Theories of the firm: from agency theory to relational contracts

¶ … Corporations Exist

Corporations and Organizations

Corporations are legal entities with different personalities from its members. They are juristic persons with rights and obligations, such as:

the right to hold assets;

the right to hire employees/the obligation to remunerate employees;

the right to sign contracts/the obligation to respect its contracts;

the right to make by-laws that help them coordinate the internal functioning; the right to sue and be sued; other rights and obligations imposed by court of laws.

The theories about firms date back in time in the first part of the 20th century. Berle and Means (1932) were among the first to observe that management has separated from the ownership for U.S. companies and this is one of the main characteristic of corporations. Later on, in the 1970s the agency theory was formalized (Ross, 1973) and it mainly paid respect to the relationship between owners and managers and various layers of management. The nexus of contracts view of organizations argues that is misguided to create a strong delimitation between markets and organizations (Alchian & Demsetz, 1972; Fama, 1980). Thus, the difference between a company firing an employee and a customer 'firing' its supplier is that the former has a legal status and the owners have a continual association.

Holmstrm and Milgrom (1994) described the company as a system, a set of complementary contractual arrangement that mitigate/incentive conflicts. According to them, the company is characterized by the employee not having ownership of the firm's assets, the employee as part of a low power-incentive scheme and by the employee being under the employer's authority. Wernerfelt's (1997) modern employment-related theory of the firm suggests that governance mechanisms are institutional mechanisms through which employees and employers adapt to environment-related changes and communicate about them.

The governance mechanism as described by Williamson (1975) is based on transaction costs. Basically, these ones dictate whether transactions are made through markets or by internalizing activities. Market-based transactions are subject to uncertainty, which generate transaction costs, whereas hierarchies generate higher costs associating with controlling a wider range of activities. The central piece of his theory is the asset specificity. The higher the specificity of a company's assets is, the more agents are likely to behave opportunistically, which is an incentive for the company to internalize activities along the value chain to protect its assets.

The traditional contract theory of the firm has recently been enriched with a more recent type of contacts: relational contract. This latest contribution suggests that each party behave in such a manner to reach the other party's expectations and the behavior is maintained by fear of retaliation of the other party(ies). Such contracts occur both between firms and within the same firm, between employees and employer (Baker, Gibbons and Murphy, 1997).

In the information era, a communication theory of the firm was developed. The theory according to which firm is a communication-hierarchy is developed around the idea that firms adapt to and process information and the focus is not on incentive conflicts, but rather on communication and coordination (Cremer, 1990; Radner, 1992; Casson, 1997).

Some of the critiques brought to the modern theory of the firm pay respect to the overemphasis on 'soft issues' such as communication, organizational cultures and such similar notions, which overlooked important factors relevant for any firm, such as: implicit/relational contracts, bounded rationality - the individual has bounded rationality, failing to get important information due to simple reasons, such as language barriers; uncertainty - which is increasing in the modern times due to the permanent change in technology.

According to Gerhard Schulmeyer, Siemens Nixdorf's CEO corporations exist "to provide "a place where the individual can do what she is good at, at a lower cost than she could do it alone." For individuals, corporations represent places where other individuals with similar interests work together building a challenging environment that stimulates creativity. Moreover, corporations offer individuals access to resources that would be unreachable to them if they were to pursue their purposes on their own. Also, corporations offer employees a certain financial comfort that again it couldn't be achieve by an individual on its own. The financial comfort refers to situations such as unproductive moments that are remunerated anyway by a salary while working for corporations.

Basically, the corporations insure the continuity of business activity during unproductive moments and manage to optimally take advantage of highly productive moments. Corporations are more efficient than individuals and they have the power to move other people and goods and have a deep impact on a country's economy. An economy based on individual wouldn't be able to efficiently engage its resources in order to obtain optimal results.

Automobiles

Most of the automobile's definitions pay respect to its initial design purpose: to run on the roads and to transport people, but not necessarily goods. To fulfill their functions, automobiles have wheels, seats and carry their own engine. They have a given capacity to transport other people according to the specific needs that inspired its design: comfort, space, speed, fashion, etc.

According to WorldMapper, in 2002 there were 590 million cars in the world.

FIG. 1 - PASSENGER CARS 2002

Source: WorldMapper (2002) those with the lowest concentration.

The statistics also show that the areas with the highest car concentrations are also the most developed from the economic point-of-view (see fig. 2).

FIG. 2 - CAR CONSUMPTION 2002

Source: WorldMapper (2002)

Nevertheless, there are studies that suggest that excessive automobile dependency may reduce economic growth (Litman & Laube, 2002). An indicator of automobile dependency is a high rate of automobile travel/capita. Automobile dependency is usually associated with high transportation costs, significant land and financial resources - roads, parking, traffic congestions and the worsening of the environment.

