Agency Cost & Corporate Governance

Agency Costs and Corporate Governance

I Introduction

Before analysing problems that occur when institutional ownership and control are separated, it should be outlined why institutions exist at all. Therefore, chapter two examines why organizations occur in economy. Chapter three addresses the agency problem, based on this organization. Chapter four addresses the common ways to solve the agency problem and chapter five gives a comparison over the three most important corporate governance systems, namely the US, the German and the Japanese one.

II "Why is there any Organization?"

The basic question that has to be addressed is: "Why is there any organization?" This question was first addressed in a satisfyingly way by Ronald Harry Coase in his 1937 published paper "The Nature of the Firm". He was given the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel for this pioneering work in 1991.

II.1 Transaction Costs

As economic theory suggests, outside the firm the price movement directs production, which is therefore coordinated through a series of exchange transactions on the market. Inside the firm this market transactions are eliminated and substituted through the entrepreneur who is coordinating the production. However, all production could be carried out without organizations only through the price mechanism. The ultimate question is if there are reasons possible for the need of organizations and therefore for the existence of firms (Coase, 1937, p. 19).

The reasons for the establishment of firms are based on the fact that there are costs of using the price mechanism. The so called "transaction costs". Possible types of these transaction costs are, among others, deciding what the relevant prices are to be able to make use of the price mechanism or the costs of negotiation and concluding a contract for each transaction, which takes place on a market. Transactions costs also occur, in another way, because the same exchange transactions are treated differently by Governments or other regulatory bodies if they take place on a market or within a firm. Sales taxes are, for example, clearly taxes on market transactions and not on the same transactions organized within a firm. Therefore, the argument for the existence of firms is that the operation of a market is connected to costs and by establishing an organization and allowing some authority to direct the resources, certain market costs are saved. For example, the costs for negotiating and concluding a new contract for each new transaction can be saved by using a less precise long term contract (Coase, 1937, p. 21-22).

II.2 The Size of Firms

Given this idea of transaction costs, also the size of firms can be explained. "A firm becomes larger as additional transactions (which could be exchange transactions co-ordinated through the price mechanism) are organized by the entrepreneur and becomes smaller as he abandons the organization of such transactions."

This internalisation of transactions will not be a chaotic process but will stop at a certain point. Or as Coase put it: "a firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm." (Coase, 1937, p.23-24)

For the growth of a firm, the question is always if it will pay to bring an extra exchange transaction under the organizing authority. "At the margin, the costs of organising within the firm will be equal either to the costs of organising in another firm or to the costs involved in leaving the transactions to be "organized" by the price mechanism." (Coase, 1937, p. 30) In this way the basic questions 1) why is there any organization and 2) to what extend, can be addressed satisfyingly.

II.3 The Definition of the Firm

Firms are neither black boxes nor individuals acting on own purpose. "It (the firm) is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may "represent" other organizations) are brought into equilibrium within a framework of contractual relations." After all, we are now able to give a definition of a firm, considering reasons for its existence, the way it works and a view on the problems that arise with the establishment of organisations.

"The private corporation or firm is simply one form of legal fiction which serves as a nexus for contracting relationships and which is also characterized by the existence of divisible residual claims on the assets and cash flows of the organization which can generally be sold without permission of the other contracting individuals." (Jensen/Meckling, 1976, p. 311)

III Agency Theory

III.1 The Principal - Agent Relationship

The organization in firms as discussed above does not only provide benefits. In this, so called "contractual view of the firm" the agency problem is an essential element. The separation of management and finance (or of ownership and control in more standard terminology) is the essence of this agency problem. The reasons why this problem occurs are simple. Not everyone with capital has good ideas where to spend it, and not everyone with a good idea where to invest, has capital. To say it in more specified terms. "The financiers need the manager's specialized human capital to generate returns on their funds. The manager needs the financiers' funds, since he either does not have enough capital of his own to invest or else wants to cash out his holdings." (Schleifer/Vishny, 1997, p. 740)

Given this situation, an agency relationship is likely to be established. "We define an agency relationship as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some services on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship are utility maximizers there is a good reason to believe that the agent will not always act in the best interests of the principal." (Jensen/Meckling, 1976, p. 308)

III.2 The Agency Problem

The agency problem now is how the financiers can assure that the manager is using their funds in their interest once they sink