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Incomplete Contracts

Milgrom and Roberts highlight at the end of the paper possible directions that study into the economic theory of the firm should take: A. Incomplete Contracts: relational contracts are only one way of replacing traditional formal long hand contracts. Another possibility is frequent short-term contracts that constantly change as conditions dictate. These short-term complete contracts can cover a surprisingly large array of conditions and therefore the cost of such contacts not the limitations of the contracts that are the associated market cost.

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However, the costs associated with the constant updating of such contracts can be greater than one long-term contract. In addition, they may not hold if monetary incentives are of limited effectiveness or asymmetric information at the time of renegotiation prevents the smooth negotiation of an efficient agreement. Milgrom and Roberts propose further investigation into short-term contracting and its limitations. B. Bargaining Theory: recent attempts have been made to understand the inefficiencies of bargaining resulting from asymmetric information.

However, this has been limited to trying to develop appropriate equilibrium concepts and proving existence. Suggestions are made that future study should focus on an understanding of the relative efficiencies of bargaining in different contexts. C. Reputations: As discussed earlier firms will attempt alleviate opportunism by way of reputation. They may forgo reputation with one customer to necessitate better future transactions in the future. A focus of future study could be how reputations are formed, used, and lost. D.

Influence Activities and Rent Seeking: Popular economic theory shows that government intervention in an economy causes inefficiencies. This has been extended to analyse the diseconomies resulting from centralisation of authority in firms. This seems to warrant a branch into two directions. Firstly, to further analyse the theory of influence in the firm. Secondly, to further investigate rent seeking in markets, courtrooms and boardrooms. E. Ownership, Residual Returns or Residual Rights: Further study is warranted on the issue of organisational ownership.

Refining the definitions of what ownership means and whether that meaning is situation dependant could answer many questions from corporate take-overs to employment practices. F. Adapting to Uncertainty: Galbraith (1977) formulated ideas relating to organisational design. He posited that an organisation’s design related to the allowance of adapting to uncertainty in its environment. They can adapt by processing more information (vertical and lateral communication systems) or by reducing the need to process information (environmental management, creation of slack resources and creation of self contained resources).

This framework opens up the possibility of looking into price theoretic changes in organisational form and showing the optimal mix of the above adaptations. G. Planning and Budgeting: Iterative planning, more specifically relating to the nature of communication needed in the price system economisation in the planning and control processes. Considering the massive resource allocation in planning and budgeting in many firms, it seems that this area requires further investigation. Question 2 C Describes the theories of corporate culture presented in Hermalin (1999).

Hermalin in his article on theories of corporate culture critically analyses the work of four other economists on the subject of culture in firms. He attempts to show how culture can be incorporated into economic theory and aid existing theory in explaining firm’s capabilities and performance. The four economists that he analyses are Kreps, Cremer, Hodgson and Lazear. Often economists dismiss culture when analysing firms or industries but Hermalin believes it is something that is worthy of study and something that can aid existing economic theory and empirical evidence.

KREPS (1990) Kreps believes that fundamental understanding of corporate culture is necessary for understanding how firms implement strategy. He also believes that economists are now suitably armed to study culture and presents the reader with the outline of theory thus far. The first analysis is on Kreps’ model first introduced in 1990. In his model, Kreps presents many examples and theories surrounding organizational behaviour. Kreps believes there are a few main ingredients that are built into corporate culture. The first is Formal Contracts.

Kreps shows that formal contracts can be too costly and in many cases given all the different contingencies are unfeasible. The second is the fact that firms are repeat players. Formal contracts are one way to induce play between two players that would otherwise not engage and the other is repeat play. Any deviation from fair play in one period can be punished by non-cooperation in the next period. A necessary condition of this is one of the players being able to play in multiple periods. Companies and their bosses are by necessity are multiple period players and therefore repeat play is a way of non-formalization by contracts.

Hermalin recognizes that these factors including formal contracts and repeated play go a long way to describe, predict and analyse the behaviour of firms and their respective employees both junior and senior. However, more importantly, he manages to identify two factors that actually ‘introduce’ culture into the equation. These are Multiple Equilibriums and Unforeseen Contingencies. Multiple equilibriums is simply recognition that repeated games have many stable outcomes and some co-ordination of players choices is needed as to which equilibrium prevails.

Kreps presents a two player two possibility game where a junior and senior of a particular firm are involved and analyses how corporate culture can affect each player’s decision-making and therefore possible outcomes. He first looks at the cultural norm of juniors deferring to seniors. If no such culture exists, it would be impossible for us or the players involved to predict the decisions or outcomes in such a game and therefore the culture reduces the risk of the potentially disastrous situation.

Culture increases the predictability of the player’s actions. Hermalin highlights that contracts can be used to formalise decisions but as these can ultimately be more costly than culture, and in many ways could be unverifiable, they are in fact mostly unfeasible. Multiple equilibriums can therefore provide a role for cultural norms to replace the need for formal contracting. Unforeseeable contingencies are then brought into play. Again, these are, in the majority uncontractable and the writing and rewriting of these contracts will be too costly.

Nevertheless, a culture of juniors deferring to seniors could possibly rule out the disastrous consequences of either no culture or hostile play. It must be noted that culture can go some way to eliminate these unfavourable consequences of unforeseen contingencies it by no means guarantees the optimal equilibrium. Kreps shows that these unforeseen contingencies add some flavour to the debate surrounding culture and hints that multiple equilibriums are the only prerequisite for the appearance of an influential culture.

Hermalin goes on to discuss cultural difference in companies from differing countries in the same industry. He uses the example from Okuno-Fujiwara (1994) and Morita (1998). This shows that American firms and Japanese firms in the same industry faced with the same multiple equilibriums may choose different outcomes dependant on their different culture. This is an example of national culture but it is something that will definitely have an affect on corporate culture. This raises the large issue of actually where corporate culture comes from. Do firms rely on incorporation of national culture or do they foster their own?

Creating this culture is costly and it can be seen that firms often rely on prevailing national cultures, which seem, on the surface, to be very weak, in fact have large consequences for the behavioral decisions of its employees. Hermalin then talks about Kreps’ work in terms of unforeseen contingencies unrelated to multiple equilibriums that he sees as the basis of his work. He summarizes Kreps’ work by stating that repeated play in a game could be a substitute for contracting. Repeated play is a less costly way of introducing cooperative behavior and is in fact not a perfect substitute but in most cases infinitely more desirable.

This is unrelated to culture however, culture is related to the actions or decisions that employees make in these repeated games. Simply if analyzing as Kreps does what constitutes fair treatment or exploitation by managers/bosses then culture will be the benchmark by which that is calculated or measured. It also goes further to measure or show what constitutes cooperative play in Kreps’ game and the future rewards/future cooperation associated with this as well as non-cooperative play and the associated punishments/ withholding of future cooperation.

Therefore culture ultimately rules out all unforeseen contingencies ex ante or substitutes for them. So Kreps essentially has two theories relating to culture. Firstly that culture ensures coordination in repeated games. The actual outcome is essentially irrelevant it is just that there is coordination as the cultural environment that the players are in dictates this. Secondly that it substitutes for unforeseen contingencies ex ante as analysis and contaractualising these would prove too costly and ultimately unfeasible.

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