9/7/2015Contract Theory1 Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University University of Sao Paulo Sao Paulo, Brazil,

04/19/23 Contract Theory 1

Contract Theory of Organizations, Accounting and

Control

Shyam Sunder,

Yale University

University of Sao PauloSao Paulo, Brazil, March 12, 2013

04/19/23 Organizanal Design 2

Outline

• Organizations as alliances among people seeking their goals• Culture of a group is the set of common knowledge

expectations its members have from one another• Control as equilibrium or balance: organization is in control

if expectations of its members from one another match what its members find in their own best interests

• Control threatened by changes in environment; without prompt repair, organization collapses

• Strategic management: anticipate threats, redesign and renegotiate alliances to restore control with respect to the changed environment.


Organizational Design

• Perspective includes a review of– Organizations,– Expectations,– Common knowledge, and – Culture;

• Disruption and threats to control• Strategic management: what top managers do to

maintain control


Contract View of Organizations

• Work of Barnard, Simon, Cyert and March, Cooper, beginning in the 1930s (“Carnegie School”)

• Useful to think about organizations as a set of contracts or alliance among people

• Simple, powerful synthesis of economic and organization theories

• Can sustain a robust theory of accounting and control (Sunder 1997)– If organization is a set of contracts,– Accounting is the operating mechanism to make the

contracts work


Contracts

• Participating agents promise to deliver resources• In exchange for the promise of inducements• Agents enter contracts if they expect to get more

than the opportunity cost of their contributions• To succeed, an organization must have a production

function to simultaneously satisfy all contracts• Otherwise dissatisfied agents abandon the alliance• Organization collapses unless an alternative set of

contracts that satisfies the condition is assembled


Agent

• Has personal goals

• From his opportunity set, chooses preferred actions

• Actions are consistent with his preferences, information and opportunity set

• Difficult to model in social sciences without a minimal level of behavioral consistency


Examples of Contracts

• Contract is a mutual expectation or understanding among agents

• Lunch date• This class• Promising a delivery schedule to customer• Explicit of implicit promise of relevant action• Legal enforceability or written form not necessary• Social conventions play an important role


Players and the Game

• Individuals have goals; they are the players

• Organization is the game in which individuals play to seek their own goals

• Perspective is applicable to a broad range of organizations—business, government, society, academia


Business Organizations

• For present discussion, consider business organizations

• Consider them as an alliance among contributors of

– Capital (shareholders, creditors)

– Labor (employees, managers)

– Factors (vendors)

– Cash (customers)

– Public services (government)

– Support (Community)

• Each party gets resources in exchange


Firm as a Set of Contracts

Managersnagerssss

Shareholders

Creditors

Employees

Customers

Vendors

Auditors

Government


Accounting in Organizations

• Operating mechanism for contracts• Necessary to assemble, implement, enforce,

modify and maintain the contract set• Five functions

– Measure resource contributions from agents– Monitor resource outflows to agents– Relate inflow and outflow for each agent– Maintain liquidity of factor markets– Common knowledge to facilitate contract renegotiation


Measuring Contributions

• Receivables and cashier

• Receiving dock for supplies

• Punch clock and quality control


Measuring Outflows

• Payroll accounts

• Tax accounts

• Cashier

• Shipping


Contract Fulfillment

• Matching resource inflows and outflows to contracts

• Performance evaluation

• Adjusting contracts to resource realizations


Maintaining Liquidity of Factor Markets

• Individuals agents come and go

• Finding replacements for departing agents in appropriate factor markets

• Convincing new people to participate

• Advertising motive in all factor markets


Facilitating Contract Renegotiation Through Common

Knowledge• Most contracts are finite term contracts

• Motive to bluff at the time of renegotiation

• Ex ante agreement to share some information as common knowledge

• Common knowledge cannot be used to bluff others

• Reduces dead weight losses to society


Expectations

• Thinking, anticipating a future event or object (e.g., salary at the end of the month)– Tinged with hope toward our preferences

• First moment of a probability distribution which is– Objective (e.g., value of a lottery ticket)

– Subjective (e.g., value of a lottery ticket)

• Two of these three meanings are subjective• Will coincide only by chance


Human Expectation Formation

• Complex• Not well understood• Risk of flying versus driving!• Contracts defined as expectations of

resource flows– Customer expectations from cars– Employee expectations from job– Investor expectations of returns


