AGENCY ECONOMICS AGENCY ECONOMICS

ANDAND

INTERNATIONAL INTERNATIONAL COMPARISONS OF COMPARISONS OF

CORPORATE GOVERNANCE CORPORATE GOVERNANCE SYSTEMSSYSTEMS

Organisational EconomicsOrganisational Economics

Transaction costs theorists view the Transaction costs theorists view the

organisation as a series of organisation as a series of transactionstransactions Both perspectives address Both perspectives address howhow owners try owners try to ensure that employees, suppliers, and to ensure that employees, suppliers, and contractors conduct themselves in a way contractors conduct themselves in a way that will help the organisation achieve its that will help the organisation achieve its goals and bgoals and both discuss oth discuss governance governance mechanismsmechanisms that can assure that can assure economic economic efficiencyefficiency and minimize problems and costs and minimize problems and costs

There are two major branches of OE:

Agency theory regards the firm as a series of contractual relationships between owners and workers

1- Agency Theory1- Agency Theory

• Assumes agents will act in Assumes agents will act in opportunisticopportunistic ways; ways; therefore, appropriate therefore, appropriate contractscontracts and and monitoringmonitoring necessary to reduce agency costsnecessary to reduce agency costs

2- Transaction Cost Economics2- Transaction Cost Economics

How to maximize efficiency of transactions by How to maximize efficiency of transactions by determining the proper determining the proper boundariesboundaries of the Org. of the Org.

What should be done internally What should be done internally versusversus what should be contracted for on the outsidewhat should be contracted for on the outside??

Agency theory is concerned about the relationship between principals (owners) and agents (employees)

Basic Points of Agency TheoryBasic Points of Agency Theory

• Organisations:Organisations: series of contractual relationships series of contractual relationships between agents and principalsbetween agents and principals

Goal: efficient arrangement (lowest agency costs) of agent-principal relationships.

Principals: owners (shareholders) of a firm

Agents: people hired by the owners to run the firm (managers and workers)

Agency Costs: costs associated with monitoring agent behavior and enforcing contracts

Basic Points of Transaction Cost PerspectiveBasic Points of Transaction Cost Perspective

• Organisations: Organisations: series of transactions, some within series of transactions, some within the Org, some across the Org’s boundariesthe Org, some across the Org’s boundaries

Goal: to determine the most efficient arrangement of transactions — whether transactions should take place inside the Org or across Orgal boundaries; seek lowest transaction costs.

Transaction: exchange of goods and services among groups within the Org. or across organisational boundaries

Transaction Costs: explicit fees or costs associated with a transaction; implicit costs of monitoring and controlling a transaction

Types of Transaction Costs

Small Numbers

Bounded Rationality Opportunism

Information Asymmetry

Asset specificity

Transaction Cost as Problem to Remedy

Organisational economists use the term “cost” to refer to a wide range of problems that owners must remedy in order to create an organization that allows for wealth maximization

1- Bounded Rationality1- Bounded Rationality

Therefore, costs are incurred by the owner in Therefore, costs are incurred by the owner in gathering and processing information in order to gathering and processing information in order to reduce these costsreduce these costs

Owners and managers unable to process all of the available information, and face uncertainty in transactions or contract relationships

Employees, suppliers, and contractors may be in a position to take advantage of the owner

Moral hazard: workers will not supply Moral hazard: workers will not supply the agreed-upon effortthe agreed-upon effort

2- Opportunism

Principals and agents often have different goals and will seek their own self-interest Agents will not always fulfill their obligations because they prefer leisure to work and are subject to shirking

Adverse selection: agents will misrepresent themselves

Costs are incurred in gathering Costs are incurred in gathering additional information and using additional information and using various governance mechanisms various governance mechanisms

3- Information Asymmetry

Information related to exchanges or transactions is not evenly distributedAgents have certain information about their own behaviour and shortcomings that is not available to the principal

Investment decisions in specific Investment decisions in specific assets have assets have implicationsimplications on how the on how the organisation governs its relationship organisation governs its relationship with employees and other firmswith employees and other firms

4- Asset Specificity

Assets that are very specific and fixed can reduce the flexibility

The organisation can more easily be The organisation can more easily be exploitedexploited by a trading partner by a trading partner

5- Small Numbers

An organisation with only a small number of potential trading partners (an oligopoly) has a problem

The Perrow CritiqueThe Perrow Critique

Agency theory focuses too much on the problems Agency theory focuses too much on the problems of agents’ behaviour, while ignoring that the of agents’ behaviour, while ignoring that the principalsprincipals often engage in opportunistic behaviour often engage in opportunistic behaviour

* Charles Perrow; Emeritus Professor of Sociology; Yale.* Charles Perrow; Emeritus Professor of Sociology; Yale.

