Williamson’s Model of Managerial Discretion

The managerial theory of firm developed by Oliver E. Williamson states that managers apply discretion in making and implementing policies to maximize their own utility rather than trying for the maximization of profit which ultimately maximize own utility subject to minimum profit. Profit works as a limit to the top managers’ behavior in the sense that the financial market and the shareholders require a
minimum profit to be paid out in the form of dividends, otherwise the job security of managers is put in danger. Hence, managers look at their self-interest while making decision on price and selling quantity of output. Manager’s decision on price and output differs from the decisions of profit maximizing firm.

Utility maximization of managers guided by their own self-interest is possible, like in Baumol’s sales maximization model, only in a corporate type of business organization with the separation of ownership and management functions. Such organizational structure permits the managers of a firm to pursue their own self-interest, subject only to their ability to keep effective control over the firm. In particular managers are fairly certain of keeping hold of their power (i) if profits at any time are at an acceptable level, (ii) if the firm shows a reasonable rate of growth over time, and (iii) if sufficient dividends are paid to keep the stockholders happy.

Williamson’s model suggests that manager’s self-interest focuses on the achievement of goals in four particular areas, namely:
  1. High salaries
  2. Staff under their control
  3. Discretionary investment expenditures
  4. Fringe benefits (i.e., additional employee benefit: an additional benefit provided to an employee, for example, a company car or health insurance)
This model depends on some assumptions which are:
  1. Weakly competitive environment.
  2. A divorce of ownership from control of firm (manager is free to perform any action)
  3. A capital market imposes minimum profit constraint (manager’s work for minimum profit imposed by a capital market).
According to Williamson, managers want ‘utility’ which is the same things as happiness or satisfaction. Top managers and chief executive officers reveal expenditure preference that is they derive utility expenditure on staff (S), managerial emoluments (M), and discretionary profits. The discretionary profit is defined as the profit level higher than the level necessary for long-term survival.

The managerial utility function includes such variables as salaries, security, power, status, prestige and professional excellence. Of these variables, only the first variable ‘salaries’ is measurable. The others are non pecuniary. Therefore, in order to make them operational, they must be expressed in terms of other variables with which they are related and which are measurable. This is captured by the concept of expense preference, which is defined as the satisfaction which managers again from certain types of expenditures. In particular, staff expenditures on well being (slack payments) and funds available for discretionary investment gives a positive satisfaction to the managers because these expenditures are a source of security and reflect the power, status, prestige and professional achievement of managers.

Staff expenditures, emoluments and discretionary investment expenses are measurable in money terms and will be used as proxy-variables to replace the non-operational concepts (e.g. power, status, prestige, professional excellence) appearing in the managerial utility function. With this background, the utility function of the managers may be written in the form

U = f  (  S,   M,   ID)

Where S = staff expenditure, including managerial salaries; M = managerial emoluments; and ID = discretionary investment; f(S, M, ID) is the utility function.

Managers have “expense preferences”, maximization of utility derived from (i) amount spent on staff (S), (ii) additions to manager’s salaries and benefits in the form of “perks” (M), (iii) discretionary profit (D) which exceed the minimum required to satisfy the shareholder’ available as a source of finance for “pet project”.

Different definitional and behavioral relations are involved in Williamson’s model. They are introduced below:
i) Demand of the firm: It is assumed that the firm has a known downward sloping demand curve defined by the function.
Q  = f1(P, S, Ɛ)
P = f2(Q, S, Ɛ)
Where, Q = output, P = price, S = staff expenditure, Ɛ = (Greek letter epsilon) = the condition of the environment or a demand-shift parameter reflecting autonomous changes in demand; f1(P, S, Ɛ) and f2(Q, S, Ɛ) are the market demand equation for the firm’s product.

An increase in staff expenditure (S) is supposed to cause an upward shift to the demand curve and thus allow the charging of a higher price. The same holds for any other change in the environment, which shifts upwards the demand curve of the firm.

ii) Production cost: The total cost of production (C) is assumed to be an increasing function of output (Q).

So, C = f3 (Q)

Where δC/δQ>0 (i.e., total cost increases with the increase in the level of output, and vice versa)

iii) Actual Profit (π): The actual profit is defined as revenue from sales (R), minus the production costs (C), and minus the staff expenditure (S) or actual profits are the difference between total revenue earned less the production costs (C) and expenditure on staff (S). This is symbolically expressed as:

π = R – C – S

iv) Reported Profit πR: This is the profit reported to the tax authorities. Reported profit (πR) is the difference between actual profits and supplementary or nonessential managerial expenditure as represented by management slack. It is the actual minus the managerial emoluments (M) which are tax deductible. So,

πR = π – M = R – C - S – M

v) Minimum Profit (π0): Minimum profit (π0) is the amount of profits (after tax) which is required to be paid as acceptable dividend to satisfy the owner-shareholders of the firm. If the shareholders do not get reasonable dividends they may sell their share and thereby expose the firm to the risk of being taken over by others, or alternatively they will vote for the dismissal of the top management. Both of these actions by the shareholders will reduce the job security of the top managerial team. Hence, managers must earn some minimum profits for the shareholders in the form of dividends to keep the shareholders satisfied so as to ensure manager’s job security. To meet this objective, the reported profits must be large enough to be equal to minimum profit (π0) plus the tax (T) that must be paid to the government. This is mathematically expressed as:

πRπ0 + T

The tax function is of the form T = Ť + t. πR
Where t = marginal tax rate or unit profit tax; Ť = a lump sum tax

vi) Discretionary investment (ID): Discretionary investment is the amount left from the reported, after subtracting the minimum profit (π0) and the tax (T). The mathematical expression for this definitional relationship is:

ID = πR - π0 – T

vii) Discretionary profit (πD): This is the amount of profit left after subtracting from the actual profit (π) the minimum profit requirement (π0) and the tax (T). The mathematical expression for this definitional relationship is:

πD = ππ0 – T

Thus, there are three types of profit concepts discussed in Williamson’s managerial utility maximization model of the firm: actual profits (π), reported profit (πR), and minimum profits (π0).

Discretionary profits should be carefully distinguished from discretionary investment. As explained earlier, discretionary profits are the amount left after minimum profit (π0) and tax (T) are deducted from actual profits (πD = ππ0 – T5) but discretionary investment equals reported profits minus minimum profits and tax. Thus, we have discretionary investment

ID = πRπ0 – T

Since difference between reported profits (πR) and actual profits (π) arise/ occur due to management slack, discretionary profits can be stated as under

πD = ID + expenditure due to management slack. Thus, if management slack is zero

πR = π and πD = ID

No comments:

Post a Comment