The behavioural theories of the firm started developing in the early 1950s. Some of the seminal work may be traced in Simon’s article ‘A Behavioural Model of Rational Choice’, published in the Quarterly Journal of Economics in 1955.
The theory has subsequently been elaborated by Cyert and March, with whose names it has been connected to this day. The writers founded their theory on four case studies and two ‘laboratory’- experimental studies.
We will develop the model of Cyert and March in the following sequence:
1. The firm as a coalition of groups with conflicting interests.
2. Process of formation of demand-goals of the different groups within the firm.
3. Definition of the goals of the firm by the top management. Satisfying behaviour of the firm.
4. Means for the resolution of the conflicting demands and interests of the various groups of the firm-coalition.
5. The process of decision-making for the implementation of the goals set by the management.
6. The environment of the firm and the treatment of uncertainty in the behavioural theory.
7. A simple model of behaviourism.
8. Comparison of the behavioural theory with the traditional theory of the firm.
9. Summary and conclusions.
The Firm as a Coalition of Groups:
With Conflicting Goals:
The behavioural theory of the firm, as developed by Cyert and March, focuses on the decision-making process of the ‘large multiproduct firm under uncertainty in an imperfect market. Cyert and March deal with the large corporate managerial business in which ownership is divorced from management.
Their theory originated from the concern about the organisational problems which the internal structure of such firms creates and from the need to investigate their effect on the decision-making process in these large organisations. Such internal organisational factors may well explain the difference in the reactions of firms to the same external stimuli, that is, to the same change in their economic environment.
The assumptions underlying the behavioural theories about the complex nature of the firm introduces an element of realism into the theory of the firm. The firm is not treated as a single-goal single-decision unit, as in the traditional theory, but as a multi- goal, multi-decision organisational coalition. The firm is conceived as a coalition of different groups which are connected with its activity in various ways managers, workers, shareholders, customers, suppliers, bankers, tax inspectors and so on.
Each group has its own set of goals or demands. For example, workers want high wages, good pension schemes, good conditions of work. The managers want high salaries, power, prestige. The shareholders want high profits, growing capital and market size.
The customers want low prices and good quality and service. The suppliers want steady contracts for the materials they sell to the firm, and so on. The most important groups, however, within the framework of the behavioural theories are those most directly and actively connected with the firm, namely the managers, the workers and the shareholders. Our next step is to examine the process by which the demand-goals of the different groups are formed.
The Process of Goal-Formation:
The Concept of the ‘Aspiration Level’:
The behavioural theory recognizes explicitly that there exists a basic dichotomy in the firm. On the one side there are the individual members of the coalition-firm, and on the other side there is the organisation-coalition called ‘the firm’. The consequence of this dichotomy is a conflict of goals individuals may have (and usually have) different goals to those of the organisation-firm.
The purpose of the behavioural theory is to determine the key variables in the decision-making process in the firm. It is not interested in the goals of the firm as such, but rather in their origin and the decision process which leads to their formation.
Cyert and March argue that the goals of the firm depend on (are determined by) the demands of the members of the coalition, while the demands of these members are determined by various factors, such as the aspirations of the members, their success in the past in pursuing their demands (past achievement), their expectations, the achievements of other groups in the same or other firms, the information available to them and so on.
Each member or group of the coalition-firm has a multiplicity of demands on the organisation-firm, often conflicting with the demands of other members and with the overall goals of the firm. The demands of each group are too many and not all of them can be satisfied in any one period, given the limited amount of resources available to the firm. Thus, in any particular period the various members (or groups) present to the top management only a part of their demands, the ones that they consider as more important, while keeping the others for later periods.
The demands of the different groups are competing for the given resources of the firm, and there is a continuous conflict. Conflict is unavoidable in any coalition whose members compete for the given resources of the firm. The different groups bargain continuously to achieve their demands.
There is a strong relation between demands and past achievement. Demands take the form of aspiration levels. Demands change continuously, depending on past achievement and on changes in the firm and its environment. In any one period the demands which will actually be presented by any particular group to the top management depend on past achievement of demands previously pursued by the particular group, on the achievement of other groups in the same firm, on the achievement of similar groups in other firms, on past aspiration levels, on expectations, and on available information.
Cyert and March argue that the relationship between demands-aspirations and past achievement depends on actual and expected changes in the performance of the firm and changes in its environment: Firstly, in a ‘steady situation’, with no growth or dynamic changes in the environment, aspirations (demands) and past achievement tend to become equal. Secondly, in a dynamic situation with growth, aspiration levels (demands) lag behind achievement.
