Following Coase’s (1937) analysis of the firm, a range of studies, labelled as “transaction cost economics” or “new institutional economics,” explored the theories of the firm, and reflected the issues of market failure such as transaction costs, the principal-agent problem, asymmetric information, opportunistic behaviour and moral hazard (e.g., Alchian & Demsetz, 1972; Arrow, 1974; Holmström, 1979; Jensen & Meckling, 1976; Williamson, 1971; 1975; 1985). Generally, this stream of studies views the firm as a nexus of contracts to alleviate incentive conflicts between shareholders and managers as well as among different members within the firm (Cheung, 1983).
According to the types of contract, the studies can be divided into two categories: the complete contracting perspective and the incomplete contracting perspective. As for the complete contracting perspective, it assumes that agents are able to anticipate all future possibilities and draw up detailed contracts without costs (e.g., Grossman &
Hart, 1986; Williamson, 1981; 1988). On the other hand, the incomplete contracting perspective highlights the costs of drafting sophisticated contracts and the importance of carrying out ex post monitoring (e.g., Alchian & Demsetz, 1972; Hart, 1988; Holmström & Milgrom, 1994). Based on an alternative perspective of contractual relations, the stakeholder management literature argues that the management should take care of not only the relationships with shareholders but also relationships with other stakeholders such as employees, customers, suppliers, governments, and communities (e.g., Evan & Freeman, 1993; Freeman, 1984; Freeman & Evan, 1990). Thus, debates over several important issues, regarding management-stakeholder relationships versus management-shareholder relationships, have been created. These issues include agency problems, fiduciary duties, property rights, and transaction costs (other than agency costs). They are discussed as follows.
Agency theory is concerned with the agency problems that are characterised by divergence of interests between the agents (managers) and principals (shareholders). It regards the firm as a nexus of explicit contracts and advocates shareholders’ primacy (Alchian & Demsetz, 1972; Jensen & Meckling, 1976). Williamson (1985) supports the corporate governance maximand that maximises shareholder value, by arguing that shareholders have fewer contractual arrangements to protect their investment than other stakeholders. According to Jensen and Meckling (1976), agency costs include monitoring costs, bonding costs, and residual loss. Principals may use incentives or monitoring mechanisms to limit opportunistic behaviours of the agent. The agents may incur expenditures for establishing bonding schemes to ensure that their actions would not be harmful to the principal. Moreover, as it is very difficult for the principal and the agent to optimise the monitoring and bonding activities with zero
cost, there must be some costs—residual loss. Hence, the critical issue of agency theory is to economise on agency costs (Fama & Jensen, 1983; Jensen, 1983).
Hill and Jones (1992) extend the concept of the firm, from a set of explicit contractual relationships to a nexus of both explicit and implicit contracts with its multiple stakeholders. They argue that agency theory is just a special case of agency- stakeholder theory. The agency theory assumes that markets are efficient and can adjust rapidly. By contrast, Hill and Jones (1992) allow for both endogenous and exogenous shocks that cause short-term market disequilibrium and power differentials between managers and other stakeholders. Consequently, disequilibrium conditions may be triggered by frictions such as barriers to entry and exit, the ability of managers and other stakeholders to enact their environment, and organisational inertia. Hill and Jones further suggest that stakeholder diffusion makes it difficult to enforce both explicit and implicit contracts, to monitor managers efficiently, and to use ‘exit’ and ‘voice’ as effective enforcement mechanisms. Hence, there exist the similar agency problems in manager-stakeholder relationships as in manager-shareholder relationships. In other words, other stakeholders are not better protected than shareholders, in terms of a contractual perspective.
A related debate is whether the managers’ duty is to serve the interests of shareholders only or of all the stakeholders. Stakeholder theory extends managers’ fiduciary duties from a shareholder-fiduciary orientation to a multi-stakeholder- fiduciary orientation (Evan & Freeman, 1993). To redefine the purpose of the firm, Evan and Freeman state, “The corporation should be managed for the benefit of its stakeholders: its customers, suppliers, owners, employees, and local communities” (1993, p82). However, other scholars argue that the concept of multi-fiduciary duty
(i.e., managers bear a duty to all stakeholders rather than only to shareholders) is morally lacking (Marcoux, 2003), and creates a ‘stakeholder paradox’ (Goodpaster, 1991). A stakeholder paradox is defined as:
It seems essential, yet in some ways illegitimate, to orient corporate decisions by ethical values that go beyond strategic stakeholder considerations to multi-fiduciary ones (Goodpaster, 1991, p. 63).
Goodpaster (1991) argues that the multi-fiduciary approach damages managers’ accountability to shareholders as it generates a contradiction that hinders and requests profit maximisation simultaneously. In a similar vein, Marcoux (2003) argues that it is not feasible for managers to perform multi-fiduciary duties among parties with competing interests. Accordingly, it is moral that fiduciary duties focus only on relationships between the managers and shareholders.
