Economics of organization tutorial

Economics of organization
and corporate governance
(Tutorial sessions)
Tutor: PhD. Pham Thi Bich Ngoc
NEU

Contents
1. Introduction:
– Transactions, firms and markets
– Neoclassical analysis
– Theory of firm
2. Economic analysis of organization:
– Transaction cost theory
– Empirical validation of TC theory
3. Corporate Governance
4. Executive compensation

1. Introduction:
- Transactions, firms and markets
- Neoclassical analysis
- Theory of firm

Transactions, firms and markets
• Firm: is a set of transactions coordinated by
managerial authority instead of by the market
• Transaction is the transfer of goods and
services from one individual to the other

Neoclassical analysis
• Accoding to neoclassical analysis, Economic
system works by itself:
– Supply adjusted to demand
– Production adjusted to consumption
• Price system = adjustment system 
coordination device

Price system as a coordination device
Prices are a perfect device to coordinate the actions
of the agents

But in reality…
• Market is imperfect
• Information is imperfect
 in order to achieve economic efficiency for all
actors, some transactions are removed from
the price system to the interior of firms

Theory of firm
3 questions should be answer:

A key theory: transaction cost theory

2. Economic analysis of organization:
Transaction cost theory
 Empirical validation of TC theory

Transaction cost theory
 What is Transaction cost?
 Type of transaction cost
Transaction cost theory
Coase’s view
₋ Why do firms exists?
₋ Boundaries of firm
₋ Limitation of Coase view
 Williamson’s view:
- Factors influence transaction cost
Transaction cost and governance structure
 Empirical validation of TC theory

What is transaction cost?
• Transaction cost (TC):
– costs to carrying out transactions in the market;
– cost of using price mechanism,
– costs that stand separate from and in addition to
ordinary production costs

Type of Transaction costs
 Cost of the acquisition of costly information
- Cost of discovering what the relevant prices are
- Cost of finding a co-contractor in the market
 Cost of negotiating and concluding a separate contract for each
exchange transaction (ex ante costs)
 Cost of monitoring performance (ex post costs) : making sure that the co-
contractor meets his or her contractual obligations
 Cost of contractual repetition for repeated transactions
13

 Transaction costs inccur before sigining contract (ex ante):
 các chi phí soạn thảo, thương lượng, và bảo vệ một hợp đồng
Transaction costs inccur after sigining contract (ex post):
 các chi phí dịch chuyển hợp đồng
 các chi phí mặc cả phát sinh khi thực hiện các nỗ lực song phương để
chỉnh sửa những tình trạng liên kết sai lầm xảy ra sau khi ký kết hợp đồng
 các chi phí thành lập và điều hành gắn liền với các cấu trúc quản trị
(thường không phải là các tòa án) mà các vụ tranh chấp được đưa ra để
giải quyết
 các chi phí về cam kết (bonding costs), đó là chi phí thực hiện các cam
kết chắc chắn.
14

TC cost associated not only with market exchange but
also with hierarchical governance
• Internal transaction cost: cost incurred within an
organization include cost of managing and monitoring
personnel and procuring inputs
• External transaction cost: When buying from an
external provider, transaction costs include cost for
source selection, contract management, and
performance monitoring
15

Coase’s view
• Why do firm exist?
Firms come into being when in some circumstances
they reduce the cost of doing transaction
• Boundaries of firm:
Every firm will expand as long as the firm’s activities
can be performed cheaper within the firm, than by
e.g. outsourcing the activities to external providers in
the market.

Transaction costs (TC)
TC differ depending on both:
– the nature of transaction
– the way it is organized (governance structure)
17

Boundaries of the firm
• Because of efficiency principle: transactions are brought through a specific
coordination device when doing so minimizes the cost of carrying them out
• Market or organization?
– Transaction occur in the market when doing so is efficient
– Transactions are brought within the firm or some other formal
organization when doing so minimizes the costs of carrying them out
• The adoption of either organizational mode is determined by the compared
level of TC
• Agents interact in the market or through a firm according to the
organizational mode that best economizes on transaction cost.
• Explains the make or buy decision
– Activities are carried out inside the firm when high transaction cost 
firm size is increased
– Activities provided in the market when low transaction cost  firm size
is reduced

• Transaction cost theory tries to explain why firms
exist, and why firms expand or source out
activities to the external envionment.
• Transaction cost theory supposes that:
– Firms try to minimize the costs of exchanging
resources with the environment
– Firms try to minimize the bureaucratic costs of
exchanges within the firm
– Firms are weighing/comparing the costs of exchanging
resources with the environment, against the
bureaucratic costs of performing activities in-house

• Transaction cost theory sees institutions and market as different possible
forms of organizing and coordinating economic transactions.
• Transaction cost explain why some firms get larger or smaller
• When external transaction costs are higher than the firm’s internal
bureaucratic costs/cost of efficiency, the firm will grow, b/c the firm is able
to perform its activities more cheaply, than if the activities were
performed in the market.
• If the bureaucratic costs for coordinating the activity are higher than the
external transaction costs, the firm will be downsized.
• The firm will continue to expand until the costs of organizing an extra
transaction within the firm become equal to the costs of carrying out
the same transaction in the market or the costs of organizing in
another firm
= The firm stops growing when at the margin, the external
transaction costs equal the internal ones

Coase view
• Coase addresses three important issues.
– There is a clear definition of a firm: transactions in a firm
are directed by an entrepreneur and not by the price
mechanism.
– There is a clear outline of the boundaries agenda: the size
of the firm is measured in the number of transaction that
is organized in the firm, as a substitute to organizing them
through the market.
– Coase poses the question of comparative statics: what
factors will cause a firm to grow or contract? It is this last
point to which economic methodology comes to bear on
organization: what is the measureable margin that will
determine the size of a firm?

