ation as in the case of the oil companies, or for investment. Currently, the Department of Justice can give permission for some of their activities through Business Review Clearance. In addition, there are exemptions to antitrust legislation possible in the Defense Production Act and the Energy Act. A Business Review Clearance still leaves the corporation liable to action by private litigants whereas exemption under the two acts does not.

These methods for achieving the type of flexibility I am calling for are fine, but they are too limited. We must in the future that is facing us allow a large number of options for creative management. We need those options for effective solving of the problems that now face us, and that will face us, because these problems are and will be international in scope. We need to put greater value on the economies we now sacrifice in the name of antitrust for the supposed increase of competition.

As we move in this direction, which I would describe as competition on a worldwide basis rather than merely domestic competition, it is important to note that we lose the control aspects of competition. To retain discipline of competition that pushes for lower prices, higher quality-the consumerism aspect of competition-we must rely increasingly on the ability of businessmen to behave like statesmen. In taking this position I find myself increasingly pushed intellectually to a position taken by Edwin Nourse who was the first head of the Council on Economic Advisers. In a book written in 1938, he said, "The greatest promise of realizing the economic progress of which our people are capable is through free action of far-seeing executives. . . . If we expect satisfactory results from the run of business executives, it means, of course, that they must retain their character as true enterpriser and not look upon their business as a device for stock jobbing, or as a means of making a short-run killing on which to retire or a short-run reputation on which to market their services elsewhere. Neither may they seek the comfort of non-competitive understanding with other companies." That description is essentially the one I would use to describe the behavior of a business statesmen.

We live in a period of growing criticism of the corporate form and we live under rules that make it difficult for corporations to act in the public interest because to do so requires action in concert. We need to find a form so that business executives acting together can function as good citizens attempting to solve problems without being subject to antitrust violation. I am convinced that increasingly as the population shows signs of rejecting big government that they will turn to business. I would close by quoting the final paragraph from Nourse's book. Though almost forty years old it is completely relevant for today.

"If the American business man demands the right of freedom of economic enterprise, society in granting it to him may properly ask that he use that freedom aggressively in the public interest. This, to our way of thinking, is the challenge which the industrial system makes to the industrial executive. If he cannot meet it, the system of free enterprise under private capitalism is doomed to a condition of invalidism, low vitality, and unproductiveness which is utterly incompatible with the natural resources, productive equipment, and man power which the nation has at its disposal."

The kinds of restrictions on corporate behavior that are recommended by many of the critics will likely be devastating to the system or relative economic freedom we enjoy. If economic freedom disappears will political freedom be far behind?

APPENDIX

CAPITAL ALLOCATION WITHIN A FIRM*

(By R. M. Cyert, M. H. DeGroot, and C. A. Holt, Carnegie-Mellon University) In previous papers we have attempted to demonstrate the usefulness of Bayesian analysis in economic models. Most of the models that have been devel

*This research was supported in part by the National Science Foundation under Grant SOC 74-02071-A01. Magdalena Müller typed the manuscript. The empirical material for this article has been gathered by R. M. Cyert in his capacity as a member of the board of directors of a number of different firms of varying size over the last five years. We have attempted to generalize these observations in the article.

1 The following articles by R. M. Cyert and M. H. DeGroot are relevant: (a) "Multiperiod decision models with alternating choice as a solution to the duopoly problem. "Quarterly Journal of Economics, Vol. 84, Aug., 1970, pp. 410-29.

(b) "Bayesian analysis and duopoly theory," Journal of Political Economy, Vol. 78, Sept./Oct., 1970, pp. 1168-84.

(c) "An analysis of cooperation and learning in a duopoly context," American Economic Review, Vol. 63, March, 1973, pp. 24-37.

oped relate to decision-making situations in which a firm is dealing with its external environment, particularly with its competitors. This paper moves to analysis of decision making within the firm. More specifically, the paper is concerned with the decisions involving the allocation of resources for capital expenditures by the firm. These decisions determine the total amount of resources that a firm allocates to capital expenditures as well as the amounts it allocates to individual divisions.

