The Nexus Of Contracts Theory Accounting Essay

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The dominant economic theories of the firm do not lead to something else, denying the fundamental differences between contract and organization and reformulating the firm as a nexus of contracts (Jensen and Meckling, 1976).

The firm as a legal fiction

In previous essay of this course we described theory of the firm presented by Coase (1937), which demonstrated that the incentive for the firm to procure in the market or to produce for their own requirements is premised on the comparative transaction cost differences. 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 expressing firms as a gathering of contracts. That is, when firms created new product solutions, production processes and organization modes to foster their competitiveness in the market, they should establish and maintain these contracts by renegotiating continuously with their participants. The firm is viewed as a:

nexus of a set of contracting relationships . . . mak[ing] clear that the . . . firm is not an individual . . . [but] is a legal fiction which 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. [2] 

The following fields of research on contracts in organizations have dispersed into different topics but in this essay we are interested in reviewing the contracts theory and the principal-agent theory (Jensen - Meckling, 1976; Holmström, 1982; Hart - Holmström, 1987), incomplete contracts (Alchian - Demsetz, 1972; Grossman - Hart, 1986; Hart, 1995b)

According to this theory, the nature of the firm is based on the organization of a collection of some different contractual arrangements. The firm is a nexus of contracts. Contract is the central modular mechanism able to play both a coordinating and incentive provision role within and between firms. Such a contractual analysis implies some sense of continuity between the firm and the market. Contractual relations are the essence of firms and human beings are parties to this nexus of contracts. Individuals exist only as regards with contracts. There are no strict ontological differences between contract and organization since organizations should be seen as contractual arrangements through which transactions pass smoothly. The firm differs from market not in nature but in degree because the contract is the basis of all governance structures. Alchian and Demsetz (1972:785) consider that the classical firm is a 'particular contractual structure [3] that possesses the properties of an efficient market, i.e, a team whose value value exceeds the sum of the market values each could get separately and where contracts aim to restrain and control the development of the actions. Theory of the firm as a nexus of contracts claim that firms arise where market contractual relationships fail. According to the nexus of contracts view, it is not useful to determine what a firm is and what it is not (Cheung, 1983). The nexus of explicit contracts view, proposes an incomplete theoretical treatment of the nature of the firm. In this view, 'we do not exactly know what a firm is' because the firm is "a shorthand description of a way to organize activities under contractual arrangements" [4] . The nexus of contracts theory does not recognize the firm distinctly from its parts but determines its nature as regards with the relations between its aggregate parts.

By a legal fiction it is meant that an economic organization must be treated as a single individual. Since the firm is a nexus of contracts, those contracts must have parties

A nexus of contracts" implies that the firm has chosen the best available of contracts. If the contracts that make up the various relationships that the firm has with all its input providers are complete contracts, then the outcome is all but predetermined with little need for innovation or entrepreneurial alertness. Agency Costs and Principal-Agent Model

Jensen and Meckling [5] (1976) formed a model by describing how the organization of the firm created agency costs, and how an optimal capital structure was a crucial factor in minimizing these costs. The model predicted that after the contract was signed there should be a monitoring "set-up" in order to control each other's behavior. The central way of monitoring such a contract was to maintain principal-agent relationships. This theoretical approach was developed by, for example, Holmström (1982) and Hart - Holmström (1987). The traditional principal-agent relation was investigated as follows. The principal has the property right to control the investing of the firm's assets. Therefore the principal (final producer) makes a contract with an agent (intermediate input producer) and assumes that the intermediate producer will fulfill his incentives. This theory of a two-tier organization design, however, highlighted the fact that there is asymmetric information in contract and deviating incentives in objectives between the principal and agent. The principal-agent theory explained the incentives between actors but it exhibited inadequacies in defining the boundaries of the firm.

According to Hart (1995a), the principal-agent theory is essential for establishing the importance of"hidden" information. While the neo-classical theory assumes that all efforts and costs are observable, the principal-agent approach instead shows that some of the costs are created because of the private information. In the public-owned firm, principals (shareholders and creditors) have various risk-return demands to be fulfilled by the hired manager who has to put their funds to productive use and generate returns with suitable risk on their funds. The problem, which is absent from the neo-classical framework, is that the manager's effort is defined and known only by him. Therefore, the compensation cannot be measured from the effort because all the other parties, such as principals, do not observe it, and this is the reason why it must be formed from the realized profit.

When the manager's compensation can be measured from the realized profit, the principals and agent will sign a contract, which specifies his responsibilities and claims according to the financiers' funds. There are two fascinating phenomena regarding such contracts. The first is that the contract can be used to specify how to adjust incentives to risk. If the manager's compensation is highly sensitive to profit, then the risk is assumed higher, and if compensation is insensitive to profit, then the purpose is to reach "lower" incentives. The second phenomenon is that such a contract can be used to determine performance-related compensation as stock options or extra shares. The principals can earn an extra bonus if the ex-ante measured profit level is reached (Hart 1995a).

