economics of organization tutorial

Economics of organization and corporate governance

(Tutorial sessions)

Tutor: PhD. Pham Thi Bich Ngoc

NEU

Contents

1. Introduction: – Transactions, firms and markets

– Neoclassical analysis

– Theory of firm

2. Economic analysis of organization:– Transaction cost theory

– Empirical validation of TC theory

3. Corporate Governance

4. Executive compensation

1. Introduction: - Transactions, firms and markets- Neoclassical analysis- Theory of firm

Transactions, firms and markets

• Firm: is a set of transactions coordinated by managerial authority instead of by the market

• Transaction is the transfer of goods and services from one individual to the other

Neoclassical analysis

• Accoding to neoclassical analysis, Economic system works by itself:

– Supply adjusted to demand

– Production adjusted to consumption

• Price system = adjustment system coordination device

Price system as a coordination device

Prices are a perfect device to coordinate the actions of the agents

But in reality…

• Market is imperfect

• Information is imperfect

in order to achieve economic efficiency for all actors, some transactions are removed from the price system to the interior of firms

Theory of firm

3 questions should be answer:

A key theory: transaction cost theory

2. Economic analysis of organization:

Transaction cost theory

Empirical validation of TC theory


What is Transaction cost? Type of transaction costTransaction cost theory

Coase’s view₋ Why do firms exists?₋ Boundaries of firm₋ Limitation of Coase view

Williamson’s view:- Factors influence transaction cost

Transaction cost and governance structure

Empirical validation of TC theory

What is transaction cost?

• Transaction cost (TC):

– costs to carrying out transactions in the market;

– cost of using price mechanism,

– costs that stand separate from and in addition to ordinary production costs

Type of Transaction costs

Cost of the acquisition of costly information- Cost of discovering what the relevant prices are

- Cost of finding a co-contractor in the market

Cost of negotiating and concluding a separate contract for each exchange transaction (ex ante costs)

Cost of monitoring performance (ex post costs) : making sure that the co-

contractor meets his or her contractual obligations

Cost of contractual repetition for repeated transactions

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Transaction costs inccur before sigining contract (ex ante):

các chi phí soạn thảo, thương lượng, và bảo vệ một hợp đồng

Transaction costs inccur after sigining contract (ex post):

các chi phí dịch chuyển hợp đồng

các chi phí mặc cả phát sinh khi thực hiện các nỗ lực song phương để chỉnh sửa những tình trạng liên kết sai lầm xảy ra sau khi ký kết hợp đồng

các chi phí thành lập và điều hành gắn liền với các cấu trúc quản trị (thường không phải là các tòa án) mà các vụ tranh chấp được đưa ra để giải quyết

các chi phí về cam kết (bonding costs), đó là chi phí thực hiện các cam kết chắc chắn.

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TC cost associated not only with market exchange but also with hierarchical governance

• Internal transaction cost: cost incurred within an organization include cost of managing and monitoring personnel and procuring inputs

• External transaction cost: When buying from an external provider, transaction costs include cost for source selection, contract management, and performance monitoring

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Coase’s view

• Why do firm exist?

Firms come into being when in some circumstances they reduce the cost of doing transaction

• Boundaries of firm:

Every firm will expand as long as the firm’s activities can be performed cheaper within the firm, than by e.g. outsourcing the activities to external providers in the market.

Transaction costs (TC)

TC differ depending on both:

– the nature of transaction

– the way it is organized (governance structure)

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Boundaries of the firm• Because of efficiency principle: transactions are brought through a specific

coordination device when doing so minimizes the cost of carrying them out

• Market or organization?

– Transaction occur in the market when doing so is efficient

– Transactions are brought within the firm or some other formal organization when doing so minimizes the costs of carrying them out

• The adoption of either organizational mode is determined by the compared level of TC

• Agents interact in the market or through a firm according to the organizational mode that best economizes on transaction cost.

• Explains the make or buy decision

– Activities are carried out inside the firm when high transaction cost firm size is increased

– Activities provided in the market when low transaction cost firm size is reduced


• Transaction cost theory tries to explain why firms exist, and why firms expand or source out activities to the external envionment.

• Transaction cost theory supposes that:– Firms try to minimize the costs of exchanging

resources with the environment– Firms try to minimize the bureaucratic costs of

exchanges within the firm– Firms are weighing/comparing the costs of exchanging

resources with the environment, against the bureaucratic costs of performing activities in-house


• Transaction cost theory sees institutions and market as different possible forms of organizing and coordinating economic transactions.

• Transaction cost explain why some firms get larger or smaller• When external transaction costs are higher than the firm’s internal

bureaucratic costs/cost of efficiency, the firm will grow, b/c the firm is able to perform its activities more cheaply, than if the activities were performed in the market.

• If the bureaucratic costs for coordinating the activity are higher than the external transaction costs, the firm will be downsized.

• The firm will continue to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction in the market or the costs of organizing in another firm

= The firm stops growing when at the margin, the external transaction costs equal the internal ones

Boundaries of the firm

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Coase view

• Coase addresses three important issues. – There is a clear definition of a firm: transactions in a firm

are directed by an entrepreneur and not by the price mechanism.