Mutuality of Expectations

• Expectations are rarely fixed• All actions create/influence expectations• Firm must manage them (problem of participative

budgeting)• With unfilled expectations, people turn away• With overfilled expectations set up disappointment later• Management gurus preach maximization—of profits,

growth, quality, EPS, stock prices, etc., instead of setting a target and sticking to it

• Pursuit of moving targets (Enron expected 91 percent growth rate in free cash flows for next 6 years)


Common Knowledge

• Technical term in philosophy, statistics, game theory and economics

• Denotes knowledge that includes knowledge about what others know

• Aumann (1976): Two people 1 and 2 are said to have common knowledge of an event E if– both know it, – 1 knows that 2 knows it, – 2 knows that 1 knows it, – 1 knows that 2 knows that 1 knows it, – and so on...


Emperor Has No Clothes



Stock Market

• Stock Market is like a newspaper beauty contest

• John Maynard Keynes, (1936)


Newspaper Beauty Contest

Which Face is the prettiest?


Which Face is the prettiest? Which Face is the prettiest? Which Face is the prettiest?

Which face will they judge to be the prettiest?










LIFO Inventory Accounting

• If your inventory prices rise, and end-of-year inventory volume is stable or rising

• You can delay paying taxes (higher net present value of cash flows)

• But have to report lower income also• Many firms don’t adopt LIFO • Apprehension about stock market reaction

(no empirical support)


Beliefs About Others’ Beliefs

• Common elements to the three stories about the emperor‘s clothes, stock market and LIFO

• Central role of what we believe about others, and about their beliefs


Emperor’s Clothes

• The scoundrels made people believe that the clothes will be invisible only to the incompetent and the stupid

• People thought that others believed it• Nobody wants to be seen as stupid or

incompetent by others, lose his/her job• Visibility of clothes was private, it was easy

to fake seeing the clothes


Emperor’s Clothes (Contd.)

• Scenario 1: Everyone was privately convinced of their incompetence, and cheered to deny it publicly

• Scenario 2: People did not believe they were incompetent just because they could see the naked emperor, but believed that others so believed, and cheered to avoid being seen as stupid


What about the Child?

• The child did not know the link between visibility and competence

• Child was innocent, and said what he saw

• People know children to be innocent

• People knew that people knew this


Keynes on Stock Market

• Price of Microsoft shares is $100

• I expect the price to be $125 a year from now.

• Is it a good buy?

• Rule 1: Yes, if your opportunity cost of capital is less than $25 for the year


Stock Market (Contd.)

• What if I now believe that the stock market’s assessment of the value of Microsoft shares a year from now will be $90?

• Can I change the beliefs of others in the market?

• If not, Rule 2: Sell at $100• Higher order rules


Should I Pay Attention to Others When I Know I Am Right?

• What if everyone believes them (who are wrong), and not me (who is right)

• Fight them? or

• Join them?


What About Accounting

• Agency problem: how to induce managers to maximize shareholder value (e.g., choose LIFO)

• Solution: Link managerial compensation to shareholder value

• Problem 2: Value manipulation• Solution: Use market, not accounting,

measures of value


Value Maximizing Manager in an Efficient Market

• LIFO can increase NPV of cash flow

• But manager maximizes stock price

• What does manager believe about how stock prices are determined?

• Suppose manager believes that stock prices depend on income, not cash

• Then manager is rationally led to reject LIFO even if it saves cash for the firm

• After these examples of the consequences of common knowledge assumption, let us consider culture


Culture

• In management, culture often treated as a counterpoint to economics

• Can think of culture of a group as the common knowledge expectation of behavior of the members of a group– Starting meetings on time

– Wearing black on black

• Expectations lie at the heart of economic models


Management Controls Again

• A viable concept of control from organizations as sets of contracts, expectations, common knowledge and culture

• An organization or group is in control when its members find it in their own best interests to behave in a manner that is expected of them by the other members of the group


Control In Versus Control of

• Control in organizations distinct from control of organizations

• Control in emphasizes – Balance and equilibrium – Symmetry of points of view of agents

