Mtp agency and transaction cost theory

Agency Theory
Transaction Cost
Strategy

1. Economic Foundation of strategy: Agency Theory & Transaction Costs Anuj Vijay Bhatia Fellow Programme in Rural Management Institute of Rural Management Anand

2. OUTLINE Agency Theory (The Principal-Agent Problem) Transaction Cost Theory

3. Agency Theory: The Principal-Agent Problem

4. Agency Problem: Preamble Jensen and Meckling (1976)* An agency relationship is a contract under which one or more persons (the principal) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. Agent responds to incentives and will not always act in the best interests of the principal. Agency theory is a theory of governance in the workplace. It tries to solve the problem of separation of ownership (shareholders) and control (professional executives and non-owners) It also tries to solve conflicts of interest between managers and employees with delegated responsibilities. * Jensen, M.C. and Meckling , W.H., 1976. Theory of the firm: Managerial behavior , agency costs and ownership structure.  Journal of financial economics ,  3 (4), pp.305-360. [ This Paper has 76,373 Citations on 18/11/2018]

5. The Agency Problem Why does the agency problem arise? Separation of ownership from control produces a condition where the interests of owner(s) and managers often diverge and that discretionary power by managers exists ( Berle , A. and Means, G., 1932. Private property and the modern corporation.  New York: Mac-Millan) First, the agency problem arises when: (a) Incentives of the Principal and Agent are not aligned (b) Information Asymmetry Moral Hazard Adverse Selection Secondly, problem of risk sharing arises when: Principal and Agent have different risk preferences Principal may be risk-averse but agent may be risk-seeking

6. Basic Set Up Assume that both agent and principal are self-interested, “rational” and seek to maximize their own utility The principal and the agent must agree upon compensation that is dependent on the output produced, serving as an incentive for the agent to produce optimal output However, the principal observes only the output and hence bases the compensation on the output and not on the actions of the agent Thus, the agent privately chooses an (output-producing) action that maximizes his own utility, which is unobservable to the principal who must reward the agent on the basis of the output observed Principal-Agent models attempt to explain the potential conflict between the various interested parties.

7. Basic Set Up It is important to note that the principal and the agent interact (and the agency problem exists) because of division of labor. If there is no division of labor, there is perhaps no agency problem. Even in a Robison Crusoe economy (one consumer and one producer), there are two actors with division of labor; that are required to interact and are interdependent The P-A Model is therefore applicable to variety of contexts. Ultimately, this basic model will explain whether: The two parties should contractually enter into the relationship; and If the relationship will work efficiently

8. Principal-Agent Framework Agency theory involves dealing with contractual issues relating to asymmetric information, moral hazard, bounded rationality, and adverse selection. Asymmetric information : When one party does not have complete knowledge of actions or characteristics of the other party Moral hazard : The agency problem that arises when actions taken by the agent are unobservable to the principal; (hidden action) actions of the elected representatives can be observed during certain times Bounded rationality : When agents are limited in their capacities to take decisions based only on the information available. Adverse selection : The agency problem that arises when some characteristics of the agent are unobservable to the principal (hidden information)

9. Agency Problem: Example Consider the case of a manufacturer-retailer relationship referenced in the diagram. The manufacturer (principal) must decide whether to sign a contract with the retailer (agent) who is able to sell the produced commodities in the retail market. The objective of the relationship is to maximize the sale of output that will benefit both the manufacturer (directly) and the agent (via margins earned on sales). The manufacturer cannot perfectly observe the prices (or price policy) set by the agent (retailer), but only the revenues. The retailer in turn expects the manufacturer to produce high quality goods that are shipped in a timely manner to ensure sales

10. Agency Problem: Example To the extent that revenues are maximized, the manufacturer continues to produce, and the manufacturer will produce more if retailer provides information on sales levels Manufacturer capacity to produce is not fully known to the retailer, therefore she is in the dark about the timing of the supply of goods For example: Maruti solves the agency problem by opening Nexa showrooms – by assuming both roles of principal and agent, Reliance markets vegetables Farmers can organize themselves to hold a stake in the retail chain (such as Reliance) and reduce uncertainty around procurement and reduce information asymmetry to ensure revenue maximization

11. ADVERSE SELECTION & MORAL HAZARD

12. Adverse Selection Adverse selection refers to hidden information , where the ‘type’ of agent is unknown to the principal Arkelof (1970)* describes the problem of adverse selection in his paper “The Market for Lemon’s”. Adverse selection is a form of market failure resulting when products of different qualities are sold at a single price because of asymmetric information, which results in too much of low quality product (lemons) and too little of high quality sales, hence there is an incentive for pre-contract (ex ante) opportunism which induces adverse selection Absence of signaling and failure of job markets could lead to recruiters not being able to effectively distinguish a ‘good’ hire from a ‘bad’ one. [ Akerlof , G.A., 1978. The market for “lemons”: Quality uncertainty and the market mechanism. In Uncertainty in Economics (pp. 235-251).]

