suggested in the previous case. (vi) Let γ * > α > γ . Lack of organizational capabilities will be the predominant reason for a spinoff. A carveout cannot be ruled out.

29

One possible interpretation is that the management will not have much difficulty in organizing products with a high elasticity of substitution within an integrated firm. Note that their organizational requirements are similar. This makes financial synergies a critical factor in the decision to spinoff. It should also be noted that a carveout is a more efficient choice if the problem of financial synergies does not appear well before organizational synergies are exhausted. A spinoff decision must exclude the possibility of a carveout. This reinforces the argument that a lack of financial synergies dominates the decision of the new product spinoff.

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In sum, products with a low elasticity of substitution will spin off entirely due to lack of organizational capabilities. Financial synergies cannot offer an explanation. Low σ products experience organizational problems since they require a different kind of organizational expertise.30

10.6 Conclusion Existing studies generally argue that the requirements of coordination and organizational capabilities will be high when the new innovative product has a high elasticity of substitution with the current product line. It is generally concluded that a decision to spin off is a result of the lack of organizational capabilities. High elasticity products tend to be spinoff candidates. However, the present analysis indicates that difficulties in attracting finances constrain the decisions of the incumbent management well before organizational limits become binding. For, a carveout will be superior if finances are available and financial synergies can be achieved. In other words, the difficulties that equity markets experience while evaluating highly substitutable products tend to dominate the spinoff decision. Studies, emphasizing organizational synergies, also tend to find it puzzling that products with low elasticity of substitution are spun off. However, notice that the present analysis suggests that they need organizational capabilities which are distinct from those necessary to manage the existing products. That is, in such contexts, the organizational problems dominate the spinoff decision. In general, claims that financial synergies dominate spinoff decisions are sound only when the products exhibit a high elasticity of substitution. Low elasticity of substitution products encounter organizational problems well before financing becomes an issue. For, financial arrangements can only make the firm realize the increases in revenue made possible by market potential and organizational capabilities to harness such market potential. Spinoff may occur even if organizational capabilities and financial synergies are not exhausted. This is basically due to the priorities that management accords to allocation of resources across product divisions. The present study also suggests that spinoff of high elasticity of substitution products may be due to disagreements about the priorities in the allocation of resources to different products that the incumbent management is willing to accept even when limitations of financial synergies are not discernible. Lower priority to low elasticity products in an integrated firm may occur even before limitations of the incumbent management with respect to organizational A high value of α necessitates a high value of γ to achieve organizational synergies. A high value of γ, in its turn, makes γ* low. Hence, irrespective of the availability of finances the maximum achievable financial synergies will be low. This does not necessarily depend on the products being substitutable on the market. The argument that market cannibalization resulting from substitutable products may induce spinoff is an additional argument. It may well be that substitutability in the market is the major reason for the necessity for greater managerial coordination.

30

References

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capabilities takes hold. For, the management may find it difficult to assess the market value of the new product. Some new products may choose to spin off because the incumbent management is averse to the market cannibalization that they are likely to generate. In this study, it was only possible to argue that the incumbent management will resist new product introduction if the priority they should accord to the new product reduces their revenue. This, in itself, may be a sufficient indicator of cannibalization without explicitly relating it to the elasticity of substitution between the products in the market. This issue deserves further analysis. Efficiency of financial choices has been summarized in this study through its effect on profit or market value. It would be worthwhile to examine the additional role of agency costs that such financial arrangements entail.