– There is a clear outline of the boundaries agenda: the size of the firm is measured in the number of transaction that is organized in the firm, as a substitute to organizing them through the market.

– Coase poses the question of comparative statics: what factors will cause a firm to grow or contract? It is this last point to which economic methodology comes to bear on organization: what is the measureable margin that will determine the size of a firm?

Williamson’s view

• According to Williamson, transaction cost occurs when a good or service is transferred across a technologically separate interface.

transaction cost arise every time a product or service is being transferred from one stage to another, where new sets of technological capabilities are needed to make the product or service

• Improves TC analysis by defining 2 sets of factors that impact TC

Factors influence TC

• The TCs related to the exchange of resources with the external environment could be reflected by the following factors:

– Human factors: • Bounded rationality

• Opportunistic behavior

– Attributes of transactions:• Uncertainty

• Asset specificity

• Frequency of transactions

Human factor: Bounded rationality

Individuals within a firm are assumed to be bounded rationality:

Limitations on human mental abilities prevent people from foreseeing all possible contingencies and calculating their optimal behavior

Limitations on human language that prevent perfect communication of those things that are known

• As a result, it is costly, both in time and resources, for individuals to acquire and interpret information about the contracting environment and the firm.

Human factors: Bounded rationality

Consequences of bounded rationality on contractingIncomplete contracting : most agreements framing behavior in the business world are incomplete

4 specific factors

1. Some contingencies not predictable at the contracting date (unforeseeable) (esp. when complex environment and transactions)

2. Even if all contingencies could be foreseen, there may be too many contingencies to write into the contract

3. Monitoring the behavior of other parties is costly

4. Enforcing contracts may involve considerable legal costs

These factors contribute to contractual incompleteness do so by creating TC

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Human factors: Opportunistic behaviours

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Contractual incompleteness opens the door to opportunistic behaviours

Opportunistic behaviour arised because of Asymmetricinformation

– Ex ante (negotiating phase, period of time prior to reachingagreement)

– Ex post (after the contract has been signed)

Human factors: Opportunistic behaviors

Ex ante

One party to the contract has an informational advantage over the other

Example:– Owner of an used car knows the

actual quality of the car => may have an incentive to conceal the actual quality of the car to the buyer

– Firms that contract with each other

– A provider of a given good or service may conceal the low quality of the good or service before the contract btw both firms is being signed

– Employment contract

Such informational asymmetries give rise to TC

Ex postOnce the contract has been signed, one party may find advantageous to fail to perform in agreement with the contract terms:.Example:

– Employment relationship, labor contract…

Gives rise to TC

Hinders arrival at an efficient agreement

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Precontractual opportunism

• Specific situation of asymetric information = adverse selection

• Informational asymmetry between buyer and seller on the quality of the good or service

• Adverse selection refers to a market process in which undesired results occur when buyers and sellers have asymmetric information (access to different information); the "bad" products or services are more likely to be selected

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http://en.wikipedia.org/wiki/Information_asymmetries


Adverse selection increases TCSolutions against adverse selection1. Signalling

– A signal that only « good agents » are able to send– Good agents provide credible information about their real type– Information credible only if low-quality agents cannot provide

that information : too costly for them to do so– Separating equilibrium

2. Compliance with quality regulations3. Warranties, technical check of vehicles…4. Role of governmental agencies + private certification

agencies

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Examples of Adverse selection in the labour market : asymmetric information about the actual productivity of the worker

• High/low productivity?

• Job applicants will always claim that they are high-productivity workers

• Uncertainty

• Transaction costs may prevent the transaction to occur !

• Collapse of the market?

• Firms may nevertheless need to hire people!

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Human factors (2) Opportunistic behaviors

How to sort out good/bad workers?• High-productivity workers have an incentive to provide credible

information about their real type• Information credible only if low-productivity workers cannot

provide that information

EDUCATION• Is way to signal the actual worker’s qualifications to potential

employers : signalling theory (Spence, 1973)• Employers can infer the real productivity of workers just by

observing their educational attainment• In technical terms: separating equilibrium

– Low-productivity workers do not invest in education– High-productivity workers do invest in education

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Conception of education?

Education does not increase the worker’s productivity= “sheepskin effect”

Education increases earnings not because it increases productivity but because certification/signal

≠ Schooling modelIncreases a worker’s productivity

Increase in productivity => increases earnings (wages)

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Implications for public policy questions?

Education increases productivity => invest in education= Human capital investments

Government programs

Education only a signalAre educational expenditures useful ???

Nevertheless, positive social rate of return : no mismatches between jobs and workers

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Postcontractual opportunismIf a firm chooses to make some input for itself in order to avoid the problems of bargaining with a supplier, the firm’s owner may not have the time or expertise that are necessary to supervise the input’s production

=> must then hire a managerThe owner may not be able to tell whether this agent is doing his/her job well

= Principal – agency relationshipSituations in which one individual (the agent)

acts on behalf on another (the principal)is supposed to advance the principal’s goal

Principal-Agent Problem' Conflicts of interest and moral hazard issues that arise when a principal hires an agent to perform specific duties that are in the best interest of the principal but may be costly, or not in the best interests of the agent.

