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Réflexions sur l’économie d’entreprise : Modèle des décisions améliorées

Réflexions sur l’économie d’entreprise : Modèle des décisions améliorées

Bertrand Belzile

Volume : 22-3 (1967)

Abstract

Some Thoughts on Managerial Economics : Model for Improving Decisions

INTRODUCTION

This paper has been especially written for those interested in the economic studies of the firm and who are more or less embarassed in using their knowledge in micro-economics: How could one conciliate profit maximization with all other objectives apparently prevailing in practice ? How could one obtain the nice theoretical demand curves ? How could one know the different cost elements for each of the many products of a firm ? Actually, those specialists are quite discouraged by the difficulties met in the passage from theory to practice.

This uneasiness also exists for the theoricians. To prove it, let us recall the famous controversy on marginalism which, for more than twenty years now, questioned the validity of the traditional economic theory. There has been much literature on this subject for the last few years both in books and magazine articles. Some of them criticize the orthodox theory by doubting of its validity as a firm theory while others propose changes or new theories.

It is known that the founders of this theory, to mention only Cournot (1838), Marshall (1890) and Chamberlin-Robinson (in the thirties), assigned to the entrepreneur a rather passive role and considered almost almighty the market forces for the factors and the products. On the contrary, since the beginning of the thirties, an increasing number of economists admit that the entrepreneur has great freedom of action i.e. he can more and more influence the external world. Cleland1 even writes that « the manager would be substituted for the market as the key element ». But one can note by simple observation that this is passing from one extreme to the other since market forces still remain generally very powerful.

Whatever is the exact relative power of each of those two elements, there is no doubt that the manager possesses a relatively large freedom of decision (especially because of his lack of information) and consequently he needs a new kind of operational framework to prepare his decisions.

Unfortunately nothing satisfying seems to be yet found. Nordquist2 notes that « among the critic  there are wide differences as to what is wrong with the theory and little agreement on what should be done ». Managers nevertheless need a better approach than the one they presently have.

Does this imply that traditional micro-economics should be discarded? If so, what should replace it? If not, how could it be made more useful for scientific management? The first step to make seems quite indicated: to discuss the validity of the orthodox marginalism.

THE VALIDITY OF THE TRADITIONAL THEORY

Cyert and March 3 state seven propositions which explain the essential content of the traditional theory on which they think that there is a general consensus. Let us mention here the three following:

« 1. — At equilibrium, the marginal rate of substitution between two products, or between two factors, is equal to the ratio of their prices.

2. — The marginal physical productivity of a factor with respect to a product is equal to their price ratio.

3. — The quantity of a good produced is selected so that its marginal cost is equal to its price ».

In the context of managerial economics, it is advisable to retain only the qualitative aspect of the preceding propositions, for one must admit that it is impossible in most of our existing firms to quantify the variables involved so to entirely apply those basic principles. On the other hand each proposition describes an ideal to reach and characterizes the way and direction of the action to undertake. To put it another way, theory does not aim at the business administration as such but must inspire it largely.

To bring the subject in proper focus, before submitting it to discussion, it is convenient to recall some of the main implicit assumptions of the theory. Cleland 4 has presented and explained five of them :

« 1. —The stationary assumption — it assumes that wants, resources and the body of knowledge are given and unchanging.

2. —The independence assumption — it assumes that wants, resources and the body of knowledge are independent of one another and of the actions of the firm.

3. —The moticational assumption — the purposes or goals of the firm are assumed to be maximizing of net benefits (or profits).

4. —The informational assumption — it assumes that there is a well-organized system for the acquisition and dissemination of relevant information to the firm and within the firm, whether this be concerning technical processes, human relations, the markets for products and raw material or facilities for production.

5. —The organizational assumption — it assumes a process for decision and actions of various individuals are related to one another in terms of maximizing purpose of the firm ».

One must recall those assumptions, since most of critics invalidate orthodox marginalism pleading the non-conformity of these hypotheses with reality.

Two assumptions: Stationary and Independence

It is quite evident that wants, resources and the body of knowledge are not given once and for all for the firm but they change with time. It is also known that market forces do not entirely dominate the firm but that they influence one another.

Motivation

It is unuseful here to dissert for a long time on the purpose of profit. The manager remains an individual even if he roughly accepts the value system prevailing in the firm. It is thus possible to see his own motivation more or less in opposition to the one of the organization. In fact, the individual first reaches for economical security, without neglecting psychological quietude, interest for work, chances for promotion prestige, power, etc. This becomes more and more obvious with the increasing separation of ownership from control. In addition to this, given the growing number of constraints to reckon with such as human relations, innovation, financing needs, etc., it seems impossible to maximize profit in the sense of the theory. We must however admit with Goetz5 that profit maximization constitutes a common denominator serving the many goals of the firm.

