Agency Problems and the Theory of the Firm

1. Agency Problems and the Theory of the Firm Eugene F. Fama The Journal of Political Economy (Apr.,1980) 892609 QF04 Hsu Wen Chu 892612 QF04 Chia Wen Ho 892619 QF04 Ming Tse Tsai

2. Introduction This paper attempt to explain how the separation of security owner ship and control, typical of large corporations can be an efficient form of economic organization. We first set aside the presumption that a corporation has owners in any meaningful sense. The two functions usually attributed to the entrepreneur – management and risk bearing – are treated as naturally separate factor within the set of contract called a firm.

3. The firm is disciplined by competition from other firms, which force the evolution of devices for efficiently monitoring the performance of the entire team and of its individual members. Individual participants in the firm, and in particular its managers, face both the discipline and opportunities provided by the markets for their services, both within and outside the firm.

4.  The Irrelevance of the Concept of Ownership of the Firm Management : A type of labor with special role decision making. Risk Bears : They may accept uncertain and possibly negative difference between total revenues and costs at the end of each production period.

5. We must dispel the tenacious notion that a firm is owned by its security holders is important because it is a first step toward understanding that control over a firm’s decision is not necessarily the province of security holders. The second step is setting aside the equally tenacious role in the firm usually attributed to the entrepreneur.

6.  Management and Risk Bearing • Alchian-Demsetz state : A firm is identified as contractual structure with : • Joint input production. • Several input owner. • One party who is common to all the contracts of the joint input. • Who has the right to renegotiate any input’s contract independently of contract with other input owner.

7. Who holds the residual claim. • Who has the right to sell his central contractual. • Risk bearers, as residual claimants, also seem to suffer the most direct consequence from the failings of the team.

8. Because of the managers’ power over the firm’s decision, their market determined opportunity wages are also likely to be most affected by market signals about the performance of the firm. If they are also in competition for the top places in the firm, they may be the informed and responsive critics of the firm’s performance.

9.  The Viability of Separation of Security Ownership and Control of the Firm The outside managerial labor market exert many direct pressures on the firm to sort and compensate managers according to performance. • on-going firm is always in the market for new managers • When the firm’s reward system is not responsive to performance the firm loses managers, and the best are least the first leave. • .

10. There is also much internal of managers by manager themselves. • Monitoring from higher to lower level managers. • Lower managers perceive that they can gain by stepping over shirking or less competent managers above them. • In short, each manager has a stake in the performance of the managers above and below him and, as a consequence, undertakes some amount of monitoring in both direction.

11. By what mechanism can top management be disciplined ? In order to monitor the manager, there will be a board dominated by security holder. Having gained control, top management may decide that collusion and expropriation of security holders wealth. So, the board must include outside director.

12. The Viability of Separation of Security Ownership and Control: Details

13. Examine more specifically conditions under which the discipline imposed by managerial labor markets can resolve incentive problems associated with the separation of security ownership and control of the firm. the manager is the firms sole security holder no incentive problems Because manager cannot avoid a full ex post settling up with himself as security holder.

14. The manager is no longer sole security holder: If the manager is in the absence of full ex post setting up for deviation. manager will consume more on the job or shirking Assessments of ex post deviations from contract will be incorporated into contracts on an ex ante basis, for example: adjustment of the manager’s wage

15. Three conditions suffice to make the wage revaluation a form of ex post setting up to resolve incentive problem 1. Manager’s talents and his tastes for consumption on the job changes through time. 2. Managerial labor markets use current and past information to revise future wage. 3. The weight of the wage revision process is sufficient to resolve any potential problems with managerial incentives.

16.  Example 1 : Marketable Human Capital Assumption 1. A manager’s human capital is a marketable asset. 2. Manager perceives that the value of his human capital changes by the amount of his deviation of contract. Why assumption 2?

17. Because a. Market’s assessment of human capital changes is also its assessment of the deviation of contract. b. Any assessment of the manager’s marginal product include noise. Information If market uses the information rationally the adjustment of manager’s wage will be complete

18. If there is some noise in the process the adjustment is not complete Other companies The ex post setting up need not involve the firm currently employment future wages may come from other firms

19. manager personal wealth Manager personal wealth may changes by 1.deviation from the contract 2.other factors Ex:prosperity But 1 is greater than 2

20.  Example 2: Stochastic Processes for Marginal Products We make specific assumptions about the stochastic evolution of a manager’s measured marginal product and about how the managerial labor market uses information from the process to adjust the manager’s future wages. Assumption 1. Manager’s measures marginal product for any period t is composed by: a. an expected value b. random noise

21. 2. The expected value of his marginal product is itself a stochastic process. 3.This process describes the manager’s marginal product both in: a. In his current employment b. In the best alternative employment manager’s measured marginal product manager’s expected marginal product random noise

