Econ 106I (Galles) – Lecture 5 (February 9^th, 2005)

4 questions: 3-4 parts each

Bring bluebook. 1.5 hours for the test.

Questions 1-60. Up to Jensen and Meckling.

Alchian, Chapter 3

Team production – leads to shirking

Profit-sharing firms – worse incentives for the monitor – more shirking.

Why are they limited in size? The free-rider problem becomes enormous as number of partners increases.

Why do they consist of people you already know? You already know that they won’t shirk.

Pilgrims had to be beaten to get them to work.

Economies of team production were low and huge monitoring issues.

(p. 93) Socialist firms

What would happen if corporations were illegal?

There will be productivity issues

Partnerships are the closest to the corporate firm

But these do not have specialist monitors

Yugoslavian firms – the workers had committee power to fire monitor.

Substitute mechanism to solve problems that corporations solve.

Unions here see this power in Yugoslavia and say, “Why can’t we fire our bosses?” Different incentive issues

Privatizations – 51% owned by existing workers. 49% sold. Why do these not work well? The workers would always vote for higher wages instead of profits.

India – Coke was offered 49% of Coca-Cola India in exchange for its secret recipe. Coca-Cola refused.

Why did Yugoslavian firms not invest as much as they should?

People could not resell their stock.

(p. 95) Corporation issues – limited liability is needed for existence.

Why would corporating be bad if there was no limited liability?

What is your downside risk if you are a millionaire?

Jensen and Meckling will talk about corporate risk

Bondholders bear bankruptcy risk.

Resellable shares are extremely important

They allow for takeover markets

There are major differences between for-profit and non-profit firms

(p. 96) Takeovers are a monitoring mechanism

Capitaliztion – When I make a decision that pays off in 30 years, I can only capture it if I have resellable shares.

Poison pill – takeover defense that does not require stockholder approval

In the event of a hostile takeover, let people who already have shares buy one at half price – makes it not worth it to take over.

Restrictions on takeover market

Biggest error is failure to recognize certain forms of capitalization

Short-run versus long-run profits. People do not maximize short-run profits

Short-run issues are dominated by capitalization.

Burn-out – big problem for non-profit organizations

If you do a good job, they ask you to do more and they don’t pay you more. Then you get burned out.

(p. 99-100) Employee unions

Alchian’s efficiency argument for unions

Employee hired specialist monitor

But unions are not owned – no one is watching the union

What if someone owned the union? Incentives become more aligned

Nepotism – “I will moderate my wage demands so that my kids can join the unions” – made people act as if they owned the unions

Government outlawed nepotism – then there were much more wage demands

Two-tiered contracts – what if they do not care about the next generation?

Company unions versus American unions

Company unions cannot strike – paid for by the firm to monitor the managers at a lower cost

Why are company unions illegal in America? American unions can rip off people and want to protect their interests

Team spirit and loyalty – hard to fake

Daimler-Chrysler – risk-takers and very risk-averse firms merged together

American-style picnic to get across team spirit

Told people to eat corn on the cobb, but in Germany, this was animal food

(p 102) User cost problem

What kind of capital should be owned by who?

Firm tends to own large equipment to prove that they will be able to pay workers

Labor unios could not do the role of the capitalists, since they don’t have the capital to back-up their promises

(p. 103) You can use my capital because I can detect the damange you cause to it – firm will own

If I cannot see the damage, you should own it.

Rental works for diamond blade saws, because they can measure how much you use. In addition, you cannot abuse it.

Two identical homes right next to each other

One inhabited by renters, one inhabited by owner

The one inhabited by owner has less hidden damage

Because this cannot be measured well, it is capitalized in the lower price of resale.

Truck drivers slack off when paid by the hour – as a result, they don’t get paid very much

If they get paid by the trip, they drive fast and dangerously – increases wear and tear to the truck.

Sollution to this – drive your own truck

New problem – costs more to finance these trucks

Penske put GPS in trucks to monitor workers to reduce bad incentives

Penske owns most of its trucks.

Sharecropping (p. 105) – Thought of as an abusive problem.

Solves user-cost problems – you have incentive to take care of property – risk sharing agreement.

Superior internal labor, capital, and idea market (p. 109)

I don’t get good information from you at an interview

The information I have about my employees is much more accurate – superior internal labor markets.

In a homogeneous labor model, this problem is ignored.

The executive secretary knows all the details – when she quits, things go bad.

Superior internal idea market

If I go to a banker to get a loan, I withhold information so the banker doesn’t steal the idea – more risk for both of us.

How do we decrease this withholding?

Hire the person. Less incentives to let the owner rip off the worker.

Capital markets – more effective at evaluating the quality of investments.

Superior internal markets – economies of scale here. Need corporate form here. Extension of Coase’s idea.

Firm can be considered a privately owned market – someone has incentive to create it.

Alchian, chapter 9: Original title: “Words, Musical or Meaningful?”

(p. 229) “Separation of ownership and control” is a meaningless phrase.

“Separation of ownership and control” notion is just one of many issues

Short-run gains offset by long-run losses

Capitalization issues are most important

(p. 229) Competition is said to be so restricted by corporations’ market power. View them like evil monopolies

Burle and Means (written in 1928 – not exactly a good time for the economy)

Even if most owners are small, if any owners are large, there is incentive for them to monitor.

Big institutional pension funds are the best monitors.

What if managers are substantial owners? Good incentives.

How do they count stock options? They are not counted, but they should be. Now it appears that managers own quite a bit more.

(p. 230) What is a useful meaning of “separation of ownership and control?” “Revoke and reassign already delegated responsibilities” is the key phrase.

Even if this weird behavior is true, the managers cannot harm the owners, because the behavior has already been capitalized.

Ultimately, you can only change the form of your compensation.

Harder to reassign authority.

1) To throw out the bums, you have to inform people

Higher costs of throwing people out

2) Once you are informed, if you are a small stockholder, you won’t even do anything.

These are some disadvantages of large corporations.

Offsetting advantages of the large corporate form.

1) Internal market (biggest advantage)

2) Greater number of owners implies greater variety of owners.

People are watching with more knowledge

3) Specialization of knowledge within the firm

Speicalized managers

Raising rivals’ costs – Mobil example

Large firms will accept tighter regulations

(p. 231) Naïve cartel theory – Just because you would like to collude doesn’t mean you can. Two capitalization issues

Why did Alchian work hard at UCLA? Not to impress UCLA, but to impress other universities, so he could get job offers and ask UCLA for more money.

Know up to page 232 for the midterm.

Good luck!