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Subject ECONOMICS

Paper No and Title 3: Fundamentals of Microeconomic Theory

Module No and Title 31: Williamson’s Model of Managerial Discretion

Module Tag ECO_P3_M31

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Williamson’s Theory of Managerial Discretion
4. Utility Function of Managers
5. The Simplified Model of Managerial Discretion
6. Summary

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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1. Learning Outcomes
After studying this module, you shall be able to

 Know the concept of managerial theory of firm

 Why Williamson model is different from other managerial theories?
 Williamson’s Utility Function
 Understand why utility maximization is the goal of the managers rather than profit
maximization?
 Know the four different categorization of profits
 Know the preferences of managers and profit curve

2. Introduction

In recent years, new theories of the firm have been developed under oligopoly which lay
stress on the role of the managers and their behavioral patterns on the price and output
decisions of the firm. It pointed out that profit maximization is not the only goal of the
managers as they are trying to pursue other goals as well. Besides, behavioral theory, the
other theories that developed was managerial theory of the firm. The three theories of the
firm which have been developed in the recent years are managerial theories of
Williamson, Marris and Baumol.
Baumol propounded a model of sales maximization in his book “Business behavior,
value and growth”. The sales maximization model says that managers of the firms seek to
maximize their sales revenue subject to a profit constraint. Under this, the objective of the
managers is to maximize sales. When the profits of firm reaches a level which is
considered satisfactory by the shareholders then managers are free to maximize their
revenue by promoting sales instead of maximizing profit. According to Marris, the
manager of the firm tries to maximize the rate of growth of the firms, that is, the
maximization of the rate of growth of demand for the products of the firm, and of the
growth of its capital supply rather than maximization of profits. In pursuing this
objective, the firm has two constraints. First, the constraints set by the available
'managerial team and its skills, and second, the financial constraint set by the desire of
managers to achieve maximum job security. The managers by jointly maximizing the rate
of growth of demand and capital maximizes their own utility as well as utility of the
shareholders. The conflicting interests of owners and management coincide with the
objective of balanced growth of the firm as it ensures fair return on owner's capital and
faith in managers who achieve this goal.

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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3. Williamson’s Theory of Managerial Discretion

Williamson’s model of managerial discretion was developed by Oliver E. Williamson in

1964. Williamson like other managerial theory of the firm assumes that utility
maximization is the sole objective of the managers of a joint stock organization. It is also
known as “Managerial discretion Theory”. Williamson emphasize that managers are
motivated by their own self interest and they tries to maximize their own utility function.
Alike Baumol sales maximization model, the utility maximization objective of the
managers are subject to the constraint that after tax profits are large enough to pay
dividends to the shareholders. However, it is pointed out that utility maximization by the
self interest seeking managers is possible only in corporate form of the business
organization as there exists separation of ownership and control. This is basically the
principal agent problem. It explains the relationship between the principal (owner) and
the agent (who performs owner’s works). The principal agent shows that whenever the
difference between ownership and control exist, then the self interest of agent makes
profits lower than in a situation where principals act as their own agents.

Profit works as a limit to the manager’s utility maximization as the shareholders require a
minimum profit to be paid out in the form of dividends. If this minimum profits is not
covered, then job security of the managers is put in danger. But, the managers are able to
hold a powerful position if (i) firm is showing a reasonable rate of growth, (ii) minimum
dividends are paid to the shareholders and (iii) profits at any time are at acceptable level.
Here the manager’s decision on price and output differs from the manager’s decision on
price and output of profit maximization firm.

Assumptions: The Williamson’s model is based on some assumptions. These are:

(i) Imperfect Competition
(ii) Separation of Ownership and management.
(iii) A minimum profit to be able to pay to the shareholders.

The factors that affect the interest of the self seeking managers are:
a. Salary and Other form of Monetary Compensation
b. Management Slack or Non-essential Management Perquisites
c. Number of Staff under the Control of a Manager
d. Magnitude of Discretionary Investment expenditure by the Manager.

