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Organization Theory and the Theory of the Firm


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Title: Organization Theory and the Theory of the Firm

Organization Theory and the Theory of the Firm
  • The following summary is based on two chapters in
    the Handbook of Industrial Organization
  • Chapter 2 on The Theory of the Firm
  • 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
    substantially the same

Main Issues
  • Behavior and organization within the firm is
    poorly understood relative to interactions
    between firms in markets the lack of data
    probably accounts for much of this gap
  • Even though applied research in this area is
    difficult, it is important to be aware of the
    main issues because they have implications for
    work in other areas
  • For example, firm behavior is the result of a
    complex joint decision process within a network
    of agency relationships employees are not
  • If agency problems are sufficiently severe, the
    firms in question may not maximize their value

1. Limits of Integration
  • What determines the scale and scope of a firm?
  • Perhaps surprisingly, we do not have very good
    answers to this question
  • It is difficult to specify measurable tradeoffs
    between the benefits and costs of integration
  • Firms form, so some integration is optimal, but
    all transactions 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 one and intervene in their operations
    only when doing so is profitable?

Firm Size
  • Microeconomics texts refer to long run average
    costs curves that eventually slope up
  • What are the sources of diminishing returns to
  • Lucas (1978) focuses on scarce managerial inputs
  • Geanakopolos and Milgrom (1985) refer to the
    benefits of coordination balanced against the
    costs of communication and information
  • Lucas (1967) focuses on adjustment costs that
    limit firm growth Jovanovic (1982) emphasizes
    imperfect knowledge about ability that limits
    growth these perspectives do not impose caps on
    size per se

Incomplete Contracts
  • The technological models do not really address
    the selective intervention problem
  • A more productive approach considers problems
    with contracting that prevent selective
  • Williamson (1975, 1985) emphasizes that contracts
    are incomplete
  • In reality, it is essentially impossible to use a
    contract to describe appropriate behavior in
    every contingency for every party
  • This has implications for organization when
    irreversible investments are required,
    contractual incompleteness can lead to hold up,
    which favors integration

Incomplete Contracts and Investment
  • Grossman and Hart (1986) establish that when
    contracts are incomplete, the allocation of
    residual control rights (rights not specified in
    the contract) becomes critical
  • If residual control rights over a particular
    asset are allocated to the owner of that asset,
    then ownership determines the ex post division of
    surplus in cases not covered by the contract
  • Thus, the ex post division of surplus depends on
  • This implies that ownership can affect the
    incentives for ex ante investments integration
    or non-integration may be optimal depending on
    which yields better incentives for investment

Information Flows and Incomplete Contracts
  • Williamson (1985) asserts that organizational
    changes imply changes in information flows
  • Certain information that is available at one cost
    before integration may not be available at the
    same cost after integration (Filson and Morales
    assume this)
  • If true, organization design definitely
    influences performance, 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 only residual control rights

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

Relation 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 only one 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

2. Capital Structure
  • Modigliani and Miller (1958, 1963) established
    that capital structure is irrelevant the value
    of a firm in a frictionless and 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
  • An entrepreneur could purchase the firm,
    repackage the same return stream to capitalize on
    the higher value and yet assure the same risk by
    arranging privately an identically leveraged

Early extensions
  • Intuitively, MM cannot be the final word on this
  • 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

  • Jensen and Meckling (1976) originated the
    incentive argument
  • Firms are run by self-interested agents, not pure
    profit maximizers
  • 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

Agency Costs of Equity
  • When outside equity is issued (equity not held by
    managers) it invites slack
  • Managers realize that if they waste a dollar, the
    outside owners will bear part of the cost
  • Thus, from a shirking point of view, the firm
    should be fully owned by management
  • However, this is not efficient because
  • managers may want to diversify for risk spreading
  • Financially constrained managers would have to
    use debt financing, which also has agency costs

Agency Costs of Debt
  • Debt and equity holders do not share the same
    investment objectives
  • A highly leveraged firm controlled by the equity
    holder will pursue riskier investment strategies
    than debt holders would like because of limited
  • 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

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

Alternative Agency Explanations
  • Grossman and Hart (1982) provide a model where a
    manager with little or no stake in the firm
    controls the allocation of funds raised from the
    capital market
  • The manager decides how much to invest and how
    much to spend on himself investment reduces the
    chance of bankruptcy
  • The manager does not want to spend all the funds
    on himself because if the firm goes bankrupt and
    he is fired he will lose quasi-rents
  • Since bankruptcy is associated with dismissal,
    the manager has to bear bankruptcy costs
  • Given this, debt financing can be an incentive

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

  • Some models suggest that the debt-equity ratio
    signals information about the return distribution
  • Myers and Majluf (1984) argue that adverse
    selection poses problems for raising outside
  • 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

  • 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)

  • Suppose capital is needed for an investment
  • By the same reasoning, debt financing is
    generally preferred to equity financing
  • If equity financing must be used then the stock
    price will always decline in response to a new
    issue (this result has empirical support) because
    the managers private information that the
    current shares are overvalued is revealed
  • One way to see this is to note that if the share
    price were to increase with a new issue then it
    would always pay to raise equity irrespective of
    project value!

