Professional Documents
Culture Documents
By Stela Bagasheva
Introduction
Governance = authority, control Traditional microeconomical practices do not explain the need for governance, as they focus on commodities. However, a problem arises when talking about many daily transactions When purchasing machinery from another party, the difference between what the two parties generate together and what they can obtain in the marketplace represent a quasi-rent, which needs to be divided. In dividing this surplus, governance plays a role. Governance system: the complex set of constraints that shape the ex-post bargaining over the quasirents generated in the course of a relationship. A main role in this system is played by the initial contract. The contract will most likely be incomplete, as it will not specify every possible unforeseen event. This creates a n interesting distinction between decisions made when the two parties entered the relationship and investments were sunk (ex-ante), and when the quasi-rent are divided (expost). Thus there is room for bargaining. Outcome of bargaining will be affected by several factors, other than the initial contract: 1. Which party has ownership of the machine while it is in the production process? 2. The availability of alternatives: How costly is it for the buyer to delay receiving the machine? - How costly is it for the manufacturer to delay the receipt of the final payment - How much more costly is it to have the job finished by another manufacturer 3. The institutional environment: - How effective is law enforcement? - What are the professional norms? - How quickly and reliably does information about the manufacturer s performance travel across potential clients? All of these conditions constitute a governance system. Necessary conditions for a governance system (otherwise there will be no scope for bargaining): 1. Relationship must generate quasi-rents. 2. Quasi-rents are not perfectly allocated ex-ante.
Corporate Governance
Governance can apply to anything: from a whole organization to a single transaction. Corporate governance refers to the governance of a corporation. Formal definition: Corporate governance is the complex set of constraints that shape the ex-post bargaining over the quasi-rents generated by the firm. This definition highlights the link between how quasi-rents are generated and how they are distributed. It also raises the question of what a firm is. Properties of a firm: It is jointly owned ( thus raises question of allocation of ownership) Complex structure Cannot be instantaneously replicated Suggestion that customers, suppliers and workers are part of the firm (REMEMBER! Corporation is the legal manifestation of a firm, thus it is wrong to say that those stakeholders are part of the corporation!)
award them accordingly. Basically, if after the activity takes place (distribution of quasirents), if the actor (be it manager, firm, supplier, customer, etc.) will not receive a sufficient reward, he has no reason to increase the value of the action. Which means that total surplus is not optimized. Another problem that destroys value is that rational agents are ready to engage into inefficient economic activity if this means the outcome ex-post is altered to their favour. For example, a manager would like for his firm to be part of a duopoly, as it would have a very high bargaining power to its supplier, and thus would be able to extract large part of the quasi rent. However, oligopolies do not maximize the total surplus, as we know from microeconomics. On the other hand, the governance structure might encourage the creation of value. By changing the ownership (one manifestation of governance) of a storage facility so that it is owned by a nearby manufacturer, it would be less costly for the manufacturer (thus value is increased) to store its products than to have to spent transportation costs to a further storage facility. In conclusion, a governance structure affects the incentives to power-seek (but also investments) and thus altering the marginal payoffs that these actions have in ex-post bargaining. 2. Inefficient Bargaining Another way by which a governance structure affects total surplus is by altering ex-post bargaining efficiency. So a governance structure can affect the degree of information asymmetry between the parties, the level of coordination costs, or the extent to which a party is liquidity-constrained. The divergence of interest amongst the different people who have control rights can lead to this kind of inefficient bargaining. This goes back to the selfish, although rational behaviour that each party exhibits. It is more costly to allocate the control over groups of people with varying level of skills, positions, and status. That is so, exactly because each one of these groups will have a different interest in the bargaining situation. Therefore, it rarely happens that governance is dispersed to actors with conflicting interests. 3. Risk Aversion The ex-ante distribution of surplus that affects the total surplus is also influenced by the varying levels and spread of risk. So if the parties have different risk profiles (risk-averse, risk-taker, and risk neutral) then conflicts are likely to occur. And conflicts = costs, which of course means insufficiency. If the different parties have different levels of risk aversion (or different opportunities to diversify risk), then the efficiency of a governance system is measured by how effectively it allocates risk to the most risk-loving party. For example, a partnership is about to make a risky investment and it is up to the two partners (with different levels of risk-aversion) to decide whether to make the investment. If the risk is efficiently spread, that would mean
that the risk-lover should be more financially impacted by a potential failure that the riskaverter. Different governance structures can also generate different amounts of risk. If the parties are risk-averse and cannot diversify the risk, the value of the total surplus is decreased (because concentrated risk creates inefficiency). In summary the objectives of a governance system should be: 1. To maximize the incentives for value-enhancing, while minimizing inefficient powerseeking 2. To minimize inefficient ex-ante bargaining 3. To minimize governance risk and to allocate the residual risk to the least risk-averse party.
RAJAN AND ZINGALES: The residual right of control (this always increases the share of surplus captured by the owner, as he has the opportunity to walk away with it) is best allocated to a group of agents who need to protect their investment against ex-post expropriation (giving away to other parties), but have little control on how much the asset is specialized (the more specialized the asset, the less value it has outside the relationship).
By this definition, we can make the assumption that shareholders are the best option when allocating the residual right of control, as their investment is money. Money is the least specialized asset, so it s the easiest to be expropriated. For example, human capital (labour) does not fit this description. So by awarding providers of funds the most of the quasi-rents, this increases their marginal incentives to invest. However, as the shareholders might have a fear that their share of the return on investment might go down, they will not use their funds for specialized purposes. So it is most efficient if providers of funds retain ownership and control of their assets, while the right to specialize the assets is given to a third party. This party should not be a mere agent, but should act in the interest of the firm. Generally, this is the board of directors.
Normative Analysis
A privately optimal governance system is not necessarily socially efficient. In a world of incomplete contracts, the legal system has an effect on the appropriation of quasirents, on the way corporate governance is structured and on the amount of finance raised. In this world, a governmental intervention that eliminate ex-post inefficiencies, while preserving the distributional consequence in the ex-ante, will increase social efficiency.