According to Marris, the manager of the firm tries to maximize the rate of growth of the firm, that is, the maximization of the rate of growth of demand for the products of the firm and of the growth of its capital supply rather than the maximization of profits.
In order to achieve this objective, the firm is facing two constraints- First, the constraints set by the available ‘managerial team and its skills, and second, the financial constraint set by the desire of managers to achieve maximum job security. The managers, by jointly maximizing the rate of growth of demand and capital, maximise their own utility as well as the utility of the shareholders.
The conflicting interests of owners and management coincide with the objective of balanced growth of the firm as it ensures a fair return on the owner’s capital and faith in managers who achieve this goal.
Robin Marris’s Theory of Managerial Enterprise
The Marris Model of the Managerial Enterprise was developed by Robin Marris in 1964. Like Willaimson, Marris’s approach is also based on the fact that whenever the difference between ownership and control exists, then the self-interest of the agent makes profits lower than in a situation where principals act as their own agents.
In other words, the Marris model is also based on the fact the ownership and control of the firm are in the hands of two different people.
He, like Williamson, also assumed that the managerial utility function includes variables such as salary, status, prestige, job security and other monetary compensation. Out of these, salary is the only quantitative variable which is measurable.
On the other hand, all other variables except salary are non-quantifiable, i.e. not measurable. The utility function of managers is a function of salary, monetary expenditure on the staff and discretionary investment.
𝑈𝑀 = 𝑓(𝑆, 𝑀, 𝐼𝐷)
Where,
𝑈𝑀 is the Utility of the Managers
S is Monetary expenditure on the staff
M is the Management slack
𝐼𝐷 is a Discretionary investment
Here, the variables expenditure on staff salary, management slack and discretionary investment is used the unquantifiable concepts like power, status, job security, dominance etc. The variable expenditure on staff, management slack and disinvestment can be assigned some nominal values. The goal of the managers is the maximization of their own utility. On the other hand, the goal of the owners of the firm, i.e. shareholders, is to maximize profits, market share, capital, output, public image etc.
𝑈𝑂 = 𝑓(𝑃, 𝑀𝑆,𝐾, 𝑌)
Where,
𝑈𝑂 𝑖𝑠 𝑡ℎ𝑒 𝑈𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑂𝑤𝑛𝑒𝑟𝑠.
P is Profit
MS is the Market share
K is Capital
Y is output
Here the goal of the manager is the maximization of their own utility.
In contrast to Williamson, Marris argues that the difference between the goal of the managers and the goals of the shareholders is not so wide as other managerial theories claim. This is so because most of the variables appearing in both functions are strongly correlated with a single variable: the size of the firm. He assumes that managers are basically concerned with the rate of growth of size.
There are various measures (indicators) of the size that exist, like capital, output, revenue, and market share, and there is no consensus about which of these measures is the best. Marris defines the size in terms of corporate capital, which is the sum total of the book value of fixed assets, inventory, and net short-term assets, including cash reserves.
According to Marris, the size and the rate of growth are not necessarily equivalent from the point of view of managerial utility. If they are used interchangeably, then there would be high mobility among managers of the firm: the managers would be indifferent between being employed and promoted within the same growing firm (enjoying higher salaries, power and prestige) and moving from a smaller firm to a larger firm where they would have the same earnings and status.
But in the world, the mobility of managers is low. Various studies have proved that managers prefer to be promoted within the same organization rather than move to a larger one, where the environment might be hostile to the ‘newcomer’ Hence managers aim at the maximization of the rate of growth rather than the absolute size of the firm.
Goal of the Firm
According to Marris, the goal of the firm is the maximisation of the balanced rate of growth of the firm, that is, the maximisation of the rate of growth of demand for the products of the firm and of the growth of its capital supply. This can be written as:
Maximise 𝑔 = 𝑔𝐷 = 𝑔C
Where,
g is the balanced growth rate
gD is the growth of demand for the products of the firm and
gC is the growth of the supply of capital
Let us understand the growth of demand for the products of the firm and the growth of supply of capital in detail. According to Marris, the utility function of owners can be written as follows:
𝑈𝑜 = 𝑓(𝑔𝑐)
Where,
𝑈𝑜 is the Utility of the Owners and
𝑔𝑐 is the rate of growth of capital.
