BA 5201 Organization and Management Organizational governance and control Instructor: Ça ğ rı Topal 1

Organizational economics How owners of a firm attempt to ensure economic efficiency through different contractual or transactional arrangements Governance mechanisms to deal with internal and external partners of the firm Agency theory Transaction cost theory 2

Agency theory Organizations: series of contractual relationships between agents and principals Principals: owners or shareholders of a firm Agents: people hired by the owners to run the firm and composed of managers and workers Agency costs: costs associated with monitoring agent behavior and enforcing contracts Goal: efficient or lowest-cost arrangement of agent-principal relationships 3

Transaction cost theory Organization: series of transactions within and outside the boundaries Transaction: exchange of goods and services among groups within or outside organizations Transaction costs: explicit fees associated with a transaction and implicit costs of monitoring and controlling a transaction Goal: most efficient arrangement of transactions or lowest possible transaction costs 4

Agency or transaction costs Bounded rationality Owners and managers are unable to process all of the available information and face uncertainty in transactions or contract relationships Employees, suppliers, and contractors may be in a position to take advantage of the owner 5

Agency or transaction costs Opportunism Principals are concerned with efficient and effective operation of the organization whereas agents with the satisfaction of self- interest regardless Moral hazard: Agents will not always fulfill their obligations Adverse selection: Principals hire the agents that misrepresent themselves as having skills, knowledge, or qualifications not possessed 6

Agency or transaction costs Information asymmetry Information related to exchanges or transactions is not evenly distributed Agents have certain information about shortcomings that is not available to the principal Asymmetry motivates key decisions as to which tasks should be conducted within or outside the organization 7

Agency or transaction costs Asset specificity The assets of an organization is fixed and specific rather than flexible and general or replicable Specific assets may be hard to transfer to another purpose or to sell at a reasonable level The organization might be locked into certain arrangements and relations with employees, suppliers, and customers 8

Agency or transaction costs Small numbers An organization may incur a transaction cost when it is faced with only a small number of potential trading partners An organization can be more easily exploited by a trading partner 9

Governance mechanisms-AT Contracting and monitoring Owners try to protect their interests by creating either behavioral contracts or outcome-based contracts Behavioral contracts specify that employees engage in certain types of behavior Outcome-based contracts tie compensation and rewards to measurable results 10

Governance mechanisms-AT Boards of directors Boards of directors have a fiduciary function to safeguard the owners’ interest Boards are composed of insiders and outsiders Insiders provide guidance in specific operational issues while outsiders provide a monitoring and oversight function Boards provide a system of checks and balances against managers’ opportunism Boards’ monitoring power is questionable 11

Governance mechanisms-AT Markets as disciplinary forces Markets can provide feedback about the company’s performance Market feedback can result in managerial rewards or punishments Markets can motivate managers to perform better for their own career 12

Governance mechanisms-TC Market control Market control relies on prices and competition in external markets to control transaction-related costs If there are many suppliers and buyers of a good or service, fair prices tend to emerge as long as there is a free flow of information Market control can be used inside the company if the output price can be determined Markets fail when there is imperfect competition 13

Governance mechanisms-TC Bureaucratic control The control of a particular transaction is done through the organization’s hierarchy or bureaucracy or mechanistic structure Control mechanisms may include comprehensive job descriptions and performance appraisal systems, statistical or numerical control systems, budgeting and accounting systems, and work rules or procedural guidelines Bureaucratic control is used when markets fail 14

Governance mechanisms-TC Clan control Clan control is used when bureaucratic control fails Clan control is associated with organic structure Clan control utilizes cultural control Clan control can be implemented through selection and training of employees 15