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The principal–agent problem or agency dilemma occurs when one person or entity (the "agent") is able to make decisions that impact, or on behalf of, another person or entity: the "principal".

The dilemma exists because sometimes the agent is motivated to act in his own best interests rather than those of the principal.

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http://en.wikipedia.org/wiki/Agent_(economics)

http://en.wikipedia.org/wiki/Principal_(commercial_law)

http://en.wikipedia.org/wiki/File:Principal_agent.png

http://en.wikipedia.org/wiki/File:Principal_agent.png

Opportunistic behaviors: moral hazard

• Moral hazard arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

• Moral hazard occurs when one person takes more risks because someone else bears the burden of those risks. A moral hazard may occur where the actions of one party may change to the detriment of another after a financial transaction has taken place.

• Moral hazard occurs under a type of information asymmetry where the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

http://en.wikipedia.org/wiki/Principal%E2%80%93agent_problem

http://en.wikipedia.org/wiki/Risk

http://en.wikipedia.org/wiki/Financial_transaction

http://en.wikipedia.org/wiki/Information_asymmetry

Opportunistic behaviors: moral hazard

Moral hazard

• P and A have differing individual objectives

• P cannot easily determine whether A’s actions and reports are being taken in pursuit of P’s goals or are self-interested misbehavior

Hidden information

A has better information than P on environment in which the firm’s activity takes place

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Opportunistic behaviors

Hidden actionCostly for P to check the actions/decisions taken by AA is free to make decisions that go against the best interest of P

Moral hazard inefficiency associated with exchange marketYou do not know whether the A with whom you are exchanging is cheating or not increases TC induces to seek for an alternative organization of the transaction : firm, internal organization

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Opportunistic behaviors: remarks

Moral hazard not only a problem of markets but also a problem in other forms of organizations

=> Attempts to deal with Moral Hazard account for many of the particular institutional arrangements both in markets and organizations

– Compare the relative efficiency of various forms of organizations and select the most efficient one

– The very boundary btw these 2 firms of organization is often a response to Moral Hazard concerns

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Opportunistic behaviors: remarks

The possibility of opportunistic behavior has different consequences according to whether the economic environment is highly competitive or not

Highly competitive (a great number of potential contractors in the market)

• Market may still be the way to organize transactions

• Because opportunistic tendencies disappear as they will be sanctioned by the market mechanism when contracts are being renewed– You will not contract again with sb who you know is unreliable !

– Economic analysis of reputation

In a small (narrow) market, the threat of opportunism may be high

• Few contractors to contract with (narrow choice of goods and services, narrow set of providers…)

• If you are the provider of another firm and work mostly for it, you may have little opportunity to sell your production to other producers…

• … even when the other firm does not comply with the terms of the contract, cheats on you…

• “Trapped” in the relationship because there is no alternative! 42

Two important implications of assumptions (bounded rationality and opportunitic behavior)

• First, boundedly rational managers find it costly to negotiate and write complete contingent claims contracts that fully describe each party’s responsibilities and rights for all future contingencies that could conceivably arise during a transaction. That is, market contracts are incomplete.

• The notion of incomplete contracts suggests that when circumstances arise which are not accounted for in the original agreement, individuals will need to negotiate revised terms which address the newly uncovered contingency. These renegotiations may lead to calculated efforts to take advantage of the vulnerabilities of one’s trading partner in the hopes of achieving a more favorable distribution of the joint economic profits derived from the exchange. Consequently, managers will find it valuable to institute costly mechanisms to monitor and enforce contractual performance that allow them to identify non-compliance and communicate instances of non-compliance to an arbiter that may provide enforcement

Attributes of transations (1) Uncertainty

2 main reasonsUnforeseen contingencies (cf. bounded rationality => agreements not made for every possible contingency)Agents’ opportunistic behavior : behavioral uncertainty strategic behavior of agents

When there is uncertainty ↑ need for sequential adaptation of the contract requires contract flexibility (renegotiation)

Governance structures (institutional arrangements) differ in their capacity to efficiently respond to uncertainty (Williamson, 1984) : ex market / vertical integration

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Attributes of transations (2) Asset Specificity

Asset specificity is:

• Degree to which an asset is committed to a specific task and cannot be redeployed to alternative uses without sacrificing the majority of its productive value

• Measured as the percentage of investment value that is lost when the asset is used outside the specific setting or relationship

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Site specificity: refers to the co-location of facilities so as to minimize inventory or production costs. It has been measured in terms of the physical proximity of contracting parties It is an asset committed to particular use owing to its location• A key consideration for a firm when it chooses a site for one of its major

production plants is the existing or future proximity of suppliers (esp. in just-in-time management)

• The asset (the plant) has less value of not used in this specific relationshipwith the firm and the suppliers

Physical asset specificity: refers to the use of co-specialized assets that are customized for a particular use or purpose.That is an investment in machinery or equipment that has one narrowlydefined purpose

Co-specialized assets• More productive when used together• Lose much of their value if used separately to produce independent

products and services46


Human asset specificity : refers to an employee’s development of firm-specific skills or knowledge • General-purpose human capital : increases the person’s productivity when

working for any of several different employers• Firm specific human capital: skills and knowledge that are valuable only in

the context of a particular firm; of little value outside the firm (idiosyncrasies of the firm)

• Workers invest in specific human capital because they expect to be rewarded by higher earnings later on.