This time-lag is crucial to the behavioural theory. During this time lag the firm is able to accumulate ‘surpluses’ or ‘excess-profits’, which may be used as a means of resolution of the conflict in the firm and which act as a stabiliser of the firm’s activity in a changing environment. Thirdly, in a period of decline of the activity of the firm, demands are larger than past achievements, because the aspiration levels of the members of the coalition adjust downwards slowly.
This process of demand and aspiration-level formation renders the behavioural theory dynamic: the aspiration levels-demands at any time t depend on the previous history of the firm, that is, on previous levels of achievement and previous aspiration levels. In summary, the demands of the various groups of the coalition-firm change continuously over time. Given the resources of the firm in any one period, not all demands which confront the top management can be satisfied. Hence there is a continuous bargaining process between the various members of the coalition-firm and inevitable conflict.
The top management has several tasks to set the goals of the firm, which often are in conflict with the demands of the various groups; to resolve the conflict between the various groups; to reconcile as far as possible the conflict in goals of the firm and of its individual groups, to take decisions in order to implement the set goals.
Goals of the Firm: Satisficing Behaviour:
The goals of the firm are set ultimately by the top management.
There are five main goals of the firm:
(a) Production goal.
(b) Inventory goal.
(c) Sales goal.
(d) Share-of-the- market goal.
(e) Profit goal.
The production goal originates from the production department. The main goal of the production manager is the smooth running of the production process. Production should be distributed evenly over time, irrespective of possible seasonal fluctuations of demand, so as to avoid excess capacity and lay-off of workers at some periods, and overworking the plant and resorting to rush recruitment of workers at other times, with the consequence of higher costs, due to excess capacity and dismissal payments or too frequent breakdowns of machinery and wastes of raw materials in period of ‘rush’ production.
The inventory goal originates mainly from the inventory department, if such a department exists, or from the sales and production departments. The sales department wants an adequate stock of output for the customers, while the production department requires adequate stocks of raw materials and other items necessary for a smooth flow of the output process. The sales goal and possibly the share-of-the-market goal originate from the sales department. The same department will also normally set the ‘sales strategy,’ that is, decide on the advertising campaigns, the market research programmes, and so on.
The profit goal is set by the top management so as to satisfy the demands of share- holders and the expectations of bankers and other finance institutions; and also to create funds with which they can accomplish their own goals and projects, or satisfy the other goals of the firm. What we said earlier about the dynamic changes in the goals of individuals or groups, holds also for the goals of the firm these goals change over time depending on the past history of the firm (past aspiration levels relative to past attainments), as well as on the conditions of the external environment and on the changes of aspirations of groups within the organisation.
The number of goals of the firm may be increased, but the decision-making process becomes increasingly complex. The efficiency of decision-making decreases as the number of goals increases. The law of diminishing returns holds for managerial work as for all other types of labour. The goals of the firm are ultimately decided by the top management, through continuous bargaining between the groups of the coalition. In the process of goal formation the top management attempts to satisfy as many as possible of the demands with which it is confronted by the various members of the coalition.
Some of the above goals may be desirable to (and consequently acceptable by) all members of the coalition. For example, the sales goal is directly desirable to the sales manager and his department, to the top management and most probably to the shareholders. But this goal is also indirectly desirable to all the other members of the coalition, since all groups know that unless the firm sells whatever it produces no one will be able to attain his own individual goals.
Other goals are desirable to only some of the groups. For example, profits are the concern of the shareholders and the top management, but not of the employees in lower administrative levels or of the workers ‘on the floor.’ The conflicts arising in the process of goal-setting at the level of top management are resolved by various means which are examined in section IV below.
The goals of the firm, like the goals of the individual members or particular groups of the coalition, take the form of aspiration levels rather than strict maximising constraints. The firm in the behavioural theories seeks to satisfice, that is, to attain a ‘satisfactory’ overall performance, as defined by the set aspiration goals, rather than maximise profits, sales or other magnitudes. The firm is a satisficing organisation rather than a maximising entrepreneur.
The top management, responsible for the coordination of the activities of the various members of the firm, wishes to attain a ‘satisfactory’ level of production, to attain a ‘satisfactory’ share of the market, to earn a ‘satisfactory’ level of profit, to divert a ‘satisfactory’ percentage of their total receipts to research and development or to advertising, to acquire a ‘satisfactory’ public image, and so on. However, it is not clear in the behavioural theories what is a satisfactory and what is an unsatisfactory attainment.
Some objectives may even take the form of sheer wishful thinking, that is, they are unquantifiable goals, of a non-operational form; for example, the goal of ‘serving best the public’, or ‘keeping a good public image’, or ‘being progressive and pioneering’, and so on. Such goals do not necessarily lead to specific actions.
