Gurbaxani & Whang: “The Impact of Information Systems on Organizations and Markets.

What is the Agency Problem?

In any organization, there are people who own the company (principals, like shareholders) and people who run it on their behalf (agents, like managers or employees). Ideally, these two groups should work toward the same goal: the company’s success. However, the owners often want to maximize profits and performance, while managers or employees might focus on their own interests—such as getting paid more for doing less work. This mismatch is known as the “agency problem.”

Relatable Example:

Imagine you hire a babysitter (the agent) to look after your children (you’re the principal). You want your children to have the best care—healthy meals, bedtime stories, and safe play. But the babysitter might prefer an easier time: turning on the TV so they don’t have to interact much. Your goals differ, creating an agency problem.

If nobody fixes this problem, the babysitter might slack off, and your children won’t receive the care you expect. In a company, similar mismatches can lower productivity and profits.

Organizations as a Web of Principal-Agent Deals

What does “Nexus of Contracts” Mean?
Instead of viewing a company as one big, uniform entity, agency theory sees it as a collection of many smaller agreements between principals and agents. Each manager, employee, and executive is bound by a contract—formal or informal—where they agree to act in the principal’s best interest.

Relatable Example:
Think of a large sports team. The coach contracts players to perform certain roles. The team owner has a contract with the coach. The equipment manager is also part of this web of agreements. If one player decides to ignore the team’s strategy to show off their own skills, it can hurt the whole team’s performance. Similarly, when people in a company don’t follow what they’ve agreed to do, the entire organization suffers.

Where Agency Problems Appear

1. Manager-Employee Relationships: Managers want employees to work hard and help the company succeed. But employees might want to do just enough to keep their job without sweating too much.Example: A fast-food manager wants the store to be clean and efficient. Some employees might cut corners by not cleaning behind the fryers, saving themselves work but lowering store quality.
2. Shareholder-CEO Relationships: Shareholders (the principal) want higher stock prices. The CEO (the agent) might be more interested in big budgets, fancy offices, or projects that boost their reputation, not necessarily what’s best for the bottom line.Example: Shareholders want a lean, profit-focused business, but the CEO might choose a luxury company retreat, which doesn’t directly improve profits.

Fixing the Agency Problem Through Contracts

Designing Better Contracts
Agency theory suggests creating contracts that guide the agent to behave in the principal’s interests. There are two main approaches:

1. Behavioral Control: The principal closely watches what the agent does.
   Example: A supervisor might schedule surprise inspections to ensure employees follow safety rules. Although this keeps people in line, it’s costly (time, money) to constantly check up on them.
2. Outcome Control: The principal sets a goal and rewards the agent if they meet it.
   Example: A salesperson gets paid a commission only if they sell a certain number of products. This encourages them to hit their targets. However, if the market suddenly slows down, the salesperson might feel it’s unfair since they can’t control external conditions.

Types of Costs in Agency Theory

1. Monitoring Costs: The money and effort the principal spends checking on the agent’s actions.
   Example: Hiring a store manager to keep an eye on the floor staff or installing security cameras increases costs.
2. Bonding Costs: The costs agents spend to prove they’re trustworthy.
   Example: An employee regularly writes detailed progress reports. It takes time, which could’ve been spent on actual work, but it reassures the boss that they’re doing a good job.
3. Residual Loss: Even after monitoring and bonding, some mismatch remains.
   Example: Despite security cameras, an employee might still take longer breaks than allowed. This small inefficiency can’t be completely eliminated.

Decision Information Costs: Centralization vs. Decentralization

What Are Decision Information Costs?
These are the costs of getting the right information to the right person at the right time so they can make good decisions.

• Centralized Structure: All decisions are made at the top. This means information must travel up the chain, which can be slow, confusing, and costly.
  Example: A local store manager must write a long report and wait weeks for headquarters to approve a simple product display change.
• Decentralized Structure: Decisions are made locally. This reduces the hassle of sending information up the line. However, it might require more monitoring to ensure everyone’s still following company goals.
  Example: Letting each store manager decide on promotions quickly solves local problems, but the company must trust and verify that these managers won’t run wild with bad ideas.

Choosing Between Centralization and Decentralization

• If it’s really hard and expensive to move information up the chain, it might be cheaper to let people at lower levels call the shots (decentralization).
• If it’s risky to let lower-level employees make decisions without oversight, it might be easier to centralize decision-making and accept the information costs.

