Industrial Revolution & Origin of Management

Industrial Revolution – Origin of Management

• The Second Industrial Revolution occurred in the late 19th and early 20th centuries.
• Industrial engineers were instrumental in manufacturing and construction during this period and large-scale companies used economies of scale to increase production efficiency.
• The stock exchange helped finance large enterprises, giving rise to Joint Stock Firms, leading to a split between ownership and management.
• The Principal-Agent relationship emerged whereby owner principles hired manager agents to run business on their behalf
• Clear roles emerged: workers handled labour, managers oversaw operations, and owners focused on investment.

Reasons for the Presence of Managers

• Managers oversee operations, resolve conflicts, ensure smooth communication and are crucial for direction, decision-making, and efficient operation.
• Zappos adopted a holacracy in 2013, a manager-less management structure expecting employees to be self-organized and make independent decisions.
• The holacracy approach led to confusion and inefficiency resulting in nearly 20% of employees left and Zappos reinstated management oversight and coordination.

Transaction Costs Economics

• Ronald Coase (1936) and Oliver Williamson (1979) argued that relying on markets alone can lead to higher costs due to government regulations, taxes, and inefficiencies.
• Firms incur additional transaction costs when depending on external markets which include:
  • Search & Information Costs which is the time and resources spent finding the right supplier or buyer.
  • Bargaining & Decision Costs pertains to the effort required to negotiate contracts and reach agreements.
  • Policing & Enforcement Costs related to ensuring compliance and monitoring contract performance.

Reasons for the Rise of Firms / Why Firms Grow

• Firms internalize activities to reduce transaction costs instead of outsourcing them, manufacturing components in-house instead of buying them from external suppliers.
• Hiring full-time employees is more efficient than relying on contract workers, because contract workers need higher monitoring and negotiation.
• The Transaction Cost Theory explains why firms emerge and grow by reducing external costs, allowing them to operate as efficiently as markets but internal management is still required to coordinate resources effectively.
• Growth continues only until firms face diminishing returns, after which they may revert to using the market for efficiency.
• Internal management is the most effective, leading to the Principal-Agent problem, which arises when managers (agents) act on behalf of owners (principals).

Principal-Agent Theory

• Principal-Agent theory addresses information asymmetry, agency dilemma, agency costs, solving agency problems, and issues of behavioural economics.
• Theory explains the relationship between a principal and an agent which expects the agent to act in the principal's best interest.
• Due to conflicting interests and information asymmetry, agents may prioritize their own goals instead.
• The Principal (Shareholders) owns the company and monitors the agent's actions while facing challenges due to lack of full information.
• The Principal seeks ways to minimize inefficiencies and align interests with the agent.
• The Agent (Managers) aims to maximize personal benefits like salary or job security, and can withhold information from the principal to protect self-interests.
• Agents has more knowledge than the principal, leading to moral hazard where agents act against the principal's best interest.
• Agency Dilemma & Costs arise when agents prioritizes personal gain over the principal's goals, leading to monitoring costs (expenses incurred by the principal), bonding costs (efforts by the agent to prove reliability), and residual loss (gap between ideal and actual performance).

Examples of Agency Problem

• Corporate Takeovers: Managers of firms resist takeovers to protect their jobs, even if it benefits shareholders.
• Entrepreneurial Conflicts: Robert Noyce and Gordon Moore left Fairchild Semiconductor to form Intel for their own self-interest and Maurice Saatchi founded M&C Saatchi after disputes at Saatchi & Saatchi.
• Financial Frauds: Scandals like Enron and WorldCom highlight how agency problems can lead to corporate misconduct.

Solutions to Agency Problems

• Law of Agency defines responsibilities and expected behavior of principals and agents.
• Employment Contracts using profit-sharing, job security threats, and tips to align agent incentives with principal goals.
• Investor Monitoring with active investor oversight, though challenging in diversified investments.
• Corporate Governance implement measures like two-tier boards, independent directors, and governance codes e.g. Cadbury Report help reduce agency issues.
• Technology & Monitoring by using tools like facial recognition and keystroke tracking to ensure productivity especially post-COVID.

Consequences of Solving the Agency Problem

• Executives Gain Wealth from Stock Rises because leaders who own stocks, like those at Apple and Google, benefit financially when stock prices increase.
• Investor Relations become more crucial because The investor relations department becomes crucial for internal shareholders to help maintain the company's reputation.
• Remuneration Committees Favor Executives are committees responsible for executive pay which are often filled with stock-owning managers, leading to potential conflicts of interest.
• Stock Overvaluation is when managers who hold stocks may try to keep share prices high and sell at the peak, creating a risk of overvaluation.

Behavioural Economics & the Agency Problem - Loss Aversion

• Managers take excessive risks to avoid losses where research by Kahneman and Tversky shows that people weigh losses more heavily than gains.
• Example: Nick Leeson & Barings Bank took even riskier positions when trying to recover losses from bad trades leading to the collapse of Barings Bank, and Kerviel took unauthorized trades worth €50 billion and when the trades were exposed in 2008, the bank suffered a €4.9 billion loss.
• Solution: The principal (e.g., shareholders) must actively monitor agents to minimize reckless risk-taking caused by loss aversion.