Williamson’s view
• According to Williamson, transaction cost occurs when a good
or service is transferred across a technologically separate
interface.
 transaction cost arise every time a product or service is
being transferred from one stage to another, where new sets
of technological capabilities are needed to make the product
or service
• Improves TC analysis by defining 2 sets of factors that impact
TC

Factors influence TC
• The TCs related to the exchange of resources with
the external environment could be reflected by the
following factors:
– Human factors:
• Bounded rationality
• Opportunistic behavior
– Attributes of transactions:
• Uncertainty
• Asset specificity
• Frequency of transactions

Human factor: Bounded rationality
Individuals within a firm are assumed to be bounded
rationality:
 Limitations on human mental abilities prevent people
from foreseeing all possible contingencies and
calculating their optimal behavior
 Limitations on human language that prevent perfect
communication of those things that are known
• As a result, it is costly, both in time and resources, for
individuals to acquire and interpret information about
the contracting environment and the firm.

Human factors: Bounded rationality
Consequences of bounded rationality on contracting
Incomplete contracting : most agreements framing behavior in the business
world are incomplete
4 specific factors
1. Some contingencies not predictable at the contracting date
(unforeseeable) (esp. when complex environment and transactions)
2. Even if all contingencies could be foreseen, there may be too many
contingencies to write into the contract
3. Monitoring the behavior of other parties is costly
4. Enforcing contracts may involve considerable legal costs
These factors contribute to contractual incompleteness do so by creating TC
26

Human factors: Opportunistic behaviours
27
Contractual incompleteness opens the door to
opportunistic behaviours
Opportunistic behaviour arised because of Asymmetric
information
– Ex ante (negotiating phase, period of time prior to reaching
agreement)
– Ex post (after the contract has been signed)

Human factors: Opportunistic behaviors
Ex ante
One party to the contract has an
informational advantage over the
other
Example:
– Owner of an used car knows the
actual quality of the car => may have
an incentive to conceal the actual
quality of the car to the buyer
– Firms that contract with each other
– A provider of a given good or service
may conceal the low quality of the
good or service before the contract
btw both firms is being signed
– Employment contract
Such informational asymmetries give
rise to TC
Ex post
Once the contract has been
signed, one party may find
advantageous to fail to
perform in agreement with
the contract terms:.
Example:
– Employment relationship, labor
contract…
Gives rise to TC
Hinders arrival at an efficient
agreement
28

Precontractual opportunism
• Specific situation of asymetric information = adverse
selection
• Informational asymmetry between buyer and seller on
the quality of the good or service
• Adverse selection refers to a market process in which
undesired results occur when buyers and sellers
have asymmetric information (access to different
information); the "bad" products or services are more
likely to be selected
29

Adverse selection increases TC
Solutions against adverse selection
1. Signalling
– A signal that only « good agents » are able to send
– Good agents provide credible information about their real type
– Information credible only if low-quality agents cannot provide
that information : too costly for them to do so
– Separating equilibrium
2. Compliance with quality regulations
3. Warranties, technical check of vehicles…
4. Role of governmental agencies + private certification
agencies
30

Examples of Adverse selection in the labour market :
asymmetric information about the actual productivity of the
worker
• High/low productivity?
• Job applicants will always claim that they are high-
productivity workers
• Uncertainty
• Transaction costs may prevent the transaction to occur !
• Collapse of the market?
• Firms may nevertheless need to hire people!
31

Human factors (2) Opportunistic behaviors
How to sort out good/bad workers?
• High-productivity workers have an incentive to provide credible
information about their real type
• Information credible only if low-productivity workers cannot
provide that information
EDUCATION
• Is way to signal the actual worker’s qualifications to potential
employers : signalling theory (Spence, 1973)
• Employers can infer the real productivity of workers just by
observing their educational attainment
• In technical terms: separating equilibrium
– Low-productivity workers do not invest in education
– High-productivity workers do invest in education
32

Conception of education?
Education does not increase the worker’s productivity
= “sheepskin effect”
Education increases earnings not because it increases productivity but
because certification/signal
≠ Schooling model
Increases a worker’s productivity
Increase in productivity => increases earnings (wages)
33

Implications for public policy questions?
Education increases productivity => invest in education
= Human capital investments
Government programs
Education only a signal
Are educational expenditures useful ???
Nevertheless, positive social rate of return : no mismatches between jobs
and workers
34

35

Postcontractual opportunism
If a firm chooses to make some input for itself in order to avoid the problems of bargaining
with a supplier, the firm’s owner may not have the time or expertise that are necessary to
supervise the input’s production
=> must then hire a manager
The owner may not be able to tell whether this agent is doing his/her job well
= Principal – agency relationship
Situations in which one individual (the agent)
acts on behalf on another (the principal)
is supposed to advance the principal’s goal
Principal-Agent Problem' Conflicts of interest and moral
hazard issues that arise when a principal hires an agent to
perform specific duties that are in the best interest of
the principal but may be costly, or not in the best interests of
the agent.
36

