Growth of Firms, Capital Market Uncertainty and Managerial Tenure

Abstract

'Managerial' theories of the firm recognize that such structural-institutional factors as separation of ownership from control, oligopolistic markets, capital market transaction costs and modern corporate organizational forms permit managers considerable discretion in pursuing goals other than the neoclassical objective of wealth maximization; these aspects of large firms have been developed by Baumol [i], 0. E. Williamson [i6], Marris [8], [9], Penrose [I I], SO'Ow [ I 3], J. Williamson [ I 5], Yarrow [I 8] and Jensen and Meckling [6]. Consequently, the performance of managerial firms with respect to pricing, marketing and investment policies may depart considerably from that of their neoclassical counterpart. The extent and social importance of managerial discretion depends primarily upon the efficacy of alternative social-control institutions for enforcing internal efficiency. More particularly, performance depends on product and capital market constraints on the manager's choice set. While most of the empirial evidence regarding the extent of non-wealth-maximizing behavior consists of casual observation of particular abuses, recent empirical work by Grabowski and Mueller [3], Kuehn [7] and Smiley [I 2] reveals that the latitude for the exercise of managerial discretion may be considerable. This paper extends the analysis of managerial models of the growing firm by examining the nature of stochastic capital market controls on the latitude of managerial discretion. Specifically, the formulation depicts management's tenure in office to be a random variable whose probability density function depends on the level of managerial discretion, where discretion is defined as the difference between managerial policy and long-run profit-maximization policy. A management that pursues profit maximization will face relatively little threat of capital market discipline, while a more divergent policy subjects managers to a greater threat of removal from office, either from owners or takeover by other firms. The approach taken here is similar to that of statistical renewal theory. The hazard function of renewal theory becomes the conditional probability that managers will be replaced in some short interval, given that they have survived to that time. There are apparent advantages to this viewpoint.