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Hellman, T., & Perotti, E. (2010). The circulation of ideas in firms and markets. Management Science, 57, 1813–1826. Hellman, T., & Perotti, E. (2011). The circulation of ideas in firms and markets. Management Science, 57, 1813–1820. Huson, M., & McKinnon, G. (2003). Corporate spinoffs and information asymmetry between investors. Journal of Corporate Finance 9, 481–503. Hyytinen, A., & Marilanta, M. (2008). When do employees leave their job for entrepreneurship? The Scandinavian Journal of Economics, 110, 1–21. Klepper, S. (2001). Employee startups in Hitech industries. Industrial and Corporate Change, 10, 639–674. Klepper, S. (2007). The organizing and financing of innovative companies in the evolution of the U.S. Automobile Industry. In N. Lamoreaux & K. Sokoloff (Eds.) Finance of innovation. M.I.T. Press. Klepper, S. (2009). Spinoffs: A review and synthesis. European Financial Management, 6, 159–171. Klepper, S., & Sleeper, S. (2005). Entry by spinoffs. Management Science, 512, 1291–1306. Klepper, S., & Thompson, P. (2010). Disagreements and intra-industry spinoffs. International Journal of Industrial Organization, 28, 526–538. Knight, F. (1957). Risk, uncertainty and profit. Harper Torch Books. Leland, H. (2007). Financial synergies and the optimal scope of the firm: Implications for mergers, spinoffs, and structured finance. Journal of Finance, 62, 765–807. Li, D., & Li, S. (1996). A theory of corporate scope and financial structure. Journal of Finance, 51, 691–709. Mehrotra, V., Mikkelson, W. & Parch M. (2003). The design of financial policies in corporate spinoffs. Review of Financial Studies, 16, 1339–1388. McNeil, C., & Moore, W. (2005). Dismantling internal capital markets via spinoff: Effects on capital allocation, efficiency and firm value. Journal of Finance, 11, 253–275. Nakamura, H. (2009). Micro-foundations for a constant elasticity of substitution production function through mechanization. Journal of Macroeconomics, 31, 464–472. Pakes, A., & Nitzan, S. (1983). Optimum contracts for research personnel, research employment, and the establishment of ‘rival’ enterprises. Journal of Labor Economics, 1, 345–365. Rao, T. V. S. R. (2015). Organizational synergy, dissonance and spinoff. International Journal of Economics and Business Research, 9, 54–64. Schrafstein, D., & Stein, J. (2000). The dark side of internal capital markets: Divisional rent seeking and inefficient investment. Journal of Finance, 55, 2537–2564. Slovin, M., Sushka, S., & Ferraro, S. (1995). A Comparison of the information conveyed by equity carve-outs, spinoffs, and asset selloffs. Journal of Financial Economics, 37, 89–104. Thompson, P., & Chen, J. (2010). Disagreements, employee spinoffs and the choice of technology. Review of Economic Dynamics, 14, 455–474. Wagner, J. (2004). Are young and small firms hothouses for nascent entrepreneurs? Evidence from german microdata. Applied Economics Quarterly, 50, 379–391. Wruck, E., & Wruck, K. (2002). Restructuring top management: Evidence from corporate spinoffs. Journal of Labor Economics, 20, S176–S218. Yang, J., Su, Q., & He, X. (2010). How the spinoff comes about, advanced management science (ICAMS). In 2010 IEEE International Conference, pp. 127–131.

Chapter 11

Conclusion

The preceding chapters acknowledged that there are various sources of managerial discretion. Several forms of managerial discretion have also been highlighted. At least conceptually managerial discretion can be eliminated completely if (a) every individual chosen to do a specific job is competent and motivated to deliver what is expected (purely psychologically or since compensation received is considered equitable and satisfactory), (b) there are enough controls at the higher level of management to ensure that the lower level group does not renege collectively even when there is coherence and synergy among them, (c) the above two features can be extended to all decisions relevant to the corporation, and (d) most importantly the subjective personal costs and objectives of everybody involved in the corporation can be completely articulated and taken care of through suitable compensations. We need to know the extent to which the maximum possible (conceptually) market value of the firm is not attained (this being the ultimate measure of managerial discretion) but we should also know the components of it to the last individual related to the organization and the reasons for such behavior. More recent developments in machine learning are making attempts to fold all the relevant features into their algorithms that aim to offer appropriate guidance to the management. Some limitations of these efforts have also been highlighted. In the final analysis, they may not have the flexibility of the human mind. The ultimate conceptualization of a perfect corporation is mostly a utopia. Google can only see the patterns programmed into its algorithms, while our mind can synthesize the nuances of a question to connect dots, that, at times, were’nt at all expected. Having a larger data set in our minds and experience may allow us to come up with more discerning answers—Conley (2018, p. 137).

