Risk and Uncertainty

Business decisions are taken with reference to future, which is highly uncertain. Future
involves change. Changes many be known or known. Even known changes may be definite or
indefinite. Changes with definite results are known as Certainty. Changes with indefinite
results are known as Risk. Such risk can be estimated and can be insured.

Types of Risk:
1. Business Risk: Production, changes in tastes and preferences of customers, policies,
competitors, quality, price of the products of competitors, business cycles etc.,
2. Financial Risk: Profits, bad debts, changes of interest rates, insolvency
3. Portfolio Risk: These risks are insurable.

Measures for Reducing Risk:
1. I nternal Planning for Risk: cost reduction, waste management, optimum use of raw
materials.
2. External Planning for Risk: This is known as Risk Shifting. Getting insured with an
insurance company.

On the other hand, if changes are unknown, their outcome is indefinite and if the risk element
is incalculable and immeasurable, it is known as Uncertainty.

Types of Uncertainty: (i) Demand uncertainty (ii) Production uncertainty (iii) Profit
uncertainty (iv) Price uncertainty (v) Cost certainty (vi) Labour uncertainty (vi) Capital
uncertainty (viii) Environmental uncertainty.
Alternative Objectives of the firm:
(1) Profit Maximisation
(2) Sales Maximisation
(3) Increasing the market share
(4) Building good business reputation
(5) Financial Stability and liquidity
(6) Maintenance of good labour relations
(7) Job satisfaction
(8) Leisure and peace of mind
(9) Staff Maximisation
(10)Being a good employer.

Traditional Theory of the Firm

The firm in the traditional theory is conceived as an entrepreneur. The owners of the firm are
the entrepreneurs as well as managers. Hence, there is no dichotomy between the
shareholders and the management. The firm in the traditional theory pursues a single goal,
that of profit maximisation and this goal is a global rationality. The goal of the firm is
consistent with the goals of the members and thus the traditional theory postulates harmony
between individual members and groups of the firm and organisation itself. The traditional
theory recognises uncertainty as inherent in the business and the entrepreneur is rewarded for
bearing this uncertainty in the form of profits. Also the traditional theory attaches equal
importance to the long run as to the short run.
MANAGERIAL THEORIES OF FIRM
Three theories of Managerialism
1. Baumols Model of Sales Revenue maximisation.
2. Marriss Theory of Managerial Enterprise
3. Williamsons Theory of Managerial Discretion

Baumols Model of Sales Revenue Maximisation
W.J.Baumol suggested Sales Revenue maximisation as an alternative goal to profit
maximisation. Managers only ensure acceptable level of profit, pursuing a goal which
enhances their own utility. Management has been separated from ownership in modern times.
This has given powers to Managers who pursue their own goals rather than the goal of the
owners. Managers ensure a minimum acceptable level of profit to satisfy the shareholders, but
would pursue a goal which enhances their own utility.

Why Managers attempt to maximise sales rather than profits? Incomes of top executives are
closely related to sales rather than profits. Banks and financial institutions are impressed by
the amount of sales and treat this as a good indicator of the performance of the firm. Large
and continuing sales enhance prestige of the Managers, who ensure regular distribution of
dividends. A steady performance with satisfactory amount of profits is preferred to irregular
spectacular profits in some one or two years. Having shown high profits, if the level is not
maintained, it will lead to discontent of shareholders. Large sales strengthens the competitive
power of the firm vis-a-vis competitors, while low or declining sales diminishes this power of
bargaining.
Separation of ownership and management combined with the desire for steady performance
which ensures satisfactory profits, tend to make the managers risk avoiders . Top Managers
in the modern firm are generally reluctant to adopt highly promising but risk-prone projects.
But this approach stabilises the economic performance of the firm and leads to development
of orderly markets.

Basic assumptions in Baumols Static Models: A firms decision making is limited to a
single period. During this period, the firm attempts to maximise total revenue rather than
physical volume of sales. Sales revenue maximisation is subject to provision of minimum
required profit to ensure a fair dividend to shareholders, thus ensuring stability of his job.

In Corporate firms, there is structural division of ownership and management which allows
managers to set goals which do not necessarily conform with those of the owners. The
shareholders are the owners. Their utility function includes variables such as profits, size of
output, size of capital, market share and public image.

Marriss Theory of The Managerial Enterprise
The Managers have other ideas. Their utility function includes variables such as Salaries,
Job security, Power and status. The owners want to maximise their utility while the
managers attempt maximisation of their own utility. Both utilities do not necessarily clash,
because the most of the variables of both the utilities, have a strong relationship with a
single variable i.e., size of the firm. It is reasonable to assume that maximising the long-run
growth of any indicator is equivalent to maximising the long-run growth rate of the others.
Owners being interested in the growth of the firm, want maximisation of the growth of the
supply of capital, which is assumed to maximise the owners utility. Managers wanting to
maximise rate of growth of the firm rather than absolute size of the firm, believe that growth
of demand for the products is an appropriate indicator of the growth of the firm.

There are two constrains in the Marriss Model: 1. The Managerial Team Constraint. Since
Management is a teamwork, hiring new managers does not expand managerial capacity
immediately. New managers take time to get integrated in the team. Managerial team
constraint sets limits to both the rate of growth of demand and rate of growth of capital. 2. The
Job Security Constraint. Managers want job security. Job security attained by pursuing a
prudent financial policy which requires the three crucial financial ratios to be maintained at
optimum levels.

Policy variables in Marriss balanced growth model are as follows: 1. The firm has the
freedom to choose its financial policy, as it subjectively determines the three financial ratios,
liquidity ratio, leverage/debt ratio and retention ratio. 2. The firm can decide its diversification
rate, either by expanding the range of its products, or by merely effecting a change in the style
of its existing range of products. OR it can adopt the two policies simultaneously. 3. Price is
not a policy variable of the firm. It is a parameter. Price is taken as given by the oligopolistic
structure of the market. Production costs are also taken as given. 4. The firm has the freedom
to decide the level of it advertising and R&D. Since Price and Production Costs are given,
increase in advt. & R&D, will imply lower profit margin and vice-versa.
The rate of growth of demand for the products of the firm: The firm is assumed to grow by
diversification and not by merger or acquisition. The growth of demand for the products of
the firm depends on the rate of diversification and the proportion of successful new
products. The rate of growth of capital supply: The shareholders who are the owners, wish
to maximise company's capital, which is the measure of the size of the firm. The main
source of finance for the growth of the firm is profit but the management can retain only
part of it, for another part has to be distributed as dividend. The rate of growth of capital is
determined by three factors: the three financial ratios determined by the managers
constituting the financial security constraint, the average rate of profit, and the rate of
diversification.

WILLIAMSONS THEORY OF MANAGERIAL DISCRETION
Williamson is of the opinion that the managers of a modern business firm organised as a
corporate unit do not maximise the profits which result in the maximisation of the utility of
the owners. Instead they maximise their own utility using their discretion. However, for
their job security, managers attempt to ensure a certain minimum of profit to shareholders
in the form of dividends. Thus profit is a constraint to the managers discretion.