Book 2 Part
- The Firm and agency theory
- Theories of the firm
- Firms range from sole practitioner to
the massive multinational corporations
- 3 approaches to an analysis and discussion
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
- Agency theory
- 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 agent¡¦s performance or to external factors
beyond the agent¡¦s control.
- There is a potential divergence between
the interests of the managers (agents) and the stakeholders (principals).
This is the principal-agent problem.
- 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.
- Three aspects are relevant to managers
i. MORAL HAZARD
- 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 manager¡¦s performance. In practice,
the principal has to trust the manager to act properly in the principal¡¦s
- The problem facing the
principal (the owner) is how to persuade an agent to act so as to maximize
the principal¡¦s 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.
ii. ADVERSE SELECTION
- The problem of adverse selection also
arises from information asymmetry.
- Even if the principal is
able to observe the agent¡¦s actions, it is not possible to know whether the
agent has acted optimally made
the correct selection.
iii. CONSTRAINTS ON MANAGERS
- Relations with principals
A1.Three areas of conflict between managers
- Perquisites: benefits of status or comfort
outside the terms of the formal contract of employment.
- Attitudes to risk: managers are likely
to be more risk-adverse than shareholders, who will have a diversified portfolio.
- Time horizons: managers are likely
to pursue actions that generate short-term improvements, on which their performance
(remuneration) will be assessed, while principals may prefer to take a longer
A2.To overcome these problems, principals
have two potential sources of power:
- Replacement of the manager
removal of managers
is difficult when ownership is fragmented or unclear.
- Provision of incentives
to link managerial
remuneration to performance.
- 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.
- Transaction Cost Analysis
- Who do firms exist?
- 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.
analysis of firms¡¦ boundaries
- Williamson¡¦s discussion of transaction
costs is designed to explain the limits or boundaries of organizations through
a combination of economic and behavioral norms.
- 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 contract¡¦as well as those arising from the related uncertainty and risks.
- Contract: formal and explicit
protect the interests
of both parties during the life of the contract.
- Market governance and hierarchical governance
D1. Advantages of market governance:
- Scale economies: a supplier with several
customers will be able to operate on a larger scale.
- Risk-pooling: by spreading its business
risk over many customers.
- Economies of scope: a supplier with
many customers will be able to offer a scope of product or service.
D2. Two behavioral assumptions:
- Bounded rationality: Managers
acting as economic agents are intendedly rational, but only limitly so. They
are limited both by the availability of information and their capacity to
process it. This shows the limits to the ability of an organization to write
contracts that fully protect its interests. It is argued that, with increasing
computing power, our ability to act rationally will improve.
- Opportunism: Self-interest
with guile, it refers to the practice of managers to make decisions in pursuit
of objectives that are inconsistent with the aims of the organization. Examples
include empire-building, patronage and nepotism as well as the pursuit of
professional objectives at the expense of broader organizational objectives.
The relevance to transaction cost analysis is that opportunism leads to uncertainty
in decision making and to sub-optimal decisions. Opportunism may increase
the cost of transaction carried out within the organization.
D3. Three principles of organizational
- Asset specificity: refers
to the extent to which the assets needed to carry out a transaction are generally
available or are specific to that transaction. Asset specificity is the result
of specialization. The more specific the asset, the less likely it is that
an organization is able to rely on market governance to minimize its transaction
- Externality: it describes
the pursuit of private goals by an agent. There may be an inconsistency in
goals between principal and agent.
- Hierarchical decomposition:
It refers to the extent to which decision-making is delegated (decomposed)
within the organization or hierarchy, enabling more rational decision and
allowing the organization to reduce the level of managerial opportunism..
D4. Market governance vs. hierarchical
- Because of bounded rationality,
many contracts written with external suppliers, under market governance, may
- Under circumstances of uncertainty,
hierarchical governance may offer an organization greater protection and control
than reliance on the market, especially if the activity is vital or of strategic
value to the organization.
- Where a transaction involves a high
level of asset specificity, the risks are likely to be lower under
- Externality is a particular risk
in the area of distribution, and reliance on market governance can lead to
loss of control.
- Hierarchical governance
also incurs costs bureaucracy,
- If hierarchical decomposition is inefficient,
market governance may be more attractive for an organization.
- Where asset specificity is high, it
is in the interest of both parties to seek continuity, both parties are strongly
- Where asset specificity is high, an
organization purchasing a good or service is likely to be at a disadvantage
when a contract is renegotiated. When it comes to renegotiating the contract
after some years, the external supplier will be at a substantial advantage
if the transaction involves highly specific assets. In addition, there will
be information asymmetry favoring the external supplier.
2.3 Applications of transaction cost analysis
- Downsizing, outplace and
contracting to reduce head counts and to convert fixed into variable costs
are common in today¡¦s climate. Such a policy is justified on cost grounds.
However, it needs also to be assessed in terms of its competitive impact
to contract out strategic
activities may carry a severe competitive penalty.
- Eg: Airlines differ in the degree of
vertical integration that they undertake.
