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CG-EconomicViews-slides1.pptComparative Corporate Governance
Economic Views of the Company and its Governance
Professor John Paterson
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Economic views of the firm
An outsider to the field of economics would probably take it for granted that economists have a highly developed theory of the firm. After all, firms are engines of growth of modern capitalistic economies, and so economists must surely have fairly sophisticated views of how they behave. In fact, little could be further from the truth.
Oliver Hart
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The basic question
- Why do firms exist?
- Appear to contradict resource allocation by price mechanism—the market
- Technological requirements—scale and efficiency demands organisation…
- …but much could be achieved by sub-contracting
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Why the basic question matters
For corporate governance, the answer has implications for:
- Who is integral to the firm
- Nature of relationship with other actors
- Role in governance
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Coase
- Market and organisation are alternative methods of coordinating production
- The firm is chosen when there is a cost of using the price mechanism
- Long-term contract to obey directions (employment) or provide goods (supply) replaces need to discover price for every transaction
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Coase (2)
- A firm consists of a system of relationships which come into existence when the direction of resources is dependent on the entrepreneur
- Division between market and organisation is determined by calculation of efficiency
- Fact of direction distinguishes contract of service from contract for services
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Alchian and Demsetz
- Dispute Coase’s idea that the basic characteristic of the firm is direction
- Power is exercised in the same way in the firm as in the market
- Focus is instead on the team use of inputs and the central role of one party in the contractual arrangements of all other inputs
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Alchian and Demsetz (2)
Questions then become:
- What is team production?
- Why does it lead to emergence of a firm?
Answer lies in the metering problem
- Ensuring rewards related to productivity
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Alchian and Demsetz (3)
- Classical economics assumes productivity creates reward automatically
- For A & D it is the system of reward that produces the level of productivity
- Team production makes metering difficult
- Leads to the appointment of a specialist monitor
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Alchian and Demsetz (4)
To ensure monitor does not shirk, they are given a bundle of rights:
- to be a residual claimant
- to observe input behaviour
- to be the central party common to all contracts with inputs
- to alter the membership of the team
- to sell these rights
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Alchian and Demsetz (5)
What happens if ownership is diversified?
- Monitoring transferred to managers
- Shareholders retain right to revise membership of management group, to take major decisions affecting company, and to sell shares if unhappy with other decisions
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Alchian and Demsetz (6)
- Accounts for market for corporate control
- Firm is a highly specialised surrogate market (a nexus of contracts)
- Shareholders confirmed as residual claimants
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Jensen & Meckling
Focus is upon the agency costs: arising because the manager will not always act in the interests of the owner, and the sum of:
- Principal’s monitoring expenditure
- Agent’s bonding expenditure
- Residual loss (cost of non-maximising decisions by agent)
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Jensen & Meckling (2)
- Taking seriously the notion of the firm as a nexus of contracts, J & M note that such costs affect all of the contractual relations and not just those between owner and manager
- Firm is a legal fiction which serves as a nexus for these contractual relations
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Jensen & Meckling (3)
- No point in trying to establish what is in and outside the firm
- There is only a set of contracts between firm and owners of various inputs and buyers of outputs
- Questions of function or social responsibility become irrelevant
- But does this also question the focus on shareholders as residual claimants?
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Williamson
Why do those who provide capital both own and control the firm?
- Non-specific assets can be financed by debt (redeployable without cost)
- Specialised assets must be financed by equity (redeployable only with cost)
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Williamson (2)
- Shareholders provide capital without guarantee of return, but with a claim on profits after other costs covered
- Other stakeholders can protect their positions with contracts, but shareholders cannot
- Shareholders thus require control rights
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Williamson (3)
- Board is one such control mechanism
- Shareholders clearly have a right to representation on the board, but other stakeholders do not
- They may, however, have informational rights
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Hart
- Switches the focus away from transaction costs (and thus authority—traceable back to Coase) and on to property rights (and thus the physical and non-human assets of the firm)
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Hart (2)
- Transaction Cost Economics cannot explain the advantage of a manager over an independent contractor
- Property rights can, because the owner of an asset has residual rights allowing him to withdraw it from employees if their work is unsatisfactory
- Hence the firm has advantages over the market
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Hart (3)
- H’s approach thus explains why ownership of physical assets leads to control over human assets
- He concedes, however, that work remains to be done to accommodate the separation of ownership and control, and the consequent delegation of authority to managers
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