Economic Foundations Conclusion – Part 1

This week, I spent my time reviewing theories used in strategic management that were derived from economics or grounded in economic concepts.

In one of my classes, we were encouraged to summarize theories by looking at the assumptions they make, how they are similar to other theories, the unit of analysis, and the predictions that can be made.

I will conclude the review of economic foundations by describing the major theories in those terms:

Industrial Organization

  • Key idea:
    • Builds on the theory of the firm. Looks at the impact of structure (read: boundaries) of firms and markets.
  • Assumptions:
    • Adds “complications” to perfectly competitive market.
  • Unit of Analysis:
    • Industry, firm.
  • Seminal papers and authors:
    • Stigler (1965)
      • Collusion is very difficult, even if firms want to do it.
    • Caves & Porter (1977)
      • Entry barriers are both due to the structure, and also endogenous to the industry. Entry decisions to an industry depends on a firm’s strategic position.
    • Demstez (1973)
      • Industries become concentrated due to their efficiency, not because of collusion.
    • Gilbert (1989)
      • Industry structure is not strictly exogenous, but is endogenous as industry incumbents try to influence the behaviors of potential rivals by engaging in strategic entry deterrence behavior (either by forestalling entry or inducing exit).
    • Shapiro (1989)
      • Overview of recent IO research that includes game theory; emphasizes the dynamics of strategic actions and the role of commitment in strategic settings, not possible to determine an overall theory of oligopoly.
    • Arthur (1989)
      • Examine the dynamics of allocation under increasing returns in a context where agents choose between technologies competing for adoption.
  • Similarity or relationship to other theories:
    • Since it addresses boundaries of the firm, perhaps TCE can be a complement.
  • What kind of predictions can be made:
    • The structure of the industry can be used to create strategy for the firm.

Managerial Theories

  • Key idea:
    • There is a separation of ownership and control of the firm. Managers seek to maximize their own utility.
  • Assumptions:
    • Managers maximize their own utility.
  • Unit of Analysis:
    • Firm.
  • Seminal papers and authors:
    • Bearle & Means (1932)
      • Separation of ownership and control of the firm.
    • Marris (1963)
      • The optimal growth level requires the rate of diversification and profit margin but also a growth-maximizing financial policy. However, because a financial policy is under the hands of managers, an optimal growth level and optimal value of fiscal policy are often set from the point of view of managers, not of shareholders.
    • Penrose (1965)
      • Some diversified growth represents efficient use of underutilized firm resources that cannot be separated out for sale. Expansion itself provides an opportunity to further growth, an opportunity that did not exist before the expansion, due to unused resources available at no extra cost. However, due to lack of managerial services (imagination, insight, creativity, experimenting etc), all potential opportunities known and open to a firm are not exploited together.
    • Chandler (1985)
      • Vertical integration is driven by a desire to keep firms’ core assets to efficiently employed (assurance of supply) while diversification is the realization of economies of scope
  • Similarity or relationship to other theories:
    • Since it discusses the separation of ownership and control, agency theory.
  • What kind of predictions can be made:
    • Features of the firm (diversification or vertical integration) as a result of managers.

Agency Theory

  • Key idea
    • Because of separation of ownership and control, problems arise aligning priorities of managers with priorities of owners.
  • Assumptions
    • “Economic man.”
  • Unit of Analysis
    • Principal-agent relationship.
  • Seminal papers and authors
    • Jensen & Meckling (1976)
      • Agency emerges as a response to managerial theory.
    • Fama (1980)
      • Market for professional managers ‘disciplines’ managers to work for performance.
    • Demsetz (1983)
      • Corporate execs, while not often among the largest shareholders, receive incomes that are highly correlated with stock performance, and it forms a strong link between management and owner interests.
    • Fama & Jensen (1986)
      • Shows how organizations characterized by separation of ownership and control are so common and survive well despite of the agency problems. They show that such organizations control the agency problems by separating management (initiation and implementation) and control (reification and monitoring) of decisions. The common features of decision control system include mutual monitoring system, board of directors consisting of outsiders, decision hierarchies etc.
    • Jensen (1986)
      • Debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. Debt creation binds managers to keep their promise to pay the debts with future cash flow, in this sense it is an effective substitute of dividend.
  • Similarity or relationship to other theories:
    • Managerial theories of the firm. Agency theory came about as a direct response to that theory.
  • What kind of predictions can be made:
    • Behavior of managers based on different control tactics.
(Adapted from course notes)
(Flashcards and other resources here)
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