The model of the managerial theory of the firm presented by Oliver E. Williamson is known as Williamson’s Model of Managerial Discretion. This model was developed by Williamson in 1963 in his article ‘Managerial Discretion and Business Behaviour’ published in ‘American Economic Review’.
Williamson argues that managers are motivated by their self-interest and they try to maximize their utility or satisfaction which depends upon the various items like salary, bonus, prestige, security, status, etc. in the firm.
So, this model is related to managerial discretion and it believes that the managers look at their self-interest while making decisions of the firm because the manager’s utility is based on managerial discretion.
The objective of a firm/manager is to maximize its own utility function with profit constraints as the job security of managers endanger if managers fail to earn a minimum profit to pay in the form of dividends to the owners.
Manager’s utility can be increased by additional values of expenditure on staff (S), managerial emoluments (M), and discretionary investment (ID). It is also argued that these provide additional utility, and it is utility ‘U’ that managers aim to maximize. The manager’s utility function is being presented as
Maximize U = f (S, M, ID)
S=Staff Expenditure: Staff expenditure includes salaries and other monetary benefits to managers and staff.
M= Managerial Emolument: It includes benefits to managers like expensive and luxury offices, luxurious cars, personal secretary, large expenses account, etc. Greater managerial emolument increases a manager’s status, prestige, and satisfaction.
ID=Discretionary Investment/Profit: It is a fund or profit which is remaining after providing dividends to the shareholders and taxation to the government. It is called discretionary investment because it can be independently spent by the management in their desired projects. Such spending allows managers to pursue their pet projects, personal investment preferences and to exercise their power and thus it increases their utility.
So, discretionary investment (ID) = 𝜋𝑅 – 𝜋0 – T=discretionary profit (DP)
Simplification of the Model
Maximize Utility (U) = f(S, M, ID)
Subject to 𝝅𝑹 ≥ 𝝅𝟎+𝑻
𝝅𝑹 is the reported profit (reported to the tax office) which is the difference between actual profit (π) and managerial emolument i.e. 𝜋𝑅 = π – M,
𝝅𝟎 is the minimum profit that satisfies the shareholders/required by the shareholders
The actual profit (π) is the current profit of the firm which is the difference between total revenue (R) and Total Cost (C) including staff expenditure i.e. π = R – C – S.
When M = 0 then the utility function can be expressed as
Maximize (U) = f(S, DP)
Where S is staff expenditure and DP is discretionary profit. So, the manager’s utility is based on staff expenditure and discretionary profit. The higher the level of staff expenditure and discretionary profit, the higher will be the level of the manager’s utility. This model can be further explained with help of the following diagram.
Graphical Presentation of Williamson’s Model of Managerial Discretion
The following graph helps to explain the model.
In the above diagram, the managerial utility curve 𝑈3 is tangent to the discretionary profit (DP) curve at point E. So, point ‘E’ is the equilibrium point where managers get maximum utility with 𝜋𝐷𝐸 level of discretionary profit and 𝑆𝐸 level of staff expenditure.
At maximum profit point ‘F’, the staff expenditure is 𝑆0 which is less than 𝑆𝐸 and 𝜋𝐷𝑀 level of discretionary profit which is higher than 𝜋𝐷𝐸 but the lower level of managerial utility.
From the above discussion, we can infer that managers do prefer higher staff expenditure than that of profit maximizers and managers also would like to sell at a lower price than that of profit maximizers. Thus, this model primarily highlights the manager’s utility while taking business decisions rather than the interest of other stakeholders. However, the profit can not be entirely ignored in this model too. The minimum level of profit that managers need to fulfill is fixed and most importantly there is the place for managers’ discretion in the investment decision that motivates managers and thus they act for the overall betterment of the business firm.
Criticisms of Williamson’s Model of Managerial Discretion
- The criticisms of Williamson’s model of managerial discretion are as follows.
- This model or theory does not explain the problems of the interdependence of firms under oligopolistic competition.
- This model or theory applies only when rivalry among the firms is not so strong.
- This model has underestimated the concept of profit maximization because this theory says that managerial utility is impossible to maximize if economic profit is maximized by the firm.
- There is no adequate evidence to evaluate this theory.