The principal–agent
problem or agency
dilemma occurs when one
person or entity (the "agent") is
able to make decisions that
impact, or on behalf of, another
person or entity: the
"principal".
The dilemma exists because
sometimes the agent is
motivated to act in his own best
interests rather than those of
the principal.
37

Opportunistic behaviors: moral hazard
• Moral hazard arises in a principal–agent problem, where one party, called
an agent, acts on behalf of another party, called the principal. The agent
usually has more information about his or her actions or intentions than
the principal does, because the principal usually cannot completely
monitor the agent. The agent may have an incentive to act inappropriately
(from the viewpoint of the principal) if the interests of the agent and the
principal are not aligned.
• Moral hazard occurs when one person takes more risks because someone
else bears the burden of those risks. A moral hazard may occur where the
actions of one party may change to the detriment of another after
a financial transaction has taken place.
• Moral hazard occurs under a type of information asymmetry where the
risk-taking party to a transaction knows more about its intentions than the
party paying the consequences of the risk. More broadly, moral hazard
occurs when the party with more information about its actions or
intentions has a tendency or incentive to behave inappropriately from the
perspective of the party with less information.

Opportunistic behaviors: moral hazard
Moral hazard
• P and A have differing individual objectives
• P cannot easily determine whether A’s actions
and reports are being taken in pursuit of P’s goals
or are self-interested misbehavior
Hidden information
A has better information than P on environment in
which the firm’s activity takes place
39

Opportunistic behaviors
Hidden action
Costly for P to check the actions/decisions taken by A
A is free to make decisions that go against the best
interest of P
Moral hazard  inefficiency associated with exchange
market
You do not know whether the A with whom you are
exchanging is cheating or not
 increases TC
 induces to seek for an alternative organization of the
transaction : firm, internal organization
40

Opportunistic behaviors: remarks
 Moral hazard not only a problem of markets but
also a problem in other forms of organizations
=> Attempts to deal with Moral Hazard account for
many of the particular institutional arrangements
both in markets and organizations
– Compare the relative efficiency of various forms of
organizations and select the most efficient one
– The very boundary btw these 2 firms of organization is
often a response to Moral Hazard concerns
41

Opportunistic behaviors: remarks
 The possibility of opportunistic behavior has different consequences
according to whether the economic environment is highly competitive or not
Highly competitive (a great number of potential contractors in the market)
• Market may still be the way to organize transactions
• Because opportunistic tendencies disappear as they will be sanctioned by
the market mechanism when contracts are being renewed
– You will not contract again with sb who you know is unreliable !
– Economic analysis of reputation
In a small (narrow) market, the threat of opportunism may be high
• Few contractors to contract with (narrow choice of goods and services,
narrow set of providers…)
• If you are the provider of another firm and work mostly for it, you may
have little opportunity to sell your production to other producers…
• … even when the other firm does not comply with the terms of the
contract, cheats on you…
• “Trapped” in the relationship because there is no alternative! 42

Two important implications of assumptions
(bounded rationality and opportunitic behavior)
• First, boundedly rational managers find it costly to negotiate and write
complete contingent claims contracts that fully describe each party’s
responsibilities and rights for all future contingencies that could conceivably
arise during a transaction. That is, market contracts are incomplete.
• The notion of incomplete contracts suggests that when circumstances arise
which are not accounted for in the original agreement, individuals will need
to negotiate revised terms which address the newly uncovered contingency.
These renegotiations may lead to calculated efforts to take advantage of the
vulnerabilities of one’s trading partner in the hopes of achieving a more
favorable distribution of the joint economic profits derived from the
exchange. Consequently, managers will find it valuable to institute costly
mechanisms to monitor and enforce contractual performance that allow
them to identify non-compliance and communicate instances of non-
compliance to an arbiter that may provide enforcement

Attributes of transations (1) Uncertainty
2 main reasons
Unforeseen contingencies (cf. bounded rationality => agreements not
made for every possible contingency)
Agents’ opportunistic behavior : behavioral uncertainty  strategic
behavior of agents
When there is uncertainty
 ↑ need for sequential adaptation of the contract
 requires contract flexibility (renegotiation)
Governance structures (institutional arrangements) differ in their
capacity to efficiently respond to uncertainty (Williamson, 1984) : ex
market / vertical integration
44

Attributes of transations (2) Asset Specificity
Asset specificity is:
• Degree to which an asset is committed to a
specific task and cannot be redeployed to
alternative uses without sacrificing the
majority of its productive value
• Measured as the percentage of investment
value that is lost when the asset is used
outside the specific setting or relationship
45

Site specificity: refers to the co-location of facilities so as to minimize
inventory or production costs. It has been measured in terms of the physical
proximity of contracting parties
It is an asset committed to particular use owing to its location
• A key consideration for a firm when it chooses a site for one of its major
production plants is the existing or future proximity of suppliers (esp. in
just-in-time management)
• The asset (the plant) has less value of not used in this specific relationship
with the firm and the suppliers
Physical asset specificity: refers to the use of co-specialized assets that are
customized for a particular use or purpose.
That is an investment in machinery or equipment that has one narrowly
defined purpose
Co-specialized assets
• More productive when used together
• Lose much of their value if used separately to produce independent
products and services
46