13. Moral Hazard Moral hazard refers to hidden action , where some action(s) of the agent are not perfectly observed by the principal. Agent is tempted (and some cases succeeds) in taking advantage of information asymmetry with principal and act opportunistically (defined as making decisions not aligned with principal’s interests) and use the firm resources to maximize wealth of the agent (often at the expense of the principal). E.g. Shareholders cannot effectively monitor management at all times, and must base incentives on available information.

14. Agency Costs Agency costs are defined as: The monitoring costs by the principal; The economic bonding costs by the agent; The residual economic loss. Jensen and Meckling (1976) maintain that agency costs are an unavoidable result of the agency relationship. The contractual relations are the essence of the firm, not only with employees, but also with suppliers, customers, creditors, and so on. Most organizations serve as a nexus for a set of contracting relationships among individuals. Since decision makers ultimately bear the agency costs, these decision makers have the economic incentive to minimize agency costs. Jensen and Meckling (1976) conclude that the level of agency cost depends, among other things, on statutory and common law, and human creativity in devising better contracts. Both the law and the sophistication of contracts relevant to the modern corporation are the products of an historical process in which there were strong economic incentives for individuals to minimize agency costs.

15. Solving Agency Problem There are three schemes that the principal can approach the agent with, each of which come with a cost of implementation to the principal. These include Carrot mechanism, Stick mechanism and a mix of carrot and stick mechanism. Carrot : the agent receives a bonus for high effort, at a low cost to the principal. Offer Incentives and Commissions Stick : the agent is fired for low effort, a high cost to the principal) Penalties for the violation of routines Limit the management discretionary power Carrot and Stick : the agent is given a bonus for a high effort but is also threatened to be fired if the effort is low, a mix of low and high cost to the principal

16. Cooperatives and Agency Problem* Principal-Agent problem: Non-alignment of interest/objectives Relations may be defined by contract, but they are incomplete Moral hazard and imperfect observability Incentive v/s risk sharing trade-off to align interest Relevant to institutional structure of cooperatives Challenge: Which ownership and capital structure will lower agency costs. Agency problem leads to member dissatisfaction Coops experience greater agency problem due to lack of capital market discipline, a clear profit motive and transitive nature of ownership. *[ Ortmann , G.F. and King, R.P., 2007. Agricultural cooperatives I: History, theory and problems.  Agrekon ,  46 (1), pp.18-46.]

17. Applications of agency theory Accounting (Information Sharing) Economics (Institutional Economics, Cooperatives) Finance (Capital Markets, Capital Structure) Marketing (Sales & Distribution, Supply Chain) Political science (Voter-Elected Representative) Organizational behavior (Compensation, Incentive Design, Performance Appraisals)

18. Transaction Costs Theory

19. Preamble What are transaction costs? Transaction costs are the costs incurred in making an economic exchange. It Includes Search and Information Costs, bargaining and decision costs, and policing and enforcement costs . Every exchange involves this cost to different extent influenced by social institutions (norms of behavior), legal institutions, political institutions and economic institutions It becomes important to understand the role of transaction costs in a principal-agent relationship, particularly under information asymmetry. Coase (1937): Inefficiency of transacting in world of imperfect information Contracts are necessary to protect from opportunistic behavior & reduce Transaction Costs. Completeness of contracts also necessary Contracts are always incomplete due to bounded rationality and lead to opportunism and Transaction Costs Helps to design the most efficient institutional arrangement for conducting transactions Firms should select those institutional arrangements where the sum of production and transaction costs are minimum

20. Transaction Costs Theory In the context of the principal-agent model, there may be a ‘contract’ (agreement) drawn up between the principal and the agent to ensure that certain goals are met A transaction cost may be incurred in enforcing and monitoring such a contract (e.g. the cost of spending time and effort in finding an agent, bargaining on the terms of the contract, and monitoring the actions of the principal/agent). The farmer might incur costs in searching for a retailer that operates in her area (these are commonly referred to as search costs) If actions (or characteristics) between the farmer and retailer are then revealed to each other via this contract (e.g. retailer will know practices of farmers, and farmer knows practices of retailer), there will be reductions in transaction costs Despite this reduction, there may be residual moral hazard and adverse selection (e.g. the farmer doesn’t know about retailer’s business plans and financial certainty)

21. Transaction Costs: Ronald Coase (1937) Ronald Coase (1937)* posed two Nobel-prize puzzles : Why do any firms emerge in a market economy? Why not just One Big Firm for whole economy? The Coase theorem states that where there is a conflict of property rights, the involved parties can bargain or negotiate terms that are more beneficial to both parties than the outcome of any assigned property rights. The theorem also asserts that in order for this to occur, bargaining must be costless; if there are costs associated with bargaining, such as those relating to meetings or enforcement, it affects the outcome.  Coase argued that market mechanism not cost-free, but involves transaction costs: time & money to search for sellers & buyers, negotiate exchange terms, write contracts, inspect results, enforce deals Firms will emerge if an “economizing” organization can reduce its production + transaction costs < market prices Firm expansion halts when intra-organizational TC > market prices. [ Coase, R.H., 1960. The problem of social cost.  Journal of law and economics ,  3 (1), pp.1-44.]

