Book 2 Part 2 The Microeconomic Environment

  1. The Firm and agency theory
    1. Theories of the firm

Firms as financial units � the performance of firm is measured and monitored through financial criteria: the balance sheet, profit and loss, source and disposition of funds (cash flow). Legal regulation and control of firms is based on their roles as financial units.

Firms as economic units � it refers to managerial economic which focus on costs. The primary objective of the firm is profit maximization. Thus, understanding how firms can maximize profit or value is important to managers.

Firms as behavioral units � firms are complex social organizations in which structure, decision processes and performance are determined as much by behavioral as by financial or economic factors.

    1. Agency theory
  1. Agency theory attempts to explain relationships between agents and principals. Based on information asymmetry, i.e. managers (agents) are informed in detail on the current and future position of the firm, whereas shareholders (principals) can see only the outcomes of the managers actions (growth, profitability are caused directly by the managers actions), as all firms operate in an environment of uncertainty. The principal not only does not have the information available to the agent, but also does not know whether the outcomes are due to the agents performance or to external factors beyond the agents control.
  2. There is a potential divergence between the interests of the managers (agents) and the stakeholders (principals). This is the principal-agent problem.
  3. How to deal with this problem? Recent studies of managerial compensation indicate a strong correlation between firm profits and managers salaries. Thus, managers appear to have a strong economic incentive to pursue value maximization through their decision.
    1. Three aspects are relevant to managers


  1. Source of moral hazard: The manager takes decisions as agent of the principal, but the principal has little information on which to judge the effectiveness of the managers performance. In practice, the principal has to trust the manager to act properly in the principals interest.
  2. The problem facing the principal (the owner) is how to persuade an agent to act so as to maximize the principals interests. This can be tackled be closer monitoring of the agent (to reduce information asymmetry) or by providing incentives to the agent. Both of these will incur costs � so- called agency costs.


  1. The problem of adverse selection also arises from information asymmetry.
  2. Even if the principal is able to observe the agents actions, it is not possible to know whether the agent has acted optimally � made the correct selection.


  1. Relations with principals

A1.Three areas of conflict between managers and owners:

A2.To overcome these problems, principals have two potential sources of power:

  1. Risk of take-over

B1. Take-over is a crude weapon for countering moral hazard arising from information asymmetry between managers and shareholders.

B2. Take-over is not a threat to not-for-profit organizations, however privatization, compulsory competitive tendering are obvious examples to improve performance in the public sector.

c. Fear of bankruptcy

C1. The impact of bankruptcy is devastating, therefore managers have a strong incentive to maintain or improve performance. Bankruptcy generally arises as a result of lenders calling in their loans.

d. Threat from competition

D1.Assuming the internal job market is reasonably efficient � internal promotion is based on merit and performance.

e. Conclusion: Constrains on managers provide a partial limit to the risks of moral hazard and adverse selection that they as agents pose to their shareholder principals. The ability of managers to behave in an unconstrained way may lead to managerial opportunism, which can be a significant source of transaction costs.

  1. Transaction Cost Analysis
    1. Who do firms exist?
  1. Coase 1930s: Firms exist because they can carry out certain activities with lower transaction costs (costs of management, control and uncertainty) than would be incurred externally. Decisions to make or buy will therefore be determined by the level of transaction costs. Optimum size of a firm is one where the cost of internalizing an extra transaction is equal to the cost of organizing that transaction externally.

2.2 Williamsons analysis of firms boundaries

  1. Williamsons discussion of transaction costs is designed to explain the limits or boundaries of organizations through a combination of economic and behavioral norms.
  2. Transaction costs: cost of managing and controlling the transaction, (activities that a firm undertakes to obtain and transform inputs and to distribute outputs) including the costs of writing the contractas well as those arising from the related uncertainty and risks.
  3. Contract: formal and explicit � protect the interests of both parties during the life of the contract.
  4. Market governance and hierarchical governance

D1. Advantages of market governance:

D2. Two behavioral assumptions:

D3. Three principles of organizational design:

D4. Market governance vs. hierarchical governance?