Human asset specificity : refers to an employee’s development of firm-
specific skills or knowledge
• General-purpose human capital : increases the person’s productivity when
working for any of several different employers
• Firm specific human capital: skills and knowledge that are valuable only in
the context of a particular firm; of little value outside the firm
(idiosyncrasies of the firm)
• Workers invest in specific human capital because they expect to be
rewarded by higher earnings later on.
Dedicated asset specificity: refers to additional investments in plant or
equipment made in order to sell the increased output to a particular
customer.
• Entails investments in general purpose plant that are made at the behest
of a particular customer
• The specificity of the asset then refers to committing funds to a specified
transaction that might have been used elsewhere
47

Brand name capital specificity
• Refers to the efforts made by the parties to enhance their
reputation
• Become affiliated with a well-known “brand name” and
become less free to pursue other opportunities
Temporal specificity
• refers to investments made to facilitate the timely response
or coordination of human assets
• Refers to a transaction that requires a temporal
coordination (synchronization) in production
• Refers to the technological conditions pertaining to the
transaction
48

Consequences of asset specificity and the hold up problem
Lock-in situations
• Outcome of a process through which a situation that involves a
great numbers of parties initially becomes a bilateral relationship =
“fundamental transformation” (Williamson)
• Once parties have invested in specific assets, they are no longer as
“free” as before, “trapped” together
Bilateral dependency
• Either party has no interest in interrupting the relationship
– Reduce the value of their specific assets (loss)
49

Problem : either party may attempt to take benefit from the
dependence of the other party
Ex post opportunistic behavior
• The investment may be devalued by the actions of the other party;
a party may be forced to accept disadvantageous terms, after it has
sunk an investment
• Possibility for a party to find itself at the mercy of the other party
– Asset specificity => no alternative opportunity
– Asset owners vulnerable to opportunistic behavior by their contracting
partners
Hold-up problem : the party that is forced to accept a worsening of
the terms of the relationship once it has sunk an investment is held
up!
50

The notion of quasi-rent : an EXAMPLE
INITIAL SITUATION
Let us imagine the case of a supplier who wants to work for a particular
client
Variable costs of producing the good needed by the client : VC = 3/year
Investment needed to produce the good : 40/year
Let us imagine that the supplier could, instead of producing for the
client, develop other investment possibilities that would generate a 5%
benefit/year
• 5% of 40 is 2/year
• = OC = opportunity cost of the investment for the client
Minimal income needed for the supplier to accept the transaction (and
produce for the client) : MININC = VC + OC = 5/year
Let us imagine that the client pays the supplier 5/year (not more because
of perfect competition between suppliers) : the supplier will engage in
the transaction
51

Attributes of transations (2) Asset
Specificity
The notion of quasi-rent : an EXAMPLE
SECOND STEP SITUATION : LOCK-IN
Now the supplier works for the client
He has developed specific investments to meet the needs of the client
His assets are less usable in alternative ways : because of his specialization, should the supplier
wish to break his link with the client and find another way of using his capital, he will only
generate an income of 0,5/year (instead of 2/year)
 New opportunity cost (of staying in the transaction) : NEWOC = 0,5/year
What is the minimal income needed for the supplier to STAY in transaction with the client ?
NEWMININC = NEWOC + VC = 3 + 0,5 = 3,5
Because the ex post opportunity cost of renewing the transaction is lower than the opportunity
cost of entering the transaction in the first place, there is a risk that the client will take
advantage of the supplier and lower he price at which he will be persuaded to buy from the
supplier
Quasi-rent (QR) = difference between the ex ante and ex post
minimal incomes
52

Specificity
EXAMPLE
Danone (food processing industry) / Wahaha
• 1996 : Danone signed a joint venture together with Wahaha
• Exclusive right for Danone for selling Wahaha products
• 2005 : Danone discovers that Wahaha managers were secretly
selling Wahaha products outside the joint venture
HOLD-UP situation
• Opportunistic behaviour of Wahaha managers
• Danone could not withdraw from the joint venture
• « trapped » in the relationship
53

Specificity
Hold-up would not occur if the contracts were complete
• the parties could specify the whole range of
circumstances that might arise and could agree on the
behaviour to be followed in each of these
• = prevention of ex post opportunism
Consequences of the hold-up problem
• Parties have no incentive to invest in specific assets
• Underinvestment in specific assets
• Less creation of value
54

Specificity
Remedies
1. Same person or firm may own both cospecialized assets
= integration (ownership; internalizing the transaction)
ex : Danone tried to adopt an integration strategy in the Wahaha case;
proposed to buy Wahaha + joint venture, but Wahaha refused  the
case went to the courts
2. Detailed contracts dealing with incompleteness
= introduction of safeguards
• Provisions granting the party owning the specific asset with a
protection against potential losses
• To prevent opportunistic behaviours
• Contract duration (life duration of specialized assets), penalties in
case of breach of contract, specific dispute resolution (arbitration)…
55

Specificity
Remedies
3. Achieving commitment through non contractual means : reputation
• Concern with one’s reputation may be an effective check on ex post opportunism
• Not fulfilling obligations results in a reputation of untrustworthiness
• People may be unwilling to interact with an agent with a bad reputation
• Bad reputation reduces future possibilities for profitable transactions (long-term
cost, to be balanced against the short-term gain of opportunism)
• May remove the incentives for opportunistic behavior
All the more important as the transaction is frequent : incentives to build and
maintain a good reputation are larger
• The more frequent the transaction
• The longer the horizon
• The more profitable the transaction
56

