Thursday, March 29, 2012

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.

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