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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Let us study them in detail.

a. Salary and other form of Monetary Compensation: The salary and other form of
monetary compensation is one of the most important factor in determining the
utility of the managers. Higher the income the managers receive, the better is the
standard of living and status. So, higher the salary and other monetary
compensation and perks, higher is the utility of the managers.

b. Management Slack or Non-essential Management Perquisites: The second factor

that is determining the utility of the managers is the amount of management slack.
The management slack consists of non-essential management perquisites such as
well-furnished office, luxurious cars, entertainment expenses etc. These perks are
giving the incentive to the managers to enhance their status and prestige in the
organization which in turn contributing to the efficiency of the firm’s operation.
These non-essential perquisites are also the part of the cost of production of the
firm.

c. Number of Staff under the Control of a Manager: The third factor that is
determining the utility of the managers is the number of staff under the control of
a manager. The greater the number of staff under the control of a manager, the
more powerful is the manager. More staff under manager enhances his status and
prestige. According to Williamson, there exist positive relationship between the
number of staff and salary of the managers. In the utility maximization model of
Williamson, he used a single variable for the number of staff and salary of the
managers as “monetary expenditure on the staff”.

d. Magnitude of Discretionary Investment expenditure by the Manager: The fourth

important factor that is determining the utility of the managers is the magnitude of
discretionary investment expenditure by the manager. The discretionary
investment refers to the amount of resources left at a manager’s disposal to be
able to spend at his own discretion. This enhances his status and prestige in
organization. Here, the discretionary investment by the managers does not include
those investment expenditures that are necessary for the survival of the firm. The
discretionary investment by the manager includes spending on furniture, latest
equipment, decoration material etc.

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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4. Williamson’s Utility Function

The managerial utility function includes variables such as salary, status, prestige, job
security and other monetary compensation. Out of these, salary is the only quantitative
variable which is measurable. On the other hand, all other variables except salary are
non- quantifiable i.e. not measurable. In the utility maximization model of Williamson,
he used a single variable for the number of staff and salary of the managers as “monetary
expenditure on the staff”. The utility function of managers is a function of salary,
monetary expenditure on the staff and the discretionary investment.

𝑈 = 𝑓1 (𝑆, 𝑀, 𝐼𝐷 )

Where U is utility
S is monetary expenditure on the staff
M is the management slack.
𝐼𝐷 is discretionary investment.

Here, the variables expenditure on staff salary, management slack and disc retionary
investment is used the unquantifiable concepts like power, status, job security, dominance
etc. The variable expenditure on staff, management slack and disinvestment can be
assigned some nominal values.

There exists a positive relationship between decision variables (S, M and 𝐼𝐷 ) and utility.
Any increase in the decision variables increase the utility of the managers. But the firm
always choose their values subject to the constraint, S ≥0 and D≥0. Williamson also
assumes that the law of diminishing marginal utility applies so that when additions are
made to each of the decision variable S, M and 𝐼𝐷 , they yield smaller increments to the
utility to the manager.

Demand curve faced by the firm is downward sloping: Under Williamson’s model the
demand curve faced by the firm is downward sloping. The demand function can be
written as:
Q = 𝑓2 (P, S, Ɛ)

P = 𝑓3 (Q, S, Ɛ)
Where Q is output
ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory
MODULE No. 31: Williamson’s Model of Managerial
Discretion
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P is price
S is staff expenditure
Ɛ the demand-shift parameter reflecting autonomous changes in demand

Demand curve is negatively sloped implies a negative relationship between price and
𝜕𝑃
quantity i.e., < 0.
𝜕𝑄

As price increases quantity decreases and as prices decreases then quantity increases. It
is also assumed that the demand is positively related to staff expenditure and to the
demand shift parameter ε. Thus,

𝜕𝑃 𝜕𝑃
> 0 𝑎𝑛𝑑 >0
𝜕𝑆 𝜕Ɛ

Any increase in staff expenditure causes an upward shift in the demand curve and thus
allow the charging of a higher price. The same holds for any other change in the demand
shift parameter which shifts the demand curve upward. It may be an increase in income,
change in taste in favour of a good etc.