Dedicated asset specificity: refers to additional investments in plant or equipment made in order to sell the increased output to a particular customer.• Entails investments in general purpose plant that are made at the behest

of a particular customer• The specificity of the asset then refers to committing funds to a specified

transaction that might have been used elsewhere

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Brand name capital specificity• Refers to the efforts made by the parties to enhance their

reputation• Become affiliated with a well-known “brand name” and

become less free to pursue other opportunitiesTemporal specificity• refers to investments made to facilitate the timely response

or coordination of human assets• Refers to a transaction that requires a temporal

coordination (synchronization) in production• Refers to the technological conditions pertaining to the

transaction

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Consequences of asset specificity and the hold up problem

Lock-in situations• Outcome of a process through which a situation that involves a

great numbers of parties initially becomes a bilateral relationship = “fundamental transformation” (Williamson)

• Once parties have invested in specific assets, they are no longer as “free” as before, “trapped” together

Bilateral dependency• Either party has no interest in interrupting the relationship

– Reduce the value of their specific assets (loss)

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Problem : either party may attempt to take benefit from the dependence of the other party

Ex post opportunistic behavior• The investment may be devalued by the actions of the other party;

a party may be forced to accept disadvantageous terms, after it has sunk an investment

• Possibility for a party to find itself at the mercy of the other party– Asset specificity => no alternative opportunity– Asset owners vulnerable to opportunistic behavior by their contracting

partners

Hold-up problem : the party that is forced to accept a worsening of the terms of the relationship once it has sunk an investment is held up!

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The notion of quasi-rent : an EXAMPLEINITIAL SITUATIONLet us imagine the case of a supplier who wants to work for a particular clientVariable costs of producing the good needed by the client : VC = 3/yearInvestment needed to produce the good : 40/yearLet us imagine that the supplier could, instead of producing for the client, develop other investment possibilities that would generate a 5% benefit/year • 5% of 40 is 2/year• = OC = opportunity cost of the investment for the clientMinimal income needed for the supplier to accept the transaction (and produce for the client) : MININC = VC + OC = 5/yearLet us imagine that the client pays the supplier 5/year (not more because of perfect competition between suppliers) : the supplier will engage in the transaction

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Attributes of transations (2) AssetSpecificity

The notion of quasi-rent : an EXAMPLE

SECOND STEP SITUATION : LOCK-IN

Now the supplier works for the client

He has developed specific investments to meet the needs of the client

His assets are less usable in alternative ways : because of his specialization, should the supplier wish to break his link with the client and find another way of using his capital, he will only generate an income of 0,5/year (instead of 2/year)

New opportunity cost (of staying in the transaction) : NEWOC = 0,5/year

What is the minimal income needed for the supplier to STAY in transaction with the client ?

NEWMININC = NEWOC + VC = 3 + 0,5 = 3,5

Because the ex post opportunity cost of renewing the transaction is lower than the opportunity cost of entering the transaction in the first place, there is a risk that the client will take advantage of the supplier and lower he price at which he will be persuaded to buy from the supplier

Quasi-rent (QR) = difference between the ex ante and ex post minimal incomes

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EXAMPLE

Danone (food processing industry) / Wahaha• 1996 : Danone signed a joint venture together with Wahaha• Exclusive right for Danone for selling Wahaha products• 2005 : Danone discovers that Wahaha managers were secretly

selling Wahaha products outside the joint venture

HOLD-UP situation• Opportunistic behaviour of Wahaha managers• Danone could not withdraw from the joint venture• « trapped » in the relationship

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Hold-up would not occur if the contracts were complete• the parties could specify the whole range of

circumstances that might arise and could agree on the behaviour to be followed in each of these

• = prevention of ex post opportunism

Consequences of the hold-up problem• Parties have no incentive to invest in specific assets• Underinvestment in specific assets• Less creation of value

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Remedies

1. Same person or firm may own both cospecialized assets= integration (ownership; internalizing the transaction)ex : Danone tried to adopt an integration strategy in the Wahaha case; proposed to buy Wahaha + joint venture, but Wahaha refused the case went to the courts

2. Detailed contracts dealing with incompleteness= introduction of safeguards• Provisions granting the party owning the specific asset with a

protection against potential losses• To prevent opportunistic behaviours• Contract duration (life duration of specialized assets), penalties in

case of breach of contract, specific dispute resolution (arbitration)…

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Remedies

3. Achieving commitment through non contractual means : reputation• Concern with one’s reputation may be an effective check on ex post opportunism• Not fulfilling obligations results in a reputation of untrustworthiness• People may be unwilling to interact with an agent with a bad reputation• Bad reputation reduces future possibilities for profitable transactions (long-term

cost, to be balanced against the short-term gain of opportunism)• May remove the incentives for opportunistic behavior

