Chapter 18
ORGANIZATION STRUCTURE AND CORPORATE GOVERNANCE
QUESTIONS AND ANSWERS
Q18.1 Describe the difference between vertical and horizontal business relationships.
Q18.1 ANSWER
A vertical relation is a business connection between companies at different points along
the production-distribution chain from raw materials, to finished goods, to delivered
Q18.2 The personal computer has evolved from a tool for computation to an Internet-centered
communications device. Is this likely to change corporate structures by increasing the
efficiency of smaller, more nimble corporations?
Q18.2 ANSWER
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Q18.3 Cite three important categories of transactions costs encountered within the firm, and
give some examples.
Q18.3 ANSWER
Three important categories of transactions costs encountered within the firm are
information costs, decision costs, and enforcement costs.
Search or information costs encompass expenses encountered in discovering the
Q18.4 What is the Coase Theorem, and why is it important in managerial economics?
Q18.4 ANSWER
According to the Coase Theorem, resource allocation will be efficient so long as
transaction costs remain low and property rights can be freely assigned and exchanged.
This transaction cost concept is important in managerial economics because it provides
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Q18.5 In a typical corporation, who are the “principals” and who are the “agents”? What is
the firm’s agency problem?
Q18.5 ANSWER
An agency problem, or natural conflict often arises between corporate owners and
Q18.6 Executive stock options are often seen as a simple and effective solution to the “other
people’s money” problem that can occur when managers with little ownership interest
mismanage firm investment opportunities. Can you foresee any advantages and/or
potential pitfalls to the use of executive stock options for this purpose?
Q18.6 ANSWER
Agency problems exist because of conflicts between the incentives and rewards that face
owners and managers. Such conflicts commonly arise given owner-manager differences
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Q18.7 What are agency costs? Describe some agency costs common among U. S.
corporations.
Q18.7 ANSWER
Agency costs are the explicit and implicit transaction costs necessary to overcome the
Q18.8 Describe three basic needs that must be met in the design of any organization.
Q18.8 ANSWER
Constructive communication within the firm is essential if customer needs are to be met
Q18.9 Discuss important differences between centralized and decentralized allocations of
decision authority within an organization. Are these methods of decision authority
allocation mutually exclusive?
Q18.9 ANSWER
With centralized decision authority, detailed judgments concerning how to best manage
corporate resources, deal with suppliers and customers, and so on, are handled by top-
line executives within the organization. Many corporations with a centralized, or “top–
Q18.10 Describe four essential components of an effective decision management and control
system.
Q18.10 ANSWER
Decision management is the vital process of generating, choosing and implementing
management decisions. Decision control is the essential process of assessing how well
the decision management process functions. To be successful, the decision management
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SELF-TEST PROBLEMS AND SOLUTIONS
ST18.1 Agency Problem. In the 1930s, economists Adolf A. Berle and Gardiner C. Means
expressed concern that managers with relatively little ownership interest might
demonstrate a suboptimal focus on transitory short-term profits rather than durable
long-run value. Berle and Means also voiced concern for value-reducing risk avoidance
on the part of management-controlled firms.
A. In general, describe the “agency problem” referred to by Berle and Means. Then,
specifically describe how inefficient risk avoidance by top managers could be a
problem.
B. What corporate governance mechanisms are commonly employed to combat the
agency problems feared by Berle and Means?
ST18.1 SOLUTION
A. So-called agency problems stem from the natural conflict that exists between owners and
managers. Given their ownership position, stockholders are the principals of the firm.
B. Although the potential for such a managerial risk-avoidance problem clearly exists,
long-term performance plans are employed on a widespread basis to force a convergence
Organization Structure and Corporate Governance 573
ST18.2 Ownership Structure. Both General Electric and Microsoft Corp. feature charismatic
and highly effective chief executive officers, display enviable records of serving growing
markets with remarkable efficiency, and enjoy sterling accounting returns and stock–
market valuations. GE and Microsoft are also huge organizations that rank near the top
in stock-market valuation among U.S. companies. Interestingly, both feature significant
institutional ownership, but are starkly different in terms of the amount of common stock
held by insiders. At GE, insider holding totals a mere 1 %, about average among
industrial giants. At Microsoft, insiders hold an astounding 4.4 % of the company.
