Separation of Ownership and Control, and Agency Costs - Essay Example

?Running Head: SEPARATION OF OWNERSHIP AND CONTROL, AND AGENCY COSTS Separation of Ownership and Control, and Agency Costs Insert Insert Grade Insert Tutor’s Name 4 January 2011 Outline Introduction Residual Claims The decision development The problem Separation of ownership from control & the creation of agency costs -Specific Knowledge and Spread out of decision roles -Dispersed residual claims and designation of decision control -Characteristics of decision control systems Agency costs in depth Conclusion Reference list Separation of Ownership and Control, and Agency Costs Introduction An organization comprises of several agreements that are both in written and written form. Such agreements exist among the main stakeholders of factors of production and clients. These agreements of how the business should be run internally spell out the rights that every representative in the business, the performance method upon which the assessment of the representatives is based and other related duties. The agreement structures together with the present production technologies and the outward lawful constraints to ascertain the cost function for conveying an output with a specific type of organization. The type of organization that survives is the one that conveys the output as per the customers’ demand at a cheaper price (Fama and Jensen, 1983, p. 302). The main agreements in any business organization outline two key things. These are the form of the lasting claims and the breakdown of the decision-making procedure that affects representatives. These are the agreements that make organizations be unique from one another and illustrate the reason behind the survival of various kinds of organizations. While concentrating on entrepreneurial organizations that require the entrepreneur to make all decisions, economists often disregard the analysis of the decision-making procedure. The survival of an organization is greatly determined by the way it stipulates the steps of the decision making process. The theory developed in this paper portrays a firm as a nexus of agreements (Belanzon and Petacconi, 2009, p. 2). It focuses on the agreements that allocate the procedure in an organization’s decision process, define residual claims, and set up mechanisms for regulating agency problems in the decision process. There is an emphasis on the factors that give survival value to organizational types that separate ownership and control. Residual Claims Most types of business organizations resort to agreement structures that reduce risks undertaken by representatives. This is achieved by introducing either fixed terms of remuneration or those that are pegged on performance. In addition, the agreements of most representatives comprise an implied or unequivocal provision that in exchange for the particular payoffs, the representative affirms that through the resources he accords, the interests of the residual claimants are met. Residual claimants emanate from one of the agent teams and it is likely to survive due to two reasons. First, it minimizes the expenses incurred while supervising the agreements made with other groups of representatives. Secondly, it minimizes those costs used to modify agreements for the dynamic risks encountered by other agent groups. The survival value of organizations is further enhanced by the agreements that express decisions towards the interests of lasting claimants. Different organizational forms have residual claims with varying controls. For instance, common stocks in large organizations are the least controlled lasting claims in regular use. Stockholders have provisions that do not require them to have any other duty in the organization, and their lasting claims are separate without limits. Such provisions enable stockholders to have unlimited risk sharing. These large scale organizations with such properties are referred to us open organizations. They are different from closed organizations which are not only smaller but also have lasting claims that are greatly restricted to internal decision representatives. The decision development Generally, the decision development has four main steps. First, there is initiation where proposals are created for resource use and organization of agreements. Secondly, there is ratification that entails selection of the decision initiatives. Third, there is implementation that involves the actuation of selected decisions. Fourth, there is evaluation that involves the assessment of the duties of the decision representatives and the execution of the rewards (Fama and Jensen, 1983, p. 303). Since both the creation and execution of decisions is conducted by the same representatives, the two roles can be summed up in the term decision management. Decision control and decision management are elements that encompass a firm’s decision system. The problem Agency problems usually come up