Information

The decision criterion, in the case of orthodox marginalism, consists of maximizing profit by equating the marginal cost to the marginal revenue. This implies that the manager knows all the alternatives opened to him : each point on a demand or cost curve, for instance, represents a subset of such alternatives. Their number being infinite, it is then impossible to know all of them perfectly. Therefore the manager will not be able to rely on conventional marginalism in its full sense. However he will have to collect and use all the economic information possible to gather.

Organization

We have mentioned that the founders of conventional marginalism gave the firm a very passive role. They did not consider it either as an organization, in its modem sense, which supposes that the interrelationships between individuals and groups are established by a communication channel through which flows all the information used in the decision making process. In this organization many conflicts may arise between the different parties thus hampering the collaboration necessary for an adequate and efficient action. That is why an effort must be made to use theory in the best possible manner in the decision making process.

General Criticism of the Theory

The traditional theory is more or less invalidated on the basis of an inconsistency between the assumptions and the reality. One cannot even say that this theory is strictly speaking a theory of the firm since it explains in the first place the allocation of resources on the market. But managers must make their decisions in the firm: they cannot only consider market forces and consequently they need a supplementary framework to the one laid down in the traditional theory.

It is thus urgent to give a better account of the actual reality and to offer better guidance to the managers. However it seems utopic to search for a substitute theory for the traditional one since, because of its high degree of abstraction, it has shed some light on the extremely complex decision process of the firm.

It can be noted with Nordquist6that « two identifiable streams of activity seem to be emerging: the first, at least in precedence, involves an elaboration of the traditional theory into a general framework of optimal choice wherein the assumption of profit maximization is replaced by constrained preference maximization. The second approach seeks to develop process-oriented models of the firm, based upon close observation of actual decision behavior in real business setting ». It would be too long to enumerate here all the proposed reforms and theories. It is sufficient to say that none of them has yet received general approbation and that, on the contrary the attempts are multiplied and perhaps more diversified.

Anyhow, the real economic problem consists of allocating scarce resources in order to satisfy unlimited needs. The traditional theory will hit that target the more it will be completed by an operational economic model. The economic system considers the individuals as consumers and workers, firms as producers of goods and services, and finally the government as the regulator of the activity of the economic agents, individuals and firms. The economic welfare depends largely upon the good functionning of the different parts of the economy.

One must admit at the beginning the unlimited complexity of reality and consequently the necessity for the managers to follow the fundamental principles of conventional marginalism. The desire of rebuilding the foundations of the traditional firm theory and, like physical sciences, to want to go from the particular to the general seems unfruitful. The dimensions of a decision in the firm being quite difficult to apprehend, it is necessary, in a first step, to go far above reality because decisions must help the firm to come nearer and nearer to the theoritical ideal. In a second step, the managers must turn to a model which considers at the same time theory and practice.

NECESSITY FOR AN OPERATIONAL MODEL

The more abstract is a theory, the better it explains the essential of a phenomena and on the other hand the less it explains the detail of it. That is at the same time its force and weakness. The traditional theory gives the managers the main guide lines but is not sufficient for their concrete decisions.

It is often said that conventional marginalism, concerning the allocation of resources on a market, does not help much the managers in their decisions.

Coase 7 states however that « the firm is the supersession of the price mechanism » and that « the main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism ». On the other hand, Peter Drucker8defines the main challenge of the entrepreneur as being the discovery of new possibilities. We could also state many other opinions all more or less different as the other. Admitting that the manager partially substituted the market as the key element, following the idea of Cleland, it is not allowed to go from one extreme to the other and deny that the market forces influence sometimes very much the decisions of the firms which, after all, buy the factors of production and also sell their products on the market.

But fundamentally such a discussion on the exact relative importance of the market and of the manager leads nowhere since everybody recognizes decision making as the main function of the manager, and decision implies freedom of action i.e. the choice of an alternative among many. It is sure that this liberty is active within the limits determinated by the market. For example, the price of a certain hour of work goes from $2.00 to $3.00. That is why the manager must know the price mechanism. He must thus know that an increase in the price of a product leads to a fall in its demand.

Therefore the manager needs to know how the allocation of resources on the market is done. He also needs an operational model which can be drawn from theoritical teachings but which sticks to the managerial reality and more particularly to the decision making process.

