Lecture 4: Agency theory &
Transaction cost theory
Week 4, Chapter 8 & 9
Agenda
• What is the agency problem (Principal agency theory)
• Monitoring, Bonding & Designing the agents reward structure
• Positive agency theory: different types of firms and why firms exist?
• Break
•
Transaction cost theory & the dimensions of transactions
•
TCE & Perspectives on different organizational forms
•
Competitive forces between markets and organizations
•
Conclusion
2
What is the Agency Problem?
• Principal agency theory: Information asymmetry exists between principal and agents
• Principal cannot directly observe the activities of the agents due to: Hidden information &
Hidden action.
• A few examples:
• Owner and the manager of a firm
• Lawyer and the clients of the lawyer
• Patient and a physician
• Shareholders and managers
3
Agency problem
• Management-controlled firms typically suffer from the agency
problem:
• Majority of the dividends are paid out to the shareholders and
the major decisions were made by the directors.
• The outside shareholders are unable to effectively monitor the
manager
• Conflicts of interest -> Hidden actions
• A crucial question in the theory of principal & agent is how well
the principal can observe the agent’s effort
PROFITS
MAXIMIZATION
SELF
ENRICHMENT
4
Monitoring and bonding
•
Monitoring: Shareholders take the initiative to monitor the behavior of managers
 E.g., auditing; board of directors etc.
•
There are some powerful mechanisms to control excessive on-the job-consumption by firm managers:
 Market for corporate control (fear of being taken over)
 Market for managerial labor (race for top positions)
 Markets for the company’s product
 Professional ethics
 Incentive for managers (bonus, pay packages), reward structure
•
Bonding: Managers take the initiative to bind themselves and be monitored
• E.g., management takes the initiative to have the firm’s books audited; membership of some selfregulation association
5
Designing the agents reward structure
• The principal has symmetrical information:
• Forcing Contract: an incentive scheme where a target output is set for the agent. The agent will only
be paid if the target is met but receives no extra payment even if he makes more effort
• The principal has no information (asymmetry): How to design the right reward structure?
• Principal has no way to observe the level of effort by the agent.
• The principal has no information but can observe the agent’s effort indirectly through certain signals
(e.g., output).
6
Reward structure under asymmetrical information
• Wage Contract: a fixed salary is set for the agent
 Not optimal solution as the principal bears the risk
 The agent will not have the incentive to do a good job.
7
Reward structure under asymmetrical information
• Rent Contract: pay-off minus a pre-agreed fixed amount.
• Agent bears the risk and has incentive to do a good job
• The challenge: Agents are risk-averse
• They face the risk of losing additional profits, if they do not perform well.
• The optimal solution: Reward based contract
• There must be risk-sharing between principal and agent
• Reward schedule should be based partially on agent’s performance
• Reservation wage: compensates for unforeseen circumstances and provides
additional compensation for good performance.
8
Reward structure - Signaling
• Limitations: A signal concerning the agent’s level of effort can often be imperfect.
• When certain compensation schemes are best
• A reward structure based on both the signal of agent’s level of effort and the pay-off is
only better if the agent is risk averse.
• Otherwise, the principal can simply give the agent a rent contract and let him bear all the
risk.
• Monitoring is often needed to obtain signals, but monitoring has also costs
• Principal needs to determine the optimal level of monitoring
• Compare the present period with previous periods
9
Example: Reward structure under asymmetrical information
• Mr. R owns an ice cream bar at the beach in England
• Ice cream sales are highly seasonal: almost all sales take place during May to September
• Mr. R decides to take a vacation this year in July to visit his sister in Alaska, and thus wants
to engage someone to run his ice cream bar when he is away
• Mr. A wants to find a summer time job and is interested in working for Mr. R in July
• The sales of ice creams are dependent on:
• Level of effort from Mr. A; but also
• Weather
• So what kind of contract should Mr. R offer to Mr. A?
10
Application
1. Should Mr. R offer a forcing contract?
2. Should Mr. R offer a wage contract?
3. What other types of contract can Mr. R offer?
4. What would be the best contract if both of them are risk neutral?
5. What would be the best contract if Mr. A is risk averse?
11
Agency theory: Why firms exist ?
Agency theory explanation of why firms exist.
• The key question: why are there many more entrepreneurial firms (manager controlled) than
workers’ cooperatives in manufacturing industries?
• Entrepreneurs, as owners are better able to monitor the firm and team production.
12
Problems with team production
•
A dilemma!
 Gains resulting from team production are joint or
non-separable
 Noone can recover the full value of the
contribution.