11.1 Overall Pattern The chapters in this book traversed from the nature of the firm, the properties of different mechanisms of designing the choices of the management, execution of © The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2023 T. V. S. Ramamohan Rao, Managerial Discretion in Imperfect Markets, https://doi.org/10.1007/978-981-99-1537-8_11

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the choices and the results achieved, the quantities of inputs including physical capital procured, the financial arrangements, and the range and extent of production, uncertainties that firms experience, the notions of the objectives of the owners, managers, and shareholders, the constraints that they experience in the execution of their objectives, and the various dimensions of managerial discretion. Note that the strategic management literature exhibited two different patterns of thought: one based on the market conditions external to the firm and the other on the environmental conditions inside the firm. In the first category, it was recognized that certain products experience stable markets while the others exhibit short-term and transient advantages. Stable markets enable the analyst to predict behavior. Hence, Porter (1980, 1985) suggested that the core of management strategy should concentrate on such products and sought to identify stable organizational mechanisms to achieve them. On the other hand, McGrath (2013) indicated that fluctuating markets offer greater returns, even if they are over a short span of time, and advocated the use of such products and the necessity to develop adaptability to move with the dynamic markets. The second category preferred to look inside the firm and emphasize the limits posed by the available physical resources (Wernerfelt (1985, 1995) and the core competence of the existing management to deliver the goals that they set up or those imposed by shareholders (Prahlad and Hammel (1990). The purpose of the analysis, either in economic theory or in management science, has been to discover patterns of regularity in the behavior of modern organizations. The belief is that only such stable patterns can be predicted to occur with some regularity in the future. The basic idea was that it would be possible to predict possible patterns and offer guidance to firms if such regularities are discernible.1 In practice, any chosen theory would be valid only in some empirical practice. Indeed, some aspects of every theory would be valid in practically every context. However, it does not appear plausible that one theory would be valid in all observed practices. Thus, as Shy (1995, p. 437) noted, “There is no single model that can be applied to the analysis of all industries. Each industry has different characteristics, such as different consumer’s tastes for the product or service, and different technologies for producing the relevant products or services. Thus, despite the fact that there are general modeling techniques, …, each market has to be explained in a specific adhoc model.” Going a step further, it can be argued that there may be unique patterns of behavior of individual firms even if a generalization to the industry level is not possible. Attempts have been made to identify a single pattern of behavior of a firm over time in the hope that such stability will in fact materialize. However, in practice, even this could not be established. It would be interesting to find out whether the variation over time can be shown to exhibit a well-defined pattern. As yet, there is very little effort to isolate the forces that alter management decisions over time. Case 1

Observe that even when there is some uncertainty in the environment (either external or internal) the management of the firm may identify the stable components and develop decisions accordingly. They will prefer to react to unexpected conditions as and when they arise. No particular planned reaction to uncertain events may be discrened.

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studies in management do not generally attempt any recognition or explanation for such variations. Thus, even case studies cannot offer guidance to the management in charting out a course of action when confronted with a new set of circumstances. However, almost all managers confront a variety of problems every day. They devise strategies to deal with them even if they have to be outside the routines that they are accustomed to. Theories of economics and management science lag behind. They cannot break away from established terminology and conventions ingrained in received theorizing that they encounter regularly. There must be an intermediate course of action to face the practical reality. It would consist of identifying as many patterns of behavior as possible and single out the conditions under which each of the patterns emerges. The various studies detailed in this book suggest that even this is a very difficult task.

