Williamson in 1964, and He Describes Managers' Utility Versus Profit Maximisation in

GREAT ZIMBABWE UNIVERSITY
DEPARTMENT OF ECONOMICS
LECTURE NOTES
WILLIAMSON’S THEORY OF MANAGERIAL UTILITY MAXIMISATION

Managerial utility maximisation theory, was developed by American economist Oliver E
Williamson in 1964, and he describes managers’ utility versus profit maximisation in
corporate environment, where management is separated from owners (shareholders).
This theory, like other managerial theories of the firm, assumes that utility
maximisation is a manager’s sole objective.
According to the theory managers take decisions that prioritise their own utility
maximisation over principals’ profits, provided the firm can generate minimum profit
demanded by the principals to maintain managers’ job security (Chang and Wong, 2003).
The basic assumptions of the model are:
1. Imperfect competition in the markets.

2. Divorce of ownership and management.
3. A minimum profit constraint exists for the firms to be able to pay dividends to their
shareholders.
Managerial Utility Function
The theory describes Managerial Utility (U) as a function of Monetary Expenditure on Staff

(S), Managerial Slack (M) and Discretionary Investment (Id).
The managerial utility function includes variables such as salary, job security, power, status,

dominance, prestige and professional excellence of managers. Of these, salary is the only
quantitative variable and thus measurable. The other variables are non-pecuniary, which are
non-quantifiable. The variables expenditure on staff salary, management slack, discretionary
investments can be assigned nominal values. Thus these will be used as proxy variables to
measure the real or unquantifiable concepts like job security, power, status, dominance,
prestige and professional excellence of managers, appearing in the managerial utility function
U = f(S, M, Id) –> max
"Monetary expenditure on staff" include not only the manager's salary and other forms
of monetary compensation received by him from the business firm but also the number of
staff under the control of the manager as there is a close positive relationship between the
number of staff and the manager's salary.
"Management slack" consists of those non-essential management perquisites such as

entertainment expenses, lavishly furnished offices, luxurious cars, large expense
accounts, etc. which are above minimum to retain the managers in the firm. These perks,
even if not provided would not make the manager quit his job, but these are incentives
which enhance their prestige and status in the organisation in turn contributing to
efficiency of the firm's operations. The Management Slack is also a part of the cost of
production of the firm.
"Discretionary investment" refers to the amount of resources left at a manager's

disposal, to be able to spend at his own discretion. For example spending on latest
equipment, furniture, decoration material, etc. It satisfies their ego and gives them a sense
of pride. These give a boost to the manager's esteem and status in the organisation. Such
investments are over and above the amount required for the survival of the firm (such as
periodic replacement of the capital equipment).
The theory considers several layers of profit:
Profit (P) is Revenue less Production Costs(C) and Monetary Expenditure on Staff(S)
Minimum Profit (Pmin) is the minimum amount of Profit after Tax required by
Shareholders to keep their stakes in the firm and/or maintain current management team.
Profit reported (Pr) is Profit (P) less Managerial Slack (M). Should be no less than
Minimum Profit (Pmin) plus Tax in order to maintain manager’s job security
Discretionary Profit(Pd) is Profit(P) less Minimum Profit(Pmin) and Tax. It represents

the amount of Profit at manager’s discretion and can be used to increase Managerial
Utility (U) through Discretionary Investments (Id) and Managerial Slack (M)
Firm's profit depends upon Staff Expenditure, provided price and market remain at
equilibrium.
Below in fig 3 is a diagram showing the Williamson’s model.
Source of diagram Moses et al (1967:212)
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 (=S 1M) 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.
Increase in both Staff Expenditure and Discretionary Profit positively contributes to

Managerial Utility, however increase in Staff Expenditure will decrease Discretionary Profit.
Managers will balance optimal combination of these factors to maximise levels of their
Utility and maintain at least Minimum Profit levels. Such equilibrium may be achieved
without achieving maximum Profit for the shareholders.
In other words, once minimum profit has been achieved managers would tend to allocate
firm’s resources towards increasing their own utility rather than maximising shareholder’s
profit.
Our study therefore suggests that the absence of incentive problems on the part of managers
is not a necessary condition for a positive association between managerial discretion and firm
performance. Given the existence of incentive problems on the part of controlling parties, self
serving managers may still be good stewards if their interests are relatively better aligned
with profit maximisation than are those of controlling parties.”
Criticism
 The model fails to describe how businesses take their price and output decisions in a
highly competitive set up.
 The relationship between better performance of managers and the increasing amounts
spent on manager’s utility by the firm is not always true.
 The model does not apply in a dynamic set up like changing demand and cost
conditions during booms and recessions.
 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.”
References
Chang, E., Wong, S.M. (2003). Managerial Discreation and Firm Performance in
China’s listed Firms: Business review Journal
Williamson O. (1964). Managerial discretion and Business Behaviour:American

Economic Review 53: 1032-1057.
Williamson, O.E. (1991) "Strategizing, economizing, and economic

organization."Strategic management journal 12.S2: 75-94.
Moses, L., Leon, G., Williamson, F. (1967)."The location of economic activity in

cities." The American Economic Review :211-222.

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GREAT ZIMBABWE UNIVERSITY

WILLIAMSON’S THEORY OF MANAGERIAL UTILITY MAXIMISATION

The basic assumptions of the model are:

1. Imperfect competition in the markets.

The theory describes Managerial Utility (U) as a function of Monetary Expenditure on Staff

The managerial utility function includes variables such as salary, job security, power, status,

"Management slack" consists of those non-essential management perquisites such as

"Discretionary investment" refers to the amount of resources left at a manager's

The theory considers several layers of profit:

Discretionary Profit(Pd) is Profit(P) less Minimum Profit(Pmin) and Tax. It represents

Below in fig 3 is a diagram showing the Williamson’s model.

Source of diagram Moses et al (1967:212)

Increase in both Staff Expenditure and Discretionary Profit positively contributes to

Williamson O. (1964). Managerial discretion and Business Behaviour:American

Williamson, O.E. (1991) "Strategizing, economizing, and economic

Moses, L., Leon, G., Williamson, F. (1967)."The location of economic activity in

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