Econ 106I (Galles) – Lecture 8 (March 2^nd, 2005)

Jensen and Meckling

Irrelevance of capital structure (Modigliani Miller theorem)

Structure only affects probability of bankruptcy and tax costs

But structure actually changes net earning stream

Agency cost issue

Changes behavior

(p. 49) Issues involving bondholders

Bondholders bear most downward risk but do not capture gains.

If you increase debt, you cannot increase dividends

Increases risk to bondholders and benefits stockholders

Large cast reserves required to decrease risk to bondholders.

If merger works, stockholders gain. If merger fails, bondholders lose.

(pp. 50-51) Bondholders worry about cost of bankruptcy.

In every business relationship, there is wealth creation.

If you can preserve business relationships (buyouts), then costs of bankruptcy go down. This will capitalize itself in lower interest rates.

Agency costs versus risk costs. The gains from sharing ownership must be greater than the agency costs associated with doing so. Efficiency.

Testable hypotheses. Check where bonding costs are low. Here, there should be lots of bonds.

Where it is easy to steal from other owners, you will see only a single owner. Finance will be in the form of loans.

If you find a way to reduce stealing costs, you will perhaps see stocks being sold. (Electronic gizmos in bars)

Conglomerates test not to have much debt, because they have high risk of bankruptcy.

Regulated utilities with risk being controlled are financed by bonds. Bondholders must worry about deregulation.

Fama

Main question: Why ought managers make decisions?

Stockholders want to diversify. This leads to small stakes in each firm.

Value as a manager is tied to performance of firm. Managers cannot diversify. Therefore, they have more at stake.

Separating management from risk bearing.

Recall Alchian’s architect example.

Large institutional shareholders were not as major as they are now. Now they exist, so you can diversify and still have a large stake in the company.

This works slightly against Fama’s argument.

This does not apply to index funds, because the investment “manager” does not control which stocks to own. No credible threats and thus no monitoring.

(p. 58) Risk-breaing argument discussed above.

(p. 59) Monitoring in internal markets. Some is top-down, but some is from bottom-up by managers seeking