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Published online by Cambridge University Press: 17 August 2016
Alfred Marshall began the second of two chapters on the subject of profits and business power with the apologetic comment that “The causes that govern Earnings of Management have not been studied with any great care till within the last fifty years”. He had just completed his argument that, in the case of Joint-stock companies, “… most of the work of management is divided between salaried directors… and salaried managers and other subordinate officials, most of whom have little or no capital af any kind; and their earnings, being almost the pure earnings of labor, are governed in the long run by those general causes which rule the earnings of labor of equal difficulty and disagreeableness in ordinary occupations”. Furthermore, he suggested that, “The supply of business power is large and elastic, since the area from which it is drawn is wide. Everyone has the business of his own life to conduct; and in this he can gain some training for business management, if he has the natural aptitudes for it.
The authors are indebted to R. Joseph Monsen, Walter Y. Oi, and William F. Sharpe for encouragement and helpful comments, and to other members of the Informal Workshop Seminar in the Graduate School of Business Administration, University of Washington who attended the session in which an early draft of this paper was presented.
We, of course, assume full responsibility for all errors and opinions.
(1) Marshall, A., Principles of Economics, Eighth Edition, New York, The Macmillan Company, 1949, p. 609 Google Scholar.
(2) Ibid., p. 604Google Scholar.
(3) Ibid., p. 606Google Scholar.
(4) Ibid., p. 608Google Scholar.
(5) Ibid., p. 626Google Scholar.
(6) D. R. Roberts describes the measurement of marginal revenue productivity as follows: “So measured the executive’s marginal revenue product is the excess of the firm’s total profit under his direction over what it would be under the direction of the best alternative executive plus the amount which would have to be paid in order to secure the latter’s services. This amount is the upper limit which the firm would be willing to pay the executive. The lower limit of his compensation would be the sum which he could command in his next best employment. If there were: (1) competition on both sides of the executive market, and (2) a continuum of alternative jobs open to the executive and of executives available to the firm, the upper and lower limits would converge and the executive would receive a determinate amount of compensation equal to his marginal revenue product. Otherwise the limits would not converge and the executive’s compensation would be indeterminate between them.”
David, R. Roberts, General Theory of Executive Compensation Based on Statistically Tested Propositions, The Quarterly Journal of Economics, Vol, LXX, May, 1956, p. 290 Google Scholar.
(7) Joseph Monsen, R. and Anthony, Downs, A Theory of the Large Managerial Firm, Journal of Political Economy, Vol. LXXIII, June, 1965, pp. 221–236 CrossRefGoogle Scholar.
(8) Economists with a strong orientation in neo-classical theory have, for the most part, considered only the implications of the separation of ownership from control for the distribution of the firm’s “profits” among “managers”, “entrepreneurs,” and “owners.” It is generally assumed that whoever is in control of the firm will see to it that profits are maximized and then divided among those with various degrees of control (control in the sense that they have some power to acquire a share of the profits). As these discussions develop they sometimes revolve around the risk-taking function of “entrepreneurial” services and the extent to which it is appropriate to consider these to be “factors” of production. See, for example, Chapter XV on “Profits” in Stonier, A. W. and Hague, D.C., A Textbook of Economic Theory, London, Longmans Green and Company, 2nd ed., 1957 Google Scholar. Also see: Martin, Bronfenbrenner, A Reformulation of Naive Profit Theory, Southern Economic Journal, April, 1960, pp. 300–309 Google Scholar; reprinted in Readings in Microeconomics, William, Breit and Harold, M. Hochman, editors, New York, Holt, Rinehart and Winston, Inc. 1968 Google Scholar.
For other stimulating reading on the subject of executive salaries see: Simon, H. A., The Compensation of Executives, Sociometry, March 1957, pp. 32–35CrossRefGoogle Scholar; Thomas, Mayer, The Distribution of Ability and Earnings, Review of Economics and Statistics, Vol. XLII, May 1960, pp. 189–95Google Scholar; and Williamson, O. A., Hierarchical Control and Optimum Firm Size, Journal of Political Economy, April 1967, pp. 123–38Google Scholar.
(9) Since V 1 is fixed, this result can also be found by taking the derivative with respect to the other input.
(10) Of course, it may be that many production functions are not of the Cobb-Douglas form, so that only in some range of output does the phenomenon of increasing marginal productivity occur.
(11) Revenue maximization as the goal of managers of oligopoly firms has been suggested, of course, by Professor William Baumol, J. in his widely discussed book, Business Behavior, Value and Growth, Revised Edition, New York, Harcourt, Brace and World, Inc., 1967 Google Scholar.
(12) Suppose that the Cobb-Douglas function is not strictly of the form depicted but rather of the form:
Then the marginal productivity of management is:
Note that this expression is simply α/V 1 times X. Therefore,
M P v1 = α/V 1 · X.
If the manager decides to increase V 2, X must rise (so long as V 1 is fixed) and the marginal productivity of V 1 will increase. It is also evident that if the amount of managerial services, V 1, also increases when X is increased, MPV1 , will rise less rapidly than it will when V 1 is held constant as X increases.
(13) It is assumed that second derivatives are sufficiently small so that second-order conditions for a maximum are satisfied unconditionally.
(14) This can be shown by consideration of equation (7). Suppose initially that no profit bonus is paid. In this case equation (7) reverts to the previous salary maximizing equation (5). Now suppose that a small value for k is introduced so that a small portion of profit is paid in bonus to the manager. If initially the manager could maximize his salary by operating the firm at a rate of output less than that which would maximize profit, then the term dπ/dX must be positive. As k is increased from 0 to some small number, MR (as shown by equation (7)) must fall in value; i.e., the MR desired by the manager in order to maximize his salary will fall as profits bonus is increased; therefore the bonus induces the manager to increase the rate of output, a decision which moves the position of the firm closer to the profit maximizing rate of output. Just the reverse will happen if the initial salary maximization position of the firm is at a rate of output greater than that bringing maximum profits. In either case the larger the profit bonus the more closely the salary maximization rate of output approaches the profit maximization position.
(15) W. J. Baumol, op cit.
(16) The analysis here is couched in the realm of profit making firms. The analysis would apply as well to “non-profit” institutions and their managers.
(17) For empirical evidence that owner-controlled firms earn greater profits than management-controlled firms, see Monsen, R. J., John, S. Y. Chiu and Cooley, D. E., The Effect of Separation of Ownership and Control on Performance of the Large Firm, The Quarterly Journal of Economics Google Scholar, (forthcoming). For other evidence see, Kamerschen, D. K., The Influence of Ownership and Control on Profit Rates, American Economic Review, Vol. LVIII, June, 1968, pp. 432–447 Google Scholar.