All the more important as the transaction is frequent : incentives to build and maintain a good reputation are larger• The more frequent the transaction• The longer the horizon• The more profitable the transaction

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Attributes of transations (3) Frequency

Frequency of transactions

• One time (marriage)

• Occasional (buying a car)

• Recurrent (daily shopping)

Frequency of transactions is another source of TC

TC increase in the numbers of transactions : opens the possibility for parties to engage in opportunistic behavior

to substitute organization (internalization) for outside mechanisms (=> avoids opportunism in the market)

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Attributes of transations (3) Frequency

But opposite view (Milgrom & Roberts, 1992)When similar transactions occur frequently over a long period of time, the party who interacts repeatedly may find it valuable to acquire info and create an institution to manage the transaction

The ability to cooperate and learn over time reduces TC• Because parties will grow to understand what is expected of them• Because the need for formal institutions to enforce arrangements may be greatly

lessened

EXAMPLE• Disputes between a supervisor and a worker are rarely resolved in courtrooms :

instead, factories may set up a special grievances committee involving the union or worker representatives, or an ombudsman may hear complaints and attempt to mediate a solution

• Special purpose institutions that can be tailored to particular circumstances of the factory

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• The above factors will all potentially increase the external transaction costs, where it may become rather expensive for a firm to control these factors. Thus, it may very well be more economic to maintain the activity in-house, so that the firm will not use resources on e.g. contracts with suppliers, supervision…

Governance structure

• The two primary conceptual insights provided by transaction cost theory are that the governance of exchange agreements between economic actors is costly and that governance forms vary in their ability to facilitate exchange depending on the attributes in the transactional environment.

• The choice of organizational governance form is seen as a central means through which management affects the costs of monitoring and administration or, more specifically, the costs of negotiating and writing contracts and monitoring and enforcing contractual performance

Governance structures


= Ways of organizing transactions

= “the institutional framework within which the integrity of a transaction is decided. Markets and hierarchies are two of the main alternatives” (Williamson, 1979)

Question: what governance structures match the transactions?

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Factors decide the choice of governance structures

Efficiency criterion

Minimization of Total cost (Production cost + transaction cost)

Transaction attributes

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The governance of contractualrelations

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The make or buy decision

The governance of contractualrelations forms

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Market

Hybrid

- Franchising

- Business alliances

- Cooperatives

Joint ventures

Firm networks (production, distribution…)

Producers’ groups

Collective brands (“Label rouge”, organic food labels…)

Partnerships

Firm/ Hierarchy/

integration

Hybrid forms

Franchising• Automobile dealerships, convenience stores, clothing stores, hotels,

restaurants (McDonald’s), gasoline retailing, car rentals…• Franchisee owns and runs a detail business using the franchisor’s brand

name• Often buys inputs or goods for resale from the franchisor• Makes contractual payments to the franchiser for use of its name• The franchisee remains the residual claimant• But the franchisor generally maintains rights to set and enforce standards

on the franchisee Share the advantages of market arrangements : attract customers, incentives to keep low costs… economies of scale in marketing and purchasing…Control exerted by the franchiser adds value by overcoming a variety of problems arising from specific assets

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Hybrid forms

Business alliancesExamples : airline alliances (Skyteam…)• Coordinate flight schedules to take advantage of scope

economies• Requires the parties to make common decisions

So why don’t the airline companies instead integrate?• Regulations limiting foreign ownership• Antitrust law• Airline cultures (labor unions…)• Tax considerations…• … But also organizational considerations (Williamson)

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Hybrid forms

CooperativesJoint venturesFirm networks (production, distribution…)Producers’ groupsCollective brands (“Label rouge”, organic food labels…)Partnerships• Example : lawyers; partnerships between firms and universities for R&D• Japanese keiretsu

– Group of related firms that consist of independent firms with close links and often a shared name

– Linked because companies in the group commonly own shares in the other members + share information network

– But remain independent : do not automatically direct purchases to related companies unless these other companies offer the best economic deal

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Several advantages combining market and hierarchy• Market is well suited to implement autonomous adaptations by agents… but

performs poorly when it comes to cooperative adaptations• Hierarchy has limited adaptative capabilities… but is able to discourage

opportunistic behavior

Hybrid as a compromise mode=> Keeps the incentive advantages of the market

– = Maintain competitive pressure on members…– … But also establish organizational mechanisms to discourage opportunistic behavior

=> Facilitated coordination (hierarchy)– Relies on restrictive contractual provisions– Private ordering (choice of the authorities who own the decision power in case of conflict)– Development of some informality in the relation to prevent opportunism (joint development

of reciprocal assets)

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Williamson draws from McNeil’s typology(1974):

– Classical contract law

– Neoclassical contract law

– Relational contract

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Classical contract lawSingle transactionsThe identity of the parties does not matterAutonomous parties (no asset specificity)Nature of the agreement perfectly delimited

