Decision Making in Marketing and Finance

An Interdisciplinary Approach to Solving Complex Organizational Problems

P. Koku

• Publisher: Palgrave Macmillan
• Year: 2014
• Print ISBN: 9781137379474
• eBook ISBN: 9781137444776
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

As interest in MBA programs and business schools more generally continues to grow, it is essential that teachers and students analyse their established strategy for decision making. The successful use of case studies in business schools shows the superior outcomes of an interdisciplinary approach to problem solving. Disappointingly, functional departmental silos within universities still exist and keep problem solvers from seeing all the effects of a given issue. In addition to providing teaching material, Decision Making in Marketing and Finance provides motives and strategies to break down functional silos in making informed and effective business and finance decisions. Koku achieves his goal by showing how value can be created for shareholders and other stakeholders, linking marketing and finance decision making, and providing much-needed teaching materials for an interdisciplinary approach to case analysis.

CHAPTER 1

Theory of the Firm

There is a fable in many cultures of what an elephant looks like to six blind men. The first of the six men who felt the elephant’s tail with his fingers described the elephant to be as thin as a rope or a snake. The second man who felt the elephant’s leg described the elephant like a huge pillar. The third man who felt the elephant’s tusk said the elephant was like a pipe. To the fourth man who felt the animal’s belly, the elephant was like a wall. To the fifth who felt the elephant’s ear, it was like a hand fan, and to the sixth man who felt the elephant’s trunk, the animal was like a tree branch.

While the origin of this story cannot be determined, it reminds us of the various definitions of the firm. It also, in a very practical way, demonstrates the imports of the bounded rationality theory. Our understanding and knowledge of a phenomenon at any time, say t2, could be completely different and perhaps even superior to the one at time t1 because of availability of new and perhaps superior information at a later time (t2); and so is our understanding of the firm. A note of caution, while the “firm,” a “corporation,” and an “organization” could have different meanings, in this chapter, we use the terms interchangeably in a generic sense to mean the same thing—the firm.

Corporations occupy a very special place in every modern economy regardless of whether the economy is characterized as an advanced, a newly developed, or a developing economy. Indeed, the contemporary firm can be referred to as the nucleus of a country’s economic engine and therefore deserving of special attention. The concept of the firm is not new even though it has, over the years, undergone several refinements. The fact that very few post-1937 academic discussions on the firm are held without any reference to Coase’s (1937) work on the nature of the firm is a testament to his insightful contribution to the theory. As alluded to by Coase, many macroeconomic analyses unintentionally but erroneously begin with an “industry” as the starting point because the concept of the firm, though not new, had not been clearly defined by economists. So what is the firm?

The importance of the firm as well as the brilliance in its “invention” can be appreciated when observed through the chain of changes that it has brought to the marketplace. First is the logic of specialization of labor. With specialization of labor, individuals get to work at or “produce” what they can do best. So an individual A who is good at putting together automobiles may become a mechanic while individual B who is good at tilling land and tending to animals may become a farmer of some sort. Similarly, some individuals may choose to become accountants or lawyers while others may become doctors or marketing specialists.

Besides the intrinsic satisfaction that goes with doing what one enjoys best, specialization of labor also implicates several other issues. For example, with specialization comes cost advantage and high efficiency. Consumers enjoy lower costs when specialization occurs because there is less wastage in terms of material and time during production. However, if everyone specializes in what they do best, then how can one get the other things that one needs but cannot produce? To answer this question, we must introduce the concept of exchange or trade. So, one can argue that specialization necessitates exchange, which also comes with its own problems. For example, how much of product C should one exchange for product D? Economists refer to this problem as a problem of finding a unit of account or a numeraire, which for the sake of simplicity we will refer to here as the problem of “value.” So, in other words, how is C valued against D? However, there is another problem besides that of value.

Imagine the number of exchanges one has to make in order to get through the day. The mechanic may not just need to find a farmer who is willing to exchange food for his services, but also a carpenter, and perhaps teachers for his children and a doctor for his wife. The nature of the problem becomes easily evident. These bilateral exchanges come with enormous costs; for example, finding someone to exchange products/services with. If the mechanic spends all day looking for individuals to exchange services with, he will not have the time to work as a mechanic, and then, of course, he will have nothing to exchange.

