CORPORATIONS - ORGANIZATION November 14, 2006

1. CORPORATIONS - ORGANIZATIONNovember 14, 2006

2. Market Environment BUSINESS ASSOCIATIONS

3. BUSINESS ASSOCIATIONSRational Behaviour – Shephard's Lemma Set of Cost Minimizers Set of Profit Maximizers

4. 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

5. BUSINESS ASSOCIATIONS Monopolies Decreasing Costs and Increasing Returns To Scale • Monopoly Firm - SR-LR ATC PROFIT MC

6. BUSINESS ASSOCIATIONS Monopolies Constant Cost – Constant Returns To Scale • Monopoly Firm - SR-LR PROFIT ATC = MC FC = 0

7. Structure BUSINESS ASSOCIATIONS

8. 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

9. 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.

10. 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

11. 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

12. Structure Sole Proprietorship BUSINESS ASSOCIATIONS

13. 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)

14. 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

15. BUSINESS ASSOCIATIONSSole Proprietorship U(V) Principal (buyer) contracts a “complete” contract with the Agent (seller) Contract Equilibrium Point E V=Value

16. 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

17. 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

18. 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

19. 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

20. 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

21. BUSINESS ASSOCIATIONSSole Proprietorship • V Vs E Us Fs F

22. BUSINESS ASSOCIATIONSSole Proprietorship • V Vs E V = E V = kE V = Wealth E = Effort Es E

23. Structure Partnership BUSINESS ASSOCIATIONS

24. BUSINESS ASSOCIATIONSPartnership • Coalition – Partnership • The Partnership Game • Connection with Prisoners Dilemna

25. BUSINESS ASSOCIATIONSPartnership • V Vs E V = kE V = Wealth E = Effort Es E

26. 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

27. 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

28. BUSINESS ASSOCIATIONSPartnership • What could offset the partnership Nash equilibrium to make it more Pareto optimal?

29. Structure Corporations BUSINESS ASSOCIATIONS

30. 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?

31. 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

32. 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)

33. BUSINESS ASSOCIATIONSCorporation • 1800’s - Restoration of limited liability to select sectors • Canals • Banks • Railways • Public companies

34. BUSINESS ASSOCIATIONSCorporation • 1929 – 1935 – Crash and Roosevelt • Securities Exchange Commission – Insider Trading • Glass-Steagall Act – Separate Financial Markets • Chapter 11 Protection For Viable Companies

35. BUSINESS ASSOCIATIONSCorporation • 1975 – 2006 – Era of Deregulation • Convergence of Financial Markets • More restrictions on insider trading • Expansion of Chapter 11 proceedings

36. 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

37. BUSINESS ASSOCIATIONSCorporation • Corporation • Shareholders • Directors • Officers • Managers • Employees

38. 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

39. 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.

40. 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

41. 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.

42. 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.

43. 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

44. 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

45. BUSINESS ASSOCIATIONSCorporation – Agency Costs • V Vs E Us Fs F

46. Structure Corporations Non-Shareholder Manager BUSINESS ASSOCIATIONS

47. BUSINESS ASSOCIATIONSCorporation – Agency Costs Principal (Shareholders) AGENT (Manager)

48. 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.

49. 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.

50. 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.