– Remedies are prescribed in case of non performance– Opportunistic behaviour is easily sanctioned by the market

Complete contractSuch transactions can be coordinated by the price system (ideal

market transaction)

Associated with a specific governance structure: market governance

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Neoclassical contract lawSome transactions involve specific investments bilateral dependency necessary to ensure the continuity of the relation

– Against possible opportunism of parties– Under conditions of uncertainty

Long-term contracts are necessary

Features of such long term contractsOperated under conditions of uncertainty (impossible to foresee all contingencies in the future and the corresponding adaptations) : contracts need to be flexibleTherefore: they are incomplete contracts (on purpose)

– Incompleteness makes adaptation possible– Reduces contracting costs ex ante

Pb: incompleteness allows opportunism => conflicts may arise => need for a thirdparty to intervene to solve conflictsAssociated with a specific governance structure: hybrids

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Relational contracts : corresponds to situations when uncertainty growsstrongly• Owing to the frequence of transactions (increased duration of the

transaction)• And increased asset specificity• Strong bilateral dependency, very costly to be held up• Ex. : employment relationship (employee invests in specific human K,

should be protected against emplye’s opportunism)

Classical and neoclassical contract law insufficient to prevent opportunisticbehaviour, because personalized relationships and repeated transactions

Relational contract Needed to sustain ongoing relations

– It would be costly to interrupt the relation otherwise (strong bilateraldependency)

– necessary to find an efficient solution against opportunism

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Unified ownership / integration provides a solution againstuncertainty + opportunism

The attributes of the transaction make it impossible to maintain the autonomy of the parties : control system and hierarchy necessary

Coordination is achieved through subordination– Adaptative and flexible

– Because it relies on authority

Hierarchy therefore allows parties for the writing of very incompletecontracts

When unforeseen contingencies, hierarchy allosw parties to adapt to new circumstances

– Through coordinated adaptation

– Through the hierarchical control of the actions and decisions of agents

However, pb: such relational contracts reduce the agents’ autonomy : their incentives to do their best

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TC Theory: empirical validation

• Model

- Asset specificity

- UncertaintyTC costs


(Market or integration)

Control variables

Validated results: Results (1) vertical integration

TC theory statement (1): when asset specificity agents prefer integration to market organization

Lots of empirical tests (Klein, 2005) validate this

• Monteverde and Teece (1982) (automobile industry) and Masten(1984) on the aeronautic industry : the probability of integrating the production of some components if physical and temporal asset specificity (engineer questionnaires)

• Anderson and Schmittlein (1984) (electronic components) : same result for post-production departments (sales and marketing) : if human asset specificity (time to train a new salesperson) then the probability of integration

• Mindler and Park (1994) and Lafontaine (2005) (franchised restaurants and hotels in the US) : if brand specificity (difference between market and book value of a franchiser’s stock) the probability of actual possession of franchised hotels and restaurants by the franchiser

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Validated results : Results (1) vertical integration

TC theory statement (2): when uncertainty or complexity or frequency agents prefer integration to market organization

Less clearly validated by empirical tests

• If no asset specificity, no quasi-rent = using the market should be OK (Klein 1988)

• Difficult to measure “pure” effect of uncertainty or complexity or frequency (must find cases with NO asset specificity)

• For uncertainty, difficult to use questionnaires to measure uncertainty… because if agents knew about it, they would act accordingly + no use using past or after-the-fact uncertainty as reference

• For complexity, very difficult to create ad hoc indicators

• Almost no studies on frequency (except Carter and Hogson, 2006, where no link was found)

Asset specificity = THE key aspect of TC theory76

Validated results : Results (2) contractual choices

TC theory statement (3): when TC contracts should be longer (reduce opportunism)

• Well-verified by empirical works

• Asset specificity : Joskow (1987) studies the contract duration of coal-based electricity plants in the US, finds that when there is asset specificity (physical and locational) contracts last longer (contracts between geographically close plants and mines + 12 years)

• Uncertainty– Saussier (1998) shows that contracts between EDF and river coal

transporters are 6 months longer when signed in an uncertain period

– Same result (3 years) for Canadian gas producers (Crocker and Masten, 1988)

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Validated results : Results (2) contractual choices

TC theory statement (4): when TC and contract duration contracts should contain more complex monetary clauses with more renegotiation possibilities (reduce opportunism)

• Well-verified by empirical works

• Coal supply (Joskow, 1987)

• Gas production (Crocker and Masten, 1988)

• US army contracts (Crocker and Reynolds, 1993)

• Coal transportation (Saussier, 2000)

• Infrastructure production (Athias and Saussier, 2007)

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Not validated result: Results (2) contractual choices

TC theory statement (5): when TC contracts try to be more detailed(reduce opportunism)… but less precise (allow for flexibility) = ambiguous effect on contract completedness

• When asset specificity contracts tend to be more complex (maximum detail on the obligations of the partners in different cases) (Godlberg and Erickson, 1987 ; Crocker and Reynolds, 1993 ; Saussier, 2000 ; Athias and Saussier, 2007)