Attributes of transations (3) Frequency
Frequency of transactions
• One time (marriage)
• Occasional (buying a car)
• Recurrent (daily shopping)
Frequency of transactions is another source of TC
TC increase in the numbers of transactions : opens the
possibility for parties to engage in opportunistic behavior
 to substitute organization (internalization) for outside
mechanisms (=> avoids opportunism in the market)
57

Attributes of transations (3) Frequency
But opposite view (Milgrom & Roberts, 1992)
When similar transactions occur frequently over a long period of time, the party who
interacts repeatedly may find it valuable to acquire info and create an institution to
manage the transaction
The ability to cooperate and learn over time reduces TC
• Because parties will grow to understand what is expected of them
• Because the need for formal institutions to enforce arrangements may be greatly
lessened
EXAMPLE
• Disputes between a supervisor and a worker are rarely resolved in courtrooms :
instead, factories may set up a special grievances committee involving the union or
worker representatives, or an ombudsman may hear complaints and attempt to
mediate a solution
• Special purpose institutions that can be tailored to particular circumstances of the
factory
58

• The above factors will all potentially increase
the external transaction costs, where it may
become rather expensive for a firm to control
these factors. Thus, it may very well be more
economic to maintain the activity in-house, so
that the firm will not use resources on e.g.
contracts with suppliers, supervision…

Governance structure
• The two primary conceptual insights provided by
transaction cost theory are that the governance of
exchange agreements between economic actors is
costly and that governance forms vary in their ability to
facilitate exchange depending on the attributes in the
transactional environment.
• The choice of organizational governance form is seen
as a central means through which management affects
the costs of monitoring and administration or, more
specifically, the costs of negotiating and writing
contracts and monitoring and enforcing contractual
performance

Governance structures
Governance structure
= Ways of organizing transactions
= “the institutional framework within which the
integrity of a transaction is decided. Markets and
hierarchies are two of the main alternatives”
(Williamson, 1979)
 Question: what governance structures match
the transactions?
61

Factors decide the choice of
governance structures
 Efficiency criterion
 Minimization of Total cost (Production cost +
transaction cost)
 Transaction attributes
62

The governance of contractual
relations
63
The make or buy decision

relations forms
64
Market
Hybrid
- Franchising
- Business alliances
- Cooperatives
Joint ventures
Firm networks (production, distribution…)
Producers’ groups
Collective brands (“Label rouge”, organic food
labels…)
Partnerships
Firm/
Hierarchy/
integration

Hybrid forms
Franchising
• Automobile dealerships, convenience stores, clothing stores, hotels,
restaurants (McDonald’s), gasoline retailing, car rentals…
• Franchisee owns and runs a detail business using the franchisor’s brand
name
• Often buys inputs or goods for resale from the franchisor
• Makes contractual payments to the franchiser for use of its name
• The franchisee remains the residual claimant
• But the franchisor generally maintains rights to set and enforce standards
on the franchisee
 Share the advantages of market arrangements : attract customers,
incentives to keep low costs… economies of scale in marketing and
purchasing…
Control exerted by the franchiser adds value by overcoming a variety of
problems arising from specific assets
65

Hybrid forms
Business alliances
Examples : airline alliances (Skyteam…)
• Coordinate flight schedules to take advantage of scope
economies
• Requires the parties to make common decisions
So why don’t the airline companies instead integrate?
• Regulations limiting foreign ownership
• Antitrust law
• Airline cultures (labor unions…)
• Tax considerations…
• … But also organizational considerations (Williamson)
66

Hybrid forms
Cooperatives
Joint ventures
Firm networks (production, distribution…)
Producers’ groups
Collective brands (“Label rouge”, organic food labels…)
Partnerships
• Example : lawyers; partnerships between firms and universities for R&D
• Japanese keiretsu
– Group of related firms that consist of independent firms with close links and
often a shared name
– Linked because companies in the group commonly own shares in the other
members + share information network
– But remain independent : do not automatically direct purchases to related
companies unless these other companies offer the best economic deal
67

relations
Several advantages combining market and hierarchy
• Market is well suited to implement autonomous adaptations by agents… but
performs poorly when it comes to cooperative adaptations
• Hierarchy has limited adaptative capabilities… but is able to discourage
opportunistic behavior
Hybrid as a compromise mode
=> Keeps the incentive advantages of the market
– = Maintain competitive pressure on members…
– … But also establish organizational mechanisms to discourage opportunistic behavior
=> Facilitated coordination (hierarchy)
– Relies on restrictive contractual provisions
– Private ordering (choice of the authorities who own the decision power in case of conflict)
– Development of some informality in the relation to prevent opportunism (joint development
of reciprocal assets)
68

relations
Williamson draws from McNeil’s typology
(1974):
– Classical contract law
– Neoclassical contract law
– Relational contract
69

relations
Classical contract law
Single transactions
The identity of the parties does not matter
Autonomous parties (no asset specificity)
Nature of the agreement perfectly delimited
– Remedies are prescribed in case of non performance
– Opportunistic behaviour is easily sanctioned by the market
Complete contract
Such transactions can be coordinated by the price system (ideal
market transaction)
Associated with a specific governance structure: market governance
70

