Profit Risk Management and the Theory of the Firm

Abstract

Since dissatisfaction with the classical theory began vigorously being registered in the 1920s and 1930s, theories of the firm have been increased abundantly. In particular, we now have many theories that trace firms' objectives to the personal preferences (utility functions) of their managers. Such theories presume that the managers of large firms can indulge their own preferences because they have market power and are sufficiently free from owners' control to use it partly for their own ends [1; 28; 31; 39], but the theories still leave us without knowledge of firms' goals because we cannot know managers' utility functions. To be sure, some predictions may be possible owing simply to the presence of managerial discretion [1; 8; 10], or to the difficulties in enforcing efficiency when competition does not do it [9; 19; 20]. More specific yet very plausible managerial preferences for larger lifetime incomes [28], security [25], technical planning for survival and growth [16], more luxurious emoluments [39], and blends of specific goals [3], can also be used to derive implications. The sharpest * For separate financial support to each of us we are grateful to the Brookings Institution and to the National Science Foundation through Grant GS31400X to the Thomas Jefferson Center at the University of Virginia. implications still are derivable by concentrating on a single argument in the manager's utility function, and two goals in particular, sales maximization [5] and growth maximization [16; 25; 32], have been traced with the same singleminded pursuit that was confined for many years to the goal of profit. But even though some implications of these three goals-profit, sales, and growth-are mutually inconsistent [5, 100; 38], each goal can be confirmed by special cases, and we have no clear resolution that tells us what the firm's goal really is. While the search for an alternative to profit maximization as an explanation of large firms' behavior has been motivated by a desire for greater realism, it is surprising that such a small role has been given to the effects of risk. Practically all of the rigorous, and therefore usefully unambiguous, new models of the firm have adhered faithfully to the certainty framework. Yet it is obvious that real-world business firms must deal with risk and in doing so they may no longer have an all-consuming interest in profit (or expected profit) maximization. In a certainty world an effort to maximize the market value of a firm implies profit maximization, but in a risky world it does not.