because agreements are not costlessly penned down and effected. Binding several agreements among representatives with varying interests, structuring and supervision costs are what encompasses agency costs. Regulating problems that affect agents in the decision process becomes crucial when the managers involved in both initiating and actuating vital decisions cannot benefit directly from the process. In the absence of effective control procedures, the decision managers may easily end up taking actions that may not be inline with the interests of the lasting claimants. An effective decision control system asserts that the control of decisions is in some way separate from their management. Both management and control of certain decisions can be done by personal decision agents. However, separation implies that an individual agent does not have the mandate to exercise select management and control rights regarding the same decisions. Separation of ownership from control & the creation of agency costs The section mainly describes is build on an the hypothesis that most organizations including large open organizations, non-profit making organizations, and financial based organizations deal with agency problems by drawing a demarcation between management and control of decisions. Specific Knowledge and Spread out of decision roles Majority of the organizations where separation of ownership and control are evidenced are complex in nature such that there is a spread out of specific knowledge appropriate to different decisions among agents at all points of the organization. Given that complex organizations have specific knowledge spread out among agents, there can be cost effectiveness in terms of decision management because the initiation and implementation of decisions can be delegated to agents who have important relevant knowledge (Jensen and Meckling, 1992, p. 4). The agency difficulties regarding diffuse decision management can thus be minimized through disjointing of management and control of decisions. In rare cases where some residual claimants rather than decision managers concentrate on residual claims, control of decision claims can be non-complex and direct. This is because residual claimants will be able to conduct both ratification and monitoring of vital decisions apart from setting rewards. It is thus expected that under the top of complex organizations there should be such delegation, distribution, and partition of decision management and control (Fama and Jensen, 1983, p. 308). Dispersed residual claims and designation of decision control Most of the complex organizations have a case where there is a spread of residual claims to several agents. The benefits of having numerous residual claimants in large organizations are that first, there is a large total risk of sharing net cash flows. Another benefit is that the high demand for wealth from by residual claimants encourages both bonding of the promised payoffs to most agents and the buying of risky assets. Thirdly, since it is costly for many residual claimants to be engaged in decision control, this encourages delegation of the same. This delegation of decision control is for instance observed in large expert partnerships like financial firms and law (Kastl, Martmort and Piccolo, 2008, p. 12). Large open organizations and financial mutuals have almost a total partition and specialism of decision control and residual risk bearing. In such cases, most of the residual claimants do not qualify to engage in the decision process, which causes them to delegate this to other agents. Inability of residual claimants in decision control should lead to a partition of the management and regulation of most decisions at all ranks within the organization. The partition and spreading out of decision management and control restrains the ability of personal decision agents from seizing the interests of residual claimants. Other benefits that arise from separation of ownership and control are letting relevant knowledge to be applied in the decision process apart from aiding in the regulation of agency challenges of dispersed residual claims. In large corporations, the advantages of separating the management and decision control are greater than the costs involved in the process (Fama and Jensen, 1983, p. 309). Characteristics of decision control systems The similarity in the mechanisms for spreading out and partitioning of the management decision control across many organizations supports the hypothesis of the characterization of the decision systems of organizations. First, there are decision hierarchies that features dispersed decision management and control structures of complex corporations like universities and large open organizations. It is where top-level agents ratify, monitor, and assess the performance of low-level agents. Such demarcation of the decision process makes it hard for decision agents at any rank to benefit from their actions that