AGENCY THEORY, CORPORATE GOVERNANCE, AND CORPORATE SOCIAL RESPONSIBILITY (CSR), Lecture notes of Managerial Economics

Download AGENCY THEORY, CORPORATE GOVERNANCE, AND CORPORATE SOCIAL RESPONSIBILITY (CSR) and more Lecture notes Managerial Economics in PDF only on Docsity! Lecture 6 MANAGERIAL AND DECISION ECONOMICS AGENCY THEORY, CORPORATE GOVERNANCE, AND CORPORATE SOCIAL RESPONSIBILITY (CSR) TRANSACTION COST APPROACH: Coase’s (1937) theory of the firm Coase argued that a firm’s conscious method of coordination creates a saving in transaction costs •Costs of using market = transaction costs •Costs of organising firm = governance costs Firms are more efficient than markets because they avoid transaction costs Entrepreneur will compare the marginal transaction costs in the market and those same costs in the firm when making decisions. Transaction costs include: •The search costs associated with gathering information about relative prices •Negotiation costs incurred when negotiating the contract that specifies the terms of the transaction •Monitoring of contracts •Costs that are created artificially by government, through the levy of sales taxes or the imposition of quotas Transaction costs can occur as a result of imperfect markets •Bounded rationality, imperfect information, opportunistic behaviour Transaction costs are a result of imperfect markets. Perfect market: transaction and governance costs =0 as prices of all products and factors of production together with consumer preference and production functions would all be fully known to decision makers. Perfect: decision makers are always make optimal transaction decisions because they have full knowledge.... Imperfect: Bounded rationality: ability to make rational decisions is limited. Info about future prices or costs will be uncertain. Negotiation costs: Co-ordinating the actions of specialised agents: costs of obtaining information / co-ordinating inputs in production / measuring performance – bounded rationality Production function relates outputs to inputs. Transaction: agreement between eco agents to exchange. Transaction costs are those incurred when using the market. E.g. workers selling labour for wages, consumers paying for commodity, producer has transaction cost of discovering the range of potential suppliers, the specifications of the products and their prices, negotiating contracts etc. Firm transaction cost = management or governance costs. Other transacton costs: consumer finding prices of substitutes for comparison. Firms reduce transaction costs by negotiating long-term contracts. However, market conditions may change. Asset specificity is a term related to the inter-party relationships of a transaction. It is usually defined as the extent to which the investments made to support a particular transaction have a higher value to that transaction than they would have if they were redeployed for any other purpose. 1 • WILLIAMSON’S APPROACH In an attempt to complete Coase’s theory Williamson argued that most contracts between a principal and agent are incomplete contracts, in the sense that both parties: -cannot identify every contingency, -are subject to bounded rationality, -might have to leave room for renegotiation (esp. in case of asset specificity). -differ in how they perceive contingencies. Note that even if both parties agree on contingencies, these might be difficult to be turned into enforceable contracts. Williamson extended transaction cost analysis by identifying the impact of various factors on transaction costs and the boundaries of the firm He stressed the importance of avoiding market transactions where the potential for opportunistic behaviour is greatest “The extent of a firm’s activities is determined where the marginal management cost is equal to marginal transaction costs.” The extent of a firm’s activity is determined where the cost of internalising an external transaction is equal to the cost of organising the transaction in the market Opportunism occurs where one party is able to exploit differences in information that is only available to that party and thereby makes an agreement in its own interest Caused by asymmetric information Limited by learning and repetition of orders. Favours internalising activity to avoid problem. 1. Asset Specificity: •Asset specificity is the degree to which resources (capital or labour) are committed to a specific task. •The degree of asset specificity reflects the level of commitment to a particular contract. •Co-dependence between supplier and buyer. •The greater the specificity of assets the more likely it is that the activity will be internalised by the firm. “Asset specificity is a term related to the inter-party relationships of a transaction. It is usually defined as the extent to which the investments made to support a particular transaction have a higher value to that transaction than they would have if they were redeployed for any other purpose.” 