Econ 106I (Galles) – Lecture 7 (February 23^rd, 2005)

Alchian Chapter 9

(p. 233) Weaknesses and the New Corporate Economy

“Profits go to those who bear risk AND make innovative decisions”

This holds when the owners are managers

Not true when you look at corporations. Owners (risk bearers) get profits

It no longer goes to those who make innovative decisions.

(p. 234) Burle and Means say that since profit doesn’t go to managers, they don’t have proper incentives

Alchian rebuts this with the architect example

Good work is rewarded in the future in the form of higher salary or by eventually becoming an owner

Discriminated-against groups often work for themselves

What should union members get in good times? They say “In good times, treat me like an owner. In bad times, don’t treat me like an owner.”

Windfall profit tax on oil – 95% of profit due to rising oil prices was taxed away. “You didn’t earn them.” But there is no “windfall profit subsidy”!

(p. 236) Separation of ownership and control do not take capitalization into account

(p. 237) Resolution between his view and separation of ownership and control lies in:

1. Blaming corporate form for problems arising from taxation

Why would you lease suits in the great depression? It was because of weird incentives from taxation

People would live better at work than at home because it is cheaper to do so

2. Corporations are advantageous in other dimensions. Therefore, corporate form might be optimal. Agency cost is unavoidable

(p. 238) Pecuniary salaries will be lower but not because stockholders are activists but because there is competition to become a manager.

It is suficient that one side of the market knows that something will happen. It will then be capitalized.

(p. 241-243) Superior internal labor and capital market.

Creates wealth at the cost of becoming a corporation

(p. 244) Just because separation of ownership and control is incorrect does not mean traditional economics is correct.

Wealth-maximization is not the same as utility maximization for workers. It is the same for the owner of the capital.

Vacations are not inefficient for managers who bear entire cost and receive entire benefit

What if something made vacations artificially cheap? Then there is an inefficiency

Non-profits are the key here. No one has incentives to prvent you from vacationing.

How many margins are eliminated by non-profits and no resellable shares?

No takeover market. Less monitoring from the outside

No bonuses in terms of stock options

This occurs anywhere where firms act like non-profit firms

Regulated monopolies

Not going to act like for-profit at the margin

**Diagram**

There is 24M to “waste” – it is cheaper to discriminate, so there will be more discrimination

You will take the 24M in on-the-job utility

More unions in regulated utilities because the owners will give in to demands

It is not waste for the owners, because they wouldn’t get to keep it anyway.

What happens if things turn bad for regulated utilities? If they drop below the profit cap, the owners start acting like owners.

“Large firms are more likely to discriminate” – They only had the data on regulated utilities which are non-profit at the margin.

Alchian says that the best thing to do here is to get the government OUT, not in.

(p. 245) The way to improve economics is to better identify the relevant incentive stories. Property rights determine incentives which determine behavior

(p. 248-249) California aqueduct was not about moving water. It was about establishing property rights to future water.

Story about alfalfa (water intensive crop) production in the middle of the desert.

By law, you couldn’t capture the property rights of the rainforest unless you cut down the trees.

After a year or two, the land is infertile because of the excess rain. Then only grass can grow. Afterwards, cattle ranchers move in

People blame the cattle ranchers for deforestation, even though it is not their fault.

Minorities benefit from being left alone. Once you change incentives, you create more margins at which there is non-profit

Sometimes it is possible to diver “waste” to places where profits can be captured. This leads to more efficient behavior

Jensen and Meckling

When you delegate authority, there is no guarantee that they will act in YOUR interest – principal agent problem

In corporations, you see this in two places

1. Owners versus managers (owners – principals, managers – agents)

2. Managers versus workers (managers – principals, workers – agents)

Agency costs = monitoring costs + incentive costs + bonding costs + residual loss

The owner wants to minimize these agency costs. When there is no owner, these costs are not minimized.

Bonding costs – agent bears these directly but principal ultimately bears these

Monitoring, incentives, and bonding costs are borne in an attempt to decrease residual loss.

(p. 44) Bottom paragraph applies the above equation.

1. Tastes of managers determine how large the residual loss is

Ethical managers have smaller residual losses

As MBA programs moved away from teaching ethics, these residual losses increased.

Religious citizens, etc.

2. As the ease of managers to “get away” with stuff increases, agency costs increase

Payoff to monitoring, incentives and bonding increase

3. Cost of monitoring – the more effective monitoring is, the smaller the magnitudes of the other three items will be.

Armored car drivers are bonded

4. Lower bonding costs will lead to a smaller residual loss, which will lead to less monitoring and less incentive alignment

5. The lower the incentive costs, the smaller the residual loss is.

If agency costs are too high, privatization may occur.

(p. 40) They differentiate their theory from Coase and Alchian/Demsetz

They overstate how different they are

“Alchian and Demsetz are too narrow”

Contractual performance is important in more dimensions than labor relationships

Jensen and Meckling with respect to limited liability

Bondholders bear bankruptcy risk – they pick up the liability

Stockholders bear normal business risks – limited liability

Specialization in bearing risk

**Diagram**

Near bankruptcy, bondholders bear more risk. This gets capitalized in higher interest rates in these situations

Also gets capitalized in restrictions on lending

Savings and loans

Customers do not care if banks go bankrupt

Taxpayers bear the bonding costs.

Executives were not allowed to take risks.

After deregulating, there were no incentives to monitor and the executives were very bad

Firms often bet the entire company – bondholders don’t like this

Why might there be a profit opportunity for bankrupt firms to merge?

There are costs of filing for bankruptcy (must sell everything very quickly)

You hold on to customers this way

This is why bondholders want mergers to go through

They will give stockholders money to vote for a merger.

If mergers are possible, bond rates decrease

Convertible bonds – bonds which can convert to stocks. Allows bondholders to capture some benefits on the up-side.

(p. 41-42) There is no inefficiency if you own 100% of your stock. As you auction off more and more, the cost of raising money increases because your incentives become worse and worse. “Rising marginal cost of equity” is due to increased agency costs.

Junk bonds are almost as risky as stocks

Before junk bonds, big firms did not have to worry about being taken over.

(p. 42) In the absence of taxes, the magnitude of incentive distortions goes up as more stock is sold. You pay for this.

Why would you issue more stocks/bonds? If the cost of issuing stocks/bonds is less than the agency costs that would be a substitute.

Stock financing is also good if the owner is risk averse.

Only bear agency costs when net benefits of bearing these costs is positive.

You will see corporations when it is optimal for them to exist.

Jensen and Meckling say that once you don’t own enough stock, you have no incentives to act efficiently. This is not true.

Galles says this is a risk issue

Golden parachute – CEO who is losing his/her job is given a lot of money if a merger goes through. This decreases their incentives to interfere with the merger.

(p. 43) You can’t eliminate agency costs

Nirvana approach to the world (Pangloss). Assume away agency costs

(p. 45) Monopoly competition and managerial behavior

“In the model, if you see deviations, it must be a monopoly since competitive firms have no room for inefficiency”

Jensen and Meckling disagree with this, because owners still have incentives to minimize lsoses in a monopoly.

If you add the word “regulated” to “monopoly,” you change incentives and mess thigns up.

(p. 46-47) Risk is taken up by bondholders in limited liability.

(p. 46) Irrelevance of capital structure

Modigliani and Miller – if there are no tax advantages and no bankruptcy costs, the form of the firm’s finace doesn’t matter

Jensen and Meckling disagree

How you finance the firm alters agency costs and therefore changes net income stream

Behavioral finance.