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CORPORATIONS - ORGANIZATION November 14, 2006 PowerPoint PPT Presentation


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CORPORATIONS - ORGANIZATION November 14, 2006. Market Environment. BUSINESS ASSOCIATIONS. BUSINESS ASSOCIATIONS Rational Behaviour – Shephard's Lemma. Set of Cost Minimizers. Set of Profit Maximizers. BUSINESS ASSOCIATIONS Monopolies. Constant Cost Monopoly MC = ATC

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CORPORATIONS - ORGANIZATION November 14, 2006

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Corporations organization november 14 2006

CORPORATIONS - ORGANIZATIONNovember 14, 2006


Corporations organization november 14 2006

Market

Environment

BUSINESS ASSOCIATIONS


Corporations organization november 14 2006

BUSINESS ASSOCIATIONSRational Behaviour – Shephard's Lemma

Set of Cost Minimizers

Set of Profit Maximizers


Corporations organization november 14 2006

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


  • Corporations organization november 14 2006

    BUSINESS ASSOCIATIONS

    Monopolies

    Decreasing Costs and Increasing Returns To Scale

    • Monopoly Firm - SR-LR

    ATC

    PROFIT

    MC


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONS

    Monopolies

    Constant Cost – Constant Returns To Scale

    • Monopoly Firm - SR-LR

    PROFIT

    ATC = MC FC = 0


    Corporations organization november 14 2006

    Structure

    BUSINESS ASSOCIATIONS


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONS

    • 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


    Business associations

    BUSINESS ASSOCIATIONS

    • 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.


    Business associations1

    BUSINESS ASSOCIATIONS

    • 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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONS

    • 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 actionuntil the contract is performed and the “end results” are observed

        • The agent applies less effort


    Corporations organization november 14 2006

    Structure

    Sole Proprietorship

    BUSINESS ASSOCIATIONS


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSSole 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)


    Business associations sole proprietorship

    BUSINESS ASSOCIATIONSSole Proprietorship

    • 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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSSole Proprietorship

    U(V)

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

    Contract Equilibrium Point

    E

    V=Value


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSSole Proprietorship

    • 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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSSole Proprietorship

    • 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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSSole Proprietorship

    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 capitalizeWB + VB

    • US(VS, FS) where FS = VB - VS


    Business associations sole proprietorship1

    BUSINESS ASSOCIATIONSSole Proprietorship

    • 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


    Business associations sole proprietorship2

    BUSINESS ASSOCIATIONSSole Proprietorship

    • 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


    Business associations sole proprietorship3

    BUSINESS ASSOCIATIONSSole Proprietorship

    • V

    Vs E

    Us

    Fs

    F


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSSole Proprietorship

    • V

    Vs E V = E

    V = kE V = Wealth

    E = Effort

    Es

    E


    Corporations organization november 14 2006

    Structure

    Partnership

    BUSINESS ASSOCIATIONS


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSPartnership

    • Coalition – Partnership

      • The Partnership Game

      • Connection with Prisoners Dilemna


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSPartnership

    • V

    Vs E

    V = kE V = Wealth

    E = Effort

    Es

    E


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSPartnership

    • V

    Vs E

    V = kE V = Wealth

    E = Effort

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

    E


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSPartnership

    • V

    Vs

    V = Wealth

    E* E = Effort

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

    E


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSPartnership

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


    Corporations organization november 14 2006

    Structure

    Corporations

    BUSINESS ASSOCIATIONS


    Business associations corporation

    BUSINESS ASSOCIATIONSCorporation

    • 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?


    Business associations corporation1

    BUSINESS ASSOCIATIONSCorporation

    • “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


    Business associations corporation2

    BUSINESS ASSOCIATIONSCorporation

    • 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)


    Business associations corporation3

    BUSINESS ASSOCIATIONSCorporation

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

      • Canals

      • Banks

      • Railways

      • Public companies


    Business associations corporation4

    BUSINESS ASSOCIATIONSCorporation

    • 1929 – 1935 – Crash and Roosevelt

      • Securities Exchange Commission – Insider Trading

      • Glass-Steagall Act – Separate Financial Markets

      • Chapter 11 Protection For Viable Companies


    Business associations corporation5

    BUSINESS ASSOCIATIONSCorporation

    • 1975 – 2006 – Era of Deregulation

      • Convergence of Financial Markets

      • More restrictions on insider trading

      • Expansion of Chapter 11 proceedings


    Business associations corporation6

    BUSINESS ASSOCIATIONSCorporation

    • 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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation

    • Corporation

      • Shareholders

      • Directors

      • Officers

      • Managers

      • Employees


    Business associations corporation7

    BUSINESS ASSOCIATIONSCorporation

    • 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


    Business associations corporation8

    BUSINESS ASSOCIATIONSCorporation

    • 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

    BUSINESS ASSOCIATIONSCorporation – 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


  • Business associations corporation agency costs1

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Business associations corporation agency costs2

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Business associations corporation agency costs3

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • V

    Vs E

    Us

    Fs

    F


    Corporations organization november 14 2006

    Structure

    Corporations

    Non-Shareholder Manager

    BUSINESS ASSOCIATIONS


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    Principal

    (Shareholders)

    AGENT

    (Manager)


    Business associations corporation agency costs4

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Business associations corporation agency costs5

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Business associations corporation agency costs6

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Business associations corporation agency costs7

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

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


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • V

    Vs E

    Us

    Fs

    F


    Business associations corporation agency costs8

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

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


    Corporations organization november 14 2006

    Structure

    Corporation

    Shareholder Manager

    BUSINESS ASSOCIATIONS


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • Horizontal Concurrent Interests (Cournot-like)

    AGENT 2:

    Inside

    Shareholder

    AGENT 1: Outside Shareholder


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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)


    Business associations corporation agency costs9

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

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

    • This creates the bilateral agency we saw earlier.


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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 - a)Vs for a fraction (1 - a) of the equity.


    Business associations corporation agency costs10

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    V

    Vs E

    E* Us

    Fs

    F


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

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

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

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

    • (Jensen & Meckling, p. 317)


    Business associations corporation agency costs11

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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


  • Business associations corporation agency costs12

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    V

    Vs E

    F


    Business associations corporation agency costs13

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • The requirement that VB and F* fall on the original budget constraintis 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 - a) of the equity is V* and the decline in his wealth is VS - VB.


    Corporations organization november 14 2006

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    V

    Vs E

    VB

    F


    Business associations corporation agency costs14

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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.


    Business associations corporation agency costs15

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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*).


    Business associations corporation agency costs16

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

    • 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 - a)V for other things was worth more to him than this amount of wealth.


    Business associations corporation agency costs17

    BUSINESS ASSOCIATIONSCorporation – Agency Costs

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


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