Summary
Summary Organization / Economic approaches to organizations CH8 and further
- Course
- Institution
- Book
Summary economic approaches to organizations Chapter 8 (except 8.3 and 8.6), 9, 12 and 13 (except 13.5 and further)
[Show more]
Connected book
Book Title:
Author(s):
- Edition:
- ISBN:
- Edition:
More summaries for
-
Complete Summary Business for Lawyers - Notes on all Chapters/Readings + Lectures + Tutorials
-
Summary lectures/chapters Foundations of international strategy
-
Summary + lecture notes Introduction to Economics and Business
2 reviews
By: basjansen6 • 2 year ago
By: jordygovaert • 7 year ago
Seller
Follow
janskelensen
Reviews received
Content preview
Economic approaches to organizationsChapter 8 Agency theory
8.1 Introduction
Agency theory discusses the relations between to people, a principal and an agent who makes
decisions on behalf of the principal. For example: the owner of a firm(principal) and the manager of a
firm (agent), the owner of an estate (principal) and her steward (principal). Two streams of literature:
- The positive theory of agency: the firm is viewed as a nexus of contracts. How do contracts
affect the behaviour of participants and why do we observe certain organizational forms in
the real world?
- The theory of principal and agent: how should the principal design the agent’s reward
structure?
Both streams of literature have their antecedents in the literature on the separation of ownership and
control.
8.2 Separation of ownership and control
The separation of ownership and control is described in the typical twentieth-century corporation.
The large corporation is owned by so many shareholders that no single shareholder owns a significant
fraction of the outstanding stock. Therefore, no single shareholder owns a significant fraction of the
outstanding stock. The situation is as follows:
- The bulk of the dividends goes to the outside shareholders
- All the major decisions are made by the corporate officers
- The outside shareholders are unable to control the corporate officers
In that situation, the interests of the officers and shareholders diverge widely. Officers are in search of
power, prestige and money, whereas the shareholders are interested only in profits.
Corporations where the officers’ portion of shares is significant is called owner-controlled and the
corporations with widely dispersed shareholdings manager-controlled. Owner controlled companies
should be much more profitable than manager-controlled companies. There are, however, powerful
mechanisms that prevent managers from engaging in excessive on-the-job consumption:
1. The stock market: managers who perform poorly must always fear that their company can be
taken over. If a corporation performs badly because of the manager, the market price of the
stock will decline. If it becomes clear why the market price is so low, a determined outsider
can try to acquire a majority of the shares at a low price.
There is a market not only for individual shares but also for whole corporations. That market
is usually called the market for corporate control and increases the pressure on managers to
perform well.
2. The market for managerial labour: we expect some competition between managers to obtain
the few top positions in the largest firms. All managers, therefore, have to worry about their
reputations and if they want to grow higher in the company they cannot think in personal
interest but have to think about profit opportunities.
3. The market for the company’s products: more competition means the less opportunity for
managers to pursue their own interests. If they do so, the company will have higher unit costs
than its competitors and will turn out products of a lower quality.
4. Even if officers of a company do not own shares in their company, their pay package may still
include a bonus related to annual profits, an option to buy stock at a later date and so on.
This can also bring the interests of top managers more in line with those of the shareholders.
8.4 Entrepreneurial firms and team production
,An entrepreneurial firm is owned and managed by the same person. Direct supervision is the most
important coordination mechanism. An alternative organization form is a workers’ cooperative, in
which the workers cooperate as peers, here mutual adjustment is de coordination mechanism.
The concept of team production is used to explain workers’ cooperatives. Team production is a
situation in which two or more people can produce more when they are working together than when
they are working separately. Some goods or services cannot be produced by one person working
alone: an example is a symphony orchestra.
People working in a team and sharing the proceeds of their work will put in a lower level of effort
than people who are self-employed. This is called shirking. If shirking by one of the team members is
easily detected by the other team member, a team member could be expelled. It is often hard to
detect shirking, and this means that the unobservability of the effort put in by the team members
causes an information problem.
Someone with the task to detect shirking is called a monitor. A team with a monitor would produce
more than a team without a monitor. Who monitors the monitor when (s)he is part of the team? The
solution is to give the monitor title to the residual funds after the other team members have been
given a fixed level of pay. (S)he will not have an incentive to shirk as a monitor.