However, they may indirectly affect other goals in that they may lead to appointment of personnel or other policy commitments. What is important about such goals is that they may be used as an excuse by the top management for justifying particular projects or expenses, given that such goals are consistent with virtually any other set of goals of particular members or groups of the coalition.
Cyert and March argue that satisficing behaviour is rational given the limitations, internal and external, within which the operation of the firm is confined. Simon introduced the concept of ‘bounded rationality to justify the satisficing behaviour of the large corporate firms. The goals, irrespective of where they originate, are finally decided by the top management and approved, normally, by the board of directors.
They take the form of aspiration levels, and, if attained, the performance of the firm is considered as “satisfactory”. The goals-targets do not normally take the form of maximisation of the relevant magnitudes. The firm is not a maximising but rather a satisficing organisation.
This behaviour is characterised by Simon. As a behaviour of ‘limited’ or ‘bounded’ rationality, as opposed to ‘global’ rationality of the entrepreneur-firm of the traditional theory. Traditional theory conceived of the entrepreneur as a person with unlimited and costless information, unlimited computational ability and with unlimited time at his disposal.
Such a rational entrepreneur could afford the luxury of pursuing maximisation of his profit by comparing diligently all possible alternative actions facing him at any one time. ‘Global’ rationality implies that the firm has a clearly defined ordering of preferences for the various goals, each of which has been set after the scrutiny of all possible alternatives, and has been assigned a definite weight, possibly in terms of probabilities.
The behavioural theory recognizes explicitly the fact that in the modern real world the entrepreneurial work is executed by the group of top management. These are people with limited time at their disposal, have limited and imperfect information and limited computational ability. Hence it is impossible for them to examine all possible alternatives open to them and choose the one that maximises profits (or anything else). Instead they examine only a small number of alternatives and choose the ‘best’ given their limited time, information and computational abilities. Thus the top management (the firm) acts with ‘bounded’ rationality.
It should be obvious that the behaviourists redefine rationality. Traditional theory defined the rational firm as the firm that maximises profit (short-run and long-run). The behaviourist school is the only theory that postulates a satisficing behaviour of the firm, which is rationed given the limited information and limited computational abilities of the managers.
Uncertainty and the Environment of the Firm:
Cyert and Match-distinguish two types of uncertainty: market uncertainty and uncertainty of competitors’ reactions. Market uncertainty refers to possible changes in customers’ preferences or changes in the techniques of production. This form of uncertainty is inherent in any market structure. It can partly be avoided by search activity and information-gathering, but it cannot be avoided completely. Given the market uncertainty the managerial firm avoids long-term planning and works within a short time-horizon. The behavioural theory postulates that the firm considers only the short-run and chooses to ignore the long-run consequences of short-run decisions.
The uncertainty arising from competitors’ actions and reactions, that is, from oligopolistic interdependence, is brushed aside by this theory by assuming that existing firms have arrived at some form of tacit collusion. The various forms of trade associations, clubs and the issue of various ‘informative’ bulletins or other publications provide a means by which firms give out information concerning their prices or future outlays of various kinds, expecting every other competitor to do the same.
This sort of modus vivendi is called a ‘negotiated environment’ by Cyert and March. The firm is assumed to ‘negotiate’ in some way or another with its competitors so as to avoid uncertainty. Thus the core problem of oligopolistic markets that of competitors’ interdependence, is ‘solved’ by assuming collusive action of the firms.
In general the theory pays too little attention to the environment and its effect on the goal-formation process and the pricing and output decisions at the level of top management. It examines internal resource allocation, assuming collusion with competitors. It says nothing about the threat of potential entry which is crucial in the present world of mergers and continuous diversification.
The environment is taken as given and as such is practically ignored in the analysis of the behaviour of the firm. This ignoring of the environment is apparent in the model that follows, which is used by Cyert and March as an illustration of the workings of their theory. The rules by which demand and costs are estimated, the rules for investment decisions and other crucial steps in the analysis are too mechanical.
The decision process as presented by this theory has very serious implications for resource allocation in the firms and in the economy as a whole. The short-run horizon postulated in one part of the theory is incompatible with investment decisions, which by their nature involve long-run considerations and hence must take into account expected future demand and competitors’ reactions.
A Simple Model of Behaviourism:
Here we briefly present the simple model used by Cyert and March as an illustration of the decision-making process within the modern large corporation. The model refers to the case of a duopoly. The decision process involves the determination of the output which is homogeneous, so that a single price will ultimately prevail in the market. Of course, each firm, in deciding its output automatically induces price changes in the market. However, when both firms finally decide their outputs, price will be determined by the market. No changes in inventories are allowed in this model.
