Firm Ownership & Governance: Maximizing Profit and Long-Term Success

1. Chapter 7 Firm Organization and Market Structure

2. Table of Contents • 7.1 Ownership & Governance of Firms • 7.2 Profit Maximization • 7.3 Owner’s vs. Manager’s Objectives • 7.4 The Make or Buy Decision • 7.5 Market Structure

3. Introduction • Managerial Problem • Many managers who receive an annual bonus based on the firm’s performance this year may take actions that increase the firm’s profit this year but reduce profits in future years. • Does evaluating a manager’s performance over a longer time period lead to better management? • Solution Approach • Owners have to decide what objectives the firm should pursue, and they need to structure incentives to induce managers to pursue these objectives. In addition, managers need to decide which stages of production the firm should perform and which to leave to others. • Empirical Methods • Ownership and governance of firms affect the firm’s objectives. • The owner-manager relationship is one of principal-agent relationship where the principal delegates tasks to an agent. This delegation creates a transaction cost called an agency cost and many features of the firm’s organization try to minimize it. • In the pursuit of their main goal, such as maximizing profit, owners and managers must make decisions about the nature of the firm, such as the make or buy decision. Market structures affect such a decision.

4. 7.1 Ownership & Governance of Firms • Private, Pubic and Non-Profit: The Private Sector • Consists of firms that are owned by individuals or other non-governmental entities and whose owners may earn a profit • Examples are Apple, Heinz, and Toyota. In almost every country, this sector provides most of that country’s gross domestic product (75% of GDPUSA). • Private, Pubic and Non-Profit: The Public Sector • Consists of firms and other organizations that are owned by governments or government agencies, called state-owned enterprises • Examples are the armed forces, the court system, most schools, colleges, universities, and Amtrak. This sector may be small or large (12% of GDPUSA). • Private, Pubic and Non-Profit:The Non-Profit Sector • Consists of organizations that are neither government-owned nor intended to earn a profit, but typically pursue social or public interest objectives (non-government, not-for-profit sector) • Examples include Greenpeace, Alcoholics Anonymous, the Salvation Army, and other charitable, educational, health, and religious organizations.

5. 7.1 Ownership & Governance of Firms • Ownership of For-Profit Firms: Sole Proprietorships • Firms owned and controlled by a single individual • Ownership of For-Profit Firms: Partnerships • Businesses jointly owned and controlled by two or more people operating under a partnership agreement. • Ownership of For-Profit Firms: Corporations • Firms owned by shareholders, who own the firm’s shares or stocks. • Each share is a unit of ownership in the firm. Therefore, shareholders own the firm in proportion to the number of shares they hold. • Shareholders elect a board of directors to represent them. In turn, the board of directors usually hires managers who manage the firm’s operations. • The legal name of a corporation often includes the term Incorporated (Inc.) or Limited (Ltd) to indicate its corporate status.

6. 7.1 Ownership & Governance of Firms • Publicly Traded Corporation • Corporations whose shares can be readily bought and sold by the general public • Stocks may be available at the New York Stock Exchange, the NASDAQ, the Tokyo Stock Exchange, the Toronto Stock Exchange, or the London Stock Exchange. • Closely Held Corporation • Shares not available for purchase or sale on an organized exchange. • Typically its stock is owned by a small group of individuals (private equity). • From Publicly Traded to Closely Held Corporation • To make the transition the closely held firm makes an initial public offering (IPO) of its shares on an organized stock exchange. • One major advantage of going public is to raise money. However, a major disadvantage is that ownership of the firm becomes broadly distributed, possibly causing the original owners to lose control of the firm. • It is also possible for a publicly traded firm to go private and convert to closely held status. Examples are Toys-R-Us and Burger King

7. Liability and Ownership Owners of a corporation are not personally liable for the firm’s debts; they have limited liability: The personal assets of the corporate owners cannot be taken to pay a corporation’s debts even if it goes into bankruptcy. Traditionally, the owners of sole proprietorships and partnerships were fully liable, individually and collectively, for any debts of the firm. Now they can be a limited liability company (LLC). The precise regulations that apply to LLCs vary from country to country and from state to state within the United States. Firm Size and Ownership Most large firms are corporations. According to the U.S. Statistical Abstract 2012, U.S. corporations are only 18% of all nonfarm firms but make 81% of sales revenue and 58% of net income. Nonfarm sole proprietorships are 72% of firms but make only 4% of the sales revenue and earn 15% of net income. Corporations that earn over $50 million are less than 1% of all corporations, but they make 77% of revenue. 7.1 Ownership & Governance of Firms