2.3 Applications of transaction cost analysis

2.4 Implications of transaction cost analysis for managers

  1. A broader definition of costs ( + transaction cost)
  1. scale diseconomies � increase in levels of seniority � more senior, more highly paid reduce factor costs
  1. hierarchical governance � high salary costs of management and administration, decision-making process is delayed and made less efficient � creating another cost
  2. management opportunism � yet another source of cost
  1. Make or buy decisions
  1. Outsourcing and the use of contractors
  1. Vertical integration
  1. Not-for-profit organizations (NFP)
  1. the identity of the principal � the owner � of organizations in the NFP sector is not clear. The agents � the managers � may be subject to fewer checks and controls.
  2. Measurement of performance may be more difficult in NFP sector.
  3. Many NFP organizations are run by professionals, who may demonstrate a powerful form of opportunism � seeking professional objectives at the expense of the broader goals of the organization.
  4. Little incentive for NFP organizations manager or staff to seek productivity improvement, this involves a trade-off with professional standards or service delivery.
  5. The option of outsourcing is unlikely to appeal to the traditional NFP manager.
  6. Many employees in NFP organizations work to a strong code, thus managerial opportunism may be less important.
  7. NFP organizations are not subject to the pressures of competition that apply the ultimate sanction of bankruptcy or take-over even they fail to improve efficiency. 2 consequences will be resulted:
  1. Labor market segmentation
    1. Changes in employment patterns UK cases ( please refers to p.98-99 book 2)
    2. Transaction costs and the labor market
    1. Benefits of internal labor markets according to transaction cost analysis:
  1. a high degree of employment stability for workers possessing valued skills/knowledge
  2. restricted points of entry, usually to relatively low-level positions, for outsiders
  3. finely graded reward systems which attach to jobs, not individuals.
  1. First, it may reduce the threat of opportunism by assigning rewards to jobs and not individuals.
  2. Second, the practice of limiting entry to lower level grades provides an effective, low cost screening device, which facilitates the identification of performers at an early stage.
  3. Third, the alignment of pay, status and promotion may help secure employees consummate.
    1. Causes of Segmentation Please refers to P105 figure 6.2, Book 2
  1. Economic dualism (Doeringer and Piore)
  2. Labor divided (Edwards, Gordon and Reich)
  3. Search for flexibility (Atkinson)

3.5 Implications of labor segmentation for society

  1. The traditional bond of mutual dependence between employer and employee is changing, job mobility will inevitably increases as the proportion of jobs in the primary or core sectors declines. More employees become self-employed, part-time working or unemployment.
  2. The decline in core employment, with its benefits of career progression, training and development and pension provision, has significant supply-side implications. Employees are increasingly willing to invest their own time and money in personal and professional development, and require a qualification that recognises this.
  3. Increasing importance of self-employment, in response to both push and pull factors. The push is provided by employers who wish to convert staff costs from fixed to variable and to save the additional costs and benefits incurred when staff are on the payroll. The pull comes from employees who seek greater flexibility and profit opportunities than are available to them on salaries or wages.
  4. Projecting forward, it is possible to see this peripheral sector becoming an underclass growing disparities in living standards growing economic burden for the economy overall result in political and social instability.
  5. Changing economic role of women women are now a significant part of the paid workforce. The great majority of them are working in the secondary or peripheral sectors (poor quality jobs � lacking security, benefits or career prospects). To some extent, this may be a matter of choice, some women prefer the flexibility of part-time work..
    1. Implications of labor segmentation for managers
  1. Segmentation is not solely an economic issue, it also has important social and political consequences. Managers have choice to structure the employment. The need for flexibility and competitiveness is likely to continue, but a dependence on low-grade labor also carries its own problems of incentives, loyalty and control and supervision costs.
  2. Doeringer and Piore argue that it is the jobs that need to be upgraded. It must be the goal of modern economies to develop high value-added businesses, that offer good reward to their employees. This will only be possible if the state and employers commit to improvement in skill levels.
  3. The external environment is not static, all managers should be aware of changes in the work force and plan accordingly. The 3 key drivers over the next two decades are likely to be: