Organization Theory and the Theory of
the Firm
The following summary is based on two chapters in the
Handbook of Industrial Organization:
1.
2.
Chapter 2 on The Theory of the Firm
Chapter 3 on Transaction Cost Economics
As the chapters were published in 1989, a great deal of recent
research is not included
However, key issues and open questions remain substantially
the same
Main Issues
• Behavior and organization within the firm is poorly
understood relative to interactions between firms in
markets; the lack of data probably accounts for much of
this gap
• Even though applied research in this area is difficult, it is
important to be aware of the main issues because they have
implications for work in other areas
• For example, firm behavior is the result of a complex joint
decision process within a network of agency relationships
– employees are not owners
• If agency problems are sufficiently severe, the firms in
question may not maximize their value
1. Limits of Integration
• What determines the scale and scope of a firm?
• Perhaps surprisingly, we do not have very good answers to
this question
• It is difficult to specify measurable tradeoffs between the
benefits and costs of integration
• Firms form, so some integration is optimal, but all
transactions are not organized in a single firm, so there
must be costs to increasing size
• Williamson (1975, 1985) poses the problem as one of
selective intervention: why not combine all firms into one
and intervene in their operations only when doing so is
profitable?
Firm Size
• Microeconomics texts refer to long run average costs
curves that eventually slope up
• What are the sources of diminishing returns to scale?
• Lucas (1978) focuses on scarce managerial inputs
• Geanakopolos and Milgrom (1985) refer to the benefits of
coordination balanced against the costs of communication
and information acquisition
• Lucas (1967) focuses on adjustment costs that limit firm
growth; Jovanovic (1982) emphasizes imperfect
knowledge about ability that limits growth – these
perspectives do not impose caps on size per se
Incomplete Contracts
• The technological models do not really address the
selective intervention problem
• A more productive approach considers problems with
contracting that prevent selective intervention
• Williamson (1975, 1985) emphasizes that contracts are
incomplete
• In reality, it is essentially impossible to use a contract to
describe appropriate behavior in every contingency for
every party
• This has implications for organization: when irreversible
investments are required, contractual incompleteness can
lead to hold up, which favors integration
Incomplete Contracts and Investment
• Grossman and Hart (1986) establish that when contracts
are incomplete, the allocation of residual control rights
(rights not specified in the contract) becomes critical
• If residual control rights over a particular asset are
allocated to the owner of that asset, then ownership
determines the ex post division of surplus in cases not
covered by the contract
• Thus, the ex post division of surplus depends on ownership
• This implies that ownership can affect the incentives for ex
ante investments; integration or non-integration may be
optimal depending on which yields better incentives for
investment
Information Flows and Incomplete
Contracts
• Williamson (1985) asserts that organizational changes
imply changes in information flows
• Certain information that is available at one cost before
integration may not be available at the same cost after
integration (Filson and Morales assume this)
• If true, organization design definitely influences
performance, because information is used in decision
making and incentive provision
• Grossman and Hart (1986) disagree with this view and
assume that integration/non-integration affects only
residual control rights
Influence Costs
• Milgrom (1988) emphasizes that integration results in
costly influence activities, which are essentially rent
seeking activities undertaken by employees within the firm
• Non-market organizations are susceptible to influence
costs because they have an authority structure that can
affect resource allocation and because there are quasi rents
associated with jobs within the hierarchy
• Bureaucratic inflexibility may be a rational response of
firms to limit the extent of influence activities
Relation to Empirical Work on Firm Size
• The authors, Holmstrom and Tirole, claim that the
incomplete contracts paradigm and its associated issues
(incentives, information flows, influence costs) is that only
one that resolves the selective intervention problem
• However, there is a need to tie these perspectives to
empirical work on the firm size distribution and firm
growth
• It remains to be seen whether precise relationships can be
drawn between these frameworks and observable firm size
2. Capital Structure
• Modigliani and Miller (1958, 1963) established that capital
structure is irrelevant: the value of a firm in a frictionless
and tax-free capital market is independent of the mix of
equity and debt and changes in dividend policy
• The reasoning is straightforward:
• If the value could be changed by altering the financial mix,
there would be a pure arbitrage opportunity
• An entrepreneur could purchase the firm, repackage the
same return stream to capitalize on the higher value and
yet assure the same risk by arranging privately an
identically leveraged position
Early extensions
• Intuitively, MM cannot be the final word on this subject
• Real world firms invest considerable effort in determining
their financial structure
• Social bankruptcy costs and non-neutral tax treatments
were early considerations that modified MM
• Equity reduces expected bankruptcy costs
• Taxes favor debt financing
• More recent explanations consider the incentive effects of
capital structure, signaling, and the effects of changes in
control rights
Incentives
• Jensen and Meckling (1976) originated the incentive
argument
• Firms are run by self-interested agents, not pure profit
maximizers
• The separation of ownership (which implies claims on the
profits) and control (management) gives rise to agency
costs
• There are agency costs with both equity and debt
Agency Costs of Equity
•
•
•
•
1.
