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.

How TCT applies to Multidimensional form organization

In the last blog, we looked at the application of TCT to understand vertical integration. In today's blog we look at the application of TCT in understanding the Multidimensional (M) -Form of organizations.

When functionally organized organizations expand their operations, size and diversity increases. The top management at such a juncture would find it extremely hard to deal with such operations; the interdependence of the various functional units makes it difficult to assign responsibilities for the outcomes of the business. 

The M form of organization resolves these difficulties by organizing the firms into product or geographical divisions where operational decisions and performance accountability are assigned to the divisional manager. The top management retains only the strategic decision making. This way the source of such a problem - bounded rationality of the top managers at the corporate office is resolved.

Another side-effect of this structuring is - the firm could function like a miniature stock market. The highest revenue generating unit would get a larger budget in the next cycle. The top management is also free to look out at diversification, acquisition and other activities of that nature. 

Analyzing Vertical Integration using Transaction Cost Theory

In the last blog we looked how Hierarchy mitigates the risks of transaction specific investment. In this blow we begin the discussion on the application of transaction cost theory and briefly understand one of the applications.

Transaction cost theory could be used to understand numerous the following types of organizations better

• Vertical Integration
• Multi-divisional form or organization
• Markets, Bureaucracies and Clans
• The Multinational Enterprise
• Hybrid form of organization

Now we look at the first of these - Vertical Integration. 

Vertical Integration is a process by which companies expand their business in the same production path, along the supply chain. Reliance’s expansion from polyester to petroleum refining is an example of this vertical integration. It could be forward or backward. We shall discuss this and more elsewhere when we talk about strategy.

Vertical Integration is one of the most researched applications of TCT. TCT scholars typically use transaction as their level of analysis instead of viewing it as an aggregate measure of value adds for the entire firm. Simply put it deals with the "make or buy" decisions.

Research has found that a high transaction specific investment would yield the decision to internalize the operation; independent of the type of transaction (which could be capital, human resource, specific skills, and location. Uncertainty is found to be less consistent in when compared to the transaction specific investment in the decision making of firms.

Use of Hierarchy to mitigate-possible abuse of transaction specific investment

In the last blog we looked at how bounded rationality is addressed in the 2 governance mechanism and what are the problems associated there in. In today's blog we look at how transaction specific investment influences the 2 governance mechanisms.

In many transactions, it could be realized that one of the parties involved in the transaction would have to make an investments in the specific transaction to facilitate its completion. This investment could in a physical modification of the technology or, modification in policies, or learning a new thing. While some of these have value only in the specific transaction, for some others it could be transferred to some other party transaction too. Transaction specific investments in general are much more valuable in the first scenario than any other use.

The existence of transaction specific investment raises the threat of opportunism. In fact, greater the transaction specific investment - greater the threat of opportunism. In such a scenario, the market governance mechanism would find itself short of satisfaction, despite the additional cost hierarchical form of governance would be chosen. The two activities done by the parties would be brought in together under a "manager" who mediates the relationship between the parties. Thus the issue of opportunism when a transactions specific investment is made would be mitigated.

Thus – hierarchy arises to resolve the problems in market governance when transaction specific investments are made and under conditions of uncertainty

Uncertainty as a determinant of the transaction governance mechanism

In the last blog, we discussed what could be the underlying logic for comapnies to choose between hierarchy and market to deal with transactions.In today's blog we look at how bounded rationality influences this choice, and what are the problems that could come by. When organizations try to deal with transactions, it is the uncertainty and the transaction specific investments that have been seen to create a large variety of problems.

It is pretty clear that bounded rationality has grown on the uncertainty organizations face - if not for the uncertainty, the bounded rationality would have no meaning. All parties involved in the transaction could ancticipate precisely how the transaction would evolve over time, and so managing it over time is very simple.A contract that specifies all the possible current and future states of the exchange and a clear statement of rights and responsibilities of the parties involved would have made the trick. 

It could thus be said that greater the level of uncertainty in a transaction, the usage of contracts as a means of governance would be difficult if not impossible; hence a more likely form of governance in that case is the hierarchy one.

In hierarchical governance, there is a dedicated third party, who decides how the unaniticipated issues that occur during the course of the transaction could be resolved. The parties donot need to anticipate the problems that might emerge eventually - they are taken up on and mediated as and when they arise.

When to choose Markets/Hierarchy as a governance mechanism

In the last blog, we looked at the 2 underlying assumptions of the TCT. In today's blog we shall discuss about how a choice of governance could be made between the market based approach and the hierarchy based approach.

Organizations will invariably choose that form of governance that reduces any potential exchange problems created by bounded rationality compared to the threat of opportunism. There is not second thought that governance of economic transactions is a costly venture. Given this premise, we could state the following regarding the choice

If organizations had to worry about minimizing the costs of governing their economic exchanges, then they would always choose market forms of governance. Alternatively, if the worry was about minimizing the effects of bounded rationality and opportunism on their exchanges, organizations would always choose hierarchical forms of governance.