The invention of money solved a major part of the problem; however, unresolved issues remained. For example, how does the farmer know how much to produce so that his produce does not go waste, and how does he ensure that he gets the best price for his produce? Most economists before Coase (1937) assigned this problem and others like it to the market forces in a free market economy. However, as pointed out by Coase, the price mechanism or market forces do not always clear the market at the lowest cost. In other words, there are costs associated with the price mechanism’s clearance of the market. Coase referred to these costs as “transaction costs.” It can therefore be argued that the firm is an additional mechanism that facilitates clearance of the market in a more efficient manner. But how does the firm accomplish this? We will discuss this later when we discuss features of the firm. In the meantime, we should discuss a few other noteworthy definitions of the firm.

Other Definitions and Objectives of the Firm

Coase (1937) was not alone in grappling with a realistic definition for the firm. It is noteworthy that in trying to come to a realistic definition of the firm, Coase reverted to the two canons established by Professor Robinson (1932) in making assumptions. According to Professor Robinson, first, assumptions must be tractable; second, they must be realistic. Using these assumptions, Coase’s discussion on the firm intended, as he put it, to “bridge what appears to be a gap in economic theory between the assumption (made for some other purposes) that resources are allocated by means of the price mechanism and the assumption (made for other purposes) that this allocation is dependent on the entrepreneur-coordinator” (p. 389).

Behavioral Theory

Consistent with the canons used by Coase (1937), that is, making assumptions tractable and realistic, several other scholars including Simon, March, and Cyert (Simon, 1955, 1964; March and Simon, 1958; Cyert and March, 1963) proposed new definitions of the firm that draw on the theories of human behavior and are different from those of neoclassical economists. According to these scholars, firms have not been created solely by the “entrepreneur-coordinator,” but instead emerge from coalitions and subcoalitions of individuals and groups such as managers, employees, shareholders, and lawmakers. This definition sets the groundwork for one of the most debated points between neoclassical economists and organizational theorists on the role of the firm.

It should come as no surprise (using Cyert and March’s (1963) definition of the firm) that all the different coalitions and subcoalitions of the firm have different objectives that may be in conflict and impose different constraints on the firm. According to this school of thought, the firm’s realistic objective therefore cannot be the maximization of shareholders’ profit since shareholders are only a part of the larger coalition or subcoalition. Furthermore, according to Simon (1964), because of computational limitations and the lack of perfect information, managers can only “satisfice” instead of maximize firm objectives.

To put things in context, it must be understood that up to this point in time, the neoclassical viewpoint of the firm—that the primary objective of the firm was to maximize its profits—still prevailed. This view was clearly articulated by Friedman (1962) as follows:

The view has been gaining widespread acceptance that corporate officials and labor leaders have a “social responsibility” that goes beyond serving the interest of their stockholders or their members. This view shows a fundamental misconception of the character and nature of a free economy. In such an economy, there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud. (p. 133)

Friedman’s more poignant indictment of corporate social responsibility, which was cited by Carroll (1999, p. 277), states, “Few trends could so thoroughly undermine the very foundations of free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible” (see also Friedman, 1970). It would appear that in Friedman’s world the managerial discretions that lead to expenditures on corporate social responsibility activities are simply the result of agency problems (Lee, 2007), which will be discussed in detail later in this book.

Pfeffer and Salancik’s (1978) definition of the firm contains elements similar to that of Cyert and March (1963). As in Cyert and March, Pfeffer and Salancik define the firm as a “coalition of interests.” These interests can be divided into two main factions, the internal and the external. The “internal” faction comprises union, managers, and the like, while the “external” faction consists of suppliers, regulators, legislators, environmentalists, and a pool of potential talents (potential employees). Because every firm generally intends to exist forever (an assumption that arguably formed the basis for accrual accounting, i.e., accounts receivable and accounts payable), the ability of the firm to draw resources as well as support from the external environment is important.

Thus, firms negotiate with their external environments to ensure and facilitate their survival. Part of “negotiating” with the external environments involves taking steps to win the support of the community in which the firm exists. Some of these activities include donating in cash or kind to the community food bank to feed the homeless, buying sporting uniforms for the local little league, and the like. Activities such as these, of course, make many scholars question the objective of corporate social responsibility activities. Some wonder if the practice is not merely a public relations ploy designed to facilitate the attainment of resources for the firm and ensure its survival or a genuine recognition on the part of the firm that it needs to “legitimize” its existence by being a “citizen” of a community.

