The Managerial Transaction Costs

Table: Managerial transaction cost

The exchange between the managers and their principals is imperfect to the degree that it is associated with managerial transaction costs. The following lists some of often mentioned managerial transaction costs.

Go back to figure explaining the main issues of the managerial agency problem.

Monitoring costs

The fact that principals need to spend money monitoring the managers (Jensen and Meckling [1976]). Alternatively, it may be the loss of performance from being unable to monitor perfectly as in the case of asymmetric information.

Perquisite consumption

An expression for managers who give themselves more luxury than would seem reasonably from the principals' point of view. For instance, corporate jets and huge offices with expensive art (Jensen and Meckling [1976]).

Pet projects

For instance, the managers may pursue technological leadership in a field not because it is the most profitable thing to do but because they derive private benefits from it (Jensen and Murphy [1990, page 243]).

Free cash flow dispersion

Jensen [1986, page 323] defines the free cash flow, as the “…cash flow in excess of that required to fund all projects that have a positive net present value when discounted at the relevant cost of capital.” The dispersion of this cash happens because managers starts using the free cash flow to invest in negative net present value projects simply because they derive personal utility from working with the money rather than from paying it to the shareholders.

Hampered capital access

Managers may prefer not to expand the capital of the firm, although they have many unexploited positive net present value projects. This is so in circumstances in which the managers believe that a capital expansion will reduce their control over the company.

Replacement resistance

Managers who ought to resign because there are other and more qualified people around may use their advantage of being in charge to prevent others from getting their jobs.

Resistance to profitable liquidation or merger

Managers may try to prevent profitable liquidations or mergers simply because they know that such decisions would mean the end of their job.

Power struggles

Equally good managers may be fighting over positions and thereby draw valuable time away from the main objective, namely to run the firm efficiently.

Excessive risk taking

It has been argued that managers may take excessive risks when they are owners themselves because equity in a leveraged firm basically is a call option whose value (ceteris paribus) increases the more risky the business (Black and Scholes [1973]). Click for numerical examples of excessive control.

Self-dealing transfer pricing

This is also called a sweetheart deal. It is the phenomenon that managers use their power in one company to make favorable deals with another company that they own in order to transfer wealth to themselves (Boycko, Shleifer and Vishny [1993]).

Excessive growth

Managers may derive more personal utility from managing a big company rather than a small company and may therefore be willing to trade off efficiency (read profits) with higher growth. This extra utility from managing a large firm rater than a small firm could, for instance, be explained by the fact that managers of large firms on average are paid more than managers of small firms.

Excessive diversification

Managers may start to engage in excessive diversification because competition laws (antitrust laws) prevent them from growing more in their core industry (Morck, Shleifer and Vishny [1990]).