•
Problems may arise…
 Members are subject to the potential opportunistic
behavior of each other
 As a result, the total output of the team is lowered
How can we deter shirking in team production?
13
Solutions?
• Contracts?
 Hard to draft contracts to accurately measure and reward
each team member’s contributions
 Agreeing on an ex-ante sharing rule?
 invites shirking
 Divide gains ex post?
 Invites haggling (negotiating, bargaining)
 Ex-ante & expost: Erodes the benefit of team production.
• Specialized monitor?
 Monitoring can increase team productivity
 Solution: Monitoring should be done by the owner of the
firm.
14
Monitor in an entrepreneurial firm…
• Monitor must have certain rights and power in order to be effective in monitoring, such as:
 Revise the contract of individual team members
 Terminate existing and enter into new contracts with team members
 Adjust pay rates of each team member
 Alter the composition of the team
15
The firm as a nexus of contracts: Positive agency theory
Positive agency theory:
• Ownership of a firm is irrelevant.
• Firm is essentially a nexus of contracts
Shareholders in a large corporation:
• Shareholders are just one group of parties that are
bound together in a nexus of contracts
• Do not own the corporation in a meaningful sense
• But just contract to receive the residual funds
16
The nature of the contract
The most important contracts should:
• Specify the nature of residual claims
• Allocate decision process of agents
• Decision management = Decision initiation + Implementation
• Decision control = Ratification + Monitoring
• Residual risk = Difference between stochastic inflows of cash and promised payments
Fama & Jansen: Different firms see different allocation patterns of the three rights.
17
Decision management, decision control, and residual risk bearing
Entrepreneurial firm:
•
Combining decision management and control to one or a few agents
• Residual claims restrict to these one or a few agents
• Owned and managed by the same persons
Large firm:
• Owned by numerous shareholders which delegates the board of directors to exercise decision control
• Separation of decision management and control
• Separation of residual risk bearing from decision management
Key: Information requirements between firms vary!
• Allocation patterns in firms must be structured to support efficient information allocation.
• Rewards must also be structured to match residual risk.
18
10-minute break
19
Williamson’s transaction costs economics
• Transaction cost economics is based on two important behavioral
assumptions:
• Human beings are bounded rational; and
• Sometimes display opportunistic behavior
• Capacity of human beings to formulate and solve complex problems is
limited, and this could be due to:
• Inability to process all available information
• Information is simply not available
• Various cognitive biases
20
Opportunistic behavior
• Trying to exploit a situation to your own advantage
• Self-interested behavior disregarding duties, obligations or moral
principles
• Williamson’s assumptions:
• Some people in some situations act opportunistically
• Transaction costs arise because it is difficult or costly to predict ex ante who will act
opportunistically and in what situations.
• Example: Inspection or contracting costs related to the purchase of a second-hand
car
21
Relax the assumption of opportunism
• Economic transactions take place in an environment characterized by BOTH:
• Capacity of rational calculation
• Reciprocity and trust
• People will not cheat their partner even if doing so would bring in some financial gain
• Trust plays a role both within and between organizations
• Personal trust
• Important in personal exchanges
• Impersonal trust
• In institutions
• Reputation
• Impersonal trust is important in exchanges between strangers
22
Transaction cost theory:
Critical dimensions of a transaction
Transaction risk
• Asset specificity (amount of investment required to make an asset work)
• Uncertainty/Complexity (e.g., legal risk, knowledge risks, operational risks, the
environment)
• Frequency (e.g., volume of transactions, dependency on external parties)
23
Asset specificity
• May lead to "hold-up" in transactions
• Asset specificity often leads to long-term contracts or even mergers
• Higher transaction costs in case of asset-specific transaction
• Three principal types of asset specificity:
• Site
• Technical (an asset)
• Human capital (skills, training etc.,)
24
Uncertainty / Complexity
• Uncertainty / complexity aggravates the problem of bounded rationality
• Complex transactions are prone to be executed within firm or by longterm contract
25
Frequency
• High asset specificity may justify an intra firm solution
• However, there are also fixed costs to set up a firm
• Fixed costs of setting up a firm might be higher than savings on
transaction costs, unless the latter happens frequently enough
26
Example: Appropria
• Mr. P wants to start a local newspaper
• The newspaper needs to be locally printed
• Mrs. Q has a press company but needs to
buy a special printer.
• The printer has no other use besides printing Mr.
P’s newspaper
• The printer is thus a specific asset
• The transaction will involve asset specificity
and lock-in.