2.
When outside equity is issued (equity not held by
managers) it invites slack
Managers realize that if they waste a dollar, the outside
owners will bear part of the cost
Thus, from a shirking point of view, the firm should be
fully owned by management
However, this is not efficient because:
managers may want to diversify for risk spreading
reasons
Financially constrained managers would have to use debt
financing, which also has agency costs
Agency Costs of Debt
• Debt and equity holders do not share the same investment
objectives
• A highly leveraged firm controlled by the equity holder
will pursue riskier investment strategies than debt holders
would like because of limited liability
• Debt holders bear the burden if the firm goes bankrupt; the
equity holders benefit only if the returns exceeds those
necessary to pay off the debt
The Tradeoff
• The optimal capital structure minimizes total agency costs:
the debt-equity ratio should be set to equalize the marginal
agency costs
• Measurement problems are enormous
• One qualitative prediction is that firms with substantial
shirking problems will have little outside equity, while
firms that can substantially alter the riskiness of the return
will have little debt
Alternative Agency Explanations
• Grossman and Hart (1982) provide a model where a
manager with little or no stake in the firm controls the
allocation of funds raised from the capital market
• The manager decides how much to invest and how much to
spend on himself; investment reduces the chance of
bankruptcy
• The manager does not want to spend all the funds on
himself because if the firm goes bankrupt and he is fired he
will lose quasi-rents
• Since bankruptcy is associated with dismissal, the manager
has to bear bankruptcy costs
• Given this, debt financing can be an incentive device
Problems with Agency Explanations
• Why should capital structure be used as an incentive
instrument when the manager could be offered more
explicit incentives that do not interfere with the capital
structure choice?
• Why can’t any incentive effect of a change in capital
structure be undone by a change in the managerial
incentive contract?
• Without an answer to this question, the agency
explanations do not really overturn MM
• This problem is also true of signaling models
Signaling
• Some models suggest that the debt-equity ratio signals
information about the return distribution
• Myers and Majluf (1984) argue that adverse selection
poses problems for raising outside equity
• Suppose the market is less informed about the value of the
firm’s future cash flows than the manager of the firm and
that there is no new investment to undertake
• Then no new equity from new shareholders can be raised if
the manager is acting in the interest of the old shareholders
Signaling
• The manager will be willing to issue new shares only if
they are overvalued (for example, if the shares are priced at
120 and the manager knows they are only worth 100)
• Realizing this, no one will buy the new shares at the asking
price
• Realizing this, the manager will avoid issuing new shares
unless debt is not a desirable alternative (for example, if
there is so much debt that more might lead to financial
distress)
Signaling
• Suppose capital is needed for an investment
• By the same reasoning, debt financing is generally
preferred to equity financing
• If equity financing must be used then the stock price will
always decline in response to a new issue (this result has
empirical support) because the manager’s private
information that the current shares are overvalued is
revealed
• One way to see this is to note that if the share price were to
increase with a new issue then it would always pay to raise
equity irrespective of project value!
Control
• The traditional explanations for capital structure ignore the
fact that equity has voting rights; equity is not just a right
to a residual return stream
• Similarly, debt contracts typically include some contingent
control rights
• The distribution of control rights is important for incentive
provision given that contracts are incomplete
• A complete theory would explain why equity holders have
voting rights and why debt contracts are linked to
bankruptcy mechanisms
3. The Separation of Ownership and
Control
• Most large firms are corporations controlled by managers
who own little of the firm
• Typical owners have little influence
• The board of directors is supposed to monitor the
management but evidence suggests that boards are rarely
active
• Further, the choice of directors is influenced more by
managers than owners
• Given this, what keeps managers from pursuing their own
private goals?
