Managerial Theories Of The Firm

Published Apr 29, 2024

Definition of Managerial Theories of the Firm

Managerial theories of the firm suggest that business decisions are not only made to maximize shareholder wealth but also reflect the objectives of its managers. These theories propose that managers, who are hired to run companies on behalf of the shareholders, may have their personal goals that diverge from those of the firm’s owners. This divergence can be due to various factors, including risk aversion, desire for job security, or the pursuit of personal prestige and power within the organization.

Examples

For instance, consider a technology firm where the founding shareholders aim to maximize long-term profits by investing in innovative but risky projects. However, the hired CEO might prefer to focus on projects that ensure stable but potentially lower returns to secure their position within the company and maintain a steady income. Here, the CEO’s actions might lead to a conflict of interest between the shareholders’ desire for growth and the executive’s personal risk aversion.

Another example can be seen in a large corporation that decides to acquire a smaller company not because it aligns with the firm’s strategic growth objectives, but because it allows the management team to oversee a larger organization. This acquisition might boost the managers’ status and increase their compensation, even if it doesn’t necessarily create shareholder value.

Why Managerial Theories of the Firm Matter

These theories highlight the potential conflicts between owners and managers in a corporation, known as the principal-agent problem. Recognizing these divergences is crucial for shaping corporate governance structures that align managers’ incentives with shareholder interests. This can include performance-based compensation, stock options, or specific clauses in employment contracts that reward long-term value creation over short-term profits.

Understanding managerial theories also provides insights into how and why companies might pursue diversification strategies, engage in mergers and acquisitions, or decide on investment plans that do not exclusively focus on maximizing shareholder wealth. They suggest that managerial behavior and decisions can significantly impact a firm’s direction, performance, and value.

Frequently Asked Questions (FAQ)

How can conflicts between managers and shareholders be minimized?

Conflicts can be minimized by designing compensation packages that align managers’ interests with those of shareholders, such as granting stock options or tying bonuses to the company’s long-term performance. Additionally, establishing a robust system of corporate governance, including a proactive board of directors, can ensure that managers’ decisions are in the best interest of the shareholders.

What role does corporate governance play in mitigating managerial divergences?

Corporate governance provides a framework for attaining a company’s objectives, encompassing practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure. Good governance practices ensure that the interests of shareholders are protected and that managers are accountable for their decisions and actions.

Can managerial theories explain why some companies perform better than others?

Yes, managerial theories can partly explain variations in company performance. Firms that effectively align their managers’ incentives with shareholder goals tend to make decisions that are more likely to enhance company value and performance. Conversely, companies with significant conflicts of interest between managers and shareholders may experience inefficiencies, leading to suboptimal performance.

Are there any criticisms of managerial theories of the firm?

Critics argue that managerial theories might overemphasize the divergence of interests between managers and shareholders, suggesting that many managers are inherently motivated to act in the best interests of the company. Critics also point out that market forces, such as the threat of takeover or the presence of active institutional investors, naturally curb managerial excesses and align their objectives with those of shareholders.

By shedding light on the complex interplay between managerial motives and shareholder interests, managerial theories of the firm contribute significantly to our understanding of corporate decision-making, governance, and performance.