Based on a public policy imperative, Boatright (1994) disputes Goodpaster’s argument by three standpoints. First, there is no direct link between the property rights of shareholders and the fiduciary duties of management. According to Boatright, the shareholders, in fact, are beneficiaries rather than the owners of a corporation. Moreover, the existence of capital markets allows for shareholders to dispose of disappointing shares or diversify their investment with little cost. Second, Boatright further argues that there is no express contract and the (implicit) contract relationship between shareholders and the management is unclear. There are no negotiations on mutual obligations and little interaction between the two parties. Third, Boatright points out that managers “are agents of the corporation, not the shareholders” (1994, p. 399). Particularly, he addresses the legal definition of agency given in the second
Restatement of Agency, Section 1(1): “(1) consent to the relation, (2) the power to act on another’s behalf, and (3) element of control” (Boatright, 1994, p. 399). Accordingly, these features do not exist in the relationship between managers and shareholders. Similarly, Phillips (2003a) argues that the fiduciary duty born by managers is to the corporation, rather than to the shareholders (or to any single stakeholder). As Phillips puts it:
If care were taken to distinguish shareholder from corporation, we would see that the shareholders, in fact, continue to control the stock that is both their asset and their investment. The assets Marcoux describes as being under the control of management are the assets of the organisation, not the shareholders (2003a, p. 80).
In brief, the stakeholder management literature supports the view that managers’ accountability is to all stakeholders of the corporation, rather than to shareholders only. Nonetheless, Boatright (2002) emphasises that contract theory itself neither leads to the shareholder or the stakeholder perspective, nor serves as a normative foundation for either the shareholder or the stakeholder primacy.
Another issue is related to property rights. Property rights have two types of definition. The narrow definition refers to “legal recourse available to owners of property (either tangible or intangible) in the case of inappropriate actions by non-owners” (Asher, Mahoney, & Mahoney, 2005, p. 7); the general definition refers to “any sanctioned behavioural relations among decision makers in the use of potentially valuable resources” (Asher et al., 2005, p. 7). Asher et al. adopt the broad definition and include any social institutions as well as legally enforceable claims.
Coase (1960) suggests that resources can be regarded as the bundle of rights instead of physical resources. Therefore, the essence of the resources owned by a firm refers to property rights rather than physical resources. Following Coase’s (1960) view, Donaldson and Preston (1995) incorporate the concept that “property rights are embedded in human rights and that restrictions against harmful uses are intrinsic to the property rights concept clearly brings the interests of others (i.e., of non-owner stakeholders) into the picture” (p. 83). Hence, ironically, they argue that “the stakeholder model can be justified on the basis of the theory of property, because the traditional view has been that a focus on property rights justifies the dominance of shareowners’ interests” (Donaldson & Preston, 1995, p. 83).
In a similar vein, by linking property rights theory to the resource-based view, Asher et al. (2005) argue that the approach to maximising shareholders’ value, which is consistent with the logic of the explicit contracting framework, cannot reveal the appropriate firm value due to its ignoring implicit contracts. They suggest taking stakeholders other than shareholders into account and posit: “when considering both explicit and implicit contracts when assessing the economic value generated by the firm, one needs to assess the economic surplus captured by all stakeholders” (Asher et al., 2005, p. 15). In other words, they acknowledge the importance of stakeholders regarding both value creation and value distribution of the firm.
One more issue is concerned with transaction costs. In addition to agency costs discussed earlier, Jones (1995) indicates three other sources of transaction costs. The first one is the information asymmetry between the seller of a resource and the buyer, which may create problems in terms of value uncertainty or opportunistic behaviour. Thus, in this respect, transaction costs involve “(a) search costs, (b) negotiating costs,
(c) monitoring costs, (d) enforcement costs, and (e) a residual loss” (Jones, 1995, p. 410). The second source is the hold-up problem discussed by Williamson (1985). The hold-up problem refers to a hindrance to investment in a specialised resource that would improve efficiency of both the supplier and the customer. Because of the difficulty of disposing of such specialised resource elsewhere, the hold-up problem may either reduce investment in specialisation or increase costs, such as negotiating, monitoring, and enforcing contracts, for preventing hold-up. The third source of transaction costs is team production (or consumption) problem. Jones (1995) describes the team production problem as the free rider of production in the economic literature and he depicts the team consumption problem as Hardin’s (1968) “tragedy of the commons”—where individuals tend to exploit or over-consume a resource owned by a society (in common). Consequently, transaction costs would inevitably increase due to opportunistic behaviours or arrangements needed to mitigate opportunism. Assuming that firms have (both explicit and implicit) contractual relationships with multiple stakeholders, Jones (1995) argues that mutual trust and co-operation, based on ethics and corporation morality, would reduce agency costs or transaction costs and there by result in efficient contracting. He further suggests, “Because the costs of opportunism and of preventing or reducing opportunism are significant, firms that contract on the basis of trust and co-operation will have a competitive advantage over those that do not use such criteria” (Jones, 1995, p. 432).