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  • Monitoring to reduce agency costs

    In the last blog we looked at the rationale for organizations to delegate. In the current blog we look at the report to monitoring that organizations adopt and the various aspects involved there in.
    Monitoring the agents is important given it is extremely important to reduce the agency costs for the principals. Broadly there are 3 varieties of monitoring, which we shall discuss here.
    In this direction, the principals would be extremely happy if they could access complete information of the agent’s behavior and if these are in synch with the principal’s choices it would be of the best interest. However this logic would be flawed if we consider the case of a scientist or top management who could immersed in thinking activity staring outside the window! The principal in such a scenario will not in any way be able to assess if this behavior is in the best interest or not thus, any mechanisms of using monitoring costs could only imperfectly reduce agency costs.
    An alternate to monitoring the agent behavior is monitoring the outcome of the agent behavior. This approach too is not without issues – it works efficiently when the tasks are not highly programmable, but gets problematic when team production is involved. Interdependence between agents makes it harder to quantify the contribution to the output.
    The third mechanism used to monitor is the use of independent directors on corporate boards. The rationale is that the independent director would be able to provide objective assessment of the decisions that board would take and contribute to reducing the agent behavior.
    Through all these mechanism the attempt is to align the interests of the principal and the agent, however achieving this 100 % is extremely difficult given that delegation always creates agency costs.

  • ReWork – Jasyon & Hansson

    It has been more than a quarter into the current year, and I haven’t really written anything! Some times you get so involved in your work that you don’t take time out for something that you value a lot!
    I recently completed reading this book – “Rework” by Jason Fried and David Hansson. The book is easily one of the best reads I have had about working. It really changes the way you work if you implement it in real.
    The logic of the argument put forth by the authors is something that would get you to move towards looking at an alternate way of approach towards working itself – hence the name – Rework. 
    Very simple ready – you could finish this off in a couple of hours straight. A must read for a all the IT tech savvy people. 
    The book as such cannot be used for people in the manufacturing sectors and SMEs… that’s something one needs to adapt from this book.

  • Why do organizations delegate?

    In the last blog we looked at the costs associated with agency problem. In today’s blog we look at some of the basic questions which come to mind given the costs discussed and then discuss about the reason why delegation happens.
    The three questions which come to mind given the costs a principal incurs to address the agency problem are
    1. Why do Principals delegate authority to agents when the problems are costly to monitor?
    2. What are the specific monitoring mechanisms that principals adopt?
    3. What are the specific bonding mechanisms that agents use?

    In reality we find two broad classes of organization – small ones and larger ones. Smaller ones are generally proprietary or partnership firms or closed corporations which operate on a small scale. The range of economic activities involved in these is all managed by the single person or the people associated effectively. There is no delegation and hence no associated agency cost. 

    In the larger organization, the simplicity of the smaller organizations is lost. The single individual is unable to engage in all the business activities given the constraints of time, energy and the bounded rationality of the person. Hence, the delegation is a necessity in these organizations, along with this comes the agency cost.
    The solution to this problem of delegation in large organization is way we could look at the decision making process (Fama and Jensen – 1983), as having 2 components 
    • Decision Management – how a decision is initiated and how it is implemented
    • Decision Control – how a decision is ratified and monitored

    This distinction allows management group to focus on its task while the control group focuses on its. It has been shown to be lead to higher-quality decisions. Stated differently, when decision making situation is likely to overwhelm the cognitive capacity of a single individual, assigning different groups to different parts of the decision making process is likely to improve the decision quality. But this also implies the associated agency costs.