A. What economic differences in the products produced by GE and Microsoft could
be used to explain such stark differences in ownership structure?
B. Legend has it that IBM turned down a chance to buy 50 % of Microsoft for $50
million in the early 1980s. Was this a mistake on IBM’s part?
ST18.2 SOLUTION
A. GE is a widely diversified manufacturer that produces a extensive variety of products in
a broad array of industries. Many of GE’s products are well-known by long-satisfied
B. With 20/20 hindsight, it is easy to say that IBM blew it by not purchasing 50 % of
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PROBLEMS AND SOLUTIONS
P18.1 Organization Structure. Determine whether each of the following statements is true or
false. Explain why.
A. A vertical relation is a business connection between companies at the same point
along the production-distribution chain.
B. A work slowdown due to an unexpected strike by unionized workers is a type of
decision cost.
C. A merger between rival retailers Wal-Mart and Target would be horizontal in
nature.
D. When a corporation files for bankruptcy, it is an admission that the organization
was unable to minimize transactions costs.
E. Because the Internet allows customers to lower information costs, it will have the
obvious long-run effect of reducing costs and boosting corporate profits.
P18.1 SOLUTION
A. False. A vertical relation is a business connection between companies at different points
along the production-distribution chain.
Organization Structure and Corporate Governance 575
P18.2 Agency Costs. Indicate whether each of the following transaction costs is explicit or
implicit, and describe how it is a manifestation of a particular type of agency problem.
A. A trader at an investment banking firm loses millions of corporate dollars through
unsuccessful rank speculation.
B. A manager fails to achieve optimum efficiency by letting past-due accounts languish
unpaid.
C. Senior executives decline value-increasing investment projects in order to make cash
flow targets during the last year of employment.
D. Value-increasing product development projects are postponed in order to boost near-
term accounting performance.
E. Executives manipulate accounting data to boost managerial compensation by placing
dismal operating performance in a better light.
P18.2 SOLUTION
A. Explicit. Significant differences in the risk exposure of managers and stockholders often
lead to an excessive risk-taking problem.
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P18.3 Ownership Structure. Describe each of the following factors as being responsible for
increasing, decreasing, or having no effect on the amount of concentrated inside equity.
Explain why.
A. High research and development expenditure requirements
B. A corporate history of poor operating performance
C. High levels of brand name recognition
D. Intense news coverage of corporate activities
E. Imposition of rate of return regulation
P18.3 SOLUTION
A. High R&D expenditure requirements are apt to increase the amount of concentrated
B. A corporate history of poor operating performance often results in a subsequent increase
D. Intense news coverage of corporate activities is apt to increase the prevalence of
P18.4 Other Peoples’ Money Problem. In 2002, Congress held hearings to investigate the
Organization Structure and Corporate Governance 577
collapse of Houston-based energy giant Enron Corp., aiming to discover how to protect
against similar disasters. The spectacular implosion of Enron led to the largest
corporate bankruptcy in U.S. history and billions of dollars in losses for investors in the
company’s debt and equity securities. According to a 217-page report from a panel of
Enron’s independent directors, Enron’s former chief financial officer Andrew Fastow
and former chief executive Jeffrey Skilling devised a complex scheme involving limited
partnership arrangements that allowed some of the company’s top executives to take
millions of dollars “they should never have received.” The document also revealed that
Enron’s former chief executive and chairman Kenneth Lay personally approved
partnership arrangements that led to enormous liabilities being kept off of Enron’s
balance sheet, thereby misleading investors as to the company’s financial soundness.
Enron’s collapse was not only scrutinized, by more than a dozen Congressional
committees, but it also became the subject of a criminal investigation by the U.S.
Department of Justice.
A. Explain how the Enron fiasco can be seen as a manifestation of the other people’s
money problem.
B. How could it have been avoided?
P18.4 SOLUTION
A. The Enron collapse and bankruptcy is an obvious manifestation of the “other peoples’
B. To combat myopic behavior, and the type of excessive risk taking evident in the Enron