• When uncertainty , contracts tend to be less precise (same studies)

Need work on CONTRACT COHESION : study of the whole nature of the contracts (duration, precision, complexity…)

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Not validated results: Results (2) contractual choices

Research is not yet operational on this dimension

Some studies try and understand if contractual characteristics are complementary or substitutable

New ‘trend’ in research : compare and contrast formal (contracts themselves) and informal (reputation, use of arbitrators, repetition of contracts) aspects of contracts

Poppo and Zenger (1998) show that those dimensions are complementary

Lots of room for future research

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Possible questions

• Opportunistic behavior:– Ex ante opportunistic behavior and adverse selection: definition, examples, relevance in

transaction cost theory– Ex post opportunistic behavior and moral hazard: definition, examples, relevance in

transaction cost theory

• Princinpal/agent problem: definition, examples, relevance in TC theory and manager control and motivation

• What is the quasi-rent, how is it produced and what does it mean for the market/firm debate in TC theory?

• What are the different kinds of asset specificity and what does asset specificity mean for the market/firm debate?

• How does TC theory explain the existence between “Pure market” and vertical integration? Give examples of some hybrid organization and explain why they are more efficient than either the market or firm integration

• Which results of TC theory are empirically validated and which are not?• Why is it so difficult to empirically test TC theory?

3. The institution of corporate governance

Contents

• Corporate governance concept

• Two tier versus unitary boads of directors

• The presence of independent administrators

• Employee and minority (women, nationalities…) representation in boards: problems and solutions

Corporate governance: concepts

• Corporate governance broadly refers to the mechanisms, processes and relations by which corporations are controlled and directed.

• Corporate governance refers o repeated mechanism that allocate authority among board of directors, senior managers and stockholders and affec and control the decision made at the top of the firm

• Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled.

• Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. In contemporary business corporations, the main external stakeholder groups are shareholders, debt holders, trade creditors, suppliers, customers and communities affected by the corporation's activities. Internal stakeholders are the board of directors, executives, and other employees.

A unitary structure

A unitary structureBoard of directors:

• The main board task is to represent, formulate and realize the interests and expectations of shareholders as the owners of the companies• The board should provide for balancing ‘two distinct powers: the power of those who own the corporation and the power of those who run it’

A unitary structure

Length of Board of directors term

Size of the Board of directors : 12.7Age restriction: age limits for chairman and CEO is 65; less than 1/3 no of directors aged over 70

Advantages and disadvantages of unitary board

Advantages

• The possibility of dialogue and better communication between executives and nonexecutives (monitoring, counsel, advice, reprimand) and the access to corporate data and information by non-executive directors.

• The board of directors proves to be flexible and relatively inexpensive, representing the interests of shareholders as well as allowing for a quick decision-making process and efficient information flow.

Disadvantages

• The negative aspects of the unitary board refers to the very powerful position of the CEO who holds the Chairman function at the same time fully controlling the work, agenda and directions of the board

• The presence of executive directors and the directors’ appointment process dependence on the CEO impacts the board’s work and responsibilities and more precisely affects

• 1) building coalition between executives and independent directors and outside directors’ support for CEO policy;

• 2) evaluation of board work;

• 3) resisting hostile takeover; and

• 4) formulating compensation policy for top management

Two-tier structure/dual structure

Two-tier structure/dual structure: board of director

- The mandates of supervisory and management boards have to be kept separately. - The supervisory board plays monitoring functions, appoints the CEO and structures executive compensation, selects the auditor and follows corporate strategy issues.

Two-tier structure/dual structure:

Positive aspects

• The strong independence of board directors provides for a better balancing of the roles of Chairman and CEO,

• High objectivity for accessing corporate policy, top management evaluation and setting executive compensation.

Negative aspects

• The major weakness of the dual model lies in its limited access to corporate data and information which has to be delivered by the management board.

• The relative separation of board members and executives is mitigated by joint meetings and specialized committees (compensation, audit and nominating).

• The threat of the dominance of the board work by representatives of controlling shareholders, particularly in the area of dividend policy, is attempted to be reduced by the presence of independent directors.

• The dual board is also often criticized for its higher costs of functioning and the lack of direct contact between executives and outside directors.

An unitary structure vs two-tiers structure: Positive and negative aspects

The presence of independent administrator

• The presence of independent administrator is a solution to solve principal/agent problem (the manager may not act in the interest of shareholders). The board of directors should control managers in the interest of shareholders.

• Should independent administrators be appointed as board members?

Characteristics of independent administrator

• Director (member) of a board of directors who does not have a material or pecuniary relationship with company or related persons (except sitting fees) (=> no relation with managers)

• Do not own shares in the company

independent administrators should be appointed as board members

For• Independent administrator can

be a solution to the principal/agent problem because:– Independent adminstrator are not

captive to the managers– IA can defend the interests of

shareholders– IA can be a faithful agents of the

shareholders

• Independent administrators play the role of agents for the minority of shareholders and ensure that the interests of the minority shareholders will be taken into account

Against

• Independent administrators may lack relevant information to effectively monitor managers

• Firms in difficulty may resort to independent administrator

Employee and minority (women, nationalities…)representation in boards

• Board-level employee representation involves employees representatives who sit on the supervisory board, board of directors, or similar structures.