- Eg: compulsory competitive tendering
- Eg: degree of backward and/or forward
- The combination of transaction cost
analysis with analysis of competitive strategy can provide a powerful insight
into the understanding of strategic management and success.
2.4 Implications of transaction cost analysis
- A broader definition of costs ( + transaction
- Production costs
raw materials, labor, facilities,
- Fixed and overhead costs
- scale diseconomies
increase in levels of seniority
more highly paid „³
reduce factor costs
- hierarchical governance
high salary costs
of management and administration, decision-making process is delayed and made
less efficient creating
- management opportunism
yet another source
- result „³
re-categorization of jobs, core „³
contain in-house, peripheral „³
within or outside the organization.
- Make or buy decisions
- Evaluate the market advantages of scale
and scope against the hierarchical advantages of control, flexibility and
- Outsourcing and the use of contractors
- Transferring the transaction from hierarchical
to market governance can reduce management staffing, and therefore costs (reduce
its fixed/salary costs by variable cost of an external contract), however,
firms may surrender some control over the activities outsource.
- The balance of these advantages
and disadvantages will depend on the nature of the transaction. If the activity
is non-strategic (strategic) in nature „³
little impact on the organization¡¦s competitive strengths if outsourcing (
create long term risk if outsourcing)
- Vertical integration
- Grant argues that technological
advances and improvements in management techniques led to a decline of the
internal administration cost relative to the transactions cost in the market.
This resulted in growth of the scope of firms. By the 1960s Galbraith was
able to write about the replacement of the market economy by the corporate
economy. However, over the past 20 years, this process has begun to be reversed
as major corporations have divested peripheral businesses and increased outsourcing.
The benefits of internalization have begun to be outweighed by the high transaction
costs, including inflexibility, of internal administrative systems. Greater
reliance on the market requires that the cost of managing external contracts
is reduced. This can be achieved by a greater dependence on relational
contracts, in which firms develop long term co-operative relationships
with their suppliers, thereby improving flexibility and reducing transaction
cost. The use of ¡§soft¡¨ contracts
with suppliers has developed most widely in Japan. Another example is Marks
and Spencer, the UK retailer, which has no written contract with its suppliers,
but operates through long established and close informal agreement. Such relationships
are highly dependent on trust, and all parties must be willing to forgo short-term
profit-maximizing opportunities in order to maintain the long-term relationship.
Marks and Spencer have rejected backward integration, they have a rigorous
insistence on forward integration, in that they control all their retail outlets
and trade only under their own name. They see that customer is the key element
of their competitive advantage.
- Not-for-profit organizations (NFP)
- The principles of transaction cost analysis
can be applied to public, voluntary as well as commercial sectors, however
there are some key differences for NFP:
- the identity of the principal
of organizations in the NFP
sector is not clear. The agents the
be subject to fewer checks and controls.
- Measurement of performance may be more
difficult in NFP sector.
- Many NFP organizations
are run by professionals, who may demonstrate a powerful form of opportunism
objectives at the expense of the broader goals of the organization.
- Little incentive for NFP
or staff to seek productivity improvement, this involves a trade-off with
professional standards or service delivery.
- The option of outsourcing is unlikely
to appeal to the traditional NFP manager.
- Many employees in NFP organizations
work to a strong code, thus managerial opportunism may be less important.
- 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
- run the risk of heavy over-staffing,
with fewer check mechanisms to trigger corrective action
- corrective action when it does come
is therefore liable to be externally imposed and traumatic
- Labor market segmentation
- Changes in employment
cases ( please refers to p.98-99 book 2)
- Transaction costs and the labor market
- General skills
lower transaction cost under
- Specific skills
lower transaction cost under
- Benefits of internal labor markets
according to transaction cost analysis:
- Identified by Doeringer and Piore:
- a high degree of employment stability
for workers possessing valued skills/knowledge
- restricted points of entry, usually
to relatively low-level positions, for ¡§outsiders¡¨
- finely graded reward systems which attach
to jobs, not individuals.
- Williamson suggests 3 areas in which
efficiency gains may be captured under internal labor markets:
- First, it may reduce the threat of opportunism
by assigning rewards to jobs and not individuals.
- 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.
- Third, the alignment of
pay, status and promotion may help secure employees¡¦ consummate.
- Causes of Segmentation
to P105 figure 6.2, Book 2
- Economic dualism (Doeringer and Piore)
- Labor divided (Edwards, Gordon and Reich)
- Search for flexibility (Atkinson)
3.5 Implications of labor segmentation
- 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.
- 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.
- 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.
- Projecting forward, it
is possible to see this peripheral sector becoming an underclass „³
growing disparities in living standards „³
growing economic burden for the economy overall „³
result in political and social instability.
- Changing economic role
of women „³
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
benefits or career prospects). To some extent, this may be a matter of choice,
some women prefer the flexibility of part-time work..
- Implications of labor segmentation
- 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.
- 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.
- 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:
- the slow decline in the size of the
work force in the mature economies
- the increasing role of women, especially
women returners, in the work place
- the increase in numbers of older people,
still physically active but largely excluded from the work force.