Agency Cost & Corporate Governance

Topics: Governance, Stock market, Principal-agent problem Pages: 21 (6746 words) Published: April 8, 2008
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...
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