ESSAY OF DEFINITION

It is now possible to formulate a tentative definition of managerial economies: a model of optimal choice among the alternatives considered by the managers and evaluated in terms of the objective that they themselves define.

The attempt may seem ventured at a time when nobody has yet defined managerial economies. This is unfortunate and perhaps explains greatly the confusion which presently exists in this field. In fact it is almost impossible to find two books dealing with the subject and using the same terms of reference. On the one hand, one will find works presenting popularization of the traditional theory, while on the other hand some authors explain techniques and methods in one or more specific areas of management.

The model is an attempt to represent the links between the activities and the objective of a firm. It simplifies complex operations thus facilating its management by establishing the main significant relations.

Everybody considers the decision process as being the main function of an executive. Moreover, managers must optimize their choice i.e. choose the best alternatives conducive to the achievement of the objective previously defined.

Considering the fact that managers do not have perfect knowledge, it is impossible for them to inventory all the alternatives. They will rather study a few of them which seem to be the most promising.

They must also evaluate the effects of the alternatives kept for study in order to facilitate the choice of the best one. It is in their interest to quantify each outcome the best they can. For planning and control to be efficient, they must compare the forecasted outcomes of a decision with its actual results: this method is called management by results. For sure the evaluation of the latter may present as many difficulties as the former. But at least the effort of evaluation leads the managers to a better preparation of their decisions, thus contributing to their improvement.

Finally, the proposed definition implies that it is the responsability of the manager to finally define the objective. However, if one assumes a rational behavior on the part of the manager, he is led to accept long-run maximization as the objective of the firm.

MODEL FOR IMPROVING DECISIONS

So far, it has been argued that the traditional theory offered the manager a weak help but a necessary one for their decisions, thus showing its limited validity in managerial economies. The necessity of an operational model that can be useful to the managers was also pointed out. The model for improving decisions must now be explained. Fortunately, what has been said earlier probably foresees the essential.

In fact, faced with the great complexity of management, one must give up the direct application of the theory as such; but one notes at the same time the necessity of following its main guide-lines.

One must therefore pass suitably from theory to practice. Nemmers9 writes « that the typical college graduate with major in economics is, unfortunately, ill-equipped to go into business after graduation ». He proposes precisely the teaching of managerial economies which would serve as a bridge between theory and practice. Unfortunately this bridge does not exist. That is what Scitovsky10 deplored when he spoke of the « unbridged gulf » twenty five years ago. One could probably explain its absence by the difficulty to use theory which finally leads to a set of qualitative propositions not quantifiable. The qualitative aspect of theory was mentioned in the preceding pages.

What shall be done then? The manager cannot act only by intuition or with confidence to the traditional analysis. The only way to get out of the deadlock is to settle the question a little to the manner of the Gordian knot. We thus find afterwards on one side the qualitative propositions of the theory and on the other side the complex decision making process involved in the task of managing. An adequate model must fulfill in the best manner possible two fundamental requirements: to conform to theory and stick to reality.

Everyone recognizes the complex, aleatory and generally uncertain character of firm management. One will never be able to apprehend all the dimensions of a decision neither will be able to predict the future so to speak.

Therefore we must turn to a model which offers some chances of improving decisions. We could explain it by refering on the one hand to the definition of the firm or managers' objective and on the other hand to the evaluation of alternatives to choose in the search for the objective defined by the managers.

Definition of the Objective

The traditional theory only sets forth the purpose of profit maximization, obtained by equating marginal cost and marginal revenue, supposing the perfect rationality of the entrepreneur-owner. The profit could thus be maximized in a theoretical sense only if the entrepreneur fully desires it and if he possesses a complete information of all the alternatives in terms of the profit objective. Hence everybody denies the possibility of profit maximization.

Many authors proposed other particular purposes aimed at by the firm such as the maximization of the sales volume or the share of the market, the satisfying profit; the firms give an increasing importance to human relations and assign large sums of money to valorize their image in the public; above all, they want to survive and maximize utility.

In such a case, it is necessary to suppose, on one hand, a certain willingness on the part of the managers to act rationnally thus striving for profit maximization in the theoritical sense and, on another hand, to accept that the practice of management inevitably keeps managers away from the theoritical ideal. This process allows one to suppose that managers search for maximum profit on the long period taking into account a long series of constraints such as the survival of the firm, the share of the market, the sales volume, the variety of products, research and development, human and public relations, etc..

