Trust vs. Monitoring - A method to avoid the principal-agent problem on the example of Toyota

Table of Contents

EXECUTIVE SUMMARY

TABLE OF CONTENTS

1 INTRODUCTION

2 SCOPE OF WORK

3 TRUST AND MONITORING
3.1 Theoretical Framework
3.2 Definitions
3.3 Characteristics of trustful relationships

4 TRUST IN PRINCIPAL-AGENT-RELATIONSHIPS

5 THE ROLE OF MONITORING

6 MAPPING TO TOYOTA’S SITUATION AND ENVIRONMENT
6.1 The firm
6.2 Instruments to reduce agency costs
6.2.1 Superior information
6.2.2 Self-managing teams
6.2.3 Intrinsic Motivation
6.3 Balancing the instruments

7 CONCLUSION

BIBLIOGRAPHY

ITM-CHECKLISTE

Executive Summary

The relationship between employer and employee or in general principal and agent is one of the important key determinants that lead to economic success within a firm. In this paper the relationship between principals and agents regarding an efficient performance of monitoring or trust instruments will be discussed.

Having set the basic framework, the instruments to increase trust within the firm will be shown on the example of Toyota. In particular, it will be shown that these instruments in- creases overall economic success and have highly impact on the relationship of principal and agent.

1 Introduction

The current situation in the economy is characterized by shorter product-lifecycles, high competition, high labour force fluctuations, increasing mobility, organisational decentralizing of firms, as well as increasing use of information technology and globalisation. The consequence of this environment is to concentrate on internal processes to reach a highlevel-productivity and to reach the firms’ objectives.

As a result of this the latitude of acting of employees and employers diverges within the firm, so the leadership and coordination have to be adapted. Conventional instruments and institutions, which have high operating expenses, do not lead to adequate results. And due to the social complexity in cooperative structures, Trust and Monitoring within the firm become more and more critical factors.¹ Within the organizational structure two things have to be decided: the level of trust and the level of monitoring the employees.

Looking at the markets, it becomes harder and harder for global players to work with the “right” employees due to globalisation and it’s possibility to gain labour force from all over the world. Investment in human capital is significant.²

As the economic awareness of costs is still present, firms try to reduce monitoring costs and try to implement structures that do not need high-level monitoring activities. Therefore the creation of trust is a challenge for firms.³ But how do firms integrate trust in their organisation? And what are the existing risks in reducing monitoring activities?

2 Scope of Work

The objective of this assignment is to demonstrate the impact of trust and monitoring within the automobile industry and to proof whether these instruments achieve suitable results within the firm’s leadership.

Having set the theoretical framework of both terms, the basic definitions of trust and moni- toring are made. Due to the high amount of possible definitions, the approach of the new institutional economy will be followed. After the fundamental definition, the role of trust within principal-agent-relationship will be presented. The principal-agent-theory provides instruments that help to identify explanations and problems of agitating actors. Afterward, the negative effects of distrust and monitoring will be shown, to see how they affect agency costs.

Having shown the theoretical definitions and approaches a practical example comes into focus: the Toyota Company and it’s dealing with trust and monitoring. The integrated instruments of Toyota will be shown, which try to implement trust. Afterwards the theoretical background will be combined with the situation of Toyota in order to assess the used instruments, if neglecting monitoring activities provide an added value.

Finally, the conclusion summarizes the achieved results and answers the question whether trust or monitoring are methods to avoid principal-agent problems.

3 Trust and Monitoring

3.1 Theoretical Framework

The approach of the neoclassical economy is bounded to the coordination of different interests on perfect markets. The market is the rational coordinating instrument that coordinates the fully transparent individual production plans by the firms⁴ with the fully transparent individual plans of consumption to maximize their profits at no charge.⁵ Due to the assumption of full information trust or monitoring are not needed.

The assumptions of the neoclassical economy are not followed by the new institutional economy. The new institutional economy discusses problems of coordination of involved actors in a complex⁶ and insecure environment. Generally, the requirements of coordina- tion can be divided into “human factors”, characterized by bounded rationality⁷ and oppor- tunism and “environmental factors”, such as specifity, insecurity and frequency.⁸ Due to this, more complex environment controlling instruments are needed to control the behav- iour of actors.