22. Transaction Costs: Internal and External Costs The model shows institutions and market as a possible form of organization to coordinate economic transactions. When the external transaction costs are higher than the internal transaction costs, the company will grow. If the external transaction costs are lower than the internal transaction costs the company will be downsized by outsourcing, for example.

23. The costs of transacting Transactions are embedded within social, political, legal institutional environments that affect transaction costs. These “rules of the game” affect property, production, distribution, and exchange relations among economic actors Transaction costs are costs of making, enforcing agreements Transaction cost theory seeks to explain variations in forms of governance of economic exchanges SOURCES OF TRANSACTION COSTS (Williamson, 1985) Environmental uncertainty and bounded rationality Bounded rationality : refers to the limited ability people have to process information Opportunism - attempt to exploit forces or stakeholders Frequency – is transaction one time or recurrent? Risk and specific assets Specific assets : Investments that create value in one particular exchange relationship but have no value in any other exchange relationship. Investments lacking alternative uses except at loss of productive value; asset specificities can be human skills, geographical sites, brand names, dedicated machinery

24. Transaction Cost & Strategy Williamson, O.E., 1999. Strategy research: governance and competence perspectives.  Strategic management journal ,  20 (12), pp.1087-1108.

25. Transaction costs and strategy Managers deciding which strategy to pursue must take the following steps: Locate the sources of transaction costs that may affect an exchange relationship and decide how high the transaction costs are likely to be Estimate the transaction cost savings from using different linkage mechanisms Estimate the bureaucratic costs of operating the linkage mechanism Choose the linkage mechanism that gives the most transaction cost savings at the lowest bureaucratic cost

26. Example: Make or Buy? Transaction cost theory examines the conditions under which organizations chose to internalize some functions (hierarchy) or to purchase them on the market (e.g., relational subcontracting) Example: When should a firm or agency train its own employees, hire external vendor (college or commercial), or create a jointly staffed program? Are employee job skill requirements changing rapidly & unpredictably? How often must newly hired or promoted workers be (re)trained? Is organizations own training staff more knowledgeable than external trainers about firm-specific and tacit skills needed by employees? Are external vendors competent, reliable & cost efficient? Example: Internalize or outsource?

27. Some applications TC theory can be applied to explain diverse organizational phenomena Difficulties in establishing micro-credit lending associations Unionization drive successes or failures Creation of “company towns” for miners, loggers Diffusion of conglomerate Mergers-acquisitions vs. technology transfers among alliance partners

28. Cooperative “represents a hybrid organizational mode blending market forces with elements of internal organization designed to minimize transaction costs”  Farmers form cooperatives with the objective to generate greater profits: (1) by obtaining inputs and services at lower costs (including transaction costs) than they could obtain elsewhere or that were not available, and  (2) by marketing their products at better prices or in markets that were previously not accessible Group action by smallholders could strengthen their bargaining power, facilitate finding institutional solutions to problems of coordination and public service provision, compensate for missing markets and reduce transaction costs. Transaction Costs and Cooperatives

29. How Cooperatives reduce transaction costs? (The case of missing market) Assuming that there are N producers, producing ‘n’ unique products. The producers also consume these ‘n’ unique products. Given that there is no marketplace, bilateral exchange is necessary. During a given time period, each visits the other in order to exchange goods. Supposing that the cost of each leg of a trip is T rupees . If there are five individuals and five consumption goods in this economy, then individual 1 makes four trips, one to each of the other four producers. Individual 2 makes three trips, and so on. Altogether, there are [N (N — 1)]/2 = 10 trips, at a total cost of 10T rupees. An establishment of a cooperative can solve this problem by creating a central marketplace which reduces the total number of trips to five with a total cost of 5T rupees . Lower the transactions costs higher will be the operational efficiency of the market Transaction Costs and Cooperatives

30. Differential transactions costs among households stem from asymmetries in access to assets, information, services and remunerative markets handling these access problems requires institutional innovation Poor infrastructure, low population density, and low effective demand make institutions necessary for risk-sharing and economies of scale in provision of agricultural services, especially in remote areas.   Formation of cooperatives reduces the transaction costs as social networks reduces the fixed costs of participation because members may be able to access information about price asymmetries and markets etc within the network.

31. Summarizing Transaction Cost Transaction Costs are the costs of organizing and transacting exchanges. This includes s earch and information Costs, bargaining and decision costs, and policing and enforcement costs. Every exchange involves this cost to different extent influenced by social institutions (norms of behavior), legal institutions, political institutions and economic institutions. Contracts are necessary to protect from opportunistic behavior & reduce Transaction Costs. Completeness of contracts is also necessary. Incomplete contracts due to bounded rationality leads to opportunism and escalated transaction costs. Optimal completeness of a contact depends upon the tradeoff between marginal benefits and marginal costs Transaction Cost Economics helps to identify important dimensions of a transaction and design efficient institutions. The most efficient institutional arrangement for conducting transactions is the one where transaction costs are minimum .