Modern Finance Theory

The usage of modern finance theory has also dramatically changed the definition of the firm. Differing from the neoclassical theory of the firm as a value maximizing entity, Fama and Miller (1972) have argued that firms exist over several periods, if not in perpetuity, instead of a single period. Furthermore, as a part of ensuring that they remain profitable and/or exist in perpetuity, firms frequently take on new projects and eliminate nonprofitable ones. Engaging in this process changes their risk levels; thus, it is not quite accurate to assume that the objective of firms is to maximize their value. Rather, the more accurate description of the objective of the firm under the modern theory of the firm, according to Fama and Miller, is to maximize the firm’s present value. This objective/definition of the firm is different from the previous in two ways. First, it integrates into the definition of the firm the concept of present value of the firm’s shares. This step is an implicit recognition that owners of the firm do hold ownership of the firm by holding shares. Second, the definition also integrates the methods of estimating riskiness of projects, which not only make up the firm, but also determine its value.

Jensen and Meckling (1976) provide a new definition of the firm that focuses on the ownership structure of firms. The authors reechoed Coase’s (1937) observation that economists have failed to clearly define the firm; instead, what economists generally refer to as the theory of the firm is actually “a theory of markets in which firms are important actors.” Jensen and Meckling reviewed the definitions of the firm provided by previous authors and concluded,

Organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals. This includes firms, non-profit institutions such as universities, hospitals and foundations, mutual organizations such as savings banks and insurance companies and co-operatives, some private clubs, and even government bodies such as cities, states and Federal governments, government enterprises such as TVA, the Post Office, transit systems, etc. (p. 310)

Jensen and Meckling (1976) arrived at a new theory of the firm by integrating the three main theories: the theory of property rights, which was implicit in Coase’s view of the firm as a network of contracts; agency theory, which was also referred to by Coase when he discussed the conditions that could arise when the “entrepreneur-coordinator” hires someone else to manage the firm; and the theory of finance.

Because of agency problems, previous commentators on the “firm” including Adam Smith (1776) have attributed certain amount of inefficiencies to the arrangements that involve separation of owners from managers. In the words of Adam Smith (The Wealth of Nations, p. 700) cited by Jensen and Meckling (1976),

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. (p. 305)

However, Jensen and Meckling (1976) characterized some of the problems with previous definitions of the firm as “special cases” of the theory of agency relationships and identified the components of agency costs as (a) monitoring costs incurred by the principal, (b) the bonding costs incurred by the agent, and (c) the residual loss. Assuming that a firm can issue only stocks and bonds, Jensen and Meckling examined how the principal and agent could arrive at an equilibrium contractual form given each party’s incentive to maximize his utility.

On property rights, the authors observed that the finer issues of the specification of individual rights are aspects of property rights that are critical for the definition of the firm. Such is the case, they argued, because individual rights determine the nature of contracts between individuals and organizations. They also determine the costs and rewards among people within organizations. Because firms are made up of a network of contracts with individuals that at times have conflicting objectives, firms often behave like markets in bringing the conflicting demands into equilibrium; thus, it would be misleading to personalize the firm in references such as its “objective functions” or its “social responsibility.”

Notwithstanding the above insights, Fama (1980) in explaining the nature of the firm suggests that the firm in which ownership is separated from management, despite the agency problems, functions much better than acknowledged by several commentators. He suggests that concerns over the seriousness of agency problems and the managerial propensity to shirk might be misplaced. In arriving at this conclusion, Fama also acknowledges the fact that to survive and thrive organizations need different expertise and different resources. The firm therefore acquires these resources in order to pursue the purpose for which it has been put together. Using the theory of property rights, Fama also argues along the lines of other economists such as Coase (1937), Alchian and Demsetz (1972), and Jensen and M...

Table of contents

• Cover
• Title
• Chapter 1 Theory of the Firm
• Chapter 2 The Customer Lifetime Value
• Chapter 3 Strategic Marketing Plan
• Chapter 4 Signaling in Finance and Marketing
• Chapter 5 New-Product Introduction
• Chapter 6 Sales Force Compensation and Management
• Chapter 7 Marketing Communication
• Chapter 8 Advertising
• Chapter 9 Pricing and Sales Promotion
• Chapter 10 Marketing Mistakes and Their Impact on the Firm
• Appendix 1 Cases
• Name Index
• Subject Index