Agency theory: Informed Principal

In the basic framework of chapter 2, we have assumed that the uninformed party has all the bargaining power and makes a contractual offer to the privately informed agent. In the case of common value, i.e., where the principal’s utility function depends on the state of nature (V  = S(q, θ) − t), let us

Agency theory: Limits to Enforcement

In this volume, we have assumed that the judicial system is perfect and benevo- lent, and consequently can enforce any contract without cost. Implicit behind this enforcement is the use of penalties that prevent both partners from breaching the contract. We now briefly discuss a model of imperfect contractual enforcement. Consider the model in

Agency theory: Dynamics and Limited Commitment

In an intertemporal framework, what is needed for the optimal dynamic contract to be credible is not only the ability of the contractual partners to commit to a contract, but the stronger assumption that those two contractual partners also have the ability to commit not to renegotiate their initial agreement. The assumption that economic agents

Agency theory: The Hold-Up Problem

Let us now consider a setting where the agent has to make some initial investment before dealing with the principal. The motivation for this contractual setting is that the agent and the principal can only meet each other after the agent’s investment has been made. Such situations are likely to occur in market environments

Agency theory: Limits to the Complexity of Contracts

In most of this book, we have deliberately chosen to emphasize simple models, where shocks are discretely distributed both in the case of adverse selection and moral hazard. However, the analysis in appendices 3.1 and 4.2 also suggests that optimal contracts may have very complex shapes in the richer case where those shocks are

Agency theory: Limits in the Action Space

Let us now come back to an adverse selection context. Our goal in this section is to understand how one can possibly endogenize the action space used to contract with the agent. 1. Extending the Action Space We start with a highly stylized model of procurement between a principal (the buyer) and an agent

Agency theory: Limits to Rational Behavior

Even though incentive theory has been developed under the standard assumption that all players are rational, it can take into account whatever bounded rationality assumption one may wish to choose.38 However, there is an infinity of possible theories of bounded rationality and, in each case, the modeller must derive spe- cific optimal contracts. Let

Agency theory: Endogenous Information Structures

One often heard criticism of incentive theory is that it takes information structures as given. A more complete view of organizational design should account for the endogeneity of these information structures. To investigate these new issues, we now assume that the agent does not know his type a priori but can decide or not

The economic theory of organizations: what it is

The economic theory of organizations as a field of study includes (1) the theory and policy of industrial organization; (2) the theory of the firm; (3) the theory of contracts; and (4) extension of these to theories of markets, governments, and nonprofit organizations. I briefly review the first three of these on the way to

The economic theory of organizations: what it isn’t

The economic theory of organizations, as any field, is subject to limita- tions. First, at its present stage of development, the economic theory of organizations is less a theory of organizations than it is a theory of the firm. Second, the economic theory of organizations includes analysis of decisions. However, in this area the

Efficient Decisions in Organizations: Efficiency criteria

In the economic analysis of organizations, managerial decisions in an organization are efficient when these decisions maximize net benefits to the organization (that is, net private benefits). These privately efficient decisions are said to be socially efficient when they also maximize net benefits to society (that is, net social benefits). In the typical analysis

Efficient Decisions in Organizations: Evaluation of assumptions

Although the model of economically efficient markets is  flexible enough to predict decision outcomes in alternative organizational forms under the restrictive conditions stated above, it is clearly limited in a number of significant ways. First, as formulated, the model cannot distinguish between the market and specific organizations that operate within the exchange market. The

Efficient Decisions in Organizations: Bounded rationality

The assumption of unbounded rationality in the model of efficient mar- kets is important enough to warrant a separate discussion. Unbounded rationality requires that all decision makers are fully informed and are able to fully process all relevant information so as to optimize their respective positions. They know their options and also the options

Efficient Decisions in Organizations: Organizations as social constructs

For-profit  corporations,  public  bureaus,  and  nonprofit  organizations are complex and bureaucratic organizations as defined by Thompson (1961, p. 8): ‘Organization theory attempts to account for order in behavior. A bureaucratic organization is a structure composed of authority, status,  technical,  and  social  relationships.’  An  organization is not only a construct of efficiency; it is also 

Theory of property rights

The theory of property rights has three parts. First, the concept of a property right is defined. Second, alternative systems of property rights are delineated. Third, the assignment of rights under different property rights systems is examined for the implications for efficiency of resource use. In the theory of property rights, the definition of

Property rights and incentives in organizations

Property rights systems are clearly important to decisions of individu- als and of organizations concerning investment in and exchange of resources. Property rights that include the right to control a resource and the right to obtain the return from a resource provide a basis for efficient use of resources when the holder of the

Property rights and the firm: the issue of separation of ownership and control

Theories of the firm  based  on  property  rights  have  been  the  focus of much research in the economics  of  organization,  both  explicitly and implicitly. These theoretical interpretations of the firm are varied, however. The explicit concerns primarily examined in this literature are transactions costs, contractual relationships in general, and the principal–agent relationship in particular.

Unbounded rationality, property rights, and managerial decision making

These developments provide support for managerial theories such as the theories that follow Williamson (1963) which assume that managers have their own objective of utility maximization, subject to a minimum profit constraint that will satisfy shareholders.  In  Williamson’s  model this is the reported profit level (πR). If πR is acceptable to shareholders, then πR

Bounded rationality, property rights, and managerial decision making

Separation of ownership and control is inherent in the corporate orga- nizational form. This situation exists even in the face of limitations on the abilities of owners (shareholders) and those in control (managers) to process information and articulate and achieve their respective goals. The property rights model and the transactions cost, contracts, and principal–agent

Property rights, incentives, and managerial decision making

Separation of ownership and control means that resource investment decisions in corporations are not made by the holders of capital. The effect of this is that the corporate market is no longer efficient. Traditionally, solutions to the principal–agent problem that is inherent in the separation issue have been proposals to redesign contracts and organizational