27
Market coordination would be costly
• After Mrs. Q buys the expensive printer, Mr. P may act opportunistically
against her:
• Reducing the price for using the printer
• Threatening to go bankrupt
• Solutions against such opportunistic behaviors
• Negotiate about the price of using the printer on a daily basis
• Obtaining a bank guarantee to secure Mr. P’s obligations
• But that only transfers the problem to the bank
28
(quasi) Organizational coordination
• More feasible solutions against such opportunistic behaviors
• Obtaining more information about Mr. P before entering into the contract
• Business plan, personal wealth, feasibility of the project
• Due diligence
• Jointly bearing the risk
• These conditions already beyond simple market contracts.
• Quasi organizational solutions: long term contract (relational contract
based on trust)
• Organizational solution: Merger between Mr. P and Mrs. Q
• Asset ownership
29
Other concerns….the asset is highly specific
The transaction also has a high degree of asset specificity for Mr. P:
• A newspaper typically suffers start-up losses during the first few years of its launch
• Mr. P needs to invest in goodwill (knowledge, skills) to operate the printing business
• Mrs. Q can also act opportunistically against Mr. P by:
• Raising the price for using the printer
• The experience gained by Mrs. Q puts her in the position of a monopolist against Mr.
P
• Lock-in effect.
30
Conclusion
• The Appropria example is characterized by high level of asset specificity
• Both parties have to invest in a transaction-specific asset (printer vs skills).
• After they have invested, they will be locked into a bilateral monopoly
• High transaction cost
• So high that market solution fails
• Need to look for organizational solutions
• Relational contract
• Merger
31
Competition of various transaction governance forms
Hybrid
Market
Organization
32
Effect of digitalization on transaction costs
• Digitalization lowers the costs of both external and internal costs.
• This often leads firms to outsource their services when it is cheaper in the market.
33
Transaction cost theory: Organizational forms
How does transaction cost economics explain the different forms of firms?
Three main organizational forms:
• Peer groups
• Simple hierarchies
• Multistage hierarchies
• U form (e.g., small businesses, startups) & M form (e.g., multinationals)
34
Transaction cost theory : Organizational forms
Peer groups:
Simple Hierarchy:
Small partnerships with equal position
for all members
In contrast with a peer group, an authority is
present.
• Possible benefits:
• Economies of scale
• Produces economies of communication
and decision-making
• Typical for small manufacturing firms
• Risk-sharing
• Associational gains
• Information-gathering
35
Different explanations: Peer groups vs Simple Hierarchies
Why do we observe so little peer groups or cooperatives, in the manufacturing industry?
• TCE
Decision making
Information costs
36
Multistage Hierarchies: Unitary form (U-form)
• U-Form structure • Functional based hierarchy- to cover all business centres
• Communication and coordination flow through the established hierarchy.
• Disadvantages: information is communicated imperfectly from the local managers to
the top manager.
37
Multistage Hierarchies: Multi-divisional form (M-form)
M-Form organization, coordination often relies on divisional managers who are responsible
for coordinating activities within their divisions.
Adapted from Chandler (1962:10)
38
Emergence of U & M form organizations
TCE
Information flow
• M form enterprises economize and address both bounded rationality and opportunism
better than U form organization.
• M-Form structure, communication can be more fluid between divisions and corporate
headquarters, allowing for better sharing of information and best practices.
39
Three internal organizational markets
Numerous transactions for goods and services take place:
• Divisions
• General office
• Operating divisions
In order to understand the issue of organizational markets
well:
• Internal market for intermediate goods and services
• Internal labor market
• Internal capital market
Market vs Organization: Internal & external competitive
forces
• internal suppliers compete with external suppliers
40
Internal markets for intermediate goods and services
In an internal market system:
• Units of the same company charge each other
prices for products and services,
• Most purchase decisions are voluntary (i.e., not
required by company policy).
• In some cases, internal suppliers even compete
with external suppliers.
• Each unit's financial statements reflect internal as
well as external purchases and sales.
41
Internal markets: Example
Transactions between headquarters and an operating division.
• Hiring of internal consultants vs external consultants
42
Internal labor market
• Different ways of internal managerial labor market
• Internal rotation of managers
• Competition among internal managers for vacancy
• Competition among internal and external candidates
• Difference between external and internal market virtually disappears
43
Internal capital market
• The general office in an M-form enterprise are in a better position to
allocate capital in external markets:
• The advantages of the general office (internal capital market):
• Internal relations enable better monitoring of the performance of division managers
• Information advantage
– Better access
– Availability of sensitive information
• If operating divisions are allowed to reinvest cashflows and raise capital
from external markets, the general office’s role decreases:
• General office is reduced to a clerical agency for preparation of financial reports
• In some cases, the operating division become autonomous companies forming a
loose federation that is owned by a single holding company
44