Williamson’s Managerial Discretionary Theory:

INTRODUCTION:
In 2009, Oliver E. Williamson, along with Elinor Ostrom, was awarded the Nobel Prize in
economics. Williamson received it “for his analysis of economic governance, especially the
boundaries of the firm.” He did this by bringing together economics, organization theory,
and contract law. According to the Nobel committee, Williamson provided “a theory of why
some economic transactions take place within firms and other similar transactions take place
between firms, that is, in the marketplace.” Williamson found that common ownership, in
the form of firms, helps to solve some market failures by mitigating transaction costs and
uncertainty.

THEORY:

Williamson has developed managerial-utility-maximisation theory as against profit

maximisation. It is also known as the ‘managerial discretion theory’. In large modem firms,
shareholders and managers are two separate groups. The shareholders want the maximum
return on their investment and hence the maximisation of profits. The managers, on the
other hand, have consideration other than profit maximisation in their utility functions. Thus
the managers are interested not only in their own emoluments but also in the size of their
staff and expenditure on them.

Thus Williamson’s theory is related to the maximisation of the manager’s utility which is a
function of the expenditure on staff and emoluments and discretionary funds. “To the extent
that pressure from the capital market and competition in the product market is imperfect, the
manager, therefore, has discretion to pursue goals other than profits.”

The managers derive utility from a wide range of variables. For this Williamson introduces
the concept of expense preferences. It means “that managers get satisfaction from using
some of the firm’s potential profits for unnecessary spending on items from which they
personally benefit.”

ASSUMPTIONS OF THIS THEORY:

This model depends on some assumptions which are:

Weakly competitive environment.

A divorce of ownership from control of firm (manager is free to perform any
action)
A capital market imposes minimum profit constraint (manager’s work for
minimum profit imposed by a capital market).
To pursue his goal of utility maximisation, the manager directs the firm’s resources in
three ways:

1. The manager desires to expand his staff and to increase their salaries. “More staff is
valued because they lead to the manager getting more salary, more prestige and more
security.” Such staff expenditures by managers are denoted by S.

2. To maximise his utility, the manager indulges in “featherbedding” such as pretty

secretaries, company cars, too many company phones, ‘perks’ for employees, etc. Such
expenditures are characterised as ‘management slack’, M by Williamson.

3. The manager likes to set up “discretionary funds” for making investments to advance or
promote company projects that are close to his heart. Discretionary profits or investments D
are what remains with the manager after paying taxes and dividends to shareholders in order
to retain an effective control of the firm.

Thus the manager’s utility function is U = f (S, M, D)

where U is the utility function, S is the staff expenditure, M is the management slack and D
the discretionary investments. These decision variables (S, M, D) yield positive utility and
the firm will always choose their values subject to the constraint, S ≥0≥M0, D≥0.
Williamson assumes that the law of diminishing marginal utility applies so that when
additions are made to each of S, M and D, they yield smaller increments of utility to the
manager.

Further, Williamson regards price (P) as a function of output (X), expenditure on staff (S),
and the state of environment which he calls ‘a demand shift parameter’ (E), so that P = f (X,
S, E).

This relationship is subject to the following constraints:

(a) The demand function is assumed to be negatively sloping: ∂P/ ∂X<0;
(b) staff expenditures help increase the demand for the firms product: ∂P/ ∂S>0; and
(c) increases in the demand shift parameter E, tend to raise demand: ∂P/ ∂E>0.

These relationships reveal that the demand for X is negatively related to P, but is positively
related to S and E. When the demand increases, the output and expenditure on staff will also
increase which will push the costs of the firm, and consequently the price will rise, and vice
versa.

In order to formalise his model, Williamson introduces four different types of profits: actual,
reported, minimum required and discretionary profits. Denoting R = revenue, C = total
production costs and T = taxes, then actual profits πA =R-C-S

If the amounts of managerial slack or emoluments (M) are deducted from the actual profits,
we get reported profits.
πR= π A= M =R –C –S –M

The minimum required profits, π0, are the lowest level of profits after paying taxes which
the shareholders must receive in order to hold shares of the firm.

Since discretionary profits (D) are what remains with the manager after paying taxes and
dividends to shareholders, therefore,

D = πR – π0 – T

To explain Williamson’s utility maximisation model diagrammatically, it is assumed for the

sake of simplicity that U=f (S, D) so that discretionary profits (D) are measured along the
vertical axis and staff expenditures (5) on the horizontal axis in Figure 3.

FC is the feasibility curve showing the combinations of D and S available to the manager. It
is also known as the profit-staff curve. UU1 and UU2 are the indifference curves of the
manager which show the combination of D and S. To begin, as we move along the profit-
staff curve from point F upwards, both profits and staff expenditures increase O till point P
is reached. P is the profit maximisation point for the firm where SP is the maximum profit
levels when OS staff expenditures are incurred.

But the equilibrium of the firm takes place when the manager chooses the tangency point M
where his highest possible utility function UU2and the feasibility curve FC touch each
other. Here the manager’s utility is maximised. The discretionary profits OD (=S1M) are
less than the profit maximisation profits SP.

But the staff emoluments OS are maximised. However, Williamson points out that factors
like taxes, changes in business conditions, etc. by affecting the feasibility curve can shift the
optimum tangency point, like M in the Figure. Similarly, factors like changes in staff,
emoluments, profits of stockholders, etc. by changing the shape of the utility function will
shift the optimum position.
Critical Appraisal:

Williamson has supported his utility-maximisation hypothesis by citing a number of

evidences which are generally consistent with his model. Thus his theory is empirically
sound as compared with other managerial theories.

This model is also superior to Baumol’s sales-maximisation model because it also explains
the facts involved in Baumol’s theory. Williamson does not treat sales maximisation as a
single criterion like Baumol but as a means of the manager for increasing his staff and
emoluments. This approach is rather more realistic.

Further, in Williamson’s model output is higher, and price and profits are lower than in the
profit maximisation model. Silbertson has shown that Williamson’s model preserves the
results of the normal profit-maximisation model in conditions of pure or perfect
competition.

Weaknesses:

But there are some conceptual weaknesses of this model:

1. He does not clarify the basis of the derivation of his feasibility curve. In particular, he
fails to indicate the constraint in the profit-staff relation, as shown by the shape of the
feasibility curve.

2. He lumps together staff and manager’s emoluments in the utility curve. This mixing up of
non- pecuniary and pecuniary benefits of the manager makes the utility function ambiguous.
But these difficulties can be overcome by introducing a three-dimensional diagram. But it
will make the analysis more complex.

3. This theory does not deal with oligopolistic interdependence and of oligopolistic rivalry.

4. According to Hawkins, most economists are reluctant to pursue Williamson’s utility-

maximisation theory “due to the knowledge that so many factors (e.g., profit, sales, output,
growth, number of staff and expenditure on plush offices and cars) are likely to give utility
to people in industry that they shall end up with a model incapable of yielding any definite
results.”