However, it seems quite difficult to define profit in a way that it could be properly measured. The accounting concept is one of the best known and the most used especially because of its possibility to measure profit objectively against rules which are conveniently applied to the exploitation of a firm. The economic concept has a much more superior significance but its use is difficult and very precarious when interfirm comparisons are made because of the strongly subjective content of its measure.

It seems however necessary to keep the economic concept in mind in managerial economies. First, let us say that a workable definition is in order: the increase (or loss) of the present value of future receipts during a given period represents the economic profit (or decrease) of a firm. We meet here just about the same problem as the one found when figuring out the profitability of investments. We finally get to the same idea of Peter Drucker 11 i.e. that the major challenge for the entrepreneur consists in finding and using new possibilities. In fact it is a matter of deciding to invest once and for all. But the profitability of a firm can change with time. The calculation of this profitability gives at the same time the measure of the economic profit and of the success of managers to innovate.

Concerning the length of the period, it depends mainly upon the capacity of forecasting. Certain firms can trust certain predictions of five years, others of seven years and others of ten years. For example, we agree on the fact that managers plan more precisely, with greater confidence and on a longer period the needs of floor area then the sales of a particular product. On the same manner it is surely easier to estimate the demand for newspaper than for women's hat.

In fact it does not seem rational for the manager to pursue another profit objective than a maximum one over a long period. Any other concept does not tend toward the optimization of decisions for there exists then an area of indetermination in the choices. So, to fix as objective a satisfying profit has two meanings: either one acts irrationnally in rejecting the best alternative in terms of profit, ceteris paribus; or one makes the optimal choice in terms of the most satisfying profit, given the limited information available. In this latter sense, the satisfying profit is the same thing as the maximum profit hereby proposed. In other words, the satisfiers' school speaks of satisfying profit when considering the impossibility of maximizing profit in the theoretical sense i.e. the impossibility to be aware of all the alternatives and to evaluate them in terms of the final objective.

In addition to this, it is often said that optimal decisions are made in terms of two objectives, the short and the long period for example. However, when one wants to classify a group of objects, he would use only one criterion; also he should do the same thing when measuring an alternative against an objective. In the logics of managing which implies foreseeing in the long run, it seems to be impossible to speak of short-run objective which in this case, appears more like a budgetary forecast. To say that a sales volume is determined for the following year in a given amount can not be construed as being the main motivation of the firm. However it is the same thing for all the other forecasts of the same kind. However it is surely desirable and even sometimes necessary to evaluate certain alternatives in terms of particular budgetary forecasts; but this does not eliminate the necessity of doing so in function of a unique objective.

Evaluation of Alternatives

Once it is agreed that managers always seek to maximize the economic value of their firm at any time, or to put it another way, want to maximize the economic profit for a given period, we must now examine how to evaluate the alternatives in relation to those criteria.

It is obvious that the book value of the total assets of a firm is most of the time different from its economic value. The same remark applies to the accounting versus economic profit. For example, the economic commitment of a firm in order to improve its human relations can considerably increase the profitability for the future periods. The same reasoning also applies to publicity, public relations, research and development etc. On the other hand the current operations expenses, such as the material employed in the manufacturing of products, generate the revenues of the present period but do not directly increase as such the potential profit of future periods.

That is why it seems necessary to make an effort to evaluate the alternatives in economic terms, even if we know that it is impossible to measure them exactly and with certainty. The difficulty of the job must not dictate another behavior. It is here that the title of the proposed model takes its full meaning. As a matter of fact, the complexity of reality is such that nobody can apprehend all the dimensions of an alternative. The managers must however try to improve their decisions by resorting to ( mathematical ) optimization techniques. One has just to look to the content of most of the recent books on managerial economics in order to be convinced of this requirement.

Fortunately it is not necessary, and even not possible in actual state of knowledge, to measure the present value of the future receipts of each alternative kept for analysis. In fact, the manager only keeps in mind alternatives which seem to be acceptable i.e. those whose present value is equal to or exceeds the respective economic commitment. It is sufficient to tempt to apprehend in the best possible manner the many dimensions of the kept alternatives in order to be able to arrange them in order and make the optimal choice.

In managerial economies, alternatives must be considered in terms of cost and revenue. One usually distinguishes current expenses from capital expenses, the latter being similar to investment. This distinction, primarily of accounting origin, does not have any economic meaning. In fact, any economic commitment, or use of resources, for the present or future periods, must be measured in relation to the present value of future receipts thus generated.