The steps may be outlined as follows (K. J. Cohen and R. M. Cyert, Theory of the Firm, Prentice-Hall, 1965):
1. Forecast of Competitors’ Reactions:
The forecast is basically a straightforward extrapolation of the past observed reactions of competitors.
2. Forecast of Firm’s Demand:
This is based on an estimate of the demand function from past observations. Future demand is thus an extrapolation of the past sales of the firm.
3. Estimation of Costs:
The cost in the current period is assumed to be the same as in the past period. However, if the profit goal has been achieved over the past two periods, average unit costs are increased by a certain percentage to allow for slack payments.
4. Specification of Goals of the Firm:
These are aspiration levels. In this model profit is the only goal of the firm. The aspiration level of profits is some average of the profits of past periods.
5. Evaluation of Results by Comparing Them to the Goals:
From the information obtained in steps 1-3 we obtain a solution, i.e. an estimate of the level of output, price, cost and profits. These are compared to the target level of profits. If the goals are satisfied by this solution the firm adopts it. If the profit and other goals are not achieved the firm proceeds to step 6.
6. If Goals are Not Attained the Firm Re-Examines the Estimate of its Costs:
Re-examination starts with costs because this variable is under the direct control of the firm. It usually involves a cut in slack and other expenses.
7. Evaluation of the New Solution by comparing it to Goals:
If the new solution with the downward-adjusted costs leads to the target profits it is adopted. If not, the firm proceeds to step 8.
8. If Goals are Not Attained the Firm Re-Examines the Estimate of its Demand:
The re-examination consists in considering possible changes in the sales strategy (more market research, more advertising, more salesmen, etc). The result is an upward adjustment of the initial estimate of demand.
9. Evaluation of the New Solution by comparing it to Goals:
If the new solution with the revised costs and demand estimates attains the target profits, it is adopted. If not, the firm proceeds to step 10.
10. If Goals are not met the Firm Readjusts Downwards its Aspiration Levels:
If with the revision of costs (in step 6) and of demand (in step 9) the goals are not attainable, the firm readjusts downwards its aspiration levels. The firm has multiple goals (although only one explicitly appears in the above model), which take the form of aspiration levels the firm is a satisfice rather than a maximiser. The goals change over time depending on past attainments, aspirations, demands of groups, and expectations. The criterion of choice for goal-setting is that the alternative selected meets the demands (goals) of the coalition.
The firm adopts the procedure of sequential consideration of alternatives. The first satisfactory alternative evoked is accepted. Where an existing policy satisfies the goals there is little search for alternatives. When failure occurs search is intensified.
The organisation seeks to avoid uncertainty. The market-originated uncertainty is avoided by undertaking information searches, by avoiding long-term planning, by following ‘regular procedures’ and a policy of reacting to feedback information rather than of forecasting the environment. The competitor-originated uncertainty is avoided by creating a ‘negotiated’ environment, that is, by some sort of collusive behaviour.
The organisation uses standard operating procedures such as task-performance rules, continuous records and reports, information-building rules, planning devices, budgeting, investment planning, and longer-run planning. It also uses ‘blue-print’ rules-of-thumb (on-costing pricing rules, slack-absorbed-in-cost rules, equipment- expansion rules). But the operating procedures and ‘blue-print’ rules aim at implementing the goals, that is, helping the lower hierarchical levels to act in a way which is consistent with the goals set by the top management.
On the above-outlined process of decision-making we note the following:
Firstly, the ‘forecasts’ of competitors’ reactions and of the demand are really an extrapolation of past experience. No allowance is made for future uncertainty.
Secondly, the estimates of costs and the rules for their upward or downward adjustment are mechanical and do not show the implications of such adjustments. Readjusting costs without looking at the cost structure of competitors, actual and potential, is too short-sighted a policy.
Thirdly, there is an implication for investment decisions which is not shown in the above outline. Investment decisions are connected with costs and with the degree of utilization of the equipment. Regarding costs, it is assumed that the average direct cost is constant when the plant is used at between 10 per cent and 90 per cent of full capacity. (This implies that the average variable cost curve has a flat stretch over the 10 per cent to the 90 per cent range of the plant capacity.)The decision rule with regard to investment runs as follows if over three consecutive periods the plant is used to its full capacity, investment should increase by 20 per cent.