2. Bounded Rationality: Decision makers only have limited information regarding the environment in which they operate, most likely concerning the activities closest to their own sphere of operations. •Bounded rationality gives rise to uncertainty. •Bounded rationality increases the cost of transacting with the market and therefore favours internalising activities within the firm. This gives rise to uncertainty and possibility of taking incorrect decisions that may prove costly. Bounded rationality may also interfere with the efficient operation of transactions. Because of limited managerial time and span of control, organizations cannot effectively manage an unlimited number of transactions internally. In addition, bounded rationality limits the capability of markets and simple contracts to handle asset specificity, because the parties cannot foresee and contract for all possible contingencies. 2 CORPORATE SOCIAL RESPONSIBILITY: Definitions: •“... is the voluntary action businesses take over and above legal requirements to manage and enhance economic, environmental and societal impacts.” -the UK’s Department for Business Innovation and Skills (now: Department for Business, Energy and Industrial Strategy) •“...refers to companies taking responsibility for their impact on society.” -European Commission •“...involves the search for an effective "fit" between businesses and the societies in which they operate. The notion of "fit" recognises the mutual dependence of business and society -a business sector cannot prosper if the society in which it operates is failing and a failing business sector inevitably detracts from general well- being.” -OECD • FIVE THEORIES OF CSR I. Adam Smith – invisible hand theory (promotion of self-interest) II. Milton Friedman - moral responsibility within the law - maximisation of shareholder returns III. Baumol – no social responsibility – in fact trying to do something extraordinary could lead to a loss of market share IV. Freeman (stakeholders) - management’s responsibility to non-investing stakeholders, not just shareholders V. Carroll - CSR Pyramid • Business Ethics: Business ethics involves the analysis of moral issues that guide how a business behaves. I. Adam Smith introduced the ‘invisible hand’ theory which suggests that society is best served by the pursuit of self-interest by consumers and producers and the absence of state intervention. “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” -Adam Smith, 1776 Wealth of Nations II. According to Milton Friedman, the only moral responsibility within the law is the maximisation of shareholder returns. •A private firm pays its duties to society by maximising its profits. •Individuals can pursue worthy causes but not at the expense of the firm •Any attempt to engage in CSR activities is a signal that an agency problem exists within the firm. III. Baumol (1991) argues that firms in contestable markets (with low entry barriers) suffer a loss in market share if they invest in CSR activities. IV. Stakeholder theory attributed to Freeman (1984) •CSR policy highlights management’s responsibility to non-investing stakeholders, not just shareholders. [employees; environment; suppliers; local community; customers] 5 V. Caroll’s (1979) CSR Pyramid • Justifications for CSR •Moral obligation -Companies have a duty to do the “right thing”. -Commercial success must honour ethical values. •Sustainability -Companies should operate in ways that secure long-term economic performance by avoiding short- term behaviour that is socially detrimental or environmentally wasteful. •License to operate -Firms taking steps to avoid interference in their affairs from regulators / governments / pressure groups by taking voluntary steps that pre-empt intervention in areas such as health and safety. •Reputation -In consumer-oriented companies, concerns about reputation often leads to high-profile cause-related marketing campaigns. • Economic Benefits of CSR •Baron (2001) introduced the term “strategic CSR” -CSR activities can be used strategically to maximise profit - “responsible” activity that allows a firm to achieve a sustainable competitive advantage, regardless of motive McWilliams and Siegel (2010) •Kurucz et al. (2008) identify four aspects of the business case for CSR: 1) Cost and risk reduction 2) Competitive advantage 3) Reputation and legitimacy 4) Synergistic value creation (resource rarity and absorption) – performance [financial, operational, customer relation and human resource] • Communication of CSR •CSR is a credence good; firms need to induce awareness -CSR may include costly actions within the value chain, which are difficult to be observed by a large scope of consumers. •Certification of CSR increases information to consumers: -FTSE4Good; Dow Jones Sustainability Index; EU Ecolabel etc. •CSR policies influence consumers’ perceptions and create ‘halo effects’. •Greenwashing describes the misleading promotion of ethical or environmental actions. 6