22. Goal Set up the managerial labor market so that the wage revision process resolves any potential incentive problems. Assumption 1. risk bears are all risk neutral 2. 1-period market interest rate=0 3. manager’s wage = expected value of his marginal product

23. If manager is a risk averse manager he will like long-term wage contract moral hazard deviation of the ex ante contract Moral hazard & Adverse selection Ex:bicycle theft insurance

24. Muth (1960) The process by which future expected marginal products are adjusted on the basis of past deviations of marginal product from expected value. expected marginal product of t expected marginal product of t-1

25. if

26. The inversed form for our model (1) (2) replace in eq(1) by in eq (2) (3) By (1) replace in (3)

27. Repeat this process

28. Although he is paid his ex ante expected marginal product,the manager does not get to avoid his ex post marginal product. EX: _____ _____ ______ …

29. to infinite “t” is 1 The weight of

30. Meaning: With interest rate=0,the risk bearers allow the manager to smooth his marginal product across future period. Result: The manager has no incentive to try to bury shirking or consumption of perquisites in his ex post measured marginal product. Any potential marginal incentive problem problems will be resolved.

31. This contains an infinite number of terms, but manager might has a finite working life. Full ex post settling up is achieved as long as the manager’s current marginal product is very nearly fully absorbed by the stream of wages over his future working life.

32.  is far from 1.0   a fair wages

33. Some Extensions

34.  More Complicated Models for the Manager’s Marginal Product (1)The marginal product Zt and its expected value are expressed in inverted form in (2)The sum of the weight on past marginal products is exactly 1.0 (3)ARMA (mixed Autoregressive moving average)

35. (4)Stationary and nonstationary process

36. Risk-Averse Risk bears If the manager switches firms: manager -----------------> Firm A: The risk bearers are left with the remains of his measured marginal products not absorbed into the expected value of his marginal product.

37. Firm B: Next firm continues to set his wage according to the same stochastic process as the last firm. On average, the switching of managers among firms does not result in gains or losses to risk bears.

38.  Risk bearers are risk-neutral Manager  (1)will switch firmshirking set up the contract in the next firm  by the past performance < 0  wage revisionlower Manager  (2)will switch firmwork hard set up the contract in the next firm by the past performance > 0  wage revisionhigher

39. Manager  (3)not switch to the other firm shirkingwage revision at the end of every period  < 0  wage revisionlower Manager  (4)not switch to the other firm work hardwage revision at the end of every period > 0  wage revisionhigher (The switches are a matter of indifference to our presumed risk-neutral risk bearers.)

40.  Risk bearers are risk-averse 1. The risk bearers offer managers contract 2. The manager’s wage tracks the expected value of his marginal product 3. Each period there is fixed discount in the wage to compensate the risk bearers for the risk of unfinished ex post settling up( a possible future shift by the manager to another firm ) 4.Satisfy the risk bearers 5.It will not be acceptable to the manager.

41. 6. 7. Both in his current firm and in the best alternative, the manager is subject to full ex post settling up.

42. 8. Any risk adjustment of his wage is an uncompensated loss which he will endeavor to avoid. 9.The manager can avoid any risk discount in his wage, and maintain complete freedom to switch among firms. (a) I don’t want to accept discount in my wage. (b) I can shift to another one firm. (c) I don’t like ex ante expected value  There is uncertainty between manager and the risk bearers

43. 10. He contracts to accept, at the end of each period, his ex post measured marginal product rather than its ex ante expected value. 11. By himself bearing all the risk of his marginal product. 12. There is, period by period, full ex post settling up with his current firm. 13. optimal contracting

44. Contractual settling up

45. (1) When there is noise in the manager’s marginal product  when the deviation of measured marginal product from its expected value  cannot be traced unambiguously and costlessly to the manager’s action  a risk-reverse manager will share part of the uncertainty( the evaluation of his performance) with the firm’s risk bearers.  less than 100% of the deviation( of his measured marginal product from its ex ante expected value)  incentive problem

46. (2) 1-period  no enforcement through wage revision process multiperiod  ex post settling up exist

47. Deviation contains information about future expected values of his marginal product 反應對未來的期望值,期末才知道  The current marginal product will contribute to the expected future marginal products.

48.  Smoothing through the capital market The manager might simply contract to take the ex post measured value of his marginal product His wage and then himself use the capital market to smooth his measured marginal product over future periods.

49. Advantage He can contract to accept full ex post settling up  avoid any risk discount in his wage

50. Manager use the capital market • average out the random noise in his measured marginal product • the manager’s current measured marginal product is eventually allocated in full to future expected marginal product • when the current marginal product has information about future expected marginal product • resolve incentive problem by imposing full ex post settling up