The theory presents too dismal a view of human beings interactions

Work goes beyond the idea of merely being a contract between owners and workers

Workers are motivated by a complex set of objectives and are capable of honest and charitable acts

CAPITALISM: alternative CAPITALISM: alternative taxonomies - examples taxonomies - examples • Market capitalism (USA, UK, Hong Market capitalism (USA, UK, Hong

Kong, New Zealand, Canada)Kong, New Zealand, Canada)

• Corporate/institutional capitalism Corporate/institutional capitalism (Sweden, Germany, Austria, (Sweden, Germany, Austria, Italy,Korea)Italy,Korea)

• State-guided capitalism (Japan, State-guided capitalism (Japan, France, Iran, Hungary)France, Iran, Hungary)

• ““Crony”capitalism (Russia, Ukraine, Crony”capitalism (Russia, Ukraine, Thailand, Indonesia)Thailand, Indonesia)

Practice of Governance: UKPractice of Governance: UK

• Most shares are held by pension funds, Most shares are held by pension funds, investment funds, and private individualsinvestment funds, and private individuals

• Banks usually do not own shares Banks usually do not own shares

• Almost all big companies are “listed”Almost all big companies are “listed”

• Stock market performance of shares Stock market performance of shares important measure of corporate successimportant measure of corporate success

• ““Hostile” takeovers fairly commonHostile” takeovers fairly common

UK: Governance AssessmentUK: Governance Assessment

• Advantages:Advantages:– Fairly open and transparentFairly open and transparent– Quick rewards for success and punishment Quick rewards for success and punishment

for failurefor failure– Responsiveness to business environmentResponsiveness to business environment

• Disadvantages:Disadvantages:– May encourage “short-termism”May encourage “short-termism”– Mergers and takeovers do not always workMergers and takeovers do not always work

Practice of Governance: GermanyPractice of Governance: Germany

• Banks have very large Banks have very large shareholdings in major corporationsshareholdings in major corporations

• Long-term (cosy?) relationshipsLong-term (cosy?) relationships

• Other shareholders are Other shareholders are proportionately less importantproportionately less important

• Hostile takeovers virtually unknown Hostile takeovers virtually unknown (exception: Vodafone/Mannesman)(exception: Vodafone/Mannesman)

German Governance: German Governance:

AssessmentAssessment • Advantages:Advantages:

– Long-term business relationshipsLong-term business relationships– Stability of employment and productionStability of employment and production– Social cohesion?Social cohesion?

• Disadvantages:Disadvantages:– Lack of transparency and opennessLack of transparency and openness– Sometimes tolerant of poor performanceSometimes tolerant of poor performance– May be unresponsive to global changeMay be unresponsive to global change

Practice of Governance: Practice of Governance: FranceFrance

• Shareholding structures more Shareholding structures more like Germany than UKlike Germany than UK

• Close state-business links, and Close state-business links, and intervention by the stateintervention by the state

• Stock market has become much Stock market has become much more important over last 20 more important over last 20 years - state uses it as a years - state uses it as a discipline measurediscipline measure

French Governance: French Governance: AssessmentAssessment• Advantages:Advantages:

– Successful use of state/business partnershipsSuccessful use of state/business partnerships– Coordinated approach to industrial strategyCoordinated approach to industrial strategy– Effective use long-term planningEffective use long-term planning

• Disadvantages:Disadvantages:– Conflicts of interest between business/stateConflicts of interest between business/state– Sometimes lack of transparencySometimes lack of transparency– Some tolerance of underperformanceSome tolerance of underperformance

Practice of Governance: Practice of Governance: RussiaRussia

• Large industrial groups, some Large industrial groups, some controlled by the “oligarchs”controlled by the “oligarchs”

• Some very big corporations are under Some very big corporations are under strong state influence (e.g.Gazprom)strong state influence (e.g.Gazprom)

• Stock market not very transparentStock market not very transparent

• Many business relationships based on Many business relationships based on personal connections, sometimes crimepersonal connections, sometimes crime

Russian Governance: Russian Governance: AssessmentAssessment• Advantages:Advantages:

– If any at all, the avoidance of disorderIf any at all, the avoidance of disorder

• Disadvantages:Disadvantages:– Lack of transparencyLack of transparency– CorruptionCorruption– Misallocation of resourcesMisallocation of resources– Excessive arbitrary state interventionExcessive arbitrary state intervention

Changes in European Changes in European GovernanceGovernance

• Most corporate governance Most corporate governance systems are tending to convergesystems are tending to converge

• Stock markets are becoming Stock markets are becoming more important, more important, BUTBUT

• Some shareholders becoming Some shareholders becoming more activist, such as pension more activist, such as pension funds like Hermes, some unit funds like Hermes, some unit trust companiestrust companies

QUESTIONS AND ISSUESQUESTIONS AND ISSUES

• Why has Governance come to the Why has Governance come to the fore in the last 25 years?fore in the last 25 years?

• What are “good” governance and What are “good” governance and “bad” governance?“bad” governance?

• In what ways does governance In what ways does governance differ in the private and public differ in the private and public sectors?sectors?

• How much difference does it make?How much difference does it make?