The managerial transaction conditions

Table: The managerial transaction conditions

These conditions are the fundamental assumptions about the economic environment and the behavior of the transacting agents and principals. In models of the managerial agency problem at least some of these conditions need to be imperfect in order for the managerial transaction costs to pose a serious problem.

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Environment Conditions

The fundamental assumption about the economic environment that associates the transactions between agents and principals

Asymmetric information

The managerial agency relation is characterized by a high degree of asymmetric information, because the managers are insiders with regard to the business they run and therefore should be better informed than the principals. This asymmetric information leaves the managers with an opportunity to pursue their own interest rather than the interest of the principals. This transaction dimension is discussed by Hart and Holmström [1987, Part 1].

Complexity / uncertainty

The managerial agency relation is characterized by a high degree of complexity / uncertainty. This is mainly so because there are many incentive mechanisms that govern the exchange between principals and managers. For a general discussion of this transaction dimension see Williamson [1985, page 56-60]. Click for three useful definitions of the concepts of certainty, risk and uncertainty.

Difficulty in measuring

The managerial agency relation is characterized with a high degree of difficulty of measuring. The quality of the managerial services is practically impossible to measure meaningfully and it is very difficult to measure financial performance. This transaction dimension is discussed by Milgrom and Roberts [1992, page 32].

Asset specificity

This transaction dimension may affect the managerial agency problem in two different ways depending on which kind of assets are considered. With regard to the asset specificity of the invested capital it has been argued that firms with a high degree of asset specificity also need to be less leveraged in order to protect the creditors' claims, Williamson [1988]. The specificity of the managers' human capital is often protected by employee contracts that reimburse them if they are fired before the contract period ends. For discussions of the asset specificity of human capital see Williamson, Wachter, and Harris [1975]. For discussions of asset specificity in general see Williamson [1985, 52-56].

Duration / frequency

The large owners and creditors normally have a long-term and ongoing relation with the firm and its managers. This long term relation may potentially decrease the managerial transaction cost. This transaction dimension is discussed by Milgrom and Roberts [1992, page 31].

Behavioral conditions

The fundamental assumptions about the behavior of the transacting agents and principals

Opportunism

This is variant of the standard utility-maximization assumption in economic theory. It says that agents always want more of what they like, and this may imply that interests are pursued in an opportunistic fashion (Williamson [1985, page 47]). Opportunism is always assumed to be present in a transaction cost based theory. The problem is the potential opportunism of managers.

Bounded rationality

Both managers and principals are subject to bounded rationality defined as limited ability of the human brain to reason. Simon [1957, page xxiv] defines it as "intendedly rational but limitedly so". This assumption is always claimed in a transaction cost based theory. For a general discussion of rationality see Williamson [1985, pages 44-47].

Risk behavior

Managers and principals are expected to be risk-averse in most situations. Among the principals the owners are assumed to be those who are in the best position to bear the cost of risk. This is so, because they may use their residual control rights to intervene if necessary and because they may control a fully diversified portfolio of assets. For precise definitions and discussions of the concept of risk see Copeland and Weston [1988, pages 85-86 and 96-102]. More info here.