Managerial utility maximisation

Managerial utility maximisation

Introduction

Williamson’s theory of managerial utility maximization is also known as managerial discretion theory which describes the utility of the manager versus maximization of the profit in the corporate world (Baker, 2018). It states that the management is separate from the shareholders /the owner where the shareholders’ aim is different from that of the manager since the shareholders want their investments to have maximum returns leading to profit maximization, while the manager/management have got other considerations within their utility functions rather than profit maximization.

According to this theory, managers implement decisions that give first priority to their maximization of utility over the profit of the principle provided that the firm is in a position for generation of minimum profit which is automatically demanded by the very principle for the job security of the manager (Foley & Williamson, 2018). Thus, the aim of this essay is to discuss the principal-agent problem of managerial economics and how and in what ways Williamson’s theory relates to the principal-agent problem.

The principal-agent problem of managerial economics occurs when one particular party that is, the agent, agree to work in favor of another one that is, the principle with the aim of incentives returns. In this scenario, the principal doesn’t have complete information on how the agent is likely to behave. The interests that belong to the principal diverge to that of the agent, thus the outcome is less than the expectation of the principle. The agent may incur a huge cost in this agreement thus resulting in conflicts of interest.

Due to the large cost incurred, the agent pursues his very own agenda and ignores principle’s interest thus resulting to principal-agent problem. An example of this problem is when Shareholders appoint managers to run the proceedings of their company and in turn, bring profit to the organization on their behalf. The expectations of the shareholders are that the manager will be able to distribute the profit earned but manager being anxious about their growth and salary rise they decide to retain/keep the profit for future use.

The following ways explain how Williamson’s theory of managerial utility maximization relates to a principle-agent problem;

Asymmetric of information

Occur when the shareholders and managers differs in attitude concerning a certain task. Asymmetric information explains that one faction in an economic relationship has got much of the information than the other party. It’s a situation where managers know much information than the owners. Managers possess information that is unknown/inaccessible to the owners, thus managers are likely to make decisions according to their own interest, then pursuing the principal’s interest.

Shareholders in most companies are not in a position to inspect everything the managers are doing since managers have got full and clear information that is partially available to shareholders. Example of a situation in a limited company occurs where he due to managers skills and expertise he has information which is relevant in the operation of that business than what the owner has. Although their objectives are common for the running of the business manager decide to pursue his own agenda and objectives rather than the owner stipulated and this is a result of the difference in experience and expertise level.

Adverse selection

Occurs when the shareholders are unable to identify manager character who always perform on their behalf. Due to the failure of the shareholders to identify the character of the manager they are unable to measure the quality that is within such industry. An example of this scenario is where the manager of the organization is able to access private information which the shareholder cannot be able to access at all. Therefore the owner is unable to detect whether the performance of the manager was good and whether his/her performance meets the owner’s interest.

This problem occurs as a result of little or no information about the values attached within the constraint that explain the characteristics possessed by a manager and the shareholders don’t know anything about the characteristics of the manager/management. The manager tries to maximize his own objectives and agenda through the hidden characteristic he has and this becomes a problem since activities selection between the shareholders and manager differs greatly in an organization

Employer and the employee

The principal-agent problem within organizations not only affects shareholder and managers but occurs also between the employer and the employee (García et al, 2015). This happens when workers refuse to carry out the duties because they think it’s harmful. Also, lack of motivation has a great contribution in the performance of duties of an organization as the compensation is due to performance and if the employee fails to deliver for maximum profit he/she fails to be compensated. In case of the inconsistent risks, the shareholder and the manager differs greatly as the shareholder is able to spread risk within or across all department of the organization to other investment (Van Thiel, 2016). Thus the compensation of the employees will depend on the profit gained in an organization.

Williamson theory of managerial utility has been used by various businesses for the implementation of their policies;

Case 1; RBS bank

The theory of Williamson managerial utility maximization help managers makes a decision that gives priorities of their own objectives over principals’ profits, as long as the organization is able to generate profit required by the principals to maintain job security of the manager. Managerial Utility (U) is defined as Monetary Expenditure on Staff (S), Managerial Slack (M) and Discretionary Investment (Id)

The RBS case is based on managerial theories of the firm in the banking sector. Various factors contributed to the investigation to be carried out where the bank’s executives were incriminated on their decision-making strategies. At this particular time, most banks had low liquidity but cash deposit was huge due to their passion for fast growth. For this reason, some banks received bails from the government for they were too big to fail. Before the financial crisis occurred the bank was in a process of going through managerial utility maximization culture.         The main objective of the company CEO was to lead the bank as being the largest financial institution in the whole world and second largest in the UK. Due to the lack of relevant information to understand the profitability of various products, products were being measured according to the volume of sales to achieve sales maximization rather than profit which could have increased bonuses thus salary increase.

The sales staff took advantage of asymmetric imbalance information for alternative methods by manipulating the system highest bonus payment for their own benefits. This made manager increase their interest. Bonus payment was increased by management as the business achieved its profit margins which were later given to shareholders to retain them. The sector had to sold mortgages, credit card and loans to increase sales. Due to this scenario, the bank failed miserably since the managerial utility maximization on a short-term process affected long-term profitability of that RBS bank since it failed to deliver minimum shareholder requirements

Case 2; Discretionary Power of Investment in Volkswagen.

The managerial utility also relies on the manager’s discretion undertaking investment that is beyond the normal operation required within the organization. Therefore, the manager can decide to invest in various technologies or in modern plants. Investments of this kind might be economically efficient or not. These investments are mostly undertaken for manager’s self-satisfaction and motives. The following case scenario explain deeply

Volkswagen has been listed in the financial press as a result of their failure to profit maximize, rather they promote revenue maximization. This results in a continuous net profit reduction when production is expanded to a large extent which can be above the point of costs and revenues maximum differences. At this state, diseconomies of scale are occurred taking away net profits whereas the company is still achieving a larger market share. Thus salaries are affected and still, the staff is increasing as the market share is increasing.

The management decided to change the way of maximizing their organization profits by employing the managerial discretionary theory in their organization. The management made short-term goals on the maximum utility which contributed to the growth of their organization. The utility functions put into consideration where the salaries, power, and security and among them only the salary can be measured. Thus the organization had to apply the concept of expense preference where managers had to derive certain types of expenditure. This discretionary approach lies at the core of the Volkswagen business model. This application has led the business to meet the demand of a large consumer market worldwide.

In conclusion, managers implement decisions gives first priority to their maximization of utility over the profit of the principle provided that the firm is in a position for generation of minimum profit in order to maintain the shareholders. This theory can be useful to an organization if handled correctly and the managers concentrate on profit maximization rather than sales maximization.

References

Baker, A. J. (2018).  Business decision making.  Routledge.

Bridge, J., & Dodds, J. C. (2018). Managerial decision making. Routledge

García, J. A., Rodriguez‐Sánchez, R., & Fdez‐Valdivia, J. (2015). The principal‐agent problem in             peer review. Journal of the Association for Information Science and Technology, 66(2), 297-308.

Van Thiel, S. (2016). A principal-agent perspective. In Theory and Practice of Public Sector          Reform (pp. 54-70). Routledge

Foley, M., Baird, M., Cooper, R., & Williamson, S. (2018). Is independence really an        opportunity? The experience of entrepreneur-mothers. Journal of Small Business and Enterprise Development, 25(2), 313-329.