Some if the reasons that lead to automobile dependency are summarized in table 2.

TABLE 1 - MARKET DISTORTIONS THAT CONTRIBUTE to AUTOMOBILE DEPENDENCY

Market Requirements

Common Transport Market Violations

Choice. Consumers need viable choices, and information about those choices.

Consumers often have few viable alternatives to owning and driving an automobile, and living in automobile-dependent communities.

Competition. Producers must face competition to encourage innovation and efficient pricing.

Most roads and public transit services are provided as public monopolies. There is often little competition or incentive for innovation.

Cost-based pricing. Consumers must bear the costs they impose. There should be no significant external costs unless specifically justified.

Automobiles use is underpriced: most costs are either fixed or external. Lower-density, automobile-dependent land use patterns are also underpriced.

Many public policies favor automobile use, including dedicated road funding, road designs that favor motor vehicle traffic over other road uses, zoning laws that provide generous free parking and lower density development, and a lack of cost-based pricing.

Source: Litman & Laube, 2002

Studies also suggest that some countries experienced their highest economic growth rates when the automobile consumption was low and the growth rates started to decrease as the automobile consumption increased (Talukadar, 1999 - see table 2).

TABLE 2 - ECONOMIC DATA on GLOBAL CITIES, 1990

Source: Litman & Laube, 2002

Why do corporations and organizations exist?

This paper argues that corporations, like automobiles, exist to move people and goods and fuel the economy. However, these two are now equal as corporations are those that create automobiles. The relation between these two is similar to that between the whole and a part of it. Corporations create automobiles to fuel the economy, but they also create other "tools" to reach the same goal, such as professionals and financial products.

Like the automobile, the organization is built from different parts: top, middle and low management. Automobiles are built from parts as well: engine, wheels, carburetor and each part has its function. For instance low management is covering the operational work, just like wheels, whereas the engine is moving the car, just like top management.

Corporations exist because they deliver better results by being more efficient in moving the people and the goods involved in the value creating process. They are also the most suitable ownership type given the diversity of investing options nowadays.

Reference List

Alchian, a.A. And Demsetz, H. 1972, 'Production, Information Costs, and Economic Organization', American Economic Review, vol.62: pp. 772-795.

Baker, G., Gibbons, R. And Murphy, K.J. 1997, Implicit Contracts and the Theory of the Firm, Working Paper.

Berle, a.A., Jr. And Means, G.C. 1932, the Modern Corporation and Private Property, New York, Macmillan.

Bureau of Transportation Statistics, 2007, http://www.transtats.bts.gov/

Casson, M. 1997, Information and Organization, Oxford, Oxford University Press.

Cremer, J. 1990, 'Common Knowledge and the Coordination of Economic Activities', in Aoki, M., Williamson, O.E. And Gustafsson, B. (eds), the Firm as a Nexus of Treaties, London, Sage.

Fama, E.F. 1980, 'Agency Problems and the Theory of the Firm', Journal of PoliticalEconomy, vol. 88: pp. 288-307.

Hess, K.L. 1996, 'The Growth of Automotive Transportation', http://www.klhess.com/car_essy.html

Holmstrm, B. And Milgrom, P. 1994, 'The Firm as an Incentive System', American Economic Review, vol. 84: pp. 972-991.

Litman, T. And Laube, F. 2002, 'Automobile Dependency and Economic Growth', Institute for Science and Technology Policy, http://www.vtpi.org/ecodev.pdf

Radner, R. 1992, 'Hierarchy: The Economics of Managing', Journal of Economic Literature, vol. 30: pp. 1382-1415.

Ross, S.A. 1973, 'The Economic Theory of Agency: The Principal's Problem', American Economic Review, vol. 63: pp. 134-139.

Talukadar, D. 1997, 'Economic Growth and Automobile Dependence', Thesis, MIT, cited in Gakenheimer, R. 1999, 'Urban Mobility in the Developing World', Transport Research a, vol. 33: p. 680.

Wernerfelt, B. 1997, 'On the Nature and Scope of the Firm: An Adjustment-Cost Story', Journal of Business vol.70: pp. 489-514.

Williamson, O.E. 1975, Markets and Hierarchies: Analysis and Antitrust Implication: A Study in the Economics of Internal Organization, New York, Free Press, 286

WorldMapper, 2002.

A www.worldmapper.org

WHY CORPORATIONS EXIST

The first column shows the countries with the highest concentration of cars per capita and the second column displays

Japan, Western Europe and North America lead the top, ranking 1st, 2nd and 3rd. At the other ending of the top, there are: South and East Asia and Southern and Northern Africa, some of the poorest regions in the world.