Political Economy of Corporate Governance (BEM/EC 185 ) The Stakes

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1 Method Political Economy of Corporate Governance (BEM/EC 185 ) The Stakes Page 1 Responsibilities Mine Yours Preparing for Thursday (BBR) What is it Corporate Governance Corporation Firms Political Economy Politics of law Politics of Regulation Politics of Businesses Ownership Control The Practical Stakes It s a big deal Public corporations account for the majority of total private output in most economies (more than 50%) Corporations account for the bulk of output (50-80%)

2 Multi-owner business firms get you into the 90% range. Yet there are problems Corporate scandals Enron, WorldCom, Tyco AIG, Citibank, Societe Generale Externalities Microsoft vs the rest of the industry; Credit crunch and agency problems in the mortgage market Detroit and parts suppliers Other stakeholders intervene Hershey Airbus/EADS Government in Bail Out These Issues are long standing As problems VOC and EIC 1600 and 1602 Chapters of Erie s Roaring Twenties and Great Depression Corporations endure Scale provides survival benefits Charters are rarely changed The consequence of bad governance The Consequence of bad governance Page 2

3 More distortion Extraction of private benefits most often is inefficient Less entry and competition Less capital Investors are not willing to fund projects if they are not protected Less growth Page 3 So How are they run? Internal organization Sources of capital Regulation and the legal system The social design problem The nature of the firm (more on this next Tuesday) A multi-actor organization Management; Investors; Labor; Government It has rules (articles of association) E.g, limited liability, one share one vote, capacity to block purchases of capital by outsiders And enforcement mechanism provided by courts. It has a well defined social goal Maximize profits But is that the only goal? Private actors have preferences What are those preferences?

4 Private profit maximization does not imply maximizing the firm s profits Four major categories Inside equity Outside equity Long term debt Short term debt Impact Inside equity is expensive but provides stable control Short term debt is cheap but exposes the firm to shocks. The financial design problem Page 4 The legal stakes Ex-ante (at Birth) Offer frameworks to design business constitutions Allow entry Reduce fraud During the life of the firm Balance the need to let the firm do what it needs to prosper Claims of third parties (shareholders) Ex post (when problems arise) Balance the value of the going concern, claims of creditors.

5 The political stakes Fiscal issues Corporate income taxes can be very important Big firms can engage in lobbying to reduce their burden (Blackstone) Location of firms affects revenues Interest group issues Labor vs capital Experts (lawyers, financiers, accountants) vs the public Incumbent firms Problem of corruption Bubble act, Credit Mobilier, Panama Canal What political regimes favor good governance? Open problem We have not solved the problem of CG! OR We know the solution but We have not solved the implementation pb Or It does not have an aggregate solution? It does not have an a-temporal solution Method (for this class) Maximize the variance across the disciplines across the globe (sort of ) Page 5

6 across time (Sort of) Mix theory with facts Key piece of theory. Page 6 Key conflict Individual sets Marginal cost effort to marginal return (MC=MR) If sole owner of firm. Sets marginal cost of effort to marginal profit of firm=> efficiency not owner of firm set marginal cost of effort to marginal personal return. MC=MR What is marginal personal return (it cant be marginal profit of firm because not owner) If own α of firm. MC=MR MC=αMR If bonus is α of firm profit. MC=MR MC=αMR If wage? Assume manager has choice of two projects. H and L. H succeeds with prob 1/2 and earns 1; if fails earns -1 L succeeds with prob 3/4 and earns 0.5 ; if fails earns 0 0< 3/8 {the company prefers the safe project) But private return is α0.5 vs α 3/8 Manager picks the unsafe project.

7 Organization Each meeting around one or two readings Class begins with discussion minutes I may take over to go through something that needs clarification I will try to sum up; What we have learned; What we would like to know Last 15 minutes, lecture to frame reading for next time Responsibilities Yours Engage the material Read Write (very short essays; so you have something to say) discuss Reading on the web Lecture slides on the web Reading questions Find an issue to think through & Write a final paper. Mine Frame the issues Lead discussion Bring issues to a conclusion Read your work and provide feed back Page 7

8 Becht, Bolton, Roehl The paper seems very long but you do not need to print the 55 pages of bibliography Please focus on Sections 1 to 5(p 1-38) and Section 8 (65-75) Find questions on the questions page Identify Central problems in CG, Public vs Private solutions Then think through whether we have fixes or trade-offs? A fix solves a problem without making other things worse A trade-off means you reduce one problem and make another worse Page 8 Questions for BBR Identify Central problems in CG Public vs Private solutions Structure of Analysis Then think through whether we have fixes or trade-offs? A fix solves a problem without making other things worse A trade-off means you reduce one problem and make another worse