The organizations necessarily would have to take a call on which approach to take considering the priority and looking at the potential outcomes of the choice of governance they make.

Assumptions of the transaction cost theory

In the last blog, we looked at Williamson's TCT formulation. In the current blog we look at the 2 essential assumptions about economic actors engaged in a transaction.
1. Bounded Rationality
2. Opportunism

Bounded Rationality is a term that we have used multiple terms thus far and essentially means - those who are engaged in a transaction are rational but have a limit to this rationality. What does this mean? I helps us realize that we would in the absence of such an assumption be writing contracts that would have unlimited complexity. Economic actors involved in the transaction simply cannot envision all the possible outcomes in an exchange relationship and there for formulate contracts for all eventualities.

Opportunism refers to incomplete or distorted information disclosure towards misleading or confusing partners in the exchange. It would be highly complex to assume that all actors are always opportunistic, however it would be easier if we begin with the assumption that actors may behave opportunistically and it is extremely costly to make the distinction who is opportunistic and who is not - this is what TCT assumes. It is this threat that in the world we deal with much more than merely the promises.

These two are important considerations - firms and people should always safeguard to avoid being victimized by the others.

Formulation of the Transaction Cost Theory - Williamson

In the last blog, we looked at how hierarchies could enable effective and efficeint handling of the transactions within the organization. In today's blog, we look at how Williamson formulates the Transaction Cost Theory - and discuss this further over the next few blogs.

Williamson approahes TCT stating that markets and hierarchies are alternative instruments for completing a set of transactions. These are called "Governance Mechanisms".

While market form of governance relies on prices, competition and contracts to keep all parties to exchange informed rights and responsibiltiies; the hierarchical form of governance get these exchanges doen under an autoritative third part (the boss) who attempts to keep all parties in the exchange informed of their rights and responsibiltiites.

The following picture summarizes these alternatives as suggested by Williamson's TCT

Hierarchy as a reason for existence of firms - Efficiency derived there in

In the last blog, we discussed why an organization would be necessary when we already have the markets that are efficient. In today's blog we look at interesting reason why organizations have a hierarchy - stated differently this approach by Alchian-Demsetz approaches the reason for firm's existence to be measurement and metering the problems.

The measuring problem emerges when we talk about 'team production'; where the underlying motivation is the production gains that occurs through cooperation amongst the people when executing a complex task. There exists an incentive to cooperate. It is always a possibility that there could some Shirking amongst team members and when this happens the incentive to cooperate reduces. Shirking could range from cheating to merely giving less than one's efforts.

The team production in such a scenario makes it difficult to assess the contribution of individual member - the means to monitor or measure do not enable rewarding based on individual productivity. This imperfect connectivity to the reward system could potentially get the members to work less diligently. Measures like, splitting the income generated equally amongst the members doesn’t eliminate the incentive to shirk. (This view might not strictly hold in the J-Form organization we discussed earlier; this again would have to be understood in the context of the society)

Such a shirking behavior would potentially prevent a high-output individual to join the team; or if s/he joins the team, they may become shirkers too!

In such a scenario it would become essential to monitor the team. Monitoring each individual would reduce the likelihood of shirking. This introduces a hierarchy of sorts for the first time. This doesn’t completely eliminate the hierarchy and there might be a need to monitor this monitor and so on. A strong case for this monitoring hierarchy with reduced chances of shirking emerges when the monitor is given the right to negotiate contracts with all the team members,  monitor their productive efforts and (crucially) claim any residual value created by the team has received their expected compensation. The final level of this monitoring would rest at the stockholders of the company - who could gain from the firm's residual profit.

Why do we require organization?

In the last blog we began our journey towards understanding the various organizational economic theories. In today's blog we initiate a discussion on "why organizations exist?"

For many this question would raise some odd feeling - Why even as such a question? We know organizations exist, so why did into this at all? It is important to understand this question - since in many ways this forms the starting point of organizational analysis and there by organizational economics.

We shall begin attempting to answer this question with Adam Smith's insight that - economy could be coordinated by a decentralized system of prices - "the invisible hand". Economics post this aimed at identifying the necessary conditions for the effective use of the invisible hand, and designing changes in these settings where the conditions are lacking. Continuing on the same lines, it would be interesting to ask - since the market is so effective in coordinating economic exchanges why would we ever need firms to manage this?

The answer to this question of the existence of firm was provided for the first time by Coase (1937) who suggested that sometimes the cost of managing economic exchanges across markets is greater than the cost of managing economic exchanges within the organizational boundaries. - This argument essentially placed "transaction costs" at the center of the analysis of the reason for firm's existence. In a way the theory put markets and organizations as alternatives to managing the same transaction.

Over the next few blogs we look at understanding the various theories that fall into this stream of organizational economics