  • Cost associated with taming the Agency Costs

    In the last blog, we began our discussion about Agency theory and its origin. In today’s blog we look at the costs associated with the prevention, and how these are resolved.
    The costs incurred to reduce the possibility of agents misbehaving are called Agency Cost. These include the monitoring expenditure by principals, bonding expenditure by agents and the residual loss of the principal. There is a strong incenting to reduce these costs – for both principals and agents. The common interest is in defining a monitoring and incentive structure that produces outcomes as close as possible to being a costless information exchange.
    Two sources for the agency problem are:
    Moral Hazards – involves situations where much of the agent’s actions is hidden from the principal or is costly to observe. Stockholders finding it difficult to monitor the behavior of their top management team.
    Adverse Selection – the agent possesses information that the principal doesn’t observe or it is very costly to obtain. This prevents the principal from fully ascertaining whether or not their interests are fully served to the best by the agent’s decision.
    These agency problems are generally resolved through monitoring and bonding. Monitoring involves observing the behavior and/or performance of agents. Bonding refers to the arrangement which penalizes agents for acting in ways that violate the interests of principals or reward them for achieving principal’s goals. Generally these are done through contracts.

  • What is Agency Problem in businesses?

    In the last blog, we looked at some of the issues that happen within the organization, but are not explained by the TCT. In today’s blog we build on this drawback and begin our discussion on “Agency Theory”. 
    Agency Theory has its origin from the property rights literature and to a very small portion on the TCT. Just like TCT, Agency theory also assumes that humans have bounded rationality, are self interested and are prone to opportunism. Both theories emphasize on information asymmetry problems in contracting and on efficiency as the engine that drives the transaction governance. The two differ in that; Agency theory emphasizes the risk attitude of principals and agents.
    When Agency theory originated, the emphasis was on the relation between managers and stockholders. It analyzed the corporate governance issues including – the role of directors, role of top management compensation. This has been extended to explain a numerous intra-organizational conflicts.
    For the sake of clarity – an agency relationship occurs when one partner (the principal) in a transaction delegates authority to another (The agent) and the welfare of the principal is affected by what choices the agent makes. The most common example we see is the relationship of investors in a firm and the mangers of the firm. 
    In the case explained above, the investor delegates the management authority to managers who may or may not have any equity ownership in the firm. The problems that could arise are:

    1. The interest of the two parties diverge
    2. Agent actions cannot be seamlessly and costlessly be monitored
    3. Information available to the principal is not the same as the information available to the agent

    These three together form the agency problem

  • Does TCT really look at what happens within the organization


    In the last blog we looked at the criticism on the Transaction Cost Theory. In today’s blog we focus on a specific drawback in the TCT which has enabled the evolution of different line of thought.

    If we carefully look at TCT we realize that underlying all the discussion is that the organization under consideration is always thought to have a single objective towards which it functions. In reality this is really not the situation, in organizations there is always a possibility of conflicts arising. These goals are generally due to conflicting goals of those associated with the firm. The TCT believes that maximizing profit is the goal, however in reality – these goals within a firm are emerging and change over time and also shifts among organization members.

    TCT though explains why organizations exist, fails when it comes to explaining how those associated with the firm agree on the goals set out to achieve. Just because, the economic exchange partners find it in their mutual self-interest to form an organization doesn’t mean that the differences in interests, tastes, and performances cease.

    This sort of indicated the early departure from the neo-classical firm theories of which TCT was the primary one. Continuing from this blog we look at some theories which tackle this specific challenge of to the theory.

  • Criticism to the Transaction Cost Theory

    In the last blog we looked at TCT being applied to hybrid organizations. In today’s blog we discuss about the criticism to the Theory.
    All is not perfect with any theory, and TCT is no exception. There are 3 major criticisms to the theory
    1. It focuses on Cost Minimization 
    2. It understates the cost of organizing
    3. It neglects the role of social relationship in economic transactions

    There are a set of theories classified under – Resource based theories, which emphasize that organizations would have to make and exploit transaction specific investment under conditions of uncertainty to gain long term competitive advantage. Minimization of transaction cost would have little advantage if transaction specific assets aren’t valued in the market. Hence, it is important to move beyond the perspective that “economy is the best strategy” for an organization.
    When we attempt to do a certain transaction in house, there is no guarantee that this would reduce the negotiations and haggling associated with the transaction. In reality, there is a higher possibility of costly bargaining and influential behavior. Even the authority to resolve such issued could behave opportunistically. Given this situation, TCT underestimates the costs associated with the organizing the transaction within the firm.
    In real life, many transactions are influenced by the expectations that are formed by the history of the relationship between the parties. This indicated that transactions are embedded in the networks of social relationship. It is these relationships that explain the situations like trade between close friends without the presence of any contracts, commitments etc. The TCT neglects the role of social relationships in transactions. 
    TCT is still an evolving field and it is important to note that the criticisms are definitely been evaluated for improvements.