11.2 Specific Patterns Turn to the possibility of identifying specific patterns with respect to isolated decisions of the management. The acknowledgment is that forces of the market outside the purview of the firm have a limited role in its functioning. The capital assets of the firm, its financial resources, the management, and other features persist over a long term and cannot be changed instantaneously. Such shifts are also not conducive to maintaining the productivity of the firm. Essentially, therefore, some short-run changes get precedence in the managerial decision process. For example, when the firm experiences shortage of liquidity it may dilute inventory rather than forego investment opportunities that are expected to have a long-term effect. Virtually, there will be several ways of resolving every problem that the management encounters. Hence, there will be a very large number of patterns of decisionmaking. Usually, the external market conditions bind the management to make some decisions. Occasions are also conceivable when a variety of considerations pertaining to the functioning inside the firm become binding. The specific patterns described below are only a few among the many possibilities and it has been difficult to identify the circumstances that led the management to pursue a specific pattern. Consider the production decisions of the firm. It is almost never possible to adjust production levels to demand determined by the market. The time lag signals planning production in advance. This also allows the possibility that the firm sets prices in advance and allows the quantity of sales to vary over time.2 For all practical purposes, fluctuating market prices will not determine the level of production. One possibility is that the expected demand (the quantity of output) signals a binding limit on production essentially due to the buildup of excess capacity which is always a result of the time required to acquire and install capital assets. For all practical purposes, capital 2

Consider the possibility of consumers developing loyalty to the products of a particular firm or network effects as in the context of social networks. Shy (1995, pp. 439–9) pointed out that the firms will resort to saturation pricing for the users and/or the advertisers as the case may be discrened.

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assets are acquired with a long-term view in perspective. The process by which expectations about future market conditions have been developed may themselves be quite varied. They may be based on past experience (adaptive expectations) or factors external to the decision-making process of the firm (changes in the factors of production and/or the levels of income, fashions, and compulsions imposed by available finances or the emerging technology). It is equally plausible that features pertaining to the firm, such as the stock of capital, the managerial capabilities, limit the quantity produced. The limited empirical evidence suggests that some firms will find either one of the constraints binding. Costs of adjusting the level of production from one time period to the next have been found to have an effect as well. On some occasions, as in the case of public sector firms, the measure of efficient performance will be the fulfillment of sales targets defined in advance. The management will then tend to underestimate the achievable targets. Many firms produce a variety of products. In such a context, the limits on the range of products will also be determined by the economies of scope implicit in the technology embodied in the capital goods. In particular, in the context of services provided by a departmental store or a movie theater the limits on the quantity offered will be determined by the space available. The actual demand, or even the anticipated demand, will not have any bearing on this decision. There is very limited evidence on the effect of non-price decisions of firms on the expected demand or the actual level of sales. Rao and Bhattacharyya (2021) offered evidence to suggest that when there is competition between firms these strategies are usually directed to identifying the demand they can expect rather than influencing it actively. In either case, there is evidence for the existence of excess capacity. The stock of capital may not have the expected influence except through the implicit cost of production. It must be noted that the observed changes in y are not purely due to the observed changes in x but they will also depend on the change in the coefficients (effects) associated with x. Such studies also opened the possibility that firms utilize subcontracting and franchising. Both the time lag in production and uncertainty in demand indicated that inventories can be utilized as a buffer between production and sales. One suggestion was that adjusting production from one period to the next would be more expensive than the costs of holding inventories. The possibility that production will be smoothed over time and inventories adjust to sales was considered. However, the empirical evidence, often considered as the Blinder paradox, indicted the opposite. There was a suggestion that firms prefer to hold sales steady so that competitive firms cannot erode their market and brand loyalty that they built over time. Many other patterns have been indicated. On the whole, such excursions did not provide many useful insights into discretionary managerial behavior. The possibility of substitution among inventories of different components of production received attention. In particular, it was noted that when firms experience a credit crunch, making the holding of inventories more expensive, they tend to increase the inventories of raw material and good-in-process to ensure that production is not severely affected. On the other hand, macroeconomic policies that offer

