SOD Cheat sheet - All slides + articles
Topic Week Core
Building blocks of 1 Incentivizing value creation
organizations Learning goals:
1. List and explain agency theory
2. Agency approach (Eisenhardt heeft een overview)
a. definition (principal delegates a task to the agent through authority)
b. unit of analysis: transaction/ contract between principal and agent
i. relationship is governed via a contract. Contract is incomplete and can only reward two aspects of the work (behavior and
output)
c. transactions:
- exchange money for goods (TCE: market or agency theory: outcome based)
- exchange for someone else time (TCE: hierarchy or agency theory: behavior based)
d. transaction governance matters under two conditions/ problems:
- information asymmetry (moral hazards: principal cannot observe agent) + adverse selection: principal cannot observe
the abilities of the agent)
- incentive misalignment
e. assumptions
- boundedly rational
- actors are self-interested (ex-ante, you do not know if the other party is self-interested → opportunistic
- agent more risk averse than the principal
f. tensions:
- cheating (outcome based increases risk of cheating) → shift risk to agent vs. shirking (behavior
based increases risk of shirking) → shift risk to principal
3. To compare the benefits and disadvantages of rewarding for input and output
When do we reward output? - outcome
- outcome is perfectly measurable
- optimal behavior is unknown
- cost of monitoring cheating is low
- principal is more risk averse/ less outcome uncertainty
When do we reward behavior? input
- behavior is perfectly measurable
- optimal behavior is known
- cost of monitoring shirking is low
- agent is more risk averse/ more outcome uncertainty
Hennart (1993) →
Different definitions
Behavior = Hierarchy (often occurs in transactions within the firm) Output = price (often occurs in market transactions)
Agency costs are now called transaction costs Otherwise basically the same (Hennart’s transaction cost ≠ Williamson’s transaction cost)
Two simple and realistic additions to the model
- Separate between cost of cheating and cost of monitoring for cheating
- Firms are better at monitoring behavior, while markets are better at monitoring output
- Acknowledge that monitoring costs are not linear
Explanation of why most transactions are governed by a combination of price and hierarchy!
, 4. Apply agency theory to determine how to govern a transaction
5. Criticize each assumption of agency theory
- if assumptions hold, propositions hold
Assumption 1: self-interest
- Are all individuals self interested? Two views:
- Of course not, but you cannot identify self-interest ex ante, therefore assuming so functions as a safeguard (Hennart)
- Of course not, and we might be able to do better if we consider that individuals have bounded self-interest (Bosse & Phillips)
Bounded self-interest?
- Act self-interested, but do not violate perceived norms of fairness (Bosse)
Reactions to fairness vs. unfairness in competitive situations?
- Fair behavior is rewarded by acting reciprocally (i.e. deviate from self-interest in favor of the other party)
- Unfair behavior is punished (i.e. act self-interested or even deviate from self-interest to work against the other party)
How does this change agency theory predictions?
- It doesn’t really change the main predictions (though it does change auxiliary predictions not discussed here)
- Does highlight a necessary condition under which agency theoretic predictions hold: Fairness
- Added assumption doesn’t overturn but slightly tweaks agency theory
Assumption 2: rationality
Do all individuals act rationally?
Separating between self-interest and moral sentiments
- Moral sentiments and self-interests not additive
- Are they substitutes or complements?
How does this impact agency theory?
- Violates main mechanism where rewards on output motivate behavior
- Do not use rewards on output when there are strong moral sentiments that motivate output (geld geven aan mensen die bloed doneren)
Four types of irrational behavior
- Framing: problem framing determines behavior Social framing: medium self interested isolated, more other regarding with communication
, allowed Legal framing: completely self-interested
- Endogenous preferences: incentives shape behavior Providing and then removing incentives for moral behavior increases immoral behavior
- Self-determination: extrinsic rewards might inhibit intrinsic rewards Paying for donating blood reduced the nr. of people that participated
- Information content of incentives: incentives provide information about the principal If incentives seem to indicate expected lack of distrust or
commitment, agent punishes principal
Assumption 3: risk preferences
Risk preference assumption is not really necessary See Hennart, very similar outcomes when just considering cost of organizing and cost of cheating/shirking
It is more an additional trade-off (as well as a convenient assumption to solve the model)
Assumption 4: unidimensional output
- Multitask situations Example: workers are required to produce output and care for the machines (mining example in hennart) Shifting attention to
one task means less attention for another
- Implications for agency theory - Very important to create an all-encompassing system Combinations of behavior and output (Hennart)
Static vs. dynamic
So far, we have evaluated a static model of the world How do dynamics affect the effectiveness of contracts?