relations
Neoclassical contract law
Some transactions involve specific investments
 bilateral dependency
 necessary to ensure the continuity of the relation
– Against possible opportunism of parties
– Under conditions of uncertainty
 Long-term contracts are necessary
Features of such long term contracts
Operated under conditions of uncertainty (impossible to foresee all contingencies in
the future and the corresponding adaptations) : contracts need to be flexible
Therefore: they are incomplete contracts (on purpose)
– Incompleteness makes adaptation possible
– Reduces contracting costs ex ante
Pb: incompleteness allows opportunism => conflicts may arise => need for a third
party to intervene to solve conflicts
Associated with a specific governance structure: hybrids
71

relations
Relational contracts : corresponds to situations when uncertainty grows
strongly
• Owing to the frequence of transactions (increased duration of the
transaction)
• And increased asset specificity
• Strong bilateral dependency, very costly to be held up
• Ex. : employment relationship (employee invests in specific human K,
should be protected against emplye’s opportunism)
 Classical and neoclassical contract law insufficient to prevent opportunistic
behaviour, because personalized relationships and repeated transactions
 Relational contract
 Needed to sustain ongoing relations
– It would be costly to interrupt the relation otherwise (strong bilateral
dependency)
– necessary to find an efficient solution against opportunism
72

relations
Unified ownership / integration provides a solution against
uncertainty + opportunism
The attributes of the transaction make it impossible to maintain the
autonomy of the parties : control system and hierarchy necessary
 Coordination is achieved through subordination
– Adaptative and flexible
– Because it relies on authority
Hierarchy therefore allows parties for the writing of very incomplete
contracts
When unforeseen contingencies, hierarchy allosw parties to adapt to
new circumstances
– Through coordinated adaptation
– Through the hierarchical control of the actions and decisions of agents
However, pb: such relational contracts reduce the agents’ autonomy : 
their incentives to do their best 73

TC Theory: empirical validation
• Model
- Asset
specificity
- Uncertainty
TC costs
Governance
structure
(Market or
integration)
Control
variables

Validated results: Results (1) vertical integration
TC theory statement (1): when asset specificity  agents prefer integration
to market organization
Lots of empirical tests (Klein, 2005) validate this
• Monteverde and Teece (1982) (automobile industry) and Masten
(1984) on the aeronautic industry : the probability of integrating the
production of some components  if physical and temporal asset
specificity  (engineer questionnaires)
• Anderson and Schmittlein (1984) (electronic components) : same result
for post-production departments (sales and marketing) : if human asset
specificity (time to train a new salesperson)  then the probability of
integration 
• Mindler and Park (1994) and Lafontaine (2005) (franchised restaurants
and hotels in the US) : if brand specificity  (difference between market
and book value of a franchiser’s stock) the probability of actual
possession of franchised hotels and restaurants by the franchiser 
75

Validated results : Results (1) vertical integration
TC theory statement (2): when uncertainty or complexity or frequency 
agents prefer integration to market organization
Less clearly validated by empirical tests
• If no asset specificity, no quasi-rent = using the market should be OK
(Klein 1988)
• Difficult to measure “pure” effect of uncertainty or complexity or
frequency (must find cases with NO asset specificity)
• For uncertainty, difficult to use questionnaires to measure uncertainty…
because if agents knew about it, they would act accordingly + no use
using past or after-the-fact uncertainty as reference
• For complexity, very difficult to create ad hoc indicators
• Almost no studies on frequency (except Carter and Hogson, 2006, where
no link was found)
 Asset specificity = THE key aspect of TC theory
76

Validated results : Results (2) contractual choices
TC theory statement (3): when TC  contracts should be
longer (reduce opportunism)
• Well-verified by empirical works
• Asset specificity : Joskow (1987) studies the contract
duration of coal-based electricity plants in the US, finds
that when there is asset specificity (physical and locational)
contracts last longer (contracts between geographically
close plants and mines + 12 years)
• Uncertainty
– Saussier (1998) shows that contracts between EDF and river coal
transporters are 6 months longer when signed in an uncertain
period
– Same result (3 years) for Canadian gas producers (Crocker and
Masten, 1988) 77

Validated results : Results (2) contractual choices
TC theory statement (4): when TC  and contract
duration  contracts should contain more complex
monetary clauses with more renegotiation possibilities
(reduce opportunism)
• Well-verified by empirical works
• Coal supply (Joskow, 1987)
• Gas production (Crocker and Masten, 1988)
• US army contracts (Crocker and Reynolds, 1993)
• Coal transportation (Saussier, 2000)
• Infrastructure production (Athias and Saussier, 2007)
78

Not validated result: Results (2) contractual choices
TC theory statement (5): when TC  contracts try to be more
detailed(reduce opportunism)… but less precise (allow for
flexibility) = ambiguous effect on contract completedness
• When asset specificity  contracts tend to be more
complex (maximum detail on the obligations of the
partners in different cases) (Godlberg and Erickson, 1987 ;
Crocker and Reynolds, 1993 ; Saussier, 2000 ; Athias and
Saussier, 2007)
• When uncertainty  , contracts tend to be less precise
(same studies)
 Need work on CONTRACT COHESION : study of the whole
nature of the contracts (duration, precision, complexity…)
79

