Question

Should decision management and decision control be separated? As part of your discussion, provide a real-world example (or provide a fictitious example) of a firm where the control (correctly) resides with the same individual as well as an example of a firm where the control is (correctly) separated.

Answer 1

Decision making can be separated into two types: Decision Management and Decision Control. The process of decision making can be described as initiation (management) >ratification (control) > implementation (management) > monitoring (control). When the organization of production concentrates management and control information in a few people, it may be efficient not to separate these functions. However, when this happens, there cannot be specialized risk bearing. Take for example land deals and concert promotions.

Typically these deals are financed by debt claims (at high interest rates) by subscribers with the promoter holding the residual claim. The debt claims are event specific. This structure occurs because it is extremely hard to ratify and monitor the venture. When specialized risk bearing is important and valuable, decision management and decision control must be separated. If the organization is complex, there may be gains from separating decision management and decision control.

Management hierarchies and incentive structures that encourage mutual monitoring are ways of monitoring decision making. Hierarchies create competition within organizations. At each level, the decision management is controlled by the next highest level. The board of directors is the highest forum for monitoring decision management. The board of directors is the ultimate form of decision control.

We can define the separation of ownership and control with reference to the owner managed firm. In such a firm, the owner/manager possesses two principal attributes. The owner/manager (1) makes management decisions of the firm and (2) has a claim to the profits of the firm. (These claims are sometimes called residual claims to reflect that they accrue after all costs and fixed claims have been satisfied.) In a large publicly-held corporation, the shareholders own residual claims but lack direct control over management decision making. Correspondingly, managers have control but possess relatively small (if any) residual claims. The lack of control by shareholders is generally attributed to what is variously called free-rider, collective action or coordination problems. Shareholders in a publicly held corporation typically have limited legal rights to control the corporation.

Shareholders do not have the right to engage in any day-to-day management of the corporation. Nor are they able to direct policy or to set compensation. And although shareholders have the right to elect directors, the management controls the voting (proxy) machinery. Typically in the US, management may use corporate funds to solicit proxies while insurgents may use corporate funds only if successful. In spite of this, voting could be an effective instrument of control absent collective action problems. However, the existence of collective action problems greatly weakens and, in many cases, eliminates voting as an effective control mechanism. In order for a shareholder to oust current management such a shareholder faces significant expected costs. The expected return on such an investment to the shareholder, however, is a small fraction of the total return and, more importantly, small relative to the costs incurred. As an example, suppose that a shareholder possesses one-hundredth of 1 percent of a corporation’s stock. Suppose that a change in management would be worth $10,000,000 to the corporation and thus $1000 to the shareholder. Let us suppose that the cost of a proxy solicitation is $100,000. Given these costs, a shareholder would be unwilling to engage in a proxy solicitation unless almost certain of winning

The benefits of separating ownership and control come from the interaction of three factors. First, under certain conditions and for certain types of decisions, hierarchical decision making may be more efficient than market allocation. Second, due to economies of scale in both production and decision making, optimal firm size can be quite large. Third, optimal investment strategy requires investors to be able to diversify and pool and to be able to change their allocations in response to changing market conditions.

As an example, suppose that a firm is considering either purchasing or making an input product. Let us consider two types of costs. Production costs refer to the cost of making the good or to the purchase price if the good is purchased from an outside supplier. Transaction costs refer to the costs of negotiating the transaction. If the input good is a standardized good then it makes sense for a firm to go to the market and simply buy the input. Since the good is standardized, production costs will be much lower to outside producers who already are producing the good than it will be to produce in-house. In addition, transaction costs will be lower through the market. The purchasing manager simply has to check a couple of prices and then make the purchase. The competitive market will constrain prices and make extensive negotiations unnecessary. In-house production, on the other hand, involves significant transaction costs including communication costs and agency costs. Thus it makes no sense to make the product in-house