Nexus Contracts Theory and Principal Agent Theory

In the previous essay of this course we described theory of the firm presented by Coase (1937), in which is demonstrated that the inducement of the firm to acquire in the market or to produce for their own necessities is premised on the comparative transaction cost divergences. In this essay, we will describe another “new theory of the firm”, presented and known as the contracting theory [1] . The contracting theory moves toward stating the firm as a grouping of contracts. That is, firms should establish and continue renegotiating contracts constantly with their participants. So the firm is view as a:

“nexus of a set of contracting relationships . . . . . . firm is not an individual . . . is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals are brought into equilibrium within a framework of contractual relations.” [2]

According to this theory, the nature of the firm is based on the organization of a collection of different contractual arrangements. The firm is seen as a nexus of contracts. Contract is the central instrument able to play a coordinating role inside the firm and amongst the firms. Since the firm is a nexus of contracts, those contracts must have parties. Contractual relations are essential to the firms and individuals (customers, employers, suppliers, creditors) are parties to this nexus of contracts. Individuals are present only as regards to contracts. In between contracts and organization, there are no strict differences since organizations are seen as contractual preparations through which transactions go ahead efficiently. Because the contract is the base of all governance structure, the firm possibly is noticed to differ from market in degree and not in the nature. By a legal fiction it is understood that the economic organization is presented and treated as a single individual [3] . Its legal personification supports its presentation. Alchian and Demsetz (1972) consider the classical firm as a ‘particular contractual structure’ [4] that owns the properties of an proficient market, i.e, a group whose value work surpasses the sum of the market work value that each member could get alone, and contracts aim to control and organize the development of these actions. Nexus of contracts as theory of the firm asserts that firms come up where market contractual arrangement dealings fail. According to the explicit nexus of contracts view, it is not useful to determine what a firm is and what it is not. [5] In this analysis, ‘we don’t exactly know what a firm is’ as the firm is “a shorthand description of a way to organize activities under contractual arrangements” [6] . The theory of nexus of contracts does not identify the firm specifically from its parts but establish its nature as regards with the relations between its collective parts. A nexus of contracts” mean that firm has selected the best obtainable of contracts.

If contracts that structure the diverse relationships that the firm has with all its input suppliers are complete contracts, then the result is completely all programmed with little require for innovation or entrepreneurial alertness. This model of contractarian theory, by condensing the firm only to a series of contracts, focuses only on the firms’ present processes or focuses on the existing resources, like an agency theory. [7] Contractual theory presumes the firm with unchanging levels of inputs and technology; this static level of this theory cannot situate with dynamic processes that comes across a firm i.e. discover of new resources.

Since the firm is a nexus of contracts, we will continue exploring the implications specified in the contracts between the business owners and the managers hired to run the activities of the firm. One of the classic examples of diverging interests of principal and agent is presented by Jensen and Meckling (1976). The contract between the owners of firm capital (the principal) who engages another person (the agent) to execute operational business decisions on his behalf is defined as an agency relationship. This process involves also delegating authority from principal to the agent. But not always the interests of the principal are in achievement harmony with the decisions taken from the agent. While an equity investor is interested in maximizing firm value, the manager who has the authority, does not always take decisions in conform to the owner interest, i.e. perk consumption (abundant office furniture or company cars) or doing business with friends at preferred conditions.

The principal can reduce the divergences from his interest with the agent, by ascertaining the proper incentives for the agent and by imposing the monitoring costs: (1) for monitoring, the agent’s interests are aligned with the principal’s interests via contracts. Monitoring is the process of the principal controlling compliance with and sanctioning deviation from these contracts. In addition in certain situations will pay the agent to use resources (bonding costs) to guarantee that he will not receive decisions that would harm the principal or to ensure that the welfare of the principal will increase if he takes such actions. 2) when bonding, the agent proves at his own cost (bonding cost), that his behavior is in compliance with the principal’s interest. This causes monitoring and bonding costs that have to be incurred as a price for the reduction in agency cost. Generally it is not possible to have always optimal situations of agents’ decisions and those decisions that would maximize the principal welfare. The result of this divergence, when measured in money is referred as “residual loss” [8] . So agency costs are defined the sum:

