CORPORATIONS - ORGANIZATION November 14, 2006. BUSINESS ASSOCIATIONS Market Environment.

CORPORATIONS - ORGANIZATION November 14, 2006

BUSINESS ASSOCIATIONS

Market Environment

BUSINESS ASSOCIATIONS Rational Behaviour – Shephard's Lemma

Set of Cost Minimizers

Set of Profit Maximizers

BUSINESS ASSOCIATIONS Monopolies

• Constant Cost Monopoly•MC = ATC•Monopoly Surplus = Monopoly Profit

• Increasing Cost Monopoly•MC < ATC•Monopoly Surplus > Monopoly Profit

• Decreasing Cost Monopoly•MC > ATC•Monopoly Surplus < Monopoly Profit


Decreasing Costs and Increasing Returns To Scale

• Monopoly Firm - SR-LRATC

MC

PROFIT


Constant Cost – Constant Returns To Scale

• Monopoly Firm - SR-LR

ATC = MC FC = 0PROFIT


Structure


• Two (2) main themes:

• Ronald Coase (1937) focused on the transaction costs of using markets to form contracts.

• Problems of the “empty core” and coalitional instability among critical “inputs” encourage the vertical (Stackelberg, hierarchial, vertical) framework


• Ronald Coase (1937) argued that activities would be included within the firm whenever the transaction costs of using markets were greater than the agency costs of using direct authority.

• Why? • Contracts are the essence of the firm, not

only with employees but with suppliers, customers and creditors.


• Incentives• The principal can limit divergences from his

interest by establishing appropriate incentives for the agents

• The principal incurs agency costs such as monitoring costs designed to limit moral hazard


• Moral Hazard• If both principal and agent to the contract are

utility maximizers the agent will not always act in the best interests of the principal.

• Why?» The principal cannot observe the “contracted”

action of the agent until the contract is performed and the “end results” are observed

» The agent “knows” the principal cannot see the action until the contract is performed and the “end results” are observed

» The agent applies less effort


StructureSole Proprietorship

BUSINESS ASSOCIATIONS Sole Proprietorship

Recall the Principal – Buyer - Contract

• A seller owns a house she values at $300,000.00

• A buyer has $500,000.00 but values the house at $400,000.00

• If the parties successfully agreed on a price, P, social surplus between the parties is optimize at $900,000.00

• (See October 3, 2006)


• A similar result applies to sole proprietorships – a “single owner”business

• A sole proprietor AS owns a business

• He or she values at VS

• A “potential buyer” AB has wealth WB but values the business at VB


U(V)

V=Value

E

Principal (buyer) contracts a “complete” contract with the Agent (seller)

Contract Equilibrium Point


• If the parties fail to agree on a price, P, social surplus between the parties is sub-optimal at VS + WB

• SS = SSS + SSB = VS + WB


• Principal Buyer Contract• Sequential Solution

If the parties successfully agree on a price, P, social surplus between the parties is optimize at WB + VB

• SS = SSA + SSB

= P + [(WB – P) + VB]

= WB + VB


From the point of view of the owner, the extent to which outsiders might pay more for the business over and above what the owner values the business might be regarded as a type of “perquisite” on which the owner could capitalize WB + VB

• US(VS, FS) where FS = VB - VS


• When the owner has 100 percent of the equity or ownership in the firm, the

value of the firm will be Vs and the perquisites are Fs


• The indifference curve is Us = U(Vs, Fs) • Us is tangent to the budget constraint,

B = cvVs + cFFs

• The level of non-pecuniary benefits or perquisites consumed is F* at equilibrium E


• V

F

Vs E

Us

Fs


• V

E

Vs E V = E

V = kE V = Wealth

E = Effort

Es


Structure Partnership

BUSINESS ASSOCIATIONS Partnership

• Coalition – Partnership• The Partnership Game• Connection with Prisoners Dilemna


• V

E

Vs E

V = kE V = Wealth

E = Effort

Es


• V

E

Vs E

V = kE V = Wealth

E = Effort

First Partner takes second partner’s effort into account and reduces his or her effort Es


• V

E

Vs

V = Wealth

E* E = Effort

Second Partner takes first partner’s reduction in effort into account and reduces his or her effort


• What could offset the partnership Nash equilibrium to make it more Pareto optimal?


Structure Corporations

BUSINESS ASSOCIATIONS Corporation

• Royal Prerogative to grant corporate charters

• Statute of Monopolies – 1600’s

• Hudson Bay Company – Royal Charter

• South Sea Bubble – 1700’s – Suspension of Limited Liability

• Adam Smith – anti-corporation – why?


• “The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.”

• Adam Smith - 1776


• Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or Iess, in the management of the affairs of such a company.”

• Adam Smith (con’t)


• 1800’s - Restoration of limited liability to select sectors

• Canals• Banks• Railways• Public companies


• 1929 – 1935 – Crash and Roosevelt

• Securities Exchange Commission – Insider Trading

• Glass-Steagall Act – Separate Financial Markets

• Chapter 11 Protection For Viable Companies


• 1975 – 2006 – Era of Deregulation• Convergence of Financial Markets• More restrictions on insider trading• Expansion of Chapter 11 proceedings


• Jensen, M. C. and Meckling, W. H., "Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Behaviour", (1976) 3 J. of Fin. Econ. 305


• Corporation • Shareholders• Directors• Officers• Managers• Employees


• Ownership structure of the corporation.

• Jensen and Meckling show the relationship of agency costs to the ‘separation and control’ issue

• Jensen and Meckling investigate the nature of the agency costs generated by the existence of debt and outside equity


• Jensen and Meckling analyze the effect of outside equity on agency costs

• Jensen and Meckling compare the behavior

of a manager when he owns 100 percent of the shares on a firm to his behavior when he sells off a portion to outsiders.