8. 7.1 Ownership & Governance of Firms • Firm Governance: Small Firms • In a small private sector firm with a single owner-manager, the governance of the firm is straightforward: the owner-manager makes the important decisions for the firm. • Firm Governance: Publicly Traded Corporation • The shareholders own the corporation. However, most of them play no meaningful role in day-to-day decision-making or even in long range planning. • Shareholders elect a board of directors and delegate many of their ownership rights to them. • The board of a large publicly traded corporation normally includes outside directors and inside directors, such as the chief executive officer (CEO) of the corporation and other senior executives.

9. 7.2 Profit Maximization • Revenue (R)is price times quantity. • Cost(C), the correct measure is the opportunity cost: the value of the best alternative use of any input the firm employs. The full opportunity cost of inputs used might exceed the explicit or out-of-pocket costs recorded in financial accounting statements. • Profit (π) is Revenue minus Cost. If π < 0, the firm makes a loss. • To add profits over time calculate the present value, in which future profits are discounted using the interest rate.

10. Two Steps to Maximize Profit: π (q) = R (q) – C (q) Profit varies with the level of output because both revenue and cost vary with output. There are two key decisions to maximize profit. First Step: Output Decision What is the output level, q, that maximizes profit or minimizes loss? Second Step: Shutdown Decision Is it more profitable to produce q or to shut down and produce no output? 7.2 Profit Maximization

11. 7.2 Profit Maximization • Rule 1: Set output where profit is maximized • If the firm knows its entire profit curve (Figure 7.1), it sets output at q*to get π*. • Rule 2: Set output where Mπ = 0 • Marginal profit , p/∆q, where ∆q = 1, is the slope of the profit curve. The maximum profit occurs where the slope is zero. • Rule 3: Set output where MR(q)=MC(q) • Marginal Profit = MR - MC. The extra income raises profit but the extra cost reduces profit. Maximum profit occurs at MR(q) = MC(q). • Using calculus: dπ (q)/dq = dR (q)/dq – dC (q)/dq = 0; MR(q)=MC(q)

12. 7.2 Profit Maximization Figure 7.1 Maximizing Profit

13. 7.2 Profit Maximization • Shutdown Rules • Should the firm shut down if its profit is negative? It depends • Shutdown Rule 1: Shut down only if loss is reduced • This rule applies to the short run and long run alike. • Shutdown Rule 2: Shut down only if revenue < avoidable cost • In the short run, variable costs are avoidable but fixed costs are unavoidable (sunk costs). • As long as revenue covers variable costs and some fixed costs, no shut down occurs. • In the long run all costs are avoidable; shutting down eliminates all costs.

14. 7.2 Profit Maximization • Profit Over Time • Firms maximize profit not only for the current period. They are normally interested in maximizing profit over many periods. • The difference between maximizing the current period’s profit and long-run profit is important in some situations. • Present Value: PV = FV / (1+i)t • Compound Interest Rate: $100 today (PV) at a 10% interest rate has a future value (FV) of $110 in one year, and $121 in two years. In general FV = PV (1+i)t, where t is the number of years. • Money in the future is worth less than money today: $100 in one year is less than $100 today. In general, PV = FV / (1+i)t • Shareholders of a firm may value a stream of profits over time by calculating the present value, in which future profits are discounted using the interest rate (see Appendix 7 for more detail).

15. 7.3 Owners’ vs. Managers’ Objectives • Consistent Objectives: Principal-Agent Problem • Owners (principal) delegate tasks to managers and other workers (agent) in most firms. • If the principal wants to maximize profit and agents want to maximize their own incomes or perks the resulting profit is not the maximum (agency cost). • Consistent Objectives: Contingent Rewards • To make the owner and manager objectives more closely aligned, many firms use contingent rewards: higher pay if the firm does well. • A year-end bonus based on the performance of the firm or a group of workers within the firm • A stock option or the right to buy a certain number of the firm’s shares at a pre-specified exercise price withina specified time

16. 7.3 Owners’ vs. Managers’ Objectives • Consistent Objectives: Profit Sharing • If profit is easily observed and the owner and manager want to maximize their own earnings, pay the manager a share of the firm’s profit. • Graph Application • In Figure 7.2, the manager (agent) earns 1/3 of the joint profit, shareholders (principals) get 2/3. The output level, q*, maximizes both shares. No conflict. • By 2005 over 70% of firms provided annual stock options to their top three executives, compared to virtually none in 1950 and about 50% in 1970. • 75% of total compensation of a chief executive at S&P 500 firms came from incentives in 2009.