• These employee representatives are directly elected by the workforce, or appointed in some other way, and may be employees of the companies, officials of organisations representing those employees, or individuals considered to represent the employees' interests in some way.

• The presence of employee representatives in the board-level structures of a company is an indirect, or representational, form of participation. It involves the expression of employees' collective interest through the intermediary of representatives and differs from direct participation in a number of ways:– it focuses on the workforce as a whole rather than individual employees or workgroups;

– its fundamental aim is the achievement of democratic input into company decision-making rather than fostering employee motivation and commitment;

– it is in general regulated by legislation or collective agreements, rather than being a unilateral management initiative.

Employee and minority (women, nationalities…)representation in boards

• Board-level representation also differs from other types of indirect participation such as works councils in that it attempts to provide employee input into overall company strategic decision-making rather than focusing on information and consultation on day-to-day operational matters at the workplace.

Employee and minority (women, nationalities…) representation in boards: is the a problem and what to do about it?

Problems

• The presence of employees is just indirect

• The presence of employees or minority (women) aims at achievement of democratic input into company decision-making rather than fostering employee motivation and commitment

• Women may not willing to participate

• Hard for women to be elected to be a member of the BoD

Solutions

• Law and regulation

• Enhancing the role and power of union

• Confirm the importance and affect of employees and women represenation on firm performance

• ‘Provide support ive conditions to facilitate the presence of employee and women on board

4. Executive compensation

Contents

• Compensation for executive

• Compensation system:– Individual compensation

• The piece rate wage system

• The tournament wage system

• Time rate system

– Collective compensation• Purpose

• Pros and Cons

• Condition of success

• Type of collective compensation

Compensation for executive

• Important question: How to pay managers to motivate them to work for the purpose of the organization?

The piece rate wage system

• Compensates the worker according to some measure of the worker’s output

• Piece rate system is initially applied for workers with a repetitive, standardized output and also for senior executives

The piece rate wage system

Pros (positive aspects)

• Incentive effect: The workers modify their behaviour (work harder)

• Sorting effect: Workers with higher (unobserved) ability will prefer to work in firms; the turnover rate of workers with low ability is increasing

Cons (negative aspects)• The quality/quantity trade-off: The quality of

ouput must also be observable without too much cost

• The ratchet effect: If output is on average higher than expected, the employer may be tempted to decrease the piece-rate

• Ouput need to be measured precisely, indicators measuring performance must be appropriate, otherwise it may also fail to reflect the actual goal of activity since agent tends to focus on indicators only

• Pernicious effects • Multitasking: need to control all tasks and

balance different tasks because performance will tend to be reduced to output of one task instead of outputs of every tasks

• Crowding out effect: Financial incentives are introduced reduce internal motivation

The tournament wage system: difinition

• Tournament wage system:

– Agents are not paid according to an absolute measure of performance on the job but rewards based on what the worker produced relative to other workers in the firm

– The firm will rank workers according to their productivity

– Rewards distributed according to the rank

Reason for using The tournament wage system

• it is easier for the firm to observe a worker’s rank than to measure the worker’s actual contribution to the firm

• Increase motivation of workes (worker allocate lot of effort to the tournament) if there is a big difference between payoff for winner and for loser

The tournament wage system: positive aspect

• Incentive effect on the agent (high level of effort)

• Easier to observe the rank than the absolute performance

• Help to justify wage differentials in organization between top managers and employees

The tournament wage system: negative aspect

• If the risk is too high, workers may refuse to participate to the tournament or at least express lower effort

• Collusion: the winner may compensate the losser• Too much competition will lead to sabotage and malfeasance

phenomenon collective cost for the firm• Player’s heterogeneity: if agent is far superior to the others, incentive

effect reduced…• Require a equitable performance appraisal system, avoid gender bias• Hard to implement either in small firm or large firm since in small firm,

people tend to have close relationship do not ensure the objectivity in performance evaluation; in large firm, it is difficult to differentiate performance of managers working in different departments

• Small difference in productivity must lead to huge difference in wage, but then the question of fairness, resource constraints…

• Can lead to high rate of turnover of average and “bottom”managers TC increase since firm need to recruit new managers and train them

• Adverse selection: attract venturesome manager if the industry is too risky and fluctuate

Collective compensation

• Objectives:– Maximize collective performance– Establish cooperation btw team members

• Pros: Peers’pressure• Cons: Target must be realistic (otherwise,

slackening of the effort)• Conditionsofsuccess

– Size of the team must be small– Team composition must be stable– Sanctioning power of the group must be effective

Collective compensation

• Type of collective compensation

– Profit sharing: optional voluntary case-báed profit-sharing plans; compulsory deferred profit-sharing plans

– Employee savings programs: company saving plans; company retirement savings plans

– Employee shares plans