Productive vs. adverse learning Over time, employees are prompted by the incentives to improve their work But at the same time, they find ways to cheat the
system
Time dynamics Initial learning is productive and value capture for the organization goes up Then, individuals also learn to ‘game’ the system and
employees capture more of the value
Implications for agency theory - Incentive systems must be changed regularly to curb adverse learning
Agency same as TCT: assumes that humans are boundedly rational, self-interested and prone to opportunism. TCT zegt niks waarom authority
(Williamson) coördinatie problemen zou oplossen → agency theory helpt hierin.
Why should authority work when assuming all individuals are self-interested? → not so obvious… → agency theory
Difference: agency emphasis on the risk attitudes of principals and agents
Building blocks of 2 Ownership of the frm → special transaction: ownership relation
organizations - Why do we need frmss → reduce transaction costs
= the bigger the stake, the more risk → diversify
- Optimal assignment of ownership to: the party involved in the firm that minimizes the cost of market contracting with non owners + the
, costs of ownership with owners
- Monitoring through ownership concentration, shareholder activism, corporate control
- Governance: which governance mechanisms are most cost-efficient? (economizing on costs) vs competence perspectives: why do some firms
outperform others? (firms have different skills, complementary assets, organizational routines)
PLF
- features: investor ownership (owners as residual claimants and residual risk bearers), transferable shares (efficient risk-bearing and flexibility in
raising capital), legal personality (ability to sign contracts and own assets and protect the going concern value of the firm), limited liability (no
claim against personal assets of investor and facilitates risk sharing), delegated management (permits continuity of the firm and specialized
management)
- Strengths and weaknesses: Private ownership is a powerful means to create economic prosperity and PLFs are optimally geared to diversify
financial risk bearing in order to facilitate large capital investments in firms. Weakness: they face agency problems due the separation of
decision-making and ownership.
- How are these weaknesses resolved? The core governance challenge of PLFs is therefore to ensure that managers take decisions that are in
line with shareholder interests.
Agency costs:
- monitoring: → observe behavior/performance
- board monitoring
- concentrated ownership
- shareholder activism
- market for corporate control
- bonding: → arrangements that penalize agents
- performance dependent executive pay
- stock options
- managerial ownership
Key takeaways:
- Private ownership is a powerful means to create economic prosperity.
- Sometimes, however, ownership is not necessary, and transactions can take place via the market.
- Transactions only take place via the firm (i.e. via ownership) when it economizes on costs as compared to markets.
- If transactions take place via the firm, ownership of the firm will be assigned to the party that minimizes the sum of transaction and ownership costs.
Topic Week Core
Building blocks of 1 Incentivizing value creation
organizations Learning goals:
1. List and explain agency theory
2. Agency approach (Eisenhardt heeft een overview)
a. definition (principal delegates a task to the agent through authority)
b. unit of analysis: transaction/ contract between principal and agent
i. relationship is governed via a contract. Contract is incomplete and can only reward two aspects of the work (behavior and
output)
c. transactions:
- exchange money for goods (TCE: market or agency theory: outcome based)
- exchange for someone else time (TCE: hierarchy or agency theory: behavior based)
d. transaction governance matters under two conditions/ problems:
- information asymmetry (moral hazards: principal cannot observe agent) + adverse selection: principal cannot observe
the abilities of the agent)
- incentive misalignment
e. assumptions
- boundedly rational
- actors are self-interested (ex-ante, you do not know if the other party is self-interested → opportunistic
- agent more risk averse than the principal
f. tensions:
- cheating (outcome based increases risk of cheating) → shift risk to agent vs. shirking (behavior
based increases risk of shirking) → shift risk to principal
3. To compare the benefits and disadvantages of rewarding for input and output
When do we reward output? - outcome
- outcome is perfectly measurable
- optimal behavior is unknown
- cost of monitoring cheating is low
- principal is more risk averse/ less outcome uncertainty
When do we reward behavior? input
- behavior is perfectly measurable
- optimal behavior is known
- cost of monitoring shirking is low
- agent is more risk averse/ more outcome uncertainty
Hennart (1993) →
Different definitions
Behavior = Hierarchy (often occurs in transactions within the firm) Output = price (often occurs in market transactions)
Agency costs are now called transaction costs Otherwise basically the same (Hennart’s transaction cost ≠ Williamson’s transaction cost)
Two simple and realistic additions to the model
- Separate between cost of cheating and cost of monitoring for cheating
- Firms are better at monitoring behavior, while markets are better at monitoring output
- Acknowledge that monitoring costs are not linear
Explanation of why most transactions are governed by a combination of price and hierarchy!
, 4. Apply agency theory to determine how to govern a transaction
5. Criticize each assumption of agency theory
- if assumptions hold, propositions hold
Assumption 1: self-interest
- Are all individuals self interested? Two views:
- Of course not, but you cannot identify self-interest ex ante, therefore assuming so functions as a safeguard (Hennart)
- Of course not, and we might be able to do better if we consider that individuals have bounded self-interest (Bosse & Phillips)
Bounded self-interest?