Our discussion will focus on the determination of capital expenditures in large, multidivisional firms. Capital expenditures include (i) the replacement of fixed assets, buildings, and equipment; (ii) the acquisition of other firms; (iii) the acquisition of new capital which is directly related to the production process; and (iv) the purchase of some items which are not directly related to the production process but which are large enough to warrant capitalization rather than expensing. For example, the purchase of snow removal equipment or the construction of a new parking lot for employees might fit into the last category. This description is not meant to be complete, but rather to serve as a reference point for our discussion.

The type of firm we have in mind is a large, decentralized organization in which each division is a profit center. The manager responsible for each division is judged by his division's contribution to the firm's total profit. The firm operates in a number of markets, and each division is in a different, though related, industry. The markets are generally oligopolistic, and the firm's market share will be different in each market. These elements characterize most of the firms in the Fortune 500.

The structure of the allocation process

The actual allocation process of the firm has generally been ignored by economists in the belief that external market considerations dominate internal decisions. Market considerations are clearly important but so is an understanding of the internal process as we shall attempt to demonstrate.

The approval process for capital allocation requests outside the division is usually a two-step process. For requests greater than the amount which the division manager can approve, but less than the amount required for approval by the board of directors, a capital allocation committee is formed within the firm. This committee includes the major operating officers at the central office, such as the chief financial officer, the president, sometimes legal counsel, some group vice presidents, and others at a similar level. Particular details may vary from firm to firm, but the basic procedure described here is generally followed. The division manager, a central committee, and the board of directors are the three sources of approval, depending upon the size of the capital appropriation request.

Each request to the capital allocation committee must contain an analysis of the proposed investment. Except for those requests that are for the purchase of items in category (iv), each one must meet the firm's criterion for investment. This criterion is usually stated in terms of a minimum rate of return on investment before taxes. A large number of firms in a variety of industries use a return of 25% before taxes as the minimum. The person or division making the request usually must give estimates of future revenue, costs, and profits for a period of years, frequently five. Where such estimates are used, the estimated return on investment for the fifth year must meet the criterion. An investment may be funded if it has strong prospects for the future even though the rate of return might be estimated to be below the minimum in the early years.

In the capital budgeting literature, the firm is often advised to determine the internal rate of return on each possible investment. Then prospective investments are to be ranked on the basis of their internal rates of return. The firm is supposed to approve each investment that has a rate of return greater than its cost of capital. This procedure is a formal, normative one as viewed from outside the firm.

In fact, however, the firm does not and cannot operate this way. Proposals come in from the divisions in a non-systematic pattern. The committee or the board,

2 A notable exception to this statement is Joseph L. Bower, Managing the Resource Allocation Process (Boston: Harvard Graduate School of Business Administration, 1970). This book contains a careful study of the allocation of resources to capital expenditures within a firm.

3 Cf. Joel Dean, Capital Budgeting (New York: Columbia University Press, 1951). See also a more recent book by the same author: Managerial Economics (Englewood Cliffs, N.J.: Prentice Hall, Inc., 1967).

depending on the size of the proposal, approves or disapproves the proposal at its regular meeting. Each proposal is dealt with on its own merits in the order in which it is submitted, so rankings and direct comparisons of projects are

rare.

In addition, the normative process as outlined may not be appropriate when there are significant uncertainties. For example, there are many risks involved in estimating revenue. The total amount of sales stemming from a proposed project is uncertain. Sales revenue will depend upon many things, including the status of the economy. The usual approach is to extrapolate in a linear fashion from the data of past periods. This approach may be modified when some synergistic factor justifies anticipating a jump in revenue. Often, there is no attempt to use notions of probability or to try to formulate estimates in a statistically justifiable manner. The basic reason for this approach is that it is believed the uncertainty is so great that good estimates are a matter of personal judgment. There is also a concern that sophisticated techniques will not be understood by the directors or the committee and, thus, the estimates might not be accepted. There may be an additional source of uncertainty from the allocation committee's point of view: estimates which are reported to the committee must be evaluated. Given the desire for capital and the advantage of first-hand knowledge, there may be a tendency for the division to bias its estimates upward to guarantee approval. For example, the division management will know where there are uncertainties in the estimates but it could suppress this information rather than pass it on to the committee. This phenomenon is known as uncertainty absorption.* If the project involves a demonstration of cost savings, it is also possible to bias the information in a manner favorable to the project. For example, Cyert, Simon, and Trow studied a decision a firm was making on buying a computer. They comment, "The narrative raises, but does not answer, the question of how choices are made in the face of these incommensurabilities and the degree to which tangible considerations are overemphasized or underemphasized as compared with intangibles as a result." In this context, a ranking of projects according to estimated rates of return may not be very useful. In this paper, we will consider the allocation committee's evaluation of both the investment proposals and of those who make the proposals.