“the monitoring expenditures by the principal,

the bonding expenditures by the agents,

the residual loss.” (Jensen and Meckling 1976)

Starting from these thoughts, there are two basic possibilities to reduce these agency costs: (1) monitoring and (2) bonding. Jensen and Meckling (1976) formed a model by describing how the organization of the firm created agency costs generated by contractual arrangement, and how an optimal capital structure was a crucial factor in minimizing these costs. The model predicted that after the contract was signed between the owners and top managements, there should be a monitoring “set-up” in order to control each other’s behavior. The essential way of monitoring such a contract was to preserve principal-agent relationships. Particularly interesting are incomplete contracts, in which is not covered every potential condition of the future. Such incomplete contracts need concentrated monitoring and regular renegotiation in order to make sure fulfillment and to fill in gaps. [9]

The agency theory treats problems of monitoring and inventiveness also in circumstances with asymmetric information (Jenson/Meckling, 1976, pp. 305-360). It regards on problems in which property rights are delegated. The group that delegates is the principal; the delegated group is the agent. Presuming an self-directed maximization of their individual utilities, the agent, who is nearer to the operational business and consequently better informed, will use this higher information to take full advantage of his own utility frequently leaving the principal not as good as he optimally could be. This is named opportunistic behavior, i.e. the agent neglects the commitments due to contracts, regulations or moral principles if he cannot be adequately sanctioned [10] . The principal will act in response by anticipating the agent’s opportunities to diverge and by regulating his claims consequently. Doing this, the critical question is not if the agent is behaving opportunistically but if he could probably do it.

Since the principal frequently cannot survey the agent’s dealings and the agent that is nearer to the market will superior be able to review the environmental influences. As result the agent can take action opportunistically. In general there are three major types of agency problems: (1) moral hazard, (2) holdup and (3) adverse selection [11] :

Moral Hazard describes situations, in which the agent uses information not observable by the principal (hides information) or performs actions not noticeable by the principal (hides action) in order to increase his own utility against the principal’s best.

Holdup describes situations in which the agent thoroughly uses spaces in incomplete contracts, in which not all future positions are specified, in his favor. After the concluding of the contract and after detailed investments has been realized and sunk costs have been sustained by the principal, the agent exposes his formerly hidden intentions explicitly interpreting the accomplishment of his commitments in his favor and obliging the principal into renegotiations.

Adverse Selection is a problem that appears in markets where one party cannot discriminate between good and bad quality of the other party, i.e. the other party has hidden characteristics. The orientation of the price at an average quality can provoke good quality suppliers to leave the market and can eventually cause a market fail. Even though this is not evidently a hierarchical relationship it is frequently summarized as an agency problem. The company in search of investment has an information advantage and is seen as the agent, the investor is seen as principal. (pp. 565-572)

The relation principal-agent relation was considered as follows. The principal has the right to control the expenditures of the firm’s resources. Consequently the principal negotiates a contract with an agent and assumes that the last one will accomplish his incentives. This hypothesis of a two-pair model emphasizes the details that exist: asymmetric information in contract and differing incentives in intentions among the principal and agent. So after the relationship of transactions and costs of Williamson we have also the incomplete contract approach:

“economic activity will be organized so as to economize on production costs plus transaction costs…and has concentrated on the identification of transaction attributes that generally effect the comparative performance of alternative governance structures in a world of selfish, bound rational actors, asymmetric information and incomplete contracts.” [12]

This relationship is made up of expectations of each other responsibility- role and behavior, and some unanticipated behavior can occur after the contract is concluded i.e. ex ante contracts have difficulties to foresee future situations or volatile transactions ex post. The problem of the agency theory is the assumption of a short term utility maximizing agent, leaving long term thinking and altruistic actions aside. According to Foss [13] , in the highly unstable and complex world, misunderstandings take place because the plans might include a set of eventualities, which are not possible to anticipate. Even if they could structure these plans, they would be unsuccessful in contracting because of difficulties in coming across a common language of negotiation about the conditions in the future. Concerning this, firms should improve positive incentives and discourage conflicts; and reduce imperfect and asymmetric information.