Boards of Directors, Corporate Governance Term Paper

In contrast, within the firm, the entrepreneur directs production and coordinates without intervention of a price mechanism; but, if production is regulated by price movements, production could be carried on without any organization at all, well might we ask, why is there any organization?" (Coase, 1937, p. 387) In simpler words if markets are so efficient why do firms exist? Coase explains, "the operation of a market costs something [such as the costs of negotiating and concluding a separate contract for each exchange transaction] and by forming an organization and allowing some authority (an "entrepreneur") to direct the resources, certain marketing costs are saved" (Coase, 1937, p. 391). Thus, firms actually present greater efficiency over markets by decreasing such costs.

That being said, if firms are so efficient, why are markets needed? (Coase, 1937). As per Coase, as the firm grows (when the entrepreneur processes additional transactions), decreasing returns to scale may occur. This development is possible for three reasons: (1) coordination costs may increase until eventually the firm is indifferent between integrating transactions and purchasing through the market; (2) the entrepreneur may fail to make the best use of the factors of productions; (3) "the supply price of one or more of the factors of production may rise, because the "other advantages" of a small firm are greater than those of a large firm" (Coase, 1937, p. 394). These three decisions are what determine when a firm should integrate or when it should rely on the market, in other words, the make or buy decision.

In contrast to Coase, Harold Demsetz (1983) looks at the firm from the perspective of the pure economic theory. He argues that there is a difference between real firms and firms according to economic theory, the latter being lean, no-nonsense institutions devoid of managerial amenities vs. real firms, which Demsetz describes as largely controlled by management possessing insignificant interest in the profitability of the firm's activities: "the [real] firm may seek to keep shareholders content with a minimum acceptable positive return, but beyond that, profit is traded off to increase the utility of management" (Demsetz, 1983, p. 377). Demsetz explains that two divisions of resources exist, production vs. consumptions. Households are defined as a theoretical institution in which rational decisions about consumption take place. The firm, on the other hand, is defined as a theoretical institution in which production (for others) take place. Both are considered to be specialized in their functions. Consumption is said to create utility and therefore households are concerned with utility increasing decisions. In addition, firms are concerned with profit maximization, which is accomplished by indirectly delivering utility creating consumption capability.

Oliver Williamson's (1981) position is to assess alternative governance structures of which firms and markets are the leading choices in terms of their capacities to economize on transactions costs. The discipline of transactions costs economics (TCE) is the means by which Williamson defines the firm and its operations: "The transactions cost approach to the study of economic organization regards transactions as the basis unit of analysis and holds that an understanding of transaction cost economizing is central to the study of organizations" (Williamson, 1981, p. 548). According to Williamson, the TCE approach addresses the firm at three different levels. First, it addresses the overall structure of the firm to determine how operating parts should be related to one another. Second, the middle level focuses on operating parts of the firm to determine which activities should be performed within the firm, outside the firm and why. In other words, the boundaries of the firm are defined at this stage. Third, TCE is also concerned with the manner in which human assets are organized and identifies appropriate governance structures given the attributes of particular work groups. Williamson claims the following proposition applies quite generally such that "governance structures that have better transaction cost economizing will eventually displace those that have worse, ceteris paribus" (Williamson, 1981, p. 574).

The boundary of the firm according to TCE is as follows..." The firm begins with "core technology," within which integration is treated as unproblematic. Forward, lateral, and backward integration, in relation to the core, are then examined" (Williamson, 1998a). For example, the firm can choose to employ backward integration into raw material vs. procuring raw material from others. Williamson explains this further by asking whether the firm will produce its own components or buy them in the market. Will the firm integrate forward into distribution or will it rely on the wholesale and retail capacities of others:.." The actions resides in the attributes of transactions in relation to the cost on the one hand and competencies of alternative modes of governance on the other" (Williamson, 1998a).

The relationship between the firm, its governance, and TCE can best be summed up by the following hypothesis: "transactions, which differ in their attributes, are aligned with governance structures, which differ in the cost and competence, so as to effect a (mainly) transactions-cost economizing result" (Williamson, 1998b). Williamson explains that governance is the means by which order is accomplished in a relationship in which potential conflict threatens to undo or upset opportunities to realize mutual gains.

There are however several remaining theories in contrast to Williamson's idea of the firm as a governance structure. These include: "...mechanism design (where a menu of contracts is used to elicit private information), agency theory (where risk aversion and multitasking are featured), the classical model of the entrepreneur and the property rights theory of the firm (where everything rests on asset ownership)"

Of these contrasting propositions the agency theory will be reviewed in more detail in the following section because of its relevance to corporate governance. The classical model of an entrepreneur proposes that the owner-manager operates the firm to maximize profits (Baumol, 1959). Therefore, the firm is controlled and owned by the same person:.." this literature fails to explain the large modern corporation in which control of the firm is in the hand of managers who are more or less separate from the firm's security holders" (Fama, 1980, p. 289).

With regard to property rights theory of the firm, Fama explains that: "The firm is viewed as a set of contracts among factors of production, with each factor motivated by its self-interest" (Fama, 1980, p. 289). In essence, the firm is a team of cooperating factors of production and the concept of ownership of the firm under this view is irrelevant because:.." control over the firm's decisions is not necessarily the province of the firm's security holder" (Fama, 1980, p. 290). In fact, the manager is separate form the risk bearer (residual claimants), as each are separate factors of productions. Fama asserts this view is more appropriate for the modern corporation.

Jensen and Meckling (1976) describe the firm as a nexus of contracts and argue that most organizations are simply legal fictions serving as a nexus for a set of relationships between individuals. To them, the firm "serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may "represent" other organizations) are brought into equilibrium within a framework of contractual relations" (Jensen and Meckling, 1976, p. 309). Furthermore, no two firms will have the same "nexus of contracts." This notion of contracts is also extended to the theory of property rights. "...specification of individual rights determines how costs and rewards will be allocated among the participants in any organization [but]...the specification of rights is generally effected through contracting" (Jensen and Meckling, 1976).

The agency problem

Agency theory is probably one of the most discussed topics in firm research. Shleifer and Vishny (1997), explain the agency problem as one of ensuring that financial suppliers' capital not be expropriated or wasted. They explain that even though a contract is drafted outlining the indented use of such funds, contracts are ultimately flawed because agents and owners are unable to foresee everything, thus making contracts inevitably incomplete. Control is then usually allocated to the managers for occurrences unforeseen in the contract; therefore, "...managers end up with significant control rights (discretion) over how to allocate investors' funds" (Shleider and Vishny, 1997, p. 742). Jensen and Meckling (1976) define an agency relationship as "a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some services on their behalf which involves delegating some decision making authority to the agent" (Jensen and Meckling, 1976, p. 309).

It is Fama and Jensen (1983) however who really break down the separation of ownership and control. They describe the organization as "...the nexus of contracts, written and unwritten, among owners of factors of production and customers. These contracts or internal "rules of the game" specify the rights of each agent in the organization, performance criteria on which agents are evaluated, and the payoff functions they face" (Fama and Jensen, 1983, p. 2).

Central contracts consist of two components: residual claims and the decision process. The decision process encompasses four steps: (1) initiation of…