3.2 Definitions

A universally valid definition of trust can not be found in relevant literature.⁹ The term of trust has to be understood depending on the current situation or the current context it is used in. Trust can on the one hand be interpreted as an individual expectation or an objective visible behaviour.¹⁰ Trust must also be seen in relation to any object.¹¹

As a fundamental factor in private or business relationships trust has different functions. In the approach of the new institutional economy trust is an “effective” instrument to re- duce complexity within human relationships.¹² Luhmann points out that actors within a system try to decrease the divergence between own perception of environment and real- ity with the use of trust.¹³ This is based on the inability of the actors to foresee any possi- ble acting alternative in the future. By using the instrument of trust the possible acting al- ternatives will be limited and self-evident.¹⁴ Another function of trust is to compensate the risk in insecure situations that has impact on the individual utility function.¹⁵ Insecure situations can be made up upon falsity, coincidence or occurrences within the environ- ment of the actor.¹⁶ Therefore Ripperger defines trust as a “freiwillige Erbringung einer riskanten Vorleistung unter Verzicht auf explizite vertragliche Sicherungs- und Kontroll- maßnahmen gegen opportunistisches Verhalten in der Erwartung, dass sicher der ande- re, trotz Fehlen solcher Schutzmaßnahmen, nicht opportunistisch verhalten wird.”¹⁷

Distrust can be described as the functional equivalent to trust.¹⁸ The distrusting party directs its expectations to the opportunistic behaviour of the second party and thinks that the disadvantageous future is more likely.¹⁹ Due to the asymmetry information the principal is not able to assess the agent’s efforts ex post. The principal is only able to assess the agent’s working result. If both actors try to achieve the same objectives, hidden actions will not be a problem. But due to the divergences, the distrusting party tries to safeguard this relationship by controlling, monitoring or by concluding a contract, which serve to synchronize the agents’ interests with those of the principal.²⁰ In practice, monitoring take a huge variety of forms: direct observations, time scheduling, cameras, or “spot checks” by special supervisors. Therefore, monitoring includes all activities that try to supervise if both contractual actors follow their commitments.

3.3 Characteristics of trustful relationships

Within trustful relationships or cooperations the actors assume that both parties act in a friendly way and have fair intentions. The cooperation is characterized by interdepend- ence and behavioural risks.²¹ The interdependence describes the different objectives of actors that can only be achieved together. And the behavioural risk accrues when the ac- tors have wide latitude to act. The existing risk is the consequence of the fact that both actors can not completely guarantee that the other actor agitates the way it is wanted. If both actors have perfect information, there will not be the necessity of having trust. In co- operative situations trust can be differentiated into an emotional and cognitive component that depends on the individual personality of the actor. On the one hand trust is experi- enced by feelings like fear or happiness. On the other hand trust is also the result of rational considerations and estimating of risks.²²

4 Trust in principal-agent-relationships

The principal-agent-theory²³ describes the contractual relationship between an ordering party (principal) and a contractor (agent).²⁴ On contractual basis²⁵ the principal transfers special assignments to the agent and wants them to be executed by the agent, who will be remunerated.²⁶ The principal takes advantage of the specialized labour force and takes advantage of information provided by the agent. Due to the present information asymmetry²⁷ and by assuming that both parties are utility maximizers “there is a good reason to believe that the agent will not always act in the best interests of the principal”.²⁸ Establishing appropriate incentives for the agent or by monitoring the agent, the principal is able to limit divergences from his own interests. An appropriate incentive structure gives the agent the possibility to participate in the operating profit of the firm. The more the contractual commitment directs on performance results, the agent tries to maximize the principal’s welfare.²⁹ Another possibility to discipline the agent is to implement institu- tions or monitoring the behaviour of the agent. But due to the complex structure it requires to enforce the rules, this instrument has high surveillance costs. To cope with the princi- pal-agent problem the principal is also able to improve the existing information systems. For the principal it is now possible to use knowledge about the agent’s performance.

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¹ Cp. Ripperger (2003), p. 3.

² Richter/ Furubotn point out, that the stability of the firm’s frame depends on the same mind, the same feelings and the same habits of all actors. Cp. Richter/ Furubotn (1999), p. 34. See also Jensen/ Meck- ling, who notice that the specification of rights is also effected by individual behaviour in organizations, including the behaviour of managers. Cp. Jensen/ Meckling (1976), p. 308.