• If a wholly owned firm is managed by the owner, he will make operating decisions which maximize his utility.

BUSINESS ASSOCIATIONS Corporation – Agency Costs

• Monitoring Costs• In some situations it will pay the Principal to supervise the

agent directly (internal costs)

• Bonding Costs• In some situations it will pay the Principal to buy insurance

(bonding costs) to reimburse the Principal should the Agent take certain actions which would harm the Principal or to ensure that the Principal will be compensated

• Residual Loss • The dollar equivalent of the reduction in welfare experienced

by the principal due to this divergence is also an agency cost


• Jensen and Meckling Assumptions• All outside equity shares are non-voting.• No complex financial claims such as

convertible bonds or preferred stock or warrants can be issued.

• No outside owner gains utility from ownership in a firm in any way other than through its effect on his wealth or cash flows.

• There exists a single manager (the peak coordinator) with ownership interest in the firm.


• The relationship between the shareholders and manager of a corporation fit the definition of a pure agency relationship

• The issues associated with the “separation of ownership and control” in the modern diffuse ownership corporation are intimately associated with the general problem of agency.


Members of Boards are classified as:

• 1. Inside Director - a member of the Board of stockholders who is also an officer or manager of the firm

• 2. Outside Director - a member of the Board who is only a shareholder


• As before, the indifference curve is Us = U(Vs, Fs)

• Us is tangent to the budget constraint, B = cv Vs + cF Fs

• The level of non-pecuniary benefits or perquisites consumed is F* at equilibrium E


• V

F

Vs E

Us

Fs


Structure CorporationsNon-Shareholder Manager


Principal(Shareholders)

AGENT(Manager)


• If the owner sells the entire equity but remains as manager, and if the equity buyer can, at zero cost, force the old owner (as manager) to take the same level of non-pecuniary benefits as he did as owner, then Vs is the price the new owner will be willing to pay for the entire equity.


• Monitoring Costs

• Monitoring is what management does.

• Management monitors the actions of other contracted parties - workers - to ensure that they are behaving in the interests of the owners of the firm.


• There are three well known alternatives using rewards:

• Pay the manager a very high salary;• Make the manager an owner of the business, a

shareholder; and,• Make the manager also a member of the Board

of Directors.


• The problem with monitoring, if it is stockholders’ monitoring top managers or managers monitoring workers, is that it is difficult and costly.


• The Board of Directors is a vehicle for stockholders that is supposed to monitor management; but, directors are not intimately involved in the daily operations and may not be especially knowledgeable of the all the aspects of the business.


• V

F

Vs E

Us

Fs


• One would not expect the new owner to be able to enforce identical behavior on the old owner at zero costs.


Structure CorporationShareholder Manager

• Horizontal Concurrent Interests (Cournot-like)


AGENT 1: Outside Shareholder

AGENT 2:

Inside

Shareholder


• If the old owner sells a fraction of the firm to an outsider, he, as manager, will no longer bear the full cost of any non-pecuniary benefits he consumes.

• (Jensen & Meckling, p. 317)


• Suppose the original owner sells a share of the firm, 1 - , (0 < a < 1) and retains for himself a share, .

• This creates the bilateral agency we saw earlier.


• If the prospective buyer believes that the owner-manager will consume the same level of non-pecuniary benefits as he did as full owner, the buyer will be willing to pay (1 - )Vs for a fraction (1 - ) of the equity.


• If the shareholder-manager is free to choose the level of perquisites, F, subject only to the loss in wealth he incurs as a part owner, his welfare will be maximized by increasing his consumption of non-pecuniary benefits.


V

F

Vs E

E* Us

Fs


• The indifference curve is still Us = u(Vs, Fs)

• The indifference curve is Us, is now tangent to the budget constraint, B* = cvVs + cFF

• The level of non-pecuniary benefits consumed is F* at equilibrium E*

• (Jensen & Meckling, p. 317)


• Conflict of Interest• “Cheater” is BOTH a manager and a

shareholder• Property right is not a sufficient deterrent

because the “loss” incurred as a “shareholder” is offset by the “gain” in perqs obtained as a manager

• Courts• Superimpose a tougher rule

» Not an “expectation damages” rule» A “strict liability” rule instead


• What is the common law response to these conflicts?

• What is the impact on the corporation of not having “conflict of interest” rules imposed on “insiders”?

• Jensen and Meckling provide one answer.


V

F

Vs E


• The requirement that VB and F* fall on the original budget constraint is equivalent to requiring that the value of the claim acquired by the outside buyer be equal to the amount he pays for it.

• This means that the decline in the total value of the firm (VS - VB) is entirely imposed on the owner-manager as an agency cost.

• His total wealth after the sale of (I - ) of the equity is V* and the decline in his wealth is VS - VB.


V

F

Vs E

VB


• The distance VS - VB is the reduction in the market value of the firm engendered by the agency relationship and is a measure of the “residual loss”, an agency cost.


• The residual loss represents the total agency costs engendered by the sale of outside equity if monitoring and bonding activities have not been allowed,

• The welfare loss the owner incurs is less than the residual loss by the value to him of the increase in perqs (F - F*).


• The difference between the intercepts on the “value” axis of the two indifference curves is a measure of the owner-manager’s welfare loss due to the incurrence of agency costs.

• The owner would sell such a claim only if the increment in welfare he achieves by using the cash amounting to (I - )V for other things was worth more to him than this amount of wealth.


• What parallels can be made between the Nash equilibrium partnership and the Nash equilibrium applicable to the shareholder manager?

CORPORATIONS - ORGANIZATION November 14, 2006. BUSINESS ASSOCIATIONS Market Environment.

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