might cause residual claimants to lose. The organizational regulations of the game strengthen the decision hierarchies. For example accounting and budgeting methods that assess and restrain the decision behavior of agents and spell out the performance approach that determines returns. Secondly, there are mutual monitoring methods. Less formal mutual monitoring among agents is part of what strengthens the formal leadership levels of complex corporations. Interaction of agents to enhance outputs makes them acquire low-cost details regarding their counterparts, details that the top rank agents may not have. This information is tapped by mutual monitoring systems for application in the control process. The interests of agents in using internal organizational markets to enhance the value of the human capital are what energize the mutual monitoring systems. Rewards and potential for human capital development are the determinants of the agent choices among organizations. The competitive interaction within the internal agent market is valued by agents because it does not only enhance the present marginal products, but also enhances development of the human capital. On realizing unbiased in the evaluation of their performance, agents may value the adjustment of the reward system that emanates from mutual monitoring information since it enhances surety on payoffs pegged on ability and proficiency (Fama and Jensen, 1983, p. 311). Given that the interplay of both formal hierarchies and less formal mutual monitoring systems lead to incentive structures and diffuse decision arrangements, which are in the interests of residual claimants, their survival value is unmistakable. Thirdly, we have the board of directors, which is manifest in both large and small organizations. The decisions made by them cannot allow the decision agents to benefit materially. Other than monitoring and ratification of vital decisions, such boards are charged with duties of hiring, laying-off, and compensating top-level decision managers (GLSEN, 2000, p. 3). The ability of the board to carry out these top rank decision control rights plays a great role in the separation of decision management and control (which is nonexistence of entrepreneurial decision maker even at the organization’s top level). Agency Costs in depth Apparently, the inadequacies on the theory of the firm are being compensated via increasing literature on agency relationships (Berhold, 1971, p. 460; Ross, 1973, p. 134-139). Agency relationship is an agreement where one or several people (principals) engage another individual (agent) to carry out a certain service on their behalf, which entails assigning certain decision making mandate to the agent (Jensen and Meckling, 1976, p. 5 ). If both the agent and the principal are people who can maximize utilities, then the agent may do things at the expense of the principal. To ensure that the agent is not swayed from his interests, the principal can introduce both incentives and monitoring costs. Monitoring costs are to take care of monitoring activities like auditing and hiring managers to pay dividends (Tan, 2003, p. 3). In some situations, the agent will be forced to spend some of his resources to justify the fact that he will not engage in act that will be detrimental to the principal and to guarantee that the principal will be bailed back incase the agent undertakes such acts (Bowrin, et al, 2007, p. 4). However, it is inappropriate to assume that without incurring any cost, the agent will carry out transactions in accordance to the expectations of the principal. Commonly, positive monitoring and bonding costs are incurred in agent relationships. Besides, the agent may take some decisions that diverge from those ones meant to improve the welfare of the principal. A cost equal to the reduction in the principal’s welfare due to the agent’s divergence is another cost of the agency relationship and is referred to as residual loss. Therefore, agent costs can be listed as monitoring costs by the principal, bonding expenses by the agent and residual losses. Agency costs emerge because of any situation that requires cooperate efforts (Jensen and Meckling, 1976, p. 6; Maloney, 2003, p. 1). An agency relationship is clearly depicted through the relationship that exists between managers and stockholders (Depken and Nguyen, 2007, p. 4). Consequently, issues surrounding ownership and control in the latest diffuse ownership are pure manifestations of agency problems. Conclusion The decision procedure of an organization encompasses decision management (initiation and implementation) and decision control (ratification and monitoring). An analysis between decision systems and residual claims brings out two complementary hypotheses. First, the decision systems that partition decision management from decision control are caused by the separation of residual risk bearing from decision management. Second, blending of decision