Not validated results: Results (2) contractual choices
Research is not yet operational on this dimension
Some studies try and understand if contractual
characteristics are complementary or substitutable
New ‘trend’ in research : compare and contrast formal
(contracts themselves) and informal (reputation, use of
arbitrators, repetition of contracts) aspects of contracts
Poppo and Zenger (1998) show that those dimensions
are complementary
 Lots of room for future research
80

Possible questions
• Opportunistic behavior:
– Ex ante opportunistic behavior and adverse selection: definition, examples, relevance in
transaction cost theory
– Ex post opportunistic behavior and moral hazard: definition, examples, relevance in
transaction cost theory
• Princinpal/agent problem: definition, examples, relevance in TC theory and
manager control and motivation
• What is the quasi-rent, how is it produced and what does it mean for the
market/firm debate in TC theory?
• What are the different kinds of asset specificity and what does asset specificity
mean for the market/firm debate?
• How does TC theory explain the existence between “Pure market” and vertical
integration? Give examples of some hybrid organization and explain why they are
more efficient than either the market or firm integration
• Which results of TC theory are empirically validated and which are not?
• Why is it so difficult to empirically test TC theory?

3. The institution of corporate
governance

Contents
• Corporate governance concept
• Two tier versus unitary boads of directors
• The presence of independent administrators
• Employee and minority (women,
nationalities…) representation in boards:
problems and solutions

Corporate governance: concepts
• Corporate governance broadly refers to the mechanisms, processes and
relations by which corporations are controlled and directed.
• Corporate governance refers o repeated mechanism that allocate
authority among board of directors, senior managers and stockholders
and affec and control the decision made at the top of the firm
• Corporate governance is the set of processes, customs, policies, laws, and
institutions affecting the way a corporation (or company) is directed,
administered or controlled.
• Corporate governance also includes the relationships among the many
stakeholders involved and the goals for which the corporation is governed.
In contemporary business corporations, the main external stakeholder
groups are shareholders, debt holders, trade creditors, suppliers,
customers and communities affected by the corporation's activities.
Internal stakeholders are the board of directors, executives, and other
employees.

A unitary structure
Board of directors:
• The main board task is to represent, formulate and
realize the interests and expectations of shareholders
as the owners of the companies
• The board should provide for balancing ‘two distinct
powers: the power of those who own the corporation
and the power of those who run it’

A unitary structure
Length of Board of directors term
Size of the Board of directors : 12.7
Age restriction: age limits for chairman and CEO is 65; less than 1/3 no of
directors aged over 70

Advantages and disadvantages of unitary board
Advantages
• The possibility of dialogue and better
communication between executives and
nonexecutives (monitoring, counsel,
advice, reprimand) and the access to
corporate data and information by non-
executive directors.
• The board of directors proves to be
flexible and relatively inexpensive,
representing the interests of shareholders
as well as allowing for a quick decision-
making process and efficient information
flow.
Disadvantages
• The negative aspects of the unitary board
refers to the very powerful position of the
CEO who holds the Chairman function at
the same time fully controlling the work,
agenda and directions of the board
• The presence of executive directors and
the directors’ appointment process
dependence on the CEO impacts the
board’s work and responsibilities and
more precisely affects
• 1) building coalition between
executives and independent directors
and outside directors’ support for CEO
policy;
• 2) evaluation of board work;
• 3) resisting hostile takeover; and
• 4) formulating compensation policy for
top management

Two-tier structure/dual structure

Two-tier structure/dual structure:
board of director
- The mandates of
supervisory and
management boards have
to be kept separately.
- The supervisory board
plays monitoring functions,
appoints the CEO and
structures executive
compensation, selects the
auditor and follows
corporate strategy issues.

Two-tier structure/dual structure:
Positive aspects
• The strong independence of
board directors provides for a
better balancing of the roles of
Chairman and CEO,
• High objectivity for accessing
corporate policy, top
management evaluation and
setting executive compensation.
Negative aspects
• The major weakness of the dual model
lies in its limited access to corporate data
and information which has to be
delivered by the management board.
• The relative separation of board members
and executives is mitigated by joint
meetings and specialized committees
(compensation, audit and nominating).
• The threat of the dominance of the
board work by representatives of
controlling shareholders, particularly in
the area of dividend policy, is attempted
to be reduced by the presence of
independent directors.
• The dual board is also often criticized for
its higher costs of functioning and the
lack of direct contact between executives
and outside directors.

An unitary structure vs two-tiers structure: Positive and
negative aspects

The presence of independent
administrator
• The presence of independent administrator is
a solution to solve principal/agent problem
(the manager may not act in the interest of
shareholders). The board of directors should
control managers in the interest of
shareholders.
• Should independent administrators be
appointed as board members?