Initial budget allocation

The firm starts the process of capital allocation by determining in its budget the amount that will be allocated within the firm to capital expenditures. The size of the investment budget will be related to the rate of growth desired by the firm. With constant prices, the reinvestment of depreciation generated annually would keep the firm at the same size and with the same product composition. With inflation the firm must invest some or all of its returned earnings in addition to depreciation in order to maintain its size. If depreciation plus retained earnings does not allow for achievement of the firm's growth goal, the firm must borrow funds. Ultimately, in this case, it may be necessary to raise more equity capital. That decision depends upon the amount of leverage the firm is willing to use. Most firms have some debt-to-equity limits that are imposed by the board.

The amount of money budgeted for capital investment is then tentatively allocated to the divisions, but the funds will not go to the division if the capital allocation requests do not gain approval. The method of making the rough allocation utilizes a "wish list" for each division manager. He is requested to submit a list of the projects for which he would like capital and a rough estimate of the amount necessary for each. The tentative budget allocation among the divisions is influenced by these submissions. However, there may also be important strategic considerations such as the rate of growth of the division that is possible and desirable from the central management's point of view. In addition, there are clearly organizational considerations that will affect the budget allocation as well as the final approval process. A division manager is judged on his performance, and his performance is generally going to improve with new capital, even when the division is charged with a cost for the capital used. The central management also wants to encourage the good manager or the division that generates a large proportion of the capital being allocated. Division managers may

J. G. March and H. A. Simon, Organizations, (New York: John Wiley and Sons, 1958) p. 165.

5 R. M. Cyert. H. A. Simon, and D. B. Trow. "Observation of a business decision," The Journal of Business, Vol. 29, October, 1956, p. 248.

resent an appropriation which is considerably below the division's contribution to profit. Incentives must be maintained and stimulated. Giving a division manager less capital than he feels he needs and less than his division generates can be discouraging. Thus there are other considerations than those that are defined to be rational in economic theory. These organizational and managerial variables must be incorporated in microeconomic models if the behavior of the firm is to be understood.

The search for projects proceeds vigorously, and project proposals do not need to be the same as those on the "wish list." As projects are conceived and evaluated, the divisional management must decide whether the project should be recommended and submitted to the appropriations committee. It should be noted at this point that the division may not consider itself in competition with other divisions. The objective of the analysis is to convince the appropriations committee that the project should be funded. If the project is large enough to require board approval the committee can send it to the board with a recommendation for approval.

Decision criteria

Some distinction should be made among four types of investments because the decision criteria vary with the type. The most straight-forward type is that of equipment replacement. The committee usually approves these requests in a routine manner unless it believes the firm should consider leaving the business. Typically, the decision is approved on grounds that the replacement is necessary if the firm is to stay in the business. The second type occurs when a new technology has been discovered. If competitors have not already adopted the new technology, the proposal is examined carefully because adoption of the new technology will generally mean that some equipment which is not completely depreciated will have to be abandoned. The third type is the acquisition of a new business. Here again the analysis is important, particularly if the management feels (as is usually the case) that it can do a better job with the business than is currently being done. Also, the amount of money involved is usually large. The fourth type is the expansion of a business or project in which the firm is already engaged. In this case the firm has generally taken a sequential approach to the investment evaluation." Records of past experiences are available, but the proposal must demonstrate that these data are indicative of the future.

One interesting question relates to the way in which projects tend to get eliminated. The minimum rate of return on projects clearly is a factor in screening out some proposals, especially at the divisional level. There are other dimensions which serve as screening devices also. On acquisitions, for example, the extent to which the proposed acquisition is related to the rest of the business will be an important dimension. Boards of directors will tend to look negatively on acquisitions that are in an unrelated industry or require managerial knowledge that the firm does not have. This position was abandoned temporarily by some firms during the period of the growth of conglomerates. Since that period, however, diversification of the kind represented by conglomerates has not been the strategy of most firms.