The monitor must have some rights:
- The power to negotiate with all the other team members
- To terminate contracts, attract new members and adjust the rates of pay of every team
member to reflect the marginal productivity of each person
- The right to sell high rights as monitor. Some of the monitor’s activities will pay off only after
a certain period of time
In the context of the entrepreneurial firm the monitor is the owner of the firm and the employees are
the members of the team. The classical entrepreneur emerges in this theory as the solution to the
problem of shirking within teams. The theory rests on two vital assumptions:
1. There is a team production
2. Monitoring by someone specializing in that function can reduce shirking
8.5 The firm as a nexus of contracts
In this paragraph we introduce separation of security ownership and control instead of just ownership
and control. In this theory ownership of the firm is an irrelevant concept. Shareholders are just one
party in a group of many parties bound together in a nexus of contracts.
Fama and Jensen see the organization as a nexus of contracts, written and unwritten, between
owners of factors of production and customers. The most important contracts specify the nature of
residual claims and the allocation of steps in the decision process of agents. The residual risk is the
risk of the difference between stochastic inflows of cash and promised payments.
The decision process of agents has 4 steps:
1. Initiation: generation of proposals for resource utilization and structuring of contracts
2. Ratification: process of culminating in choosing which of the initiatives is to be implemented
3. Implementation: the execution of the ratified decisions
4. Monitoring: the measurement of the performance of decision agents and implementation of
rewards
Step 1 and 2 together is called decision management. Step 3 and 4 is called decision control.
Two hypothesis about the relations between risk-bearing and decision processes of organizations:
1. The separation of residual risk-bearing from decision management leads to decision systems
that separate decision management from decision control.
, 2. Combining decision management and decision control in the work of a few agents leads to
residual claims that are largely restricted to those agents.
Non complex organization (small organizations): if specific information relevant to decisions is
concentrated in one or a few agents. Specific information is detailed information that is costly to
transfer between agents. In non-complex organizations it is efficient to allocate both decision
management and decision control to those agents who have the specific information. Residual claims
are also allocated to the important decision agents.
In large public corporation there are many shareholders. This has advantages because the total risk to
be shared is large and there are large demands for capital in order to be able to make fixed promises
to other agents. It is very costly for all of the shareholder to be involved in decision control, so they
delegate decision control to the board.
8.7 Applying agency theory
Two kinds of agency problems occurring in large corporations are described.
8.7.1 The CEO as agent of the shareholders
In companies with a separation of ownership and control, there is an agency problem between the
shareholders as the principal and the company’s top manager or CEO as the agent. There may be a
lack of alignment between the desires and objectives of the CEO and those of the shareholders
because there usually is information asymmetry between those parties. Several reasons:
- The problem of free cash flow: free cash flow is the difference between the generated cash
flow and the amount it can invest in projects with a positive net present value. According to
financial theory, free cash flow should be returned to the shareholders, but the CEO may with
to retain it in order to diversify into other lines of business.
- The problem of a possible difference in attitude towards risk: if one of the investments of
shareholders fails, that is probably offset by the good performance of their other firms. A
CEO, by contrast, works normally for one firm only. The CEO’s human capital depends on how
well that single firm performs. Consequently, the CEO of a widely held firm may be more risk-
averse than the shareholders.
- The problem of different time horizons: shareholders are entitled to all the company’s future
cash flows, without any time horizon. Managers serve only for a period of time. That may give
them a bias for investment projects with high accounting returns in the short term, even if
the NPV of such projects is negative.
- The problem of on-the-job consumption (paragraph 8.3, hoeven we niet te kennen)
Solutions to these problems:
1. Narrow the gap between the interests of principal and agent: by offering the agent an
incentive contract. This can be done by offering the CEO a remuneration package including
shares or share options. This is an organization solution.
2. Reducing the information symmetry between principal and agent: to improve the functioning
of the market for managerial labour and/or the market for corporate control. Monitoring can
be done internally (organizational solution) or done by various parties external such as stock
market analysts, credit-rating agencies, private equity firms (market solution).
8.7.2 The CEO and managers of business units
In a corporation with several business units, we have a situation with one principal and several
agents. The CEO is the principal, the managers of the business units are the agents. Suppose the CEO
engages you as a consultant to device incentive contracts for business unit managers. How useful is
the theory explained in previous sections?
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller janskelensen. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $3.24. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
56326 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 14 years now