We must also say that most of current expenses, in the accounting sense of the word, generate revenues and consequently a profit (loss) that could be equalized to the economic profit for the purposes of actual management. This is due to the fact that the current expense, as defined by the accountant, generates a revenue only during the same period.

The interest of this approximation, not to say equality, rests in the possibility of using modern methods of accounting management in managerial economies 12. At the same time the managerial economist considerably reduces the number of alternatives to be evaluated by new and sometimes difficult methods. The main alternatives which cannot be conveniently handled for the present time by the accountant are those regarding investments, research and development, public and human relations, publicity, etc. One could give to these types of alternatives two common characteristics : in the first place a more or less high degree of uncertainty regarding the results forecasted for many years, and in the second place a more or less complex flow or relationships between the different alternatives.

The impact of a decision is as much in space than in time, within a firm or within a group of firms. One will never perfectly know such impact : that is why we will have to continually enlarge the frontiers of knowledge. Another reason for this is the fact that optimization techniques cannot generally be directly applied to each specific problem of decision without a previous adaptation. This implies at the same time that managers and other specialists of the firm must have better knowledge of mathematics which enables them to use these techniques with the best possible result.

In addition to this, specialists will probably always have to evaluate the alternatives in relation to sub-objectives. But the managers will have to choose in last resort the optimal alternative in terms of economic profit. In other words, techniques can only lead to a sub-optimization but the managers must do more i.e. optimize. Firm specialists must only suggest choices or make routine decisions ; the managers have the responsibility of doing the synthesis in tempting to apprehend in the best way possible the dimensions of a decision in terms of the final objective.

The main objection to the quantified model lies in the impossibility of apprehending the dimensions of reality and especially to measure some of them. But this is not the real problem. For, at the starting point, nobody can deny this impossibility : it is the evidence. But does this imply that the firm manager, or anyone who prepares a decision, can trust his intuition? It seems undeniable that this way of behavior is less and less appropriate and that the scientific method rapidly takes over. That is how the model for improving decisions consists of evaluating in the best manner a reasonable number of alternatives in terms of economic profit leading to an optimal choice.

CONCLUSION

The model for improving decisions is in the first place a general frame in which the decisions of the firm could be laid down. We must study specific problems, such as stock management, in using techniques in one particular area of management, but the proposed solutions must be incorporated in the global model.

A particular effort must be done in order to come out which a better definition of the objective and sub-objectives of the firm and to quantify the means to achieve them, while realizing that the firm constitutes a system in the cybernetic sense and that we must then give an increasing importance to the control and regulation mechanisms.

We agree with Lesourne 13 who predicts the evolution of economic studies in the two following ways :

— « Les critères seront plus riches et s'adapteront davantage à la situation réelle de l'entreprise.

— L'effort de mesure sera plus intense et permettra d'accroître le domaine du quantitatif ».

(1) CLELAND, SHERRILL, « A Short Essay on a Managerial Theory of the Firm », in Linear Programming and the Theory of the Firm, by Boulding et Spivey, the Macmillan Company, New York, 1960, p. 208.

(2) NORDQUIST, GERALD L., « The Breakup of the Maximization Principle », in The Quarterly Review of Economics and Business, University of Illinois, Vol. 5, No. 3, 1965, p. 33.

(3) CYERT, RICHARD M. and MARCH, JAMES G., A Behiavioral Theory of the Firm, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1963, p. 6.

(4) CLELAND, op. cit. p. 208

(5) GOETZ, BILLY E.,Quantitative Methods: a survey and guide for managers, McGraw-Hill Inc., 1965, p. 24.

(6) NORDQUIST, op. cit. p. 43.

(7) COASE, R.H., « The Nature of the Firm », Economica, New Series Vol IV (1937), pp. 386-405.

(8) DRUCKER, PETER, « La fonction d'entrepreneur dans l'entreprise économique »Bulletin des Relations industrielles, Vol. 3, No. 17, May 6, 1965, p. 5.

(9) NEMMERS, ERWIN ESSER, Managerial Economics, John Wiley & Sons Inc 1964, p. VII

(10) SCITOVSKY, TIBOR, « Recent Publications on Cost », Accountina Review XVIII (1943), p. 72.

(11) DRUCKER, op. cit. p. 5.

(12) One must refer, for instance, to the Direct Costing method as exposed by Gérard de Bodt in Direct Costing et programmation économique de l'entreprise à produits multiples, Dunod, Paris, 1964.

(13) LESOURNE, J., Du bon usage de l’étude économique dans l'entreprise, Collection Recherche et Décision, Dunod, Paris, 1966, p. 156.