Transaction Cost Economics: Internal vs. External Coordination

External Coordination Costs and Vertical Integration
Dealing with external suppliers involves writing contracts, managing relationships, and checking product quality—these are external coordination costs. Sometimes, companies reduce these costs by doing more tasks in-house, known as vertical integration.

Relatable Example:
If you run a bakery and rely on a farmer for flour, you must regularly negotiate prices and ensure quality. If those negotiations become a headache, you might buy a small farm and produce your own wheat. You lose the flexibility of buying from others, but you no longer pay the external coordination costs of dealing with a supplier.

Production Costs in Markets vs. Hierarchies

• Market: If you buy from a specialized supplier, they can produce goods cheaply due to their efficiency and scale.
• Hierarchy (In-House): Doing it yourself might increase your control, but it often costs more because you lack the supplier’s efficiencies.

How IT (Information Technology) Shapes Company Size and Structure

IT’s Dual Impact on Firm Size
Information technology can lower both external and internal coordination costs.

• Lower External Costs: With good IT, a company can easily communicate with outside partners, making it cheaper to outsource. This can lead to smaller, more flexible companies.
  Example: An online clothing brand can easily outsource production to a factory overseas by sharing digital designs instantly.
• Lower Internal Costs: IT can also help large companies communicate and monitor their teams more efficiently, making it easier to run a big organization.
  Example: A large manufacturer can use advanced software to track inventory, sales, and staff performance in real-time, staying efficient despite its size.

Optimal Firm Size Depends on IT’s Impact

• If IT mostly helps you work smoothly with outsiders, you might stay small and nimble.
• If IT mainly makes internal management easier, you might grow bigger because you can handle more complexity in-house.

Growing Vertically vs. Horizontally

Vertical vs. Horizontal Expansion

• Vertical Growth: The company takes over more steps in its production process internally. This can reduce dealing with outside suppliers but raises internal complexity and costs.
  Example: A coffee shop that also buys a coffee farm and a roasting facility is vertically integrating—it controls every step from bean to cup.
• Horizontal Growth: The company expands into more markets or product lines, seeking economies of scale (making goods cheaper by producing more) and spreading fixed costs over many units.
  Example: A bakery opening new branches in different neighborhoods is expanding horizontally, potentially getting flour cheaper by buying in bulk.

Costs of Horizontal Expansion
While getting bigger can lower the cost per unit, it can make coordination with suppliers more complicated—or simpler, if you consolidate them. Sometimes adding new stores means new supplier contracts, more complexity, and thus higher coordination costs.

Deeper Context, Examples, and Future Considerations

1. Where the Theories Come From:
   Agency theory and transaction cost economics have been developed over decades by economists and management scholars. They help us understand why companies look and behave the way they do.
2. Case Studies:
   Real-world examples help illustrate these ideas:
   • Benetton: An Italian clothing brand that managed a large network of stores by relying on IT systems to reduce coordination costs, allowing for a decentralized structure.
   • IBM and Ford: These companies have integrated production and supply chains, using IT to manage complex operations internally.
3. New Tech Trends:
   Tools like AI, cloud computing, and big data now make it cheaper to communicate, monitor, and manage operations. This can encourage both more outsourcing and more internal complexity, depending on how the technology is applied.
4. Different Industries, Different Outcomes:
   The best structure for a tech startup might be very different from a large manufacturing firm. IT’s impact varies by industry and company goals.
5. Limitations of These Theories:
   Real people aren’t always perfectly rational and might behave in unpredictable ways. Trust, loyalty, and company culture also matter—things that aren’t fully captured by agency theory or transaction cost economics.
6. Practical Implications:
   Managers can use these insights to decide whether to centralize decisions or delegate them, to produce in-house or outsource, and to invest in IT that best suits their growth strategy.
7. A Decision-Making Framework:
   By understanding agency costs, transaction costs, and the role of IT, leaders can create a roadmap for choosing the company’s size, structure, and level of integration. They can weigh the costs and benefits before making changes that affect how their business operates.
8. Visual Aids:
   Flowcharts, diagrams, or cost curves can help people visualize how increasing size affects costs, or how adding IT systems might lower certain costs but raise others.
9. Conclusion:
   In the end, a company’s shape—whether big or small, centralized or decentralized, vertically integrated or spread across multiple markets—depends on balancing various costs and benefits. As technology evolves, it continually changes the rules, challenging companies to adapt their structures to stay competitive.