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liberal credit to improve production levels tend to be directed to providing credit to the consumers so that the inventories of the firm can be moderated to desired levels.3 Observe that the consequences of certain decisions of the management are often considered as the reasons for their decisions. To attribute the decisions to some well-defined features of the market or organizational mechanisms and tracing the consequences in the form of changes in profit or the market value of the firm are rarely attempted. This is the basic lacunae in the studies of industrial organization. A further dimension of such changes has been brought to attention. The emphasis of the management of some firms places an emphasis on the continuity of the firm over time and investments in physical capital instead of investments in inventory. However, managerial discretion and their preferences may be to recover the finances sunk into capital investments as soon as possible even if it is at the expense of the growth of the firm. Irrefutable evidence is not forthcoming though these controversies suggest plausible reasons for the emergence of managerial discretion in one direction rather than the other. Firms appear to feel that shareholders prefer high dividend as well as high market value which place a limit on the profits that can be achieved, thus limiting the ability to finance new investments. In general, the loss of control due to debt has been a deterrent. The debt–equity ratio chosen by the management may be looked upon as a tradeoff between cost and control. With a predominant emphasis on the inflexible interest payments on debt and dividend payments, the equity holders may not have any influence on the efficiency of the management in choosing appropriate product diversification and capital investment. In a governance relationship, the shareholders and the board of directors may be conditioned by inadequate information with respect to product market conditions. By way of contrast, firms that utilize an implicit contract are affected by the long-term strength of product market conditions and the business risk of high debt–equity ratio. Increasing risks are a major reason for delegating decisions to the management in an implicit contract. There have been several references to the tradeoff between the different strategies of firms and between two or more of their objectives. The basic organizational arrangements tend to be inefficient as the size of the firm increases or more activities are added to the firm. This results in franchising, subsidiaries, and so on. If finances for capital investments can be obtained at no extra cost, then retentions are not a first charge and a constant dividend payout ratio will preferred. If there is uncertainty in the profits that will be available through the product markets, then the management would be compelled to truthfully portray future prospects through dividend decisions. A satisfactory trend in net worth and share prices may induce shareholders to forego dividends in favor of long-term capital gains. On the other hand, since managers do not have any claim on capital gains, etc., they do not want to take the risks of high debt. They would prefer to pay off dividends to keep the 3

Note that liberal credit was also expected to improve the investment climate and along with it macroeconomic growth. However, equally important is the observed outcome that such liberal credit was directed to speculative activities like the Bitcoins and so on.

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shareholders satisfied. The overwhelming empirical evidence is that shareholders view dividend decisions as primary from a long-term perspective. We thus have an example of why dividends = f (profit) in the sense of Lintner is not enough to understand why dividend decisions are primary. A lot more probing of the intentions of the shareholders and managers is necessary. On the other hand, managements consider dividend decisions primary due to their preference. They are not primary because the shareholders demand it. Uncertainty may arise due to (a) difficulties in ascertaining the prices that new product introduction will provide, (b) management may find activities as increasing their burden and not offering returns to them; so that they may be uncertain and may not even deliver the promises apriori, (c) information asymmetry in financial markets, (d) inability of firms to discover the strategic choices of rival firms, and (e) inability of the management to foresee complex problems and/ or efficiently resolve them—may be true even in governance relations and not just in implicit contracts. The following responses to uncertainty have been documented: (a) absorb the risk reduction in profits, etc., if there is no loss dynamically, (b) find out pdf of the random variable and act, (c) tradeoff profit to reduce uncertainty (σ 2 ), (d) diversify production to reduce overall risk, (e) hold inventory to cushion uncertainty, and (f) create greater confidence in shareholders (by providing a stable dividend rate) and aspire for a stable position for themselves.