Cost of Production: The total cost of production is assumed to be an increasing function

of output. This can be expressed as

C = 𝑓4 (Q)

Where C is cost

Q is output

𝜕𝐶
The total cost increases with the increase in the level of output i.e. 𝜕𝑄 > 0.

Concept of profit in the model: The various concepts of profit used in the Williamson
model needs to be understood clearly before moving to the main model. Williamson has
put forth four main concepts of profits. These are actual profit, discretionary profit,
reported profit and minimum profit.

(i)Actual profit II: The actual profit is defined as the revenue from sales less the
production costs and the staff expenditure.

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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Π = R – C – S where R is revenue, C is the cost of production and S is the staff

expenditure.

(ii) 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 emoluments as represented by the management slack. It is the actual profit
minus the managerial emoluments (M) which are tax deductible. So,

πR = π – M = R – C - S – M
(iii)Minimum Profit (π0): Minimum profit (π0) is the amount of profits (after tax) which
is required to be paid as acceptable dividend to the 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
change of the top management. Both of these actions by the shareholders will reduce the
job security of the top managerial team. Hence, some minimum profits should be earned
by the manager for the shareholders in the form of dividends to keep them satisfied.
Through this he can ensure his job safety. To meet this objective, the reported profits
must be at least as high as minimum profit (π0) plus the tax (T) that must be paid to the
government. This is mathematically expressed as:

πR ≥ π 0 + T

The tax function is of the form T = Ť + t. πR

Where t is marginal tax rate or unit profit tax and Ť is the lump sum tax.

iv) Discretionary profit (πD): Discretionary profit is the amount of profit left after
subtracting from the actual profit (π) the minimum profit requirement (π0) and the tax
(T). It can be expressed as:

πD = π – π0 – T

Discretionary Investment (ID): Discretionary investment is the amount left from the
reported profit after subtracting the minimum profit (π0) and the tax (T). It can be
expressed as:

ID = π R - π 0 – T
Discretionary profit is different from discretionary investment. Discretionary profits are
the amount left after minimum profit (π0) and tax (T) are deducted from actual profits
(πD = π – π0 – T) but discretionary investment equals the amount left from the reported

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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profit after subtracting the minimum profit (π0) and the tax (T). Thus, we have
discretionary investment

ID = πR – π0 – T

Since difference between reported profits (πR) and actual profits (π) arises due to
management slack, discretionary profits. It can be written as πD = ID + Amount of
management slack. Thus, if management slack is zero then

πR = π and πD = ID

5. The Simplified Model of Managerial Discretion

Under Willaimson’s model, the objective is the maximisation of the utility function
subject to the minimum profit constraint. The minimum profit should be such that it is
sufficient to pay satisfactory profit to shareholders and pay for necessary investment.
Here we are taking a simple case where there is no management slack i.e. M=0.

Objective Max U=f(S,𝐼𝐷 )

Subject to π ≥ π0 + T

As there is no management slack, the discretionary investment absorbs all the

discretionary profit. Thus the managerial utility function can be written as

U=f[S,( π - π0 + T)]

Here, we are also assuming that there is no lumpsum tax i.e. Ť=0 so that T=t π. Thus,

U=f[S,( 1-t)π - π0 ]

Where ( 1-t)π - π0 is the discretionary profit πD.