17. 7.3 Owners’ vs. Managers’ Objectives Figure 7.2 Profit Sharing

18. 7.3 Owners’ vs. Managers’ Objectives • Conflictive Objectives: Revenue Objectives • Sometimes profit can be manipulated by owners or managers. So profit sharing is not possible. • Revenue sharing: executive compensation is primarily determined by the firm’s revenue. But, managers prefer to maximize revenue rather than profit. • Graph Application • In Figure 7.3, the manager is paid a share of revenue. It is best for the manager to set output at q = 5, where revenue is 25 and profit just 5. The output that maximizes profit, q = 3, where profit is 9 and revenue is 21, is not chosen.

19. 7.3 Owners’ vs. Managers’ Objectives Figure 7.3 Revenue Maximization

20. 7.3 Owners’ vs. Managers’ Objectives • Conflicting Objectives: Personal Effort and Earnings • A manager who receives a fixed salary or a compensation not tied to performance and who values leisure may not work hard to maximize profit. • If a board insists on a profit target, a manager may only satisfice it. • Conflicting Objectives: Social Objectives • Corporations often make large contributions to hospitals, universities, environmental projects, disadvantaged groups, or other causes. Are these managers pursuing social policy with shareholders’ money? • Conflicting Objectives: Perks • Some perks save a manager’s time and increase productivity. However, some managers unilaterally grant themselves perks with little or no tangible advantage to the firm. If the firm reduces the manager’s salary by the cost of such benefits, then these benefits do not harm the firm’s bottom line.

21. 7.3 Owners’ vs. Managers’ Objectives • Monitoring & Controlling Manager’s Actions: Direct Monitoring • If the owner and manager work side by side, monitoring the manager is easy. • However, most of the time the owner cannot observe the actions of the manager; profit is subject to uncertainty; and parties cannot write an enforceable contract. • Monitoring & Controlling Manager’s Actions: Indirect Monitoring • Board and Managers: Senior executives are restricted in their ability to carry out activities outside the firm (disclosure conflict of interest) • Shareholders and Board: rules may require to have outside directors; nature and frequency of elections. But, difficult to specify or legally enforce what constitutes appropriate effort for board members. • Say-on-Pay (SOP), the Dodd–Frank Wall Street Reform, and Consumer Protection Act of 2010: shareholders vote periodically on compensation going to senior executives.

22. 7.3 Owners’ vs. Managers’ Objectives • Takeovers & the Market for Corporate Control • Managers can be disciplined through the market for corporate control: outside investors buy enough shares to take over control of an under-performing publicly traded firm. • Poison Pill Defense • Firms can defend with a shareholder rights plan (poison pill) in the United States. • Poison pills may not prevent a takeover, but usually benefits the original managers or board of directors to induce them not to further fight the takeover.

23. 7.4 The Make or Buy Decision • Horizontal and Vertical Dimensions • Managers make decisions that affect the structure of the firm in two dimensions • Horizontal dimension: size of the firm in its primary market • Vertical dimension: stages of the production process in which the firm participates • Supply Chain Management • To produce and sell a good involves many sequential stages of production, marketing, and distribution activities. • A manager decides how many stages the firm will undertake itself • Also, at each stage, whether to carry out the activity within the firm or to pay for it to be done by others.

24. Figure 7.4 Vertical Organization Stages of Production Figure 7.4 illustrates the sequential or vertical stages of a relatively simple production process (such as bread). At the top of the figure, in the upstream, firms use raw inputs (such as wheat) to produce semi-processed materials (such as flour). Then, in the downstream, the same or other firms use the semi-processed materials and labor to produce the final good (such as bread), q = f(M, L). In the last stage, the final consumers buy the product. 7.4 The Make or Buy Decision

25. 7.4 The Make or Buy Decision • Vertical Integration • A firm that participates in more than one successive stage of the production or distribution of goods or services is vertically integrated. • A firm may vertically integrate backward and produce its own inputs, or forward and buy its former customer. • A firm can be partially vertically integrated. It may produce a good but rely on others to market it. Or it may produce some inputs itself and buy others from the market. • Some firms buy from a small number of suppliers or sell through a small number of distributors. These firms often control the actions of the firms with whom they deal by writing contractual vertical restraints that create quasi-vertical integration (franchisor and franchisee).

