Transcript
9th Tutorial
Alternative Theories of the Firm
Solutions
True or False
1. In agency terms, shareholders are principals and managers are agents. True. Principles employ agents to undertake work on their behalf; and shareholders employ managers to undertake the running of the company on their behalf. See section 8.1 of Begg and Ward. True/False
2. The separation of ownership from control can lead to the generation of agency costs. True. Agency costs occur when the actions of the agent deviate from what would be considered optimal by the principal. For example, a manager using the company’s money to buy a new car would represent an agency cost. See section 8.1 of Begg and Ward. True/False
3. “Satisficing” is the attainment of minimum levels of performance. True. “Satisficing” is the attainment of acceptable levels of performance whereas maximising is the attainment of the maximum levels of performance. See section 8.2 of Begg and Ward. True/False
4. Agency costs are the wages associated with employing an agent. True. Agency costs are the broader costs associated with employing an agent, which include the costs of inappropriate decisions/behaviour by the agent and the costs of monitoring the agent. See section 8.1 of Begg and Ward. True/False
Question 1
Assess whether, or not firms, are profit maximizers.
Students should be aware that the traditional profit maximising theories of the firm have been criticised for being unrealistic. The criticism are mainly of two sorts (1) that firms wish to maximise profits but for some reasons are unable to do so (2) firms have aims other than profit maximisation. In order to maximise profits firms need to set MC=MR. Even though professional accounts are also schooled to this idea it is very difficult to collect data on MC and MR, especially when it comes to firms which sell and make multiple products and services. Moreover, input and output prices are likely not to be very stable which will lead to constant changes in MC and MR. Taking this into consideration firms in reality can at best only approximate profit maximisation, but can never be fully sure what is the optimal level of profits.
Aside from these practical problems there are other reasons why a firm might be pursuing other objectives than profit maximisation. The traditional theory of the firm assumes that it is the owners of the firm that make price and output decisions. It is however reasonable to assume that owners want to maximise profits, but the question is do owners in fact make the decisions? In reality owners and managers are often different in person and pursue different motives, which lead to agency problems. It can hence be assumed that managers may want to maximise their own utility, which may well involve pursuits that conflict with profit maximisation. Managers may, for example, want to pursue higher salaries, greater power, or prestige, greater sales … Managers will have to assure that sufficient profits are made to keep the owners happy. Alternative theories of the firm to those of profit maximisation therefore tend to assume that firms are profit satisficers. Profit satisficing occurs where decision makers (managers) in a firm aim for a target level of profit rather than the absolute maximum level. Alternative theories include:
Long run profit maximisation – An alternative theory, which assumes that managers aim to shift costs and revenue curves so as to maximise profits over some longer time period.
Managerial utility maximisation (Williamson, 1964) – An alternative theory that assumes that managers are motivated by self-interest. They will adopt whatever policies are perceived to maximise their own utility. E.g. big cars, expense accounts, more staff.
Sales revenue maximisation (Baumol, 1958) - An alternative theory of the firm that assumes that managers aim to maximise the firms short run total revenue. Mangers maximise sales because they are readily measurable and comparable across divisions and firms. However, as they maximise sales they sacrifice profits.
Growth maximisation - An alternative theory of the firm that assumes that managers seek to maximise the growth in sales revenue or the capital value of the firm over time.
Question 2
Explain what is understood by the principal-agent theory and agency costs.
Need to discuss the principal-agent problem. An agency relationship is a contract under which one or more persons (principal) engage another person (agent) to perform some services on their behalf, which involves giving some decision-making authority to the agent. If both parties in the relationship are utility maximisers there is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergence from this interest by establishing appropriate incentives for the agent (e.g. performance related pay such as shares, options, or cash) and by incurring monitoring costs to limit the aberrant activities of the agent, hence control him. The costs associated with the principal agent problems are also referred to as agency costs.
Provide examples of reward schemes that can be used to align agents and principal interests. Discuss the advantages and disadvantages of each of them.
How can companies align the interests of agents and principals and hence overcome the principal-agent conflict? When the output is easy to verify, managers can be paid according to the output produced. So, for example, packers are paid according to the number of boxes that have been filled. However, when it comes to managers and many other occupations it is more difficult to verify output as outputs are numerous, varied and difficult to quantify. Reward schemes that can be used by companies instead include perks (more expensive car, bigger office etc.), cash payments, shares etc. See the table below.
Cash Shares
Usually annual bonus plan. Tends to emphasis on short-term performance and hence improves agent-principle problem in the short run.
Good if the company is in a mature market-can be certain what the financial reward will be.
Usually uses accounting indicators as performance criteria. Links managerial rewards to past performance and generates no further commitment on the part of the manager since the present cash bonus is not affected how well the company is doing in the future.
Related to long-term performance plans, foster longer decision horizon among managers. They are likely to select strategies with long-term payoffs.
Managers are less likely to be penalised for short-term fluctuations over which they have little control.
Reduces agent principle problem as managers become shareholders, i.e. binds them to the company, as they become owners, and hence are likely to act in the company’s best interest.
More risky in terms that the values of the reward may decrease due to market developments.
Question 3
a) Explain what a moral hazard problem is.
Moral hazard occurs when someone agrees to undertake a certain set of actions but then, once a contractual arrangement has been agreed, behaves in a different manner.
b) Provide one example of economic situation where a moral hazard problem can arise.
One example is that of financial bail-outs of lending institutions by governments, central banks or other institutions. These can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.
c) Describe how a firm can correct a moral hazard problem.
In order to reduce agency costs, principals have to develop contracts that align agents’ interests with their own. “Payment according to performance” is forcing the agent to work hard to receive greater pay. A more complicated example is the use of stock options in the financial packages offered to senior managers of leading companies.
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