11.3 Organizational Arrangements Most activities, i.e., transactions within and between units of a firm, that have a longterm bearing on the performance of a firm, cannot be efficiently conducted through the market mechanism. Practically, every modern corporation some transactions are conducted through the market mechanism, some are through contracts with individuals outside the firm as well as within it, and yet others by administrative authority vested in some individuals. The actual combinations vary depending on many factors that are not as yet documented adequately. Many transactions are not conducted on markets. Instead, contracts, governance by shareholders, different groups responsible for decision-making, and several hybrids are discernible in practice. Consider the context of facemasks and sanitizers—infrequent purchases but urgent in a pandemic. They are sold on the market at a fixed price that has very little to do with supply and demand. A theory which outlines the combinations used in any corporation, the specific purpose for which they are used, and the reasons thereof need to be developed. Consider the following: in the context of many products, sold through geographically separated markets, the quantities of output made available as well as their prices are fixed. Though uncertainty is offered as a reason for such a choice, it is necessary to investigate other possible reasons. Studies, related to multi-product firms, provided evidence regarding two other factors: the uncertainties associated with market demand and the organizational arrangements for production. In general, organizational arrangements do not affect

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the performance of a firm on their own. Instead, strategic choices should be implemented through an organizational mechanism. That is, the effect of a strategy reveals itself only through such interaction. Rao and Saha (1994a, 1994b) provided empirical evidence regarding this. While estimating equations like y = f (x), it must be noted that the observed changes in y are not purely due to the observed changes in x but they will also depend on the change in the coefficients (effects) associated with x. Similar studies, of the coefficients of a regression changing with some decisions of the firm, have been missing however important such effects may be. Such studies also opened the possibility that firms utilize subcontracting and franchising as alternative organizational mechanisms. That is, contracting was considered as an instrument that can alter the dependence on markets. In general, it was suggested that the nature of technology, and not the differences in the demand for various products, determines the choice of organizational arrangements. Paucity of data has been a severe constraint in providing reliable inference.

11.4 Concept of Efficiency In general, two or more individuals agree to work together and be governed by some constraints and objectives placed on them by external market conditions, different levels of management within the firm, as well as the resource availability and the competence of individuals. Efficiency considerations depend on the functions being assessed and the maximum of the objectives that can be expected from the team working together. Both the generation of synergy (a necessary condition) and equitable sharing of gains (a sufficient condition) require attention. Cost considerations, achieving the maximum profit (a short-term goal) or the market value of the firm (a long-run objective), have a role in defining efficiency. Note that it may not be possible to take the conflicting objectives of all individuals into account. In such a case, the level at which efficiency should be achieved will itself become an issue. A system where every subgroup is efficient may perform at a less than optimum. Some changes will be necessary to improve its performance. The management alone cannot be held responsible for the observed inefficiency. Thus, managerial discretion is a useful concept. But defining efficiency in mechanisms design is at best arbitrary. A system that is efficient today may not remain so in the future. Dynamic adjustments, based on learning by doing, will be necessary to improve efficiency. Defining managerial discretion and measuring it will depend on the subunit under consideration. A general theory appears implausible.

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11.5 Managerial Discretion There is as yet very little information about managerial discretion despite voluminous theoretical literature. In a general sense, the management of a firm chooses strategies to either minimize cost or maximize profit. Cost minimization receives prominence if the external product and financial markets are not a constraint. However, the management may consider the costs and gains to itself while developing cost-minimization choices. Some deviation from minimum cost emerges as managerial discretion if their returns and position are not at stake. Some choices of the management may be due to market imperfection. For example, the choice of a lower level of profit-maximizing output due to the inelasticity of demand in product markets. Similarly, the management may refrain from an efficient organizational arrangement if the cost of collecting information and devising efficient strategies turn out to be in excess of the expected returns. Clearly, managements may underestimate cost or overestimate gains and undertake organizational restructuring. While there may be many possible sources of managerial discretion, the following are typical examples. The management (1) may not use an input at a lower price citing the higher search costs of doing so (2) may not introduce a new technology or a new product saying that complex organizational arrangements reduce efficiency and increase cost (3) may utilize non-price strategies to increase the market share of the firm by incurring extra cost and reduce profit and hope to gain over time at the expense of short-term returns. More generally, the following represent some specific dimensions of discretion: choice of objectives, choice of product range, choice of organizational structure and control, level and composition of inventories, and non-price choices. The argument so far assumed that managements function in an implicit contract and that their discretion is contingent on their objectives. However, in a governance context aspects of managerial discretion are discernible either due to the objectives of the board of directors or the constraints they place on the management. There may be several patterns of managerial discretion, and any one of them may be applicable to one or a few firms instead of all of them generally. However, no significant efforts have been made to examine the tradeoff between them or examine whether one hypothesis is superior to the others. Further, most studies started with a hypothesis about management and tested it against empirical data.