  • 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
  • A complete theory would explain why equity
    holders have voting rights and why debt contracts
    are linked to bankruptcy mechanisms

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?

Internal Discipline
  • Executive compensation plans often have incentive
    provisions bonuses, stock, stock options, and
    other contingent compensation
  • Extensive theoretical and empirical work on
    executive compensation has been done
  • Further, directors are supposed to monitor
  • 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 in incentive provision and
    monitoring, but there is more work to be done

Labor Market and Product Market Discipline
  • Fama (1980) suggests that internal discipline is
    not as necessary as agency theory suggests
    because the managerial labor market provides
  • 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

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 replace the managers with others who

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

Behavioral Assumptions
  • Friedman (1953) reflects the view of most
    economists the realism of assumptions is not
    important the usefulness of a theory depends on
    its implications
  • Williamson argues that assumptions are important
    behavioral assumptions determine the set of
    feasible contracts, for example
  • Williamson describes contracting man as opposed
    to rational man
  • Contracting man is subject to bounded rationality
    and opportunism
  • Efforts to mislead, disguise, confuse are
    possible these are difficult to incorporate into
    rational actor models

Incomplete Contracts
  • Bounded rationality and opportunism imply
  • All feasible contracts are incomplete
  • Given this, structures that facilitate
    gapfilling, dispute settlement, adaptation, etc.,
    are part of the problem of economic organization
  • 2. Contracts are not guarantees
  • Institutions that mitigate opportunism are

The Role of Legal Enforcement
  • It is often assumed that property rights are well
    defined and that courts dispense justice at zero
  • In this view, parties follow contracts and when
    one party does not the other appeals to the
  • Llewellyn (1931) argued that contracts are more
    of a framework highly adjustable, a framework
    which almost never accurately indicates real
    working relations, but which affords a rough
    indication around which such relations vary, an
    occasional guide in cases of doubt, and a norm of
    ultimate appeal when relations cease in fact to
  • Klein has followed up on this view of relational
  • Recently, Baker, Gibbons, and Murphy have
    provided formal models using the theory of
    infinitely repeated games

  • 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
  • The frequency with which they occur
  • The degree and type of uncertainty to which they
    are subject
  • Asset specificity
  • Asset specificity is the most critical attribute

Asset Specificity
  • Asset specificity refers to the degree to which
    an asset can be redeployed to alternative uses
    and by alternative users without sacrificing its
    productive value
  • Given that contracts are incomplete and
    contractual man is opportunistic, investments in
    relationship specific assets are 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

Asset Specificity
  • Asset specificity can take many forms
  • Firm-specific human capital is one example
  • Untenured faculty members tend to under-invest in
    location-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

Markets vs. Hierarchies
  • According to Williamson, there are three main
    differences between market and internal
  • Markets promote high-powered incentives and
    restrain bureaucratic distortions
  • 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
  • Internal organization has access to distinctive
    governance instruments

Asset Specificity and Organization
  • Internal organization is favored when asset
    specificity is great
  • The specificity ensures that there are no
    separate demands to be aggregated
  • Integration overcomes the hold up problem
  • There are many other organizational implications
    of asset specificity and transaction costs

Another Implication Second Sourcing
  • Buyers in the semiconductor industry have
    insisted that semiconductor producers license
    their design of chips to other manufacturers
  • This is an excessive requirement if concern for
    idiosyncratic disruptive events at the producer
    was the main issue the producer could
    subcontract but retain control over total
  • The buyers demand licensing because they are
    reluctant to specialize their product to a
    particular chip provided by a monopolist they
    wish to avoid hold up

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 differences between 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

Data Problems
  • When pursuing transaction-cost arguments, it is
    quite easy to tell loose stories that seem
  • Recent research has emphasized that it is
    critical to dig deep into the data to formulate
    and evaluate transaction costs arguments
  • For example, Kenney and Klein (1983) attribute
    the practice of block booking of films to
    measurement problems no one could forecast
    success, so distributors would make all or
    nothing arrangements with exhibitors
  • Recently, Hanssen questions this argument using
    evidence from real block booking contracts
    exhibitors could exclude some films from the

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