Characteristics of independent
administrator
• Director (member) of a board of directors who
does not have a material or pecuniary
relationship with company or related persons
(except sitting fees) (=> no relation with
managers)
• Do not own shares in the company

independent administrators should be
appointed as board members
For
• Independent administrator can
be a solution to the
principal/agent problem because:
– Independent adminstrator are not
captive to the managers
– IA can defend the interests of
shareholders
– IA can be a faithful agents of the
shareholders
• Independent administrators play
the role of agents for the minority
of shareholders and ensure that
the interests of the minority
shareholders will be taken into
account
Against
• Independent administrators
may lack relevant
information to effectively
monitor managers
• Firms in difficulty may
resort to independent
administrator

Employee and minority (women, nationalities…)
representation in boards
• Board-level employee representation involves employees representatives
who sit on the supervisory board, board of directors, or similar structures.
• These employee representatives are directly elected by the workforce, or
appointed in some other way, and may be employees of the companies,
officials of organisations representing those employees, or individuals
considered to represent the employees' interests in some way.
• The presence of employee representatives in the board-level structures of
a company is an indirect, or representational, form of participation. It
involves the expression of employees' collective interest through the
intermediary of representatives and differs from direct participation in a
number of ways:
– it focuses on the workforce as a whole rather than individual employees or workgroups;
– its fundamental aim is the achievement of democratic input into company decision-
making rather than fostering employee motivation and commitment;
– it is in general regulated by legislation or collective agreements, rather than being a
unilateral management initiative.

Employee and minority (women, nationalities…)
representation in boards
• Board-level representation also differs from other types of
indirect participation such as works councils in that it
attempts to provide employee input into overall company
strategic decision-making rather than focusing on information
and consultation on day-to-day operational matters at the
workplace.

Employee and minority (women, nationalities…) representation
in boards: is the a problem and what to do about it?
Problems
• The presence of employees is just
indirect
• The presence of employees or
minority (women) aims at
achievement of democratic input
into company decision-making
rather than fostering employee
motivation and commitment
• Women may not willing to
participate
• Hard for women to be elected to
be a member of the BoD
Solutions
• Law and regulation
• Enhancing the role and power of
union
• Confirm the importance and affect
of employees and women
represenation on firm
performance
• ‘Provide support ive conditions to
facilitate the presence of
employee and women on board

Contents
• Compensation for executive
• Compensation system:
– Individual compensation
• The piece rate wage system
• The tournament wage system
• Time rate system
– Collective compensation
• Purpose
• Pros and Cons
• Condition of success
• Type of collective compensation

Compensation for executive
• Important question: How to pay managers to motivate them
to work for the purpose of the organization?

The piece rate wage system
• Compensates the worker according to some measure
of the worker’s output
• Piece rate system is initially applied for workers with
a repetitive, standardized output and also for senior
executives

The piece rate wage system
Pros (positive aspects)
• Incentive effect: The
workers modify their
behaviour (work
harder)
• Sorting effect: Workers
with higher
(unobserved) ability will
prefer to work in firms;
the turnover rate of
workers with low ability
is increasing
Cons (negative aspects)
• The quality/quantity trade-off: The quality of
ouput must also be observable without too
much cost
• The ratchet effect: If output is on average
higher than expected, the employer may be
tempted to decrease the piece-rate
• Ouput need to be measured precisely,
indicators measuring performance must be
appropriate, otherwise it may also fail to
reflect the actual goal of activity since agent
tends to focus on indicators only
• Pernicious effects
• Multitasking: need to control all tasks and
balance different tasks because performance
will tend to be reduced to output of one task
instead of outputs of every tasks
• Crowding out effect: Financial incentives are
introduced  reduce internal motivation

The tournament wage system: difinition
• Tournament wage system:
– Agents are not paid according to an absolute
measure of performance on the job but rewards
based on what the worker produced relative to
other workers in the firm
– The firm will rank workers according to their
productivity
– Rewards distributed according to the rank

Reason for using The tournament wage system
• it is easier for the firm to observe a worker’s
rank than to measure the worker’s actual
contribution to the firm
• Increase motivation of workes (worker
allocate lot of effort to the tournament) if
there is a big difference between payoff for
winner and for loser

The tournament wage system:
positive aspect
• Incentive effect on the agent (high level of
effort)
• Easier to observe the rank than the absolute
performance
• Help to justify wage differentials in
organization between top managers and
employees

The tournament wage system:
negative aspect
• If the risk is too high, workers may refuse to participate to the tournament
or at least express lower effort
• Collusion: the winner may compensate the losser
• Too much competition will lead to sabotage and malfeasance
phenomenon  collective cost for the firm
• Player’s heterogeneity: if agent is far superior to the others, incentive
effect reduced…
• Require a equitable performance appraisal system, avoid gender bias
• Hard to implement either in small firm or large firm since in small firm,
people tend to have close relationship  do not ensure the objectivity in
performance evaluation; in large firm, it is difficult to differentiate
performance of managers working in different departments
• Small difference in productivity must lead to huge difference in wage, but
then the question of fairness, resource constraints…
• Can lead to high rate of turnover of average and “bottom”managers  TC
increase since firm need to recruit new managers and train them
• Adverse selection: attract venturesome manager if the industry is too risky
and fluctuate

Collective compensation
• Objectives:
– Maximize collective performance
– Establish cooperation btw team members
• Pros: Peers’pressure
• Cons: Target must be realistic (otherwise,
slackening of the effort)
• Conditionsofsuccess
– Size of the team must be small
– Team composition must be stable
– Sanctioning power of the group must be effective

Collective compensation
• Type of collective compensation
– Profit sharing: optional voluntary case-báed
profit-sharing plans; compulsory deferred profit-
sharing plans
– Employee savings programs: company saving
plans; company retirement savings plans
– Employee shares plans

Economics of organization tutorial

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