11.6 What Then? Studies of industrial organization and management science concentrate on steady trends both in explaining such events and providing guidance to the management.

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They provide a situation-specific explanation in case of deviations. The case study approach in management goes a step further. However, such contexts cannot be replicated and provide little assistance to management in case of unexpected events. The components of the system and overall system change abruptly and quite frequently. The studies of industrial organization cannot explain the reasons for the changes let alone forecast them in advance. The intrinsic stochastic variability is poorly understood. Some theories, data, and analytical tools are relevant for a major portion of the activities of the management. The strategy of management scholars is to transfer such knowledge to prospective managers. However, increasingly, the market dynamics throws up very different and often intractable issues that may only have a shortterm bearing on the prospects of the firm. Confronted with such innumerable new problems management develops implementable solutions as the situation arises. In doing so, they may be compelled by circumstances such as satisfying the shareholders or worker unions. To separate such constraints on the decisions of the management may turn out to be quite subjective. It is then difficult to pinpoint the efficiency of a proposed alternative. For each of the empirical studies considered in the book, it was necessary to supplement received theory with alternative hypotheses in order to develop coherent economic analysis. These alternatives were developed either by modifying the constraints in the decision-making process of the firm or by explicitly recognizing the behavioral pattern that may in fact be operating. The studies reported here therefore have the virtue of extending the theoretical analysis while providing an insight into the applicability of the basic theory that has been developed. Turn to the observed data. They are a result of the interaction of several ex ante choices of several agents involved in the exchange. The modeling to test the theoretical specification must acknowledge the constraints that this process entails. In particular, it is necessary to investigate whether the implied consequences are the source of the decisions made. In some contexts, where the decision-maker is not sure about the consequences, or a combination of them that should drive the choice, would nonetheless be made to explain such choices. Modeling any phenomenon does not generally depend on theories that utilize data that reflects empirical reality. What are the different factors (not commonalities) that explain the behavior from one unit of time to another? Is the external environment responsible? Is the management decision responsible? Is the range of variables causing the problem or the change in effect of a specific variable causing the problem? Similarly, the same factor or source and for the same firm may have a different quantitative effect at different periods. There is no information about such effects since the current research is not oriented that way. More often than not, individual decision-makers act on incomplete information. They may do so since the costs of acquiring more information may be disproportionate to the expected gains. As a result, some decisions may be influenced by fewer variables than those envisaged in theory. However, econometric model specification may include too many variable compared to the subset that actually influences the observed data.

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As Rao (2003) noted, even in the context of a single decision-maker (a) the factors that motivate decisions vary over time, (b) the intensity of response to any given explanatory variable will not be the same at every point of time, (c) the effects of some variables persist over time (not merely in the distributed lag sense) and cumulative values (or threshold limits) determine the observed outcomes, and (d) two or more variables may combine in complex ways to produce the observed outcome. Studies are not oriented to disentangle these differences. Searching for a few commonalities and depending on them exclusively to provide managerial guidance has been the rule.4 Studies of industrial organization have been adopting empirical methods purely based on the choice of the investigator. The general hope is that such approaches will eventually guide us toward the most efficient way of going about the problem. But this appraisal and course correction is rarely attempted. In general, the relevant questions are not posed (as in the context of retail inventories), the explanation of the observed phenomenon is not related to the decisionmaking process and the constraints in generating observed data, the temporal variations in the sources of the decisions and their quantitative impact on outcomes is not adequately articulated, and the empirical methods utilize statistical techniques that do not portray the empirical reality in most managerial situations. In the ultimate analysis, it must be acknowledged that (a) theories should start by integrating practically relevant observations of behavior and (b) estimation methods should take the constraints implied by the managerial choices into account. However, several alternative specifications would be necessary to portray the observed behavior of the management of the firm. The expected advantage in modifying the analytical thought process is that the changes in the decisions, the discretionary choices, and the quantification procedures will become more transparent.5 The pragmatic choices may concentrate on the stable trends but they should also consider the consequences of random occurrences and their effects on the system. This may not materialize any time soon. In the meantime, there are several attempts at developing machine learning algorithms that are expected to be useful in managerial decisions, Essentially, as Conley (2018, p. 22) remarked, “wisdom is the capacity for wholistic or systems thinking that allows one to the gist of something by synthesizing a variety of information quickly. The skill of pattern recognition helps you to come 4