Graphical Representation of the Williamson’s model: The graphical representation of

the equilibrium of the firm requires the construction of the indifference curves map of
managers and the profit curve. An indifference map is the family of indifference curves.
An indifference curve is a curve which shows different combination of two goods
yielding the same level of satisfaction to the consumer. In other words, it identifies the

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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various combinations of goods among which the consumer is indifferent. Here, the
indifference curve under Williamson model shows the relationship between monetary
expenditure on the staff and the discretionary investment. These are the two variable that
are determining the utility function of the managers. The indifference curve is shown in
the figure where staff expenditure (S) is measured on x-axis and discretionary profit (ΠD)
on y-axis. Each indifference curve shows various combinations of staff expenditure (S)
and discretionary profit (ΠD) which give the same level of satisfaction to the managers.

Consider the figure 1 below:

Figure 1: Indifference Map

It is assumed that the indifference curves of managers are of well behaved:

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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 Indifference curves are downward sloping

 They are convex to the origin implying diminishing marginal rate of substitution
of staff expenditure and discretionary profit.

 Two indifference family of indifference curves can never intersect each other

 Higher the indifference curve higher is the level of satisfaction.

 The indifference curves do not intersect the axes. The indifference curves do not
intersect the axes. This is very important property and need to be explained
properly. We have seen that expenditure on staff and discretionary profit are
positively related to utility function of the managers. Any increase in expenditure
on staff or discretionary profit or in both results in an increase in the satisfaction
of the managers by increasing the utility. This assumption restricts the choice of
managers to positive levels of both staff expenditures and discretionary profits,
implying that the firm will choose values of ΠD and S ‘that will yield positive
utility. It is shown in the figure. If the indifference curve do not intersect the axes
then the model excludes the corner solutions, such as points A, B, C, D etc.,
where discretionary profit (ΠD) would be zero in the final equilibrium of the firm.

Consider figure 2:

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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Figure 2: Indifference curves do not intersect

We have derived the indifference curve of the managers and have seen that they are well
behaved. Now let us determine the profit function and then the equilibrium analysis of
the firm. The relationship between S, staff expenditure, and ΠD, discretionary profit, is
determined by the profit function. The profit function explains the relationship between
profit and output. We have seen that output is a function of price of product, expenditure
on staff and the demand shift parameter. Thus, the profit function is a function of price of
product, expenditure on staff and the demand shift parameter

Π= ƒ(Q) = f(P, S, Ɛ)

Where, Π is profit,

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion
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Q is output

P is price

S is expenditure on staff

Ɛ demand-shift parameter reflecting autonomous changes in demand

The profit function which explains the relationship between Π 0 and S is shown below in
figure 3:

Figure 3: Profit curve

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
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We can see from the figure that profit curve initially rises, reaches a maximum and then
falls thereafter as the level of production increases. It starts increasing from point a,
reaches maximum at point b and then starts falling and becomes negative after reaching
point c. So, initially both discretionary profits and staff expenditures increases with the
level of production. This increase continues till the maximum point on the profit curve.
Beyond point b where with the increase in production profit curve starts falling, staff
expenditures continue to increase. If these expenditures continue to increase and exceed
point ‘c’, then the minimum profit constraint is not satisfied. So the region before point
‘a’ and to the right of ‘c’ are not feasible solutions. It should be clear from the above
discussion that the drawn profit curve does not include the minimum profit requirement
Π0. Williamson’s model implies higher output, lower price and lower level of profit than
the profit- maximization model.

6. Summary

Williamson’s model of managerial discretion was developed by Oliver E. Williamson in

1964. Williamson like other managerial theory of the firm assumes that utility
maximization is the sole objective of the managers of a joint stock organization. It is also
known as “Managerial discretion Theory”. Williamson emphasize that managers are
motivated by their own self-interest and they tries to maximize their own utility function.
Alike Baumol sales maximization model, the utility maximization objective of the
managers are subject to the constraint that after tax profits are large enough to pay
dividends to the shareholders. However, it is pointed out that utility maximization by the
self-interest seeking managers is possible only in corporate form of the business
organization as there exists separation of ownership and control.

ECONOMICS PAPER No. 3: Fundamentals of Microeconomic Theory

MODULE No. 31: Williamson’s Model of Managerial
Discretion