8

The appropriations committee makes the selection of projects that go to the board. Occasionally there will be projects that are approved because of the organizational considerations involved. There may well be an individual or a division needing either encouragement or compensation for some previous defeat." These considerations can lead to an approval of projects that might in some strict sense not meet all of the criteria. In general, however, the appropriations committee will be careful about the documentation and the positive arguments for projects that it sends to the board. It will not want to embarrass the chairman or the president of the firm by having the board refuse to

The problems of allocating funds centrally in a decentralized organization are similar in non-profit organizations. For example, each college in a university would like to keep Its tuition and the overhead on research grants and receive a share of the other revenues of the university. Whenever a college or department receives less than it thinks it generates, the dean or department head immediately feels treated unjustly. Frequently deans of business schools and in recent years deans of law schools have been particularly restive because of such considerations.

7 This tonic is considered in our recent working paper entitled "A Bayesian Analysis of Sequential Investments."

6 Cf. Wall Street Journal. April 28, 1976, p. 1.

R. M. Cvert and J. G. March, Behavioral Theory of the Firm, Englewood Cliffs, N.J., Prentice Hall, Inc., 1963, p. 29.

fund a project that has been recommended by the committee and, therefore, by the management.

For the most part, however, the board follows the recommendations of the committee. The management knows more about the projects than the directors, and the board will rarely attempt to kill a proposed project. At worst, considerations may be raised that will force management to delay a project temporarily while a new analysis is made.

From the point of view of the appropriations committee, the sponsor of a project is the manager who makes the primary recommendation. The sponsor is on the firing line, and the eventual success or failure of the project may affect the sponsor's status in the organization. In evaluating a proposal, the committee must consider both the credibility of the sponsor and the ability of the sponsor's division to generate profitable projects. At the "wish list" stage, prior to receiving a careful project evaluation, the committee's beliefs about the profitability of a project will be influenced by past rates of return on projects in the sponsor's division. These prior beliefs will be modified if the project proposal conveys useful information. The information content of the proposal depends on both the credibility of the sponsor and the strength of the case made for the project. Again, the committee's evaluation will depend on past experience with the sponsor.

At the same time it must be recognized that it is difficult to analyze past results because it is difficult to separate the effects on profits of new investments from the many other changes that take place over the period of a year. Nevertheless, post-audits of the results of projects are made and reported to the committee and the board. These audits give a measure of the ability of managers to estimate rates of return accurately. In turn approval will tend to be influenced by the committee's perception of the ability of the individual sponsors to make good estimates. Similarly, at the next level, the board's decision is based on its confidence that the management's recommendations are good. Again, this confidence will presumably evolve from past results. At each stage of the allocation process, the sponsor's recommendations must be evaluated by the committee in the context of previous experience with the sponsor. Credibility

10

Each capital proposal specifies both the total funding requested A and a vector f of various estimates of rates of return. The components of f are estimates of the rates of return for a period of years under the assumption of different economic conditions prevailing. The amount that is actually awarded will depend on A, f and the credibility of the manager making the proposal. If the estimated rates of return have been consistently higher than the division's actual rate of return, the committee will deflate estimates, and the sponsor will lose credibility in the process. This possibility is clearly stated in an interview with a manager which is reported by Bower: "

What it really comes down to is your batting average. Obviously anything cooked up, I have to sell and approve. My contribution is more in the area of deciding how much confidence we have in things. The whole thing-the size, the sales estimate, the return, is based on judgment. I can kill or expand a product based on my judgment. I decide the degree of optimism incorporated into the estimates. You know your numbers change depending on how you feel. The key question is "How much confidence has the management built up over the years in my judgment?" A guy in my position must think this way. He loses his usefulness when he loses the confidence of higher executives in the company. Otherwise his ideas won't be accepted when he goes up.

For any given vector f the committee's beliefs about the actual rate of return f for the proposed project can be represented by a conditional probability distribution F(rf)." This distribution has evolved from previous experience both with the particular manager and with managers in general. The manager's credibility with the committee is summarized by this distribution. The form of the distribution at any time will be affected by the quality of the estimates ř on previous projects. If f has been a poor estimator then the committee will assign a significant probability to the occurrence of a large negative return. Since managements are generally sensitive to "downside risk," the probability

10 Sample request forms can be seen in Bower, op. cit., p. 62.

11 J. Bower, op. cit., p. 59.

18 In this assumption, we are ignoring the problems associated with the concept of a group probability measure.