2. From BBR s point of view are problems of corporate governance problems of the market or problems of regulation. What do you think?

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1 BEM 185 meet 2 Becht Bolton Roell A primer for theory; A list of questions 1. What are the central problems of corporate governance, what do you think is the most important? Why? 2. From BBR s point of view are problems of corporate governance problems of the market or problems of regulation. What do you think? Page 1 Separation of ownership from control Agency problem Conflicts among stakeholders Social Choice problem Minority oppression Free rider problem Corporate governance Separation of ownership from control: Agency (Review) Definition Π=F(k,e)-(1+r )k C(e) {F assume concave (DMR)} k is supplied by investors, outside option is government bonds that have a return r e by the manager; outside option is leisure so effort has a cost C(e). Max Π set first partials to zero Π/ k=0 F(k,e)/ k=1+r Π/ e=0 F(k,e)/ e=c (e) That defines the first best. (what is efficient in the absence of any problem) But who chooses k and e? Agency review Manager--She wants to trade off efforts and the rewards to effort. Profits are thus no obviously in her objective function. U(y,e)=y(e) c(e); y is income e is effort Suppose manager gets a fixed wage then what? U(y,e)=w c(e); then effort is zero? Suppose that owners say that they want to earn at least r; if not then fire manager. Fix k. Now let e be the effort level such that Π=F(k,e)-(1+r )k w; that is what the manager chooses But that does not say that profits are maximized. Suppose that w is larger than the manager s outside option w and effort e Then she chooses between w c(e) and w -c(e ). That says nothing about whether

2 F(k,e)/ e>c (e). Second now suppose that manager chooses k. then she is likely to set k such that w c(e(k))=w -c(e ) and Π/ k=0 F(k,e)/ k=1+r; but that is still not optimatility. So we are going to have to work at it. Page 2 Possible solutions Central problem: align the firm s objectives and the manager s (shareholder) objectives. Π=F(k,e)-(1+r )k C(e) U m (y,e)=y(e) c(e); U(Π,y,k)=F(k,e)-(1+r )k y(e) F(k,e) is given by by technology, c(e) by the manager s personal preferences; r by the market. Fixed wage- no monitoring Fixed wage-monitoring on sales Fixed wage-monitoring on profits Pay for performance What else?

3 Strategic conflicts Definition: Solution : Edison vs J.P. Morgan Minority oppression Definition Conflicts among stakeholders Page 3 Solution Union Pacific and the central Pacific Free rider problem (Collective action) Returns as a public good Investment in good governance is a private cost. Insiders vs outsiders Solutions : Control (its in the political power associated with voting) A seductive idea that could fix all these problems why: Strategic conflicts Minority oppression Free rider problem (Collective action) From Control to the market for control, If the firm has bad (good) management V=V b <V g. So someone should have the incentive to buy the firm So someone should buy the firm, fire the managers and set the firm on the right course. To do so they buy a controlling stake S Idea: pay SV b invest c and realize SV g in returns. So market for control corrects problems Why might this idea wrong?

4 Obstacles to the market for control Firm may be too expensive relative to gains S to large or S(V g -V b )<c Financial structure may make it difficult to do so Banks or debt market do not fund takeovers Poison pills Articles of association make it difficult to contest control Management may be entrenched (staggered boards) Minority block holders may be able to veto changes Government may intervene Page 4 Block holders Over coming free ridding Assume many share holders each own α Each can invest c, to raise profits; by some amount ΔΠ When do you do it? c has to be les than αδπ. c and ΔΠ; are outside the scope of corporate governance. (given by say the technology and the legal environment) What can be chosen is α Block Holders (2) Where is the trade-off for the block holder More profits better So why not go all the way to sole owner? Where is the trade-off the investors More profits better What about collusion between manager and block holder. If the block holder is small If the block holder is large

5 Forward to next week Alchian & Demsetz Cai Incomplete Contracts and the structure of the firm Page 5 Contracts Remedy 1: Sole ownership Remedy 2: contracts So Theorists assume contracts are incomplete. Problems of information Observable Verifiable Situations were contracts simply cannot be executed Too costly to specify a full future, so something do not get planned Key idea If contracts are complete (and costless to enforce) Then we can solve any problem with a contract. Because we can tell any actor precisely what to do (and punish him\her if they do not follow the rules) Firms could be one workers, or all workers in the same firm would achieve efficiency If contracts are incomplete Division of labor between firms and markets matters How firms are organized also matters Theory of the firm What is a firm? Transaction costs What is the difference between a firm and a market? How big might a firm be? From Coase to A&D Coase assumes that the firm is essentially a sole proprietorship. Alchian and Demzets challenge this Why? Because between the 1950s and 1970s Partnerships essentially disappeared. So what is a corporation? What is a partnership? From A&D to Cai In A&D, the key issue is monitoring.

6 Effort Investment What happens if we think of a different problem. Two levels (Spinning and Weaving, Hardware and software) non contractible investment Does ownership structure matter? Because of its consequences for incentives coming from equity? Because of its consequences for control? Page 6 When the contract fails People have to renegotiate. Standard assumption, how they divide what is left over depends on their ownership stake. If you own nothing you get nothing That tells us where we will end up Now earlier people have to make non-contractible decisions. hard to work beyond basic work. How much to invest in relationship specific knowledge Problem They cant contract on that Owners will share the output by some formula How to Own, Who should own Joint Ownership/Partnership Popular before 1950 Newly Popular in high tech and other Joint Ventures Integration Vertical =>Popular in Manufacturing Horizontal => the mirage of the internet If so by whom?