- Act self-interested, but do not violate perceived norms of fairness (Bosse)
Reactions to fairness vs. unfairness in competitive situations?
- Fair behavior is rewarded by acting reciprocally (i.e. deviate from self-interest in favor of the other party)
- Unfair behavior is punished (i.e. act self-interested or even deviate from self-interest to work against the other party)
How does this change agency theory predictions?
- It doesn’t really change the main predictions (though it does change auxiliary predictions not discussed here)
- Does highlight a necessary condition under which agency theoretic predictions hold: Fairness
- Added assumption doesn’t overturn but slightly tweaks agency theory
Assumption 2: rationality
Do all individuals act rationally?
Separating between self-interest and moral sentiments
- Moral sentiments and self-interests not additive
- Are they substitutes or complements?
How does this impact agency theory?
- Violates main mechanism where rewards on output motivate behavior
- Do not use rewards on output when there are strong moral sentiments that motivate output (geld geven aan mensen die bloed doneren)
Four types of irrational behavior
- Framing: problem framing determines behavior Social framing: medium self interested isolated, more other regarding with communication
, allowed Legal framing: completely self-interested
- Endogenous preferences: incentives shape behavior Providing and then removing incentives for moral behavior increases immoral behavior
- Self-determination: extrinsic rewards might inhibit intrinsic rewards Paying for donating blood reduced the nr. of people that participated
- Information content of incentives: incentives provide information about the principal If incentives seem to indicate expected lack of distrust or
commitment, agent punishes principal
Assumption 3: risk preferences
Risk preference assumption is not really necessary See Hennart, very similar outcomes when just considering cost of organizing and cost of cheating/shirking
It is more an additional trade-off (as well as a convenient assumption to solve the model)
Assumption 4: unidimensional output
- Multitask situations Example: workers are required to produce output and care for the machines (mining example in hennart) Shifting attention to
one task means less attention for another
- Implications for agency theory - Very important to create an all-encompassing system Combinations of behavior and output (Hennart)
Static vs. dynamic
So far, we have evaluated a static model of the world How do dynamics affect the effectiveness of contracts?
Productive vs. adverse learning Over time, employees are prompted by the incentives to improve their work But at the same time, they find ways to cheat the
system
Time dynamics Initial learning is productive and value capture for the organization goes up Then, individuals also learn to ‘game’ the system and
employees capture more of the value
Implications for agency theory - Incentive systems must be changed regularly to curb adverse learning
Agency same as TCT: assumes that humans are boundedly rational, self-interested and prone to opportunism. TCT zegt niks waarom authority
(Williamson) coördinatie problemen zou oplossen → agency theory helpt hierin.
Why should authority work when assuming all individuals are self-interested? → not so obvious… → agency theory
Difference: agency emphasis on the risk attitudes of principals and agents
Building blocks of 2 Ownership of the frm → special transaction: ownership relation
organizations - Why do we need frmss → reduce transaction costs
= the bigger the stake, the more risk → diversify
- Optimal assignment of ownership to: the party involved in the firm that minimizes the cost of market contracting with non owners + the
, costs of ownership with owners
- Monitoring through ownership concentration, shareholder activism, corporate control
- Governance: which governance mechanisms are most cost-efficient? (economizing on costs) vs competence perspectives: why do some firms
outperform others? (firms have different skills, complementary assets, organizational routines)
PLF
- features: investor ownership (owners as residual claimants and residual risk bearers), transferable shares (efficient risk-bearing and flexibility in
raising capital), legal personality (ability to sign contracts and own assets and protect the going concern value of the firm), limited liability (no
claim against personal assets of investor and facilitates risk sharing), delegated management (permits continuity of the firm and specialized
management)
- Strengths and weaknesses: Private ownership is a powerful means to create economic prosperity and PLFs are optimally geared to diversify
financial risk bearing in order to facilitate large capital investments in firms. Weakness: they face agency problems due the separation of
decision-making and ownership.
- How are these weaknesses resolved? The core governance challenge of PLFs is therefore to ensure that managers take decisions that are in
line with shareholder interests.
Agency costs:
- monitoring: → observe behavior/performance
- board monitoring
- concentrated ownership
- shareholder activism
- market for corporate control
- bonding: → arrangements that penalize agents
- performance dependent executive pay
- stock options
- managerial ownership
Key takeaways:
- Private ownership is a powerful means to create economic prosperity.
- Sometimes, however, ownership is not necessary, and transactions can take place via the market.
- Transactions only take place via the firm (i.e. via ownership) when it economizes on costs as compared to markets.
- If transactions take place via the firm, ownership of the firm will be assigned to the party that minimizes the sum of transaction and ownership costs.
