Organization Theory and the Theory of the Firm

8/3/2019 Organization Theory and the Theory of the Firm

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Organization Theory and the Theory of

the Firm

The following summary is based on two chapters in theHandbook of Industrial Organization:

1. Chapter 2 on The Theory of the Firm

2. 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 substantiallythe same


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M

ain Issues

Behavior and organization within the firm is poorlyunderstood relative to interactions between firms inmarkets; the lack of data probably accounts for much of

this gap

Even though applied research in this area is difficult, it isimportant to be aware of the main issues because they haveimplications for work in other areas

For example, firm behavior is the result of a complex jointdecision process within a network of agency relationships employees are not owners

If agency problems are sufficiently severe, the firms inquestion may not maximize their value


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1. Limits of Integration

What determines the scale and scope of a firm?

Perhaps surprisingly, we do not have very good answers tothis question

It is difficult to specify measurable tradeoffs between thebenefits and costs of integration

Firms form, so some integration is optimal, but alltransactions 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 oneand intervene in their operations only when doing so is

profitable?


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Firm Size

Microeconomics texts refer to long run average costscurves 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 ofcoordination balanced against the costs of communicationand information acquisition

Lucas (1967) focuses on adjustment costs that limit firmgrowth; Jovanovic (1982) emphasizes imperfectknowledge about ability that limits growth these

perspectives do not impose caps on size per se


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Incomplete Contracts

The technological models do not really address theselective intervention problem

A more productive approach considers problems withcontracting that prevent selective intervention

Williamson (1975, 1985) emphasizes that contracts areincomplete

In reality, it is essentially impossible to use a contract to

describe appropriate behavior in every contingency forevery party

This has implications for organization: when irreversibleinvestments are required, contractual incompleteness canlead to hold up, which favors integration


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Incomplete Contracts and Investment

Grossman and Hart (1986) establish that when contractsare incomplete, the allocation of residual control rights(rights not specified in the contract) becomes critical

If residual control rights over a particular asset areallocated to the owner of that asset, then ownershipdetermines the ex post division of surplus in cases notcovered 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 beoptimal depending on which yields better incentives forinvestment


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Information Flows and Incomplete

Contracts

Williamson (1985) asserts that organizational changesimply changes in information flows

Certain information that is available at one cost beforeintegration may not be available at the same cost afterintegration (Filson and Morales assume this)

If true, organization design definitely influencesperformance, 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 onlyresidual control rights


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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


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R

elation 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 onlyone 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


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2. Capital Structure

Modigliani and Miller (1958, 1963) established that capitalstructure is irrelevant: the value of a firm in a frictionlessand 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 thesame return stream to capitalize on the higher value andyet assure the same risk by arranging privately anidentically leveraged position


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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


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Incentives

Jensen and Meckling (1976) originated the incentive

argument

Firms are run by self-interested agents, not pure profitmaximizers

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


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Agency Costs of Equity

When outside equity is issued (equity not held bymanagers) it invites slack

Managers realize that if they waste a dollar, the outsideowners will bear part of the cost

Thus, from a shirking point of view, the firm should befully owned by management

However, this is not efficient because:

1. managers may want to diversify for risk spreadingreasons

2. Financially constrained managers would have to use debtfinancing, which also has agency costs


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Agency Costs of Debt

Debt and equity holders do not share the same investment

objectives

A highly leveraged firm controlled by the equity holderwill 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


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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


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Alternative Agency Explanations

Grossman and Hart (1982) provide a model where amanager with little or no stake in the firm controls theallocation of funds raised from the capital market

The manager decides how much to invest and how much tospend on himself; investment reduces the chance of

bankruptcy

The manager does not want to spend all the funds onhimself because if the firm goes bankrupt and he is fired hewill lose quasi-rents

Since bankruptcy is associated with dismissal, the managerhas to bear bankruptcy costs

Given this, debt financing can be an incentive device


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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 cant 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


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Signaling

Some models suggest that the debt-equity ratio signals

information about the return distribution

Myers and Majluf (1984) argue that adverse selectionposes problems for raising outside equity

Suppose the market is less informed about the value of the

firms 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


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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)


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Signaling

Suppose capital is needed for an investment

By the same reasoning, debt financing is generallypreferred to equity financing

If equity financing must be used then the stock price willalways decline in response to a new issue (this result hasempirical support) because the managers privateinformation that the current shares are overvalued isrevealed

One way to see this is to note that if the share price were toincrease with a new issue then it would always pay to raiseequity irrespective of project value!


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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


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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?


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Internal Discipline

Executive compensation plans often have incentiveprovisions: bonuses, stock, stock options, and othercontingent compensation

Extensive theoretical and empirical work on executivecompensation 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 inincentive provision and monitoring, but there is more workto be done


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LaborMarket 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


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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 replacethe managers with others who will


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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


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Behavioral Assumptions

Friedman (1953) reflects the view of most economists: therealism of assumptions is not important; the usefulness of atheory depends on its implications

Williamson argues that assumptions are important;behavioral assumptions determine the set of feasiblecontracts, for example

Williamson describes contracting man as opposed torational man

Contracting man is subject to bounded rationality andopportunism

Efforts to mislead, disguise, confuse are possible: these aredifficult to incorporate into rational actor models


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Incomplete Contracts

Bounded rationality and opportunism imply:

All feasible contracts are incomplete

Given this, structures that facilitate gapfilling, disputesettlement, adaptation, etc., are part of the problem ofeconomic organization

2. Contracts are not guarantees

Institutions that mitigate opportunism are important


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The Role of Legal Enforcement

It is often assumed that property rights are well defined and that courtsdispense 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 accuratelyindicates real working relations, but which affords a rough indicationaround which such relations vary, an occasional guide in cases ofdoubt, 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 modelsusing the theory of infinitely repeated games


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Transactions

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:

1. The frequency with which they occur

2. The degree and type of uncertainty to which they are

subject

3. Asset specificity

Asset specificity is the most critical attribute


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Asset Specificity

Asset specificity refers to the degree to which an asset canbe redeployed to alternative uses and by alternative userswithout sacrificing its productive value

Given that contracts are incomplete and contractual man isopportunistic, investments in relationship specific assetsare 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


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Asset Specificity

Asset specificity can take many forms

Firm-specific human capital is one example

Untenured faculty members tend to under-invest inlocation-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


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Markets vs. Hierarchies

According to Williamson, there are three main differences

between market and internal organization:

1.M

arkets promote high-powered incentives and restrainbureaucratic 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


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Asset Specificity and Organization

Internal organization is favored when asset specificity is

great

The specificity ensures that there are no separate demandsto be aggregated

Integration overcomes the hold up problem

There are many other organizational implications of asset

specificity and transaction costs


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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 differencesbetween 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


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Data Problems

When pursuing transaction-cost arguments, it is quite easyto tell loose stories that seem reasonable

Recent research has emphasized that it is critical to dig

deep into the data to formulate and evaluate transactioncosts arguments

For example, Kenney and Klein (1983) attribute thepractice of block booking of films to measurementproblems: no one could forecast success, so distributorswould make all or nothing arrangements with exhibitors

Recently, Hanssen questions this argument using evidencefrom real block booking contracts: exhibitors couldexclude some films from the package


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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

Organization Theory and the Theory of the Firm

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