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WILLIAMSON’S MODEL OF MANAGERIAL DISCRETION

Prof. Prabha Panth,Osmania University

Hyderabad

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Manager’s discretion• Managers, in imperfect markets, want to

maximise their own Utility, • not profits for owners or shareholders.• They have the discretion to do so.• Williamson’s model differs from Baumol’s

in four ways: Minimum profits for minimum investment and

growth of the firm. Managers want to maximise their own utility.

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Satisfaction or utility of managers depends on 3 variables,

1) Staff expenditure S. used as a proxy for sales. Includes management salaries, administrative expenses, selling expenditure. More the staff exp, more sales. Power and prestige of managers increases with S.

2) Management emoluments, M: or management slack – i.e. luxurious offices, fancy cars, perks,

3) Discretionary investments, Io: amount spent at his own discretion, e.g. on latest equipment, furniture, decoration material, etc. to satisfies ego and give them a sense of pride. These give a boost to the manager's esteem and status in the organisation. 

Managers use that combination of above variables that maximises their own satisfaction.

Maximise Um = f(S, M, Io) Where Um = Manager’s Utility

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• Discretion of managers: where owners and govt expectations are satisfied.

• Minimum Profit Restraint =Minimum rate of dividend + Minimum investment + Tax on profits

• Actual Profit > Minimum Profit Difference between Maximum possible Profit

and Minimum profit constraint = Area of Discretion.

Larger the gap, more the discretion of managers.

Can be used by managers to maximise their own utility.

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• Layers of Profit: Actual profit RA = R – (C+S), where C = cost of

production, S = Staff expenditure Reported profit, RR = RA – M, (M = managerial

emoluments) Minimum profits RM = RR – Tax, Discretionary profits RD = RA – RR,

i.e. RD = RA – (C + S + M + Tax) or (M + Io)These expenditures reduce profits.RD = is most important for the manager.

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Objective: to maximise Manager’s satisfaction. Given S (staff expenditure and Io (discretionary Inv),UM = f( S, Io)Indifference curves can be drawn between Io and S. Fig 1. shows the various levels of utility (U1, U2, U3) derived by the manager by combining different amounts of discretionary profits and staff expenditure. Higher the indifference curve, higher the manager’s utility. Manager tries to reach highest indifference curve possible given the constraints.

U3

U2

U1

S

Io

0

Figure 1

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Relationship between S, Rd and profit function

• R = f(Q) = f(S) – Rm• Optimum output

determined by marginalist rule. (MC=MR, MC)

• Market conditions are given,

• Then relationship between Rd and S is given in Fig.2

• As sales expenditure , Rd first rises up to b (Rd max), then falls.

• At b, Rd max, S1 not yet max.

• At c, S max, but Rd = 0

Rd

Rd max

S max, but Rd =0

S1 S0

Figure 2

a

b R=f(S) – Ro)

c

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Equilibrium of the firm•Firm’s equilibrium is given at the tangency of profit-staff expenditure curve, with the highest possible managerial IC.

•E = manager’s utility maximising W and S2.

•b = profit maximising output, S1.

•But Rd* < R max,• S2 > S1•Managers equilibrium at E, where profit curve is tangent to highest U3..

•But at E, Rd* < Rm, and S2 > S1.

•Thus managers prefer more staff expenditure, rather than maximise profits.

S1 S0

Figure 3

a

b

cS2

U1

U2U3

E

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Criticism: No empirical proof of such managerial

behaviour. Managers may not have so much freedom, Trade unions may demand more S, The model does not discuss how price is

determined. Interdependence in oligopoly is not discussed.