Agency theory and firm boundaries

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In this lecture, market presence and activities will be discussed.

First topic is the theory of transaction cost economics.

Transactions can take place in both the market (external) or within the organization (internally). Transaction cost economics (TCE) analyzes the transactions, where the costs made in performing the transaction are the transaction costs. These can be search and information costs, bargaining costs and policing and enforcement costs. Firms exist as the costs of market transactions must be higher than the internal costs of transaction. At first the market costs are lower and transactions take place on the market. However, at a certain price and quantity level, it will be cheaper to take transaction internal, and ‘buy’ them. In conclusion, we may say:

  • Activities are internalized when the costs of outsourcing are higher than the (transaction) costs of internalization
  • Activities are outsourced when the costs of internalization are higher than the (transaction) cost of out-sourcing

The TCE are influenced by bounded rationality and bounded reliability (found in the book in chapter 1). Together with some environmental factors (complexity and the small number of players) this generates the General Transaction Costs. These are present for all transaction. Additionally, costs can increase by three characteristics of assets: specificity, uncertainty/complexity and frequency. The higher the degree of these characteristics, the higher the market transactions costs (so, higher than the internal costs), and these tend to be externalized.

The second topic is the Agency Theory.

The Agency Theory, also known the principal-agent problem, addresses the issue of agency costs, which is the costs of difference in objectives. These objectives are the objectives of an agent (in a firm the officers or managers) and the principals (the shareholders or owners). These differences lead to losses, when the principal pays the agent to perform in a certain way that is beneficial for the principal, but costly for the agent. The other way around, they also occur when the principal can only observe the actions of the agent in a rather difficult or costly manner. Agency costs also increase when there is information asymmetry, uncertainty or risks.

Two solutions to this problem exist, to either fully specify all contracts or monitor all agents, but this might be very costly and the costs of this may be higher than the agency costs themselves.

The third topic in this lecture is on entry modes, namely Foreign Distributors, Strategic Alliances and Mergers and Acquisitions. This is perfectly described in the book in chapter 11, 12 and 13, and only the additions are given below.

When looking at Foreign Distribution as an entry mode, a vicious circle can be found as commitments is mainly short-term by the home country, which reduces the efforts made by the foreign distributor, which again reduces the probability of success, which then decreases commitment in the first place. Therefore, FD is unlikely to  succeed.

When firms gain from a Strategic Alliance, it often is as both firms in the alliance commit to sharing just enough information, to jointly create new FSAs, also known as Alliance-specific advantages (ASAs). These are only transferable to other locations within the alliance, and the individual firm within the alliance cannot claim the ASA. Additionally, with the creation of ASAs, stability and incentive to commitment is increased.

Two problems with Mergers and Acquisitions are found: the underestimation of the costs of integration, and the overestimation of the benefits.