On the other hand, the utility function of the managers may be written as follows:
𝑈𝑀 = 𝑓(𝑔𝐷,𝑆)
Where,
𝑈𝑀 is the Utility of the managers and
𝑔𝐷 is the rate of growth of demand for the products
S is Job Security
Marris assumes the utility function of managers is a function of the rate of growth of demand for the products and Job security. He assumes that salaries, status and power of managers are strongly correlated with the growth of demand for the products of the firm. Hence, managers will enjoy higher salaries and will have more prestige the faster the rate of growth of demand for the products.
Marris recognizes that the drive for the rate of growth is not without constraints. Thus in the model, there are two constraints – the managerial team constraint and the job security constraint. Let us examine these constraints in detail.
The Managerial Constraint:
Marris adopts Penrose’s thesis of the existence of a definite limit on the rate of efficient managerial expansion. At any one time period, the capacity of the managerial team determines the upper limit to the growth of the firm. There is a limit to the output increased by hiring new managers because of their lack of experience and the time lag involved in attaining the required skills.
Penrose’s theory is that planning and execution of the operations of the firm are the results of teamwork which require the cooperation and coordination of all managers. There is a time lag when a new manager is fully ready to join the teamwork necessary for the efficient functioning of the firm. Thus, although the ‘managerial ceiling’ is receding gradually, the process cannot be speeded up.
Similarly, the other factor that also limits the rate of growth of the firm is ‘research and development’. Research and Development imply any new ideas or innovations which affect the growth of demand for the products of the firm. The work in the R & D department is a slow process, and it cannot be expanded quickly.
In order to enhance research and development, you need to hire new scientists and designers, which requires time to contribute efficiently. Research and development also cannot expand output continuously. The managerial constraint and research and development capacity of the firm set limit both the rate of growth of demand (gD) and the rate of growth of capital supply (gc).
The Job Security Constraint:
This is natural that managers want job security. This desire for security by managers is reflected in their preference for service contracts, generous pension schemes, and their dislike for policies which endanger their position by increasing the risk of their dismissal by the owners. The risk of dismissal of managers arises if their policies lead the firm towards financial failure (bankruptcy) or render the firm attractive to be take-over by other competitors.
In the first case, the shareholders may replace the old staff in the hope that by appointing new management, the firm will be run more successfully, whereas in the second case, if the take-over is successful, the new owners may decide to replace the old management.
Marris suggests that managers would like to seek job security by adopting a cautious and prudent financial policy. The prudent financial policy would consist of the following:
(a) Non-involvement with risky investments. The managers should choose projects which guarantee a steady performance. They should not involve in ventures that are risky, i.e. highly profitable if successful but will endanger the managers’ position if they fail.
(b) Financing growth mainly from the profit levels being generated by the present set of products.
To judge the prudence of a financial policy, Robin Marris proposed the concept of financial constraint (a). This financial constraint is determined by the risk attitude of the top management. The management who is a risk lover would like to prefer a high value of a, while the management who is risk-averse would like to prefer a low value of a.
According to Marris, the financial constraint a is the weighted average of the three security ratios, i.e. the leverage (or debt ratio), the liquidity ratio, and the retention ratio.
i. Leverage Ratio:
The leverage or debt ratio is defined as the ratio of the value of debt to the total assets of the firm:
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑟 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 (𝑎1) = 𝑉𝑎𝑙𝑢𝑒𝑜𝑓𝑑𝑒𝑏𝑡𝑠 / 𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡s
The leverage ratio measures the extent of reliance on borrowing for expansion purposes. A lower leverage ratio would retard growth, and a higher leverage ratio would invite takeover bids and increases the rate of failure.
ii. Liquidity Ratio
The liquidity ratio is defined as the ratio of liquid assets to the total assets of the firm:
𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 (𝑎2) = 𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑠𝑠𝑒𝑡𝑠 / 𝑇𝑜𝑡𝑎𝑙𝑎𝑠𝑠𝑒𝑡s
A low liquidity ratio implies the possibility of insolvency of the firm, whereas a high liquidity ratio increases the security. If the liquidity ratio is too high, then it would have an adverse effect on the rate of growth.