Again this rule has dangerous implications for resource allocation. If the firm extrapolates in the future its past performance, without considering possible changes in the environment in the future, serious misallocations may occur. Unless the equipment is short-lived any mechanical rules for investment decisions which do not take into consideration the future are ‘irrational’ from the point of view of the firm, no matter what its goals are, and most probably wasteful for the economy as a whole, given the now rapid rate of technological progress.
Fourthly, the adjustment of the aspiration levels, if all other adjustments of costs and demand forecasts fail, is perhaps the most serious defect of the theory. The postulate of ‘satisficing behaviour’ loses its meaning, since almost any performance, by continuous downward readjustment of goals, can be considered as ‘satisfactory’.
The behaviourist school postulates that by the downward revision of the goals to lower ‘satisficing’ levels whenever the initial targets are not attained ‘the firm does the best under the circumstances’. Surely this behaviour renders any judgement on the performance of the firm impossible, since the ‘satisficing’ criterion changes continuously, thus becoming non-operational.
The behavioural theory has contributed to the development of the theory of the firm in several respects. Its main contributions are: firstly, the insight into the process of goal-formation and the internal resource allocation, and secondly, the systematic analysis of the stabilizing role of ‘slack’ on the activity of the firm.
The behavioural theory deals with the allocation of resources within the firm, and the decision-making processes, an aspect neglected in the traditional theory. In the latter the firm was assumed to react to the all-powerful environment. The behaviourist school assumes that the firm has some discretion, and does not necessarily take the constraints of the environment as definite and impossible to change.
The traditional theory stressed the role of the market (price) mechanism for the allocation of resources between the various sectors of the economy, while the behavioural theory examines the mechanism of the resource allocation within the firm. Clearly the two theories are complementary rather than substitutes. Actually various theorists have attempted to incorporate the behavioural aspects of Cyert and March’s theory into their own models.
Cyert and March’s definition of ‘slack’ shows that this concept is equivalent to the ‘economic rent’ of factors of production of the traditional theory of the firm. The contribution of the behavioural school lies in the analysis of the stabilising role of ‘slack’ on the activity of the firm. Changes in slack payments in periods of booming and depressed business enable the firm to maintain its aspiration levels despite the changing environment.
It should be pointed out that Cyert and March deal only with one form of slack, the managerial slack. Slack payments accruing to other members of the firm-coalition and their short-run and long-run implications for the performance of the firm are not examined. The behavioural theory has, however, serious shortcomings.
The behavioural theories basically provide a simulation approach to the complexity of the mechanism of the modern multigoal, multiproduct corporation. Simulation, however, is a predictive technique. It does not explain the behaviour of the firm; it predicts the behaviour without providing an explanation of any particular action of the firm.
The behavioural theories do not deal with industry equilibrium. They do not explain the interdependence and interaction of firms, nor the way in which the interrelationship of firms leads to an equilibrium of output and price at the industry level. Thus the conditions for the attainment of a stable equilibrium in the industry are not determined. No account is given of conditions of entry or of the effects on the behaviour of established firms of a threat by potential entrants.
The behavioural theory, although dealing realistically with the search activity of the firm (in the sense that search is considered as problem-oriented), cannot explain the dynamic aspects of invention and innovation, which are by their nature long-run activities with long-run implications.
The ‘plasticity’ (readjustment) of the aspiration levels downwards whenever the set targets are not attained deprives the theory of objective criteria for the evaluation of ‘satisfactory’ performance. To judge whether the performance of a firm is satisfactory one should have a ‘constant measuring-rod’, that is, a well-defined set of (long-run) goals. If goals are readjusted downward whenever their attainment has not been achieved, how are we to judge the performance of the firm? The ‘measuring-rod’ behaves like an elastic ruler that stretches and shrinks, depending on the attainment or not of the aspiration (goals) initially set.
No exact predictions can be derived from the postulates of the behavioural theory. The acceptance of satisficing behaviour renders practically the theory into a tautological structure: whatever the firms are observed to do can be rationalized on the lines of satisficing.
The behavioural theory implies a short-sighted behaviour of firms. Surely the uncertainty of the market cannot be avoided by short-term planning. Most decisions require a long-term view of the environment.
The behavioural theory resolves the chore problem of oligopolistic interdependence by accepting tacit collusion of the firms in the industry. This solution is unstable, especially when entry takes place, a situation brushed aside by the behavioural theorists. Cyert and March based their theory on four actual case studies and two experimental studies conducted with hypothetical firms.
It is obvious that the theory is founded on too few case studies for it to be possible to show that it has the generality appropriate to a theory of the firm. However, the part that describes the decision-making process and the allocation of resources in large complex organisations could be incorporated in, and hence enrich, other theories of the firm.