Consider the context of medical science. The biochemical reactions in human bodies are so complex that medical science cannot spell out the exact reasons for the manifest symptoms or the disease. What is generally done is to take note of the symptoms (even after the battery of tests they conduct) and prescribe medicines. The situation described here is very much the same. It has not been possible to say that specific strategies and objectives of the management are the reasons for the observed outcomes. Hence, the inferences and prescriptions of strategies are based on correlating the two on the basis of accumulated experience. In general, the machine learning algorithms and artificial intelligence confront a similar situation. 5 Rubenstein (2006, p. 873) holds the following view. “Applied economists often feel the need for a model before they mine data for a pattern of regularity. Do we need economic theory to find these regularities? Would it not be better to go in the opposite direction by observing the real world, whether through empirical or experimental data, to find unexpected regularities? Personally I doubt that there is a need for preconceived theories to find regularities”.

References

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to account for the bigger picture.” In this context, it is important to note, as von Neumann (1958) put it, that the computers, and algorithms designed to use them, refer to information available at pre-specified locations and utilize them in a logically defined sequence while arriving at a solution based on the situation that is being studied (pre-specified). On the contrary, the human brain is capable of referring to random pieces of information at arbitrary locations, and construct algorithms based on the situation that is being studied (not pre-specified). Both these features of problem-solving are different from those utilized by machine learning algorithms. Thus there is a difficulty in accepting their usefulness however well constructed they may be (notwithstanding the Bayesian probability rules they currently employ). Randomness in the types and location of the relevant information, and methods of assimilating them to arrive at a solution, are intrinsic properties of the human brain. Machine learning algorithms may be unequal to such a task. Having said that, the following words of caution from Schumpeter (1950, p. 132) should be kept in perspective. “ technological progress is increasingly becoming the business of teams of trained specialists who turn out what is required and make it work in predictable ways. The romance of earlier commercial adventure is rapidly wearing away, because so many more things can be strictly calculated and that of the old to be visualized in a flash of genius.” With the above considerations in perspective machine learning algorithms should proceed along the following lines. (a) Consider a corporation to have three basic divisions: production, marketing, and finance. Develop a model to characterize the optimum performance of each division by visualizing possible synergies within each of them. The lack of synergy will then provide a characterization of managerial discretion. (b) It is necessary to develop synergies in the relations between divisions to add to the machine learning algorithms. The functioning of the corporation can be deemed to be efficient only when there is synergy within each division and also between divisions. Managerial discretion should be minimized though some of it will remain even in the best possible case. (c) As a practical reality, it must be acknowledged that the lack of synergy in one or more divisions may yet be necessary to achieve synergy of the entire corporation. Thus, it would be important to acknowledge the emergence of franchising, subsidiaries, carveouts, and spinoffs. That is, several smaller corporations operating independently and in tandem may well be the most efficient environment. The details of defining efficiency and synergy within each division and across divisions appear to necessitate different approaches. The finer details have yet to be systematized.

References Conley, C. (2018). Wisdom @ work. Double Day. McGrath, R. (2013). The end of competitive advantage: How to keep your strategy as fast as your business. Harvard University Press.

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