Therefore to ensure security, the management should choose the value of 𝑎1, which is neither too high nor too low. In his model, Marris assumed that the firm operates in a region where there is a positive relationship between liquidity and security.
iii. Retention Ratio
The retention ratio is defined as the ratio of retained profits to total profits:
𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 (𝑎3) = 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 / 𝑇𝑜𝑡𝑎𝑙𝑝𝑟𝑜𝑓𝑖𝑡s
According to Marris, retained profits are the most important financial source for the growth of capital. The high level of retained profits cannot keep shareholders happy. And a too-high retained profit implies that management is taking the risk of displeasing the shareholders.
Two Characteristics of Financial Constraint are:
(i). Marris assumed that the financial constraint is negatively related to a2, and positively related to a1 and a3.
(ii). Marris also assumed that there is a negative relation between ‘job security’ (s) and the financial constraint a. It implies that if a is increased, the job security of managers declines, and if a is decreased, the job security of managers increases.
Thus, the financial constraint determines the level of job security and hence limits the rate of growth of the capital supply and also the rate of growth of the size of the firm.
Equilibrium of the Firm
According to Marris, the goal of the firm is the maximization of the balanced rate of growth of the firm, that is, the maximization of the rate of growth of demand for the products of the firm and of the growth of its capital supply. This can be written as:
Maximize 𝑔 = 𝑔𝑐 = 𝑔D
Where,
g is the balanced growth rate
gD is the growth of demand for the products of the firm and
gC is the growth of the supply of capital
Let us first discuss the growth of demand, then the supply of finance, followed by their interaction.
Rate of Growth of the Demand:
The rate of growth of demand for the products depends on the following:
i. The rate at which new products are tried-Diversification rate and
ii. The percentage of successful new products
𝑔𝐷 = 𝑓(𝑑, 𝑘)
Where,
d is the diversification rate,
k is the proportion of successful new products.
The two forms of diversification are:
Differentiated Diversification:
The firm may introduce a completely new product whose close substitutes are not available. These new products create new demand and thus compete with other products for the income of the consumer. According to Marris, this is the most important form in which the firm seeks to grow.
Imitative Diversification:
The firm may introduce a product whose close substitutes are available from existing competitors. It is almost certain to induce competitors’ reactions. Given the uncertainty regarding the reactions of competitors, the firm prefers to diversify with new products. There exists a positive relationship between diversification and the rate of growth of demand.
The proportion of successful new products, k, depends on the rate of diversification d, the advertising expenses, the Price of new successful products, the research & development expenditure and on the intrinsic value of the products.
𝑘 = 𝑓(𝑑, 𝐴, 𝑃, 𝑅&𝐷, 𝑖𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐𝑣𝑎𝑙𝑢𝑒)
The proportion of successful new products, k, is positively related to advertisement expenditure and research and development expenditure. Marris has used the average profit margin (m) as a proxy for advertisement and research and development expenditure. The average profit margin m is negatively related to advertisement and R&D expenditure, and the proportion of successful new products is also negatively related to the average profit margin.
The proportion of successful new products depends on diversification as well. The rate of new products introduced in each period if too many new products are introduced too fast, the proportion of falls increases. Thus, the rate of growth of demand, gD, is a function of diversification d and average profit margin m.
𝑔𝑑 = 𝑓3 (𝑑, 𝑚), 𝜕𝑔d/𝜕d 0 𝑎𝑛𝑑 𝜕𝑔d/𝜕𝑚 < 0
The growth rate of demand is positively correlated with the diversification rate (d) and negatively related to the average profit margin.