³ Ripperger notices that in some cases trust might sometimes be the only acting option available. Cp. Ripperger (2003), p. 4.

⁴ This assignment follows the definition of Coase, which describes firms as a system of relationships, which come into existence when direction of resources is dependent on an entrepreneur. Cp. Coase (1937), p. 22.

⁵ Cp. Cezanne/ Mayer (1998), p. 1345.

⁶ Luhmann notices that the definition of complexity has to be very abstract, but it can be understood as the plurality of possible options generated within a bounded system.

⁷ Conlisk observes that human cognition is a scarce resource and models of bounded rationality are a fundamental tenet of economics. Cp. Conslisk (1996), p. 692.

⁸ Cp. Cezanne/ Mayer (1998), p. 1349.

⁹ For a presentation of different definitions of trust cp. Schödel (2005), pp. 40 - 50.

¹⁰ Cp. Ripperger (2003), p. 6.

¹¹ Ripperger perceives the essence of trust is rather intangible and vague. But it will be increasingly com- plicated with the confusing variety of possible ways to use the term. Cp. Ripperger (2003), p. 6.

¹² Ripperger also sees trust as the only option to reduce complexity, when no other possibilities are avail- able. Cp. Ripperger (2003), p. 14.

¹³ Cp. Luhmann (1989), p. 4.

¹⁴ Luhmann notices that “die vertraute Welt dann relativ einfach und in dieser Einfachheit durch ziemlich enge Grenzen gesichert [wird]”. Luhmann discerns also that trust requires familiarity. Cp. Luhmann (1989), p. 19.

¹⁵ Cp. Ripperger (2003), p. 19 and Riemer/ Klein (2001), p. 710. Sprenger describes trust to compensate “mangelndes Wissen”. Cp. Sprenger (2002), p. 56.

¹⁶ Ripperger sees insecurity as the fundamental attribute of environment. Cp. Ripperger (2003), p. 13. Luhmann describes trust as an instrument to avoid risk. Cp. Luhmann (1989), p. 19.

¹⁷ Cp. Ripperger (2003), p. 45.

¹⁸ Cp. Luhmann (1989), p. 43.

¹⁹ Cp. Schödel (2005), p. 36.

²⁰ Cp. Jensen/ Meckling (1976), p. 323; Schödel (2005), p. 36; Ripperger (2003), p. 70; Clement (2005), p. 365.

²¹ Cp. Sprenger (2002), p. 60 and Schödel (2005), p. 37.

²² Cp. Ripperger (2003), p. 95.

²³ For a detailed presentation of safeguarding strategies within principal-agent-relationships cp. Clement (2005). Jensen/ Meckling define an agency relationship “as a contract under which one or more per- sons (the principal(s) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.” Cp. Jensen/ Meckling (1976), p. 308.

²⁴ For instance employer and employee, vendor and purchaser or owner and executive manager. Jensen/ Meckling point out that this kind of relationship exists in all kind of organizations and in all cooperative efforts such as universities, governmental authorities, unions, mutual companies or bureaus. Cp. Jen- sen/ Meckling (1976), p. 309. Coase emphasizes that essentials of those relationships are related to “master and servant” or “employer and employee”. The servant has the right to act on the behalf of the master; otherwise the contract is a contract for sale of goods or the like. The Master must have the right to control the servant’s work. Cp. Coase (1937), p. 29.

²⁵ Jensen/ Meckling indicate the high importance of the contract by saying that the specification of rights was generally effected through contracting. Cp. Jensen/ Meckling (1976), p. 308.

²⁶ Cp. Kieser (2002), p. 209.

²⁷ The asymmetric of information and external effects are the fundamental elements of the principal-agent- theory. Cp. Ripperger (2003), p. 64.

²⁸ Cp. Jensen/ Meckling (1976), p. 308. Hart emphasizes, when both parties have made relationship- specific investments, “the parties are (at least partially) “locked in,” and hence they are at each other’s mercy and opportunistic behavior may rule”. Cp. Hart (1990), p. 139.

²⁹ Cp. Kieser (2002), p. 214.