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Williamson’s model of managerial discretion
1) Williamson's model of managerial discretion posits that in imperfect markets, managers will seek to maximize their own utility rather than profits for owners. 2) The model suggests that manager's utility depends on three variables: staff expenditures which boost sales and prestige; management emoluments such as perks; and discretionary investments for ego and pride. 3) Managers have an area of discretion between the actual profits earned and the minimum profits expected by owners, within which they can allocate resources to maximize their own satisfaction defined by the three variables.
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Williamson’s model of managerial discretion
- 1. … … … … … … … … … … … … … … … … … … … … … … … … WILLIAMSON’S MODEL OF MANAGERIALDISCRETION Prof. Prabha Panth, Osmania University Hyderabad
- 2. … … … … … … … … … … … … … … … … … … … … … … … … 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. 2Prabha Panth
- 3. … … … … … … … … … … … … … … … … … … … … … … … … Satisfaction orutility 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 3Prabha Panth
- 4. … … … … … … … … … … … … … … … … … … … … … … … … • Discretion ofmanagers: 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. 4Prabha Panth
- 5. … … … … … … … … … … … … … … … … … … … … … … … … • Layers ofProfit: 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. Prabha Panth 5
- 6. … … … … … … … … … … … … … … … … … … … … … … … … Objective: to maximise Manager’ssatisfaction. 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. 6 U3 U2 U1 S Io 0 Figure 1
- 7. … … … … … … … … … … … … … … … … … … … … … … … … 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 Prabha Panth 7 Rd Rd max S max, but Rd =0 S1 S 0 Figure 2 a b c
- 8. … … … … … … … … … … … … … … … … … … … … … … … … Equilibrium of thefirm •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. 8 S1 S 0 Figure 3 a b cS2 U1 U2 U3 E
- 9. … … … … … … … … … … … … … … … … … … … … … … … … Criticism: No empiricalproof 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. Prabha Panth 9