• Control of emphasizes– Manipulation, even exploitation

• Disparity in bargaining powers of agents


Comprehensive Perspective on Control

• Rules, incentives, monitoring, enforcement to align behavior and expectations

• Consider two traders on eBay– Buyer expects to have the appropriate goods delivered– Seller expects to be paid– When expectations of both are met, the system is in

control

• The concept extends well beyond the traditional scope to employees and managers to include shareholders, customers, vendors, and others


Threats to Control

• Environment of organizations changes continually (factor and product market conditions)

• A contract set which is in control today, will not be in control tomorrow if conditions change

• Left to itself, the organization will collapse because a fixed set of contracts cannot remain in expectational equilibrium except by sheer chance


If Individual Condition Is Not Met

• People who do not expect to get from the organization at least the opportunity cost of their contributions will go elsewhere

• This is the definition of opportunity cost• Shareholders will not buy your stock if they

can higher risk-adjusted return elsewhere• Customers will not buy your goods if they

can get better price or quality elsewhere


If Aggregate Condition Is Not Met

• Firms runs out of resources to meet its obligations (expenses exceed revenue)

• Some agent(s) disappointed because the promises made to them are not fulfilled

• These agents quit (and probably impose additional costs on the organization—e.g., law suits)

• If these individuals were essential for the production function of the firm, their departure makes things worse

• If they were not essential, the firm did not choose the optimum production function


No Coercion

• Matching of agent actions to what others expect of them should not be achieved through coercion

• It has to be created through socially legitimate incentives and motivational methods

• What is legitimate varies across societies• Performance-based compensation may be

considered coercive in some societies but not in others


Not Based on Misunderstanding

• Participant actions and others’ expectations of them may just happen to match due to misunderstanding

• Such a match is not sustainable; it disappears as soon as the participants get better information

• A match based on misunderstanding does not imply control


Not Based on False Promises

• A match may sometimes be obtained through false promises—e.g., Ponzi schemes

• Again, these are not sustainable

• Disclosure of truth destroys the organization

• Such a house of cards is not “in control”


Disintegration of Organizations

• When actions do not match the expectations, people are disillusioned and quit

• Organizations disintegrate

• Miscalculation, coercion, misunderstanding, or misrepresentation by agents destroy control


Functions of Top Management

• This function goes by many labels (long term planning, strategic management, etc.)

• It always amounts to the same thing:– Monitor your environment– Anticipate changes in factor and product markets– Redesign contracts to be in control under the new

conditions– Renegotiate contracts– Implement new contracts

• Perpetual revision of corporate plans to retain their desirability from the point of view of all participants


Let Me Summarize

• Control a key concept in management

• Need an appropriate model of organizations to study control

• Help do accounting and control better

• Find appropriate place for control in the intellectual structure of the discipline of management


Role of Accounting

• Organizations as sets of contracts or alliances among people

• Agents seeking their own goals contribute resources in exchange for inducements

• Accounting helps define, implement, enforce and modify contracts, serving a critical function in organizations


Design of Organizations and Controls

• Both designs depend on conditions prevailing in the appropriate markets

• Market for managerial labor differentiated stewardship model from bookkeeping

• Market for capital differentiated financial reporting model from stewardship

• Market for products differentiates government and not-for-profit model from private good organizations


Expectations and Common Knowledge

• Contracts are based on expectations• Expectations not well-understood yet• First as well as higher orders of knowledge play

important part in management• Not always reasonable to assume common

knowledge• Breakdown of common knowledge has important

consequences for behavior and outcomes in organizations and markets


Culture and Control

• Culture of a group can be thought of as expectations its members hold about the behavior of others in the group

• An organization is in control if the behavior of its members corresponds to the expectations of others

• Control is a state of expectational equilibrium


What’s Management For

• Changing environment threatens control• Top management must anticipate and deal with

these threats to control• Set of feasible corporate plans is too large to

contemplate and analyze• Due to time limitations, managers search in the

neighborhood of existing plans and settle on satisficing solutions

• Simon’s boundedly rational behavior


Thank You

• Please send your comments to

• [email protected]

• www.som.yale.edu/faculty/sunder/research

mailto:[email protected]

http://www.som.yale.edu/faculty/sunder/research

Documents

9/7/2015Contract Theory1 Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University University of Sao Paulo Sao Paulo, Brazil,