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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