Internal Discipline
• Executive compensation plans often have incentive
provisions: bonuses, stock, stock options, and other
contingent compensation
• Extensive theoretical and empirical work on executive
compensation has been done
• Further, directors are supposed to monitor managers
• In practice, directors may lack adequate incentives; many
have close ties to the managers
• Following the publication of the handbook, there has been
additional work on boards of directors and their roles in
incentive provision and monitoring, but there is more work
to be done
Labor Market and Product Market
Discipline
• Fama (1980) suggests that internal discipline is not as
necessary as agency theory suggests because the
managerial labor market provides discipline
• A manager who does not maximize value will be punished
by the labor market
• Thus, reputational concerns provide incentives
• Product markets may also discipline managers; this effect
is likely to be stronger in more competitive markets
• If the firm is a monopolist then there may be little
incentive to avoid slacking off
Capital Market Discipline
• Take-over threats also discipline managers
• If managers do not maximize firm value, then there is a
profit opportunity for someone to buy the firm and replace
the managers with others who will
4. Transaction Cost Economics
The basic transaction cost economics strategy for deriving
testable hypotheses is:
Assign transactions (which differ in their attributes) to
governance structures (the adaptive capacities and
associated costs of which differ) in a transaction cost
minimizing way
Transaction cost economics relies more on comparative
institutional analysis than notions of global optimums
Behavioral Assumptions
• Friedman (1953) reflects the view of most economists: the
realism of assumptions is not important; the usefulness of a
theory depends on its implications
• Williamson argues that assumptions are important;
behavioral assumptions determine the set of feasible
contracts, for example
• Williamson describes “contracting man” as opposed to
“rational man”
• Contracting man is subject to bounded rationality and
opportunism
• Efforts to mislead, disguise, confuse are possible: these are
difficult to incorporate into rational actor models
Incomplete Contracts
Bounded rationality and opportunism imply:
•
All feasible contracts are incomplete
Given this, structures that facilitate gapfilling, dispute
settlement, adaptation, etc., are part of the problem of
economic organization
2. Contracts are not guarantees
Institutions that mitigate opportunism are important
The Role of Legal Enforcement
• It is often assumed that property rights are well defined and that courts
dispense justice at zero cost
• In this view, parties follow contracts and when one party does not the
other appeals to the courts
• Llewellyn (1931) argued that contracts are more of “a framework
highly adjustable, a framework which almost never accurately
indicates real working relations, but which affords a rough indication
around which such relations vary, an occasional guide in cases of
doubt, and a norm of ultimate appeal when relations cease in fact to
work”
• Klein has followed up on this view of “relational contracts”
• Recently, Baker, Gibbons, and Murphy have provided formal models
using the theory of infinitely repeated games
Transactions
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•
1.
2.
3.
•
Generating testable implications from transaction cost
economics requires that we describe features of
transactions that affect transaction costs
According to Williamson, transactions differ along three
dimensions:
The frequency with which they occur
The degree and type of uncertainty to which they are
subject
Asset specificity
Asset specificity is the most critical attribute
Asset Specificity
• Asset specificity refers to the degree to which an asset can
be redeployed to alternative uses and by alternative users
without sacrificing its productive value
• Given that contracts are incomplete and contractual man is
opportunistic, investments in relationship specific assets
are discouraged
• A simple dynamic model can illustrate the problem:
initially parties agree on an ex post division of the surplus,
then one party makes such an investment, then the other
party may attempt to bargain for more favorable terms
(incompleteness allows that this is possible)
• Looking ahead, the investing party under-invests
Asset Specificity
• Asset specificity can take many forms
• Firm-specific human capital is one example
• Untenured faculty members tend to under-invest in
location-specific activities (serving on university
committees, etc.) and emphasize investments that the
market values (publications in refereed journals)
• A faculty member who invests solely in location-specific
activities is vulnerable to being exploited by his/her
employer
Markets vs. Hierarchies
According to Williamson, there are three main differences
between market and internal organization:
1. Markets promote high-powered incentives and restrain
bureaucratic distortions
2. Markets can sometimes aggregate demands to
advantage, which allows for optimal scale and scope (a
firm may not be able to achieve scale in an input itself,
or sell the excess to its competitors)
3. Internal organization has access to distinctive
governance instruments
Asset Specificity and Organization
• Internal organization is favored when asset specificity is
great
• The specificity ensures that there are no separate demands
to be aggregated
• Integration overcomes the hold up problem
• There are many other organizational implications of asset
specificity and transaction costs
Another Implication: Second Sourcing
• Buyers in the semiconductor industry have insisted that
semiconductor producers license their design of chips to
other manufacturers
• This is an excessive requirement if concern for
idiosyncratic disruptive events at the producer was the
main issue – the producer could subcontract but retain
control over total production
• The buyers demand licensing because they are reluctant to
specialize their product to a particular chip provided by a
monopolist – they wish to avoid hold up
Capital Structure
• Transaction cost economics emphasizes that the asset characteristics of
investment projects matter, and that the governance structure properties
of debt and equity are key attributes
• The attributes of projects and the governance structure differences
between debt and equity should be aligned in a discriminating way
• When physical asset specificity is moderate, projects are easy to
finance with debt
• When asset specificity rises, the claims of debt holders afford only
limited protection because the asset is not re-deployable
• The benefits of closer oversight also grow when asset specificity rises
• These effects make equity finance (which is more intrusive through the
board of directors and through large shareholders) more beneficial
Data Problems
• When pursuing transaction-cost arguments, it is quite easy
to tell loose stories that seem reasonable
• Recent research has emphasized that it is critical to dig
deep into the data to formulate and evaluate transaction
costs arguments
• For example, Kenney and Klein (1983) attribute the
practice of block booking of films to measurement
problems: no one could forecast success, so distributors
would make all or nothing arrangements with exhibitors
• Recently, Hanssen questions this argument using evidence
from real block booking contracts: exhibitors could
exclude some films from the package
Data Problems
• Klein, Crawford, and Alchian (1978) use GM-Fisher Body
as an example of how relationship specific investments can
lead to holdup and integration
• Recently, Coase questioned their findings based on a more
in-depth investigation of the relationship between GM and
Fisher Body
• Both block booking and GM Fisher Body have been the
subject of recent debates in the literature
• It is important to get the institutional details right before
theorizing about them