management and decision control in some agents results to residual claims that are greatly limited to these agents. Separation of residual risk bearing from decision management is featured in complex organizations where specific information relevant for decisions is spread out among agents in the entire organization. Instead of delegating all decision management and control to the residual claimants, advantages from better decisions can be obtained by allocating decision functions to agents at all levels within the organization. Separation of decision control from decision management can then be used to control the urgency problems of such diffuse decision approaches. The efficacy of these decision systems is enhanced by rewarding agents for implementing and initiating decisions and for ratification and monitoring the decision roles of other agents. Since residual claims are diffused among numerous agents in complex organizations, it is therefore exorbitant for all of them to be engaged in decision control. Consequently, there is a division decision control from decision risk bearing. This leads to agency problems between residual claimants and decision agents. These problems are solved by separating decision management from decision control at all points. This limits the mandate of individual agents in expending residual claimants’ interests. Diffusion and partition of managing decisions contributes to the survival of complex organizations since relevant particular knowledge is applied in the process and they aid in the control of agency problems of dispersed residual claims. The main building components of the diffuse decision control systems in complex organizations are formal decision hierarchies where high-level agents ratify and monitor the decision initiatives of low-level agents. Moreover, the board of directors forms the common peak of decision control systems of organizations. Reference List Belanzon, S. & Petacconi, A., 2009. When is a nexus of contracts more firm like? Theory and evidence from business groups. (Online). Available from: http://portale.unibocconi.it/wps/allegatiCTP/Patacconi_021209.pdf (Accessed January 4, 2011). Berhold, M., 1971. A theory of Linear Profit sharing incentives. The Quarterly Journal of Economics, Vol. 85, No. 3. The MIT Press. (Online). Available from: http://www.ppge.ufrgs.br/giacomo/arquivos/ecop137/berhold-1971.pdf (Accessed January 4, 2011). Bowrin, A. et al, 2007. The Theoretical Foundations of Corporate Governance. (Online). Available from: http://www.virtusinterpress.org/additional_files/book_corp_govern/sample_chapter02.pdf (Accessed January 4, 2011). Depken, C.A. & Nguyen, G.X., 2007. Agency Costs, Executive Compensation, Bonding, and Monitoring: A Stochastic Frontier Approach. (Online). Available from: http://www.belkcollege.uncc.edu/cdepken/P/agencycosts.pdf (Accessed January 4, 2011). Fama, E.F. & Jensen, M.C., 1983. Separation of Ownership and control. Journal of Law and economics, Vol. 26, No. 2. Chicago: The University of Chicago Press. (Online). Available from: http://docs.google.com/viewer?a=v&q=cache:XvX8oKTaMGEJ:www.wiwi.uni-bonn.de/kraehmer/Lehre/SeminarSS09/Papiere/Fama_Jensen_Separation_ownership_control.pdf+Separation+of+Ownership+and+control,+and+agency+costs&hl=en&gl=ke&pid=bl&srcid=ADGEEShMb4sMEYoZYMtAq6ZCIqWFHQHMjyq7ZS8fmInvAwglxmWtRYNDoCdge_7HBAZwNla7MpN6Noi1pPwSEXGw5S6RKrljKue0T56WZp-2SMkY8KYI5hvkY0UjVgZFFcCfbQdLCw5K&sig=AHIEtbQclAjSPjceDWX-YPdVCKhYP597Gg&pli=1 (Accessed January 4, 2011). Gill Foundation. 2000. Strengthen the Board of Directors. (Online). Available from: http://www.glsen.org/binary-data/GLSEN_ATTACHMENTS/file/127-1.pdf (Accessed January 4, 2011). Jensen, M.C. & Meckling, W.H., 1992. Specific and General Knowledge and Organizational Structure. (Online). Available from: http://mcadams.posc.mu.edu/econ/Jensen,%2520Specific%2520and%2520General%2520Knowledge.pdf (Accessed January 4, 2011). Jensen, M.C. & Meckling, W.H., 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. (Online). Available from: http://www.sfu.ca/~wainwrig/Econ400/jensen-meckling.pdf (Accessed January 4, 2011). Kastl, J. Martmort, D., & Piccolo, S., 2008. Delegation and R&D Spending: Evidence from Italy: Centre for Studies In Economics and Finance. (Online). Available from: http://www.csef.it/WP/wp192.pdf (Accessed January 4, 2011). Maloney, 2003. A Study in Property Rights: Inter-firm Contracting. (Online). Available from: http://myweb.clemson.edu/~maloney/827/3.pdf (Accessed January 4, 2011). Ross, S.A., 1973. The Economic Theory of Agency: The Principal’s Problem.” American Economic Review LXII (May). (Online). Available from: http://www2.uah.es/econ/MicroDoct/Ross_1973_The%20economic%20theory%20of%20agency.pdf (Accessed January 4, 2011). Tan, R., 2003. Agency Theory: Exploring Jenson and Meckling’s Work. (Online). Available from: http://www.oaktree-research.com/index2.php?option=content&do_pdf=1&id=27 (Accessed January 4, 2011). Read More