Rate of Growth of Capital Supply:
The rate of growth is financed from two sources: internal and external. The internal source of finance is profits. The external source of finance may be obtained by the issue of new bonds or from bank loans. Marris assumed that the main source of finance for growth is profits. This is because of two reasons.
i. The issue of new shares as a means of obtaining funds is, for prestige and other reasons, not often used by an established firm.
ii. The external source of finance is limited by the security attitude of managers, that is, from their desire to avoid mass dismissal.
According to Marris, the rate of growth of capital supply is proportional to the level of profits.
𝑔𝑐 = 𝑎. P
Where,
𝑔𝑐 is the growth rate of corporate capital
P is the net rate of profits, after depreciation and tax, earned on productive assets.
a is the financial security coefficient
The level of total profits, P, depends on the average rate of profit, m, and on the capital-output ratio, O, which is the efficiency of the performance of the firm. So, P is a function of the average profit rate and overall capital-output ratio.
𝑃 = 𝑓(𝑚, 𝑂) 𝑤ℎ𝑒𝑟𝑒 𝜕𝑃/𝜕𝑚 > 0
The overall capital-output \ ratio is not a simple arithmetic average of the capital/output ratios of the individual products of the firm but is a function of the diversification rate d. It can be written as:
𝑂 = 𝑓(𝑑)
For a given capital, the relationship between the capital-output ratio and diversification is up to a certain level of d positive, reaches a maximum, and then starts falling as the number of new products increases the overall output.
Output is at maximum when the d is at its optimum level allowing the optimal use of the managerial team and the R & D personnel. Beyond the optimal point, the total output decreases with further increases in d. Hence the success rate for new products falls and efficiency declines.
Substituting for capital-output function in the profit function, we obtain:
𝑃 = 𝑓(𝑚, 𝑑)
Now substitute the profit function P in the gc function we obtain:
𝑔𝑐 = 𝑎. 𝑓(𝑚, 𝑑) = 𝑎. 𝑃
The rate of growth of capital is determined by three factors the financial policies of the managers, the average rate of profit and the diversification rate. If all the security constraints on leverage, liquidity and retention ratio are operative, the value of a becomes unique. This unique value of a then becomes a constraint in the model. This can be written as:
𝑎 ≤ 𝑎∗
And 𝑔𝑐 ≤ 𝑎∗. 𝑃 where 𝑎∗ is the value of a associated with financial policies in which all the security constraints are effective.
The Complete Form of the Marris Model:
The complete summarization of the above equations is as follows:
𝑔𝐷 = 𝑓(𝑚, 𝑑)(𝐷𝑒𝑚𝑎𝑛𝑑𝐺𝑟𝑜𝑤𝑡ℎ𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛)
𝑃 = 𝑓(𝑚, 𝑑)(𝑃𝑟𝑜𝑓𝑖𝑡𝑅𝑎𝑡𝑒𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛)
𝑔𝑐 = 𝑎. 𝑓(𝑚, 𝑑) = 𝑎. 𝑃 (𝑆𝑢𝑝𝑝𝑙𝑦𝑜𝑓𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛)
𝑎 ≤ 𝑎∗ (𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡)
𝑔𝑐 = 𝑔𝐷 (𝐵𝑎𝑙𝑎𝑛𝑐𝑒𝑑𝐺𝑟𝑜𝑤𝑡ℎ𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛)
The firm is in equilibrium where 𝑔𝐷[= 𝑓(𝑚, 𝑑)] = 𝑔𝑐 [= 𝑎. 𝑓(𝑚, 𝑑) = 𝑎. 𝑃]. Here the equilibrium equation depends upon two unknown variables, m and d. The model cannot be solved unless one of the variables, m or d, is subjectively determined by the managers. Once the managers define a and one of the other two policy variables, the equilibrium rate of growth can be determined.
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