26. 7.4 The Make or Buy Decision • Vertical Integration is Relative • All firms are vertically integrated to some degree. • At one extreme, we have firms that perform only one major task and rely on markets and outsourcing for all others. For example, a computer retailer. • At the other extreme, we have firms that perform most stages of the production process. For instance, Foster Farms. • However, no firm is completely integrated: It would have to run the entire economy. As Carl Sagan observed, “If you want to make an apple pie from scratch, you must first create the universe.”

27. 7.4 The Make or Buy Decision • Profitability & Supply Chain Decisions • Firms decide whether to vertically integrate, quasi-vertically integrate, or buy goods and services from markets or other firms depending on which approach is the most profitable. • Key Considerations for Profitable Vertical Integration • First, the firm has to take into account all relevant costs including some that are not easy to quantify such as transaction costs. • Second, the firm must ensure a secure and flexible supply of needed inputs to its production process. • Third, the firm may vertically integrate even if doing so raises its cost of doing business so as to avoid government regulations.

28. 7.4 The Make or Buy Decision • Reducing Transaction Costs • Probably the most important reason to integrate is to reduce transaction costs, especially the costs of writing and enforcing contracts. • A manufacturing firm may decide to vertically integrate forward (downstream) into distribution if the expense from trying to prevent opportunistic behavior by these firms is high. • Opportunistic behavior is particularly likely when a firm deals with only one other firm: a classic principal-agent problem. • Another potential source of transaction costs is a need for coordination. American Apparel felt coordination costs were high enough to justify vertical integration.

29. 7.4 The Make or Buy Decision • Security and Flexibility of Inputs • A common reason for vertical integration is to ensure supply of important inputs. • Having inputs available on a timely basis is very important. Costs would skyrocket if a car manufacturer had to stop assembling cars while waiting for a part. Backward (upstream) integration to produce the part itself may help to ensure timely arrival of parts. • Alternatively, this problem may be eliminated through quasi-vertical integration contracts (reward prompt delivery, penalize delays), or just-in-time systems. • It is also important to be able to vary production quickly. A firm may want to cut output during a recession, and reduce its use of essential inputs. By vertically integrating, firms may gain greater flexibility.

30. 7.4 The Make or Buy Decision • Avoiding Government Regulation • Firms may also vertically integrate to avoid government price controls, taxes, and regulations. • A vertically integrated firm avoids price controls by selling to itself. For example, steel buyers bought steel producers that didn’t want to sell as much as before the U.S. government price controls. • More commonly, firms integrate to lower their taxes. Tax rates vary by country, state, and type of product. A vertically integrated firm can shift profit from a high-tax country/state to a low-tax country/state by changing its transfer price between the firm’s divisions.

31. If there is relatively little demand for a product at current prices, the entire industry is small, each firm produces all successive steps of the production process. All firms are vertically integrated. As the market and the industry grows, firms vertically disintegrate. Each firm buys services or products from specialized firms. As an industry matures further, new products often develop and reduce much of the demand for the original product. The industry shrinks in size. Firms vertically integrate again. 7.4 The Make or Buy Decision Market Size & Life Cycle of a Firm

32. More to Consider for Vertical Integration When making horizontal and vertical decisions, managers need to consider the behavior of actual and potential rival firms. Profit may be affected by the output and price levels of rivals, as well as the entrance of new firms into the market. The Four Main Market Structures The behavior of firms depends on market structure: the number of firms in the market, the ease with which firms can enter and leave the market, and the ability of firms to differentiate their products from those of their rivals. The four main market structures are perfect competition, monopoly, oligopoly and monopolistic competition. Their main characteristics are in Table 7.2. 7.5 Market Structure

33. 7.5 Market Structure Table 7.2 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Perfect Competition

34. Managerial Solution • Managerial Problem • Does evaluating a manager’s performance over a longer time period lead to better management? • Solution • The answer depends on whether the reward induces the manager to sacrifice long-run profit for short-run gains. • If the reward is based on a single year firm’s performance, most likely it is a bad incentive. It may induce to increase profit that year in detriment of future profits. • Paying over time gives a better incentive structure: bonuses based on more than one year or bonuses clawed back to performance in subsequent years.

35. Table 7.1 Some Takeover Defense Terms