To quote Hart (1995a,b), the principal-agent model relates to the incentives between owners and manager but there are two shortcomings in this model called comprehensive contracts and boundaries of the firm. Firstly, the contract is called comprehensive in circumstances when "it specifies all parties' obligations in all future states of the world." In such circumstances the question "how to govern" assets is unnecessary because, as determined in the multi-period principal-agent model, the initial contract specifies all conditions in advance. Thus the governing question matters only if some decisions in the future are poorly determined in the initial contract, and a governance structure is needed to make these decisions. Secondly, the principal-agent model has turned out to explain the internal organization of firms but is incapable of outlining the boundaries of the firm. The problem here is that the incentive schemes formed in the principal-agent contract do not distinguish whether firms are operating individually or when the balance shifts in favor of an integrated organization. The principal-agent approach offers the same incentive schemes even if firms are operating with an arm's length contract or their operations are merged to one single firm. Transaction Costs and Incomplete Contracts

As discussed in the previous chapter, the main foundation concerning the principal-agent contracting approach is that such contracting is costly and parties try to find as complete contracts as possible to govern in order to minimize costs. As Holmström and Tirole (1989) denoted in their survey: "The main hypothesis is that contractual designs, both implicit and explicit, are created to minimize transaction costs between specialized factors of production". Even if this hypothesis investigates the relationships between contracts and costs there are compelling reasons to reconsider also this finding. One reason is that the significance of contractual design to minimize costs is noticed, but still there remains an unsolved question of how firms can solve contractual incompleteness by organizing their actions to minimize these costs. As noted in Hart (1995b) the principal-agent approach misses this recognition that the contract itself is costly, and agency theory itself causes some costs because of its lack of "the comprehensive contracts".

To begin the discussion of comprehensive contracts one should notice that the main definition of the incomplete contract approach. O. Williamson presented a central approach to understand the common relationships between transactions and costs:

"economic activity will be organised so as to economise 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."2

Thus, the incomplete contract approach is introduced as misbehavior between the firms and their interest groups. Such a contractual relationship is composed of expectations of each other's roles and behavior, and some unexpected behavior after the contract is signed can exist, i.e., ex ante contracts are unable to predict stochastic or unpredictable transactions ex post (Foss 1997). In other words, the main framework on why transaction costs exist is the same as reasons for incomplete contracts. According to the study by Foss, in the complex and highly unpredictable world, misapprehensions occur because the plans might contain a set of contingencies, which are impossible to forecast. Even if they can form these plans, they fail in contracting due to difficulties in finding a common language to negotiate the states in the future. Finally, the insufficient and asymmetric information leads to the bounded rationality and non-verifiable issues, which cause conflicts when the relevant information remains private ex post.

Concerning this citation, Holmström and Tirole (1989) summarized that as firms organize their production, they should first, tend to enhance favorable incentives and avoid conflicts between interest groups and, second, decrease asymmetric and imperfect information.

4 Agency Problems

This chapter focuses on an agency-theoretic analysis of the relationship between principal-investor and agent-investee, the investee being a young growth company. Financing relationships are incomplete and relational contracts. They are characterized by a strong informational asymmetry (see Schmidt/Terberger (1997), p. 69) since the principal often cannot observe the agent's actions, and the agent who is closer to the market will better be able to assess environmental influences. In consequence the investee can act opportunistically. In general there are three major types of behavioral uncertainty: (1) moral hazard, (2) holdup and (3) adverse selection.

One of the classic examples of diverging interests of principal and agent was originally presented by Jensen and Meckling (see Jensen/Meckling (1976), pp. 312-333;

While an equity investor is interested in maximizing firm value, the manager who owns part of the company is interested in a mix of increasing firm value (investor role) and non-pecuniary benefits (manager role), i.e. perk consumption (lavish office furniture or company cars) or doing business with friends at preferred conditions.

Starting from these thoughts, there are two basic possibilities to reduce these agency costs: (1) moni-toring and (2) bonding (see Jensen/Meckling (1976), p. 323). The division of solutions and mitigations into just these two types has to be seen as incomplete. They are only some aspects that mitigate only some problems, e.g. the perk consumption or the effort problem (see chapter 5).

(1) For monitoring, the agent's interests are aligned with the principal's interests via contracts. Moni-toring is the process of the principal controlling compliance with and sanctioning deviation from these contracts. (2) When bonding, the agent proves at his own cost (bonding cost), that his behavior is in com-pliance with the principal's interest. Auditing by external firms at the agent's expense is a good example for that. This causes monitoring and bonding costs that have to be incurred as a price for the reduction in agency cost. The effects of monitoring and bonding can easily be shown when integrated in the example