  • Understanding Hybrid Organizations using TCT

    In the last blog we looked at TCT being applied to Multi-National Organization. In the current blog we focus our discussion on a class of organizations which are not completely market based or nor hierarchy based.
    When we look at business environment, we find quite a few organizations which operate on the basis of long term contracts, some which are joint-ventures, a large number of franchisees and some interesting cases of network organization (for example the Japanese auto industry). These organizations are not completely based on markets for their transactions nor are they completely based on an internal hierarchy to handle transactions. These are called – hybrid organizations for the sake of analysis in TCT.
    If we look at the reason for their very existence – it could be pointed to the stronger incentives and adaptive capabilities comparative to the hierarchies while simultaneously offering a greater administrative control comparative to the markets. If the stability of these organizations is considered it wouldn’t be very difficult to realize that the success of these models indicates that they are relatively stable for a considerable period of time. These sorts of hybrid organizations come in with their own set of pros and cons with respect to the issues of opportunism, information asymmetry, knowledge transfer etc. This is a separate subject of discussion not within the purview of today’s blog. 
    With this article, we conclude the discussion on application of TCT; however it would be interesting to just make a mention of some of the other applications which we haven’t discussed. These include the application of TCT to understand 
    • How firms are financed
    • Role of Corporate Governance
    • Influence of Trust on exchanges in a transaction 

    are some of these.

  • Applying TCT to Multinational Enterprises

    In the last blog we looked at an extension of TCT model by Ouchi, in today’s blog we look at the application of TCT to Multinational Enterprises (MNEs).
    The essential search by theorists studying this topic could be reframed – “why do MNE’s exist?” Just like we began discussion on why does an organization exist; TCT was applied on MNEs to figure out which of the transactions would be internalized and which transaction would be driven by market exchange. It is in market imperfections that we find the answers. Markets for different assets and more so for knowledge are subject to imperfections. Research by Organization Theorists – Buckley and Casson as early as 1976 has concluded that markets are more efficient when there are large number of buyers and sellers. When the transaction has high uncertainty, is complex and is heterogeneous, and is catering to a small number of buyers and traders – internationalization is seen to be more effective.
    Continuing on this initial work, Teece (in 1986) attempted to determine the boundaries of an organization. When trading of knowledge becomes difficult – generally due to the following reasons 
    • It would mean giving away the knowledge
    • lack of necessary infrastructure capabilities, communication codes or even culture.

    In such situations, firms tend to internalize the activities.
    In many ways, when we look the application of TCT to MNEs it seems to be a special case of application of TCT to vertical integration.

  • Extension of the Transactional Cost Theory – Clan Control

    In the last blog we looked at how TCT is applicable in the case of Multidimensional Organization. In today’s blog we look at an extension of the TCT – Ouchi’s work on Transaction Cost Framework.
    Ouchi classified organizational mechanisms of control into 3 classes:

    • Market based
    • Bureaucracies
    • Clans

    Markets coordinate through prices, Bureaucracies through authority and rules, while Clans through a combination of authority with shares belief and values.
    Ouchi relies on goal incongruence and performance ambiguity as the crucial dimensions affecting an exchange. If we analyze the 3 classifications on these dimensions, we will find that markets would be an effective mechanism when the goal incongruence of the parties involved is high and performance ambiguity is low. If we move further to a scenario where the ambiguity associated with performance would increase and market based mechanism would not suffice, the need for congruent goal would be felt higher – this is when the bureaucratic governance would be seen as efficient. When the performance ambiguity is extreme, clan governance begins to find its holding – This mechanism requires extreme people processing (ouchi 1979) or socialization (ouchi 1980) to be the means of control.
    In many ways the work by Ouchi has had significant bearing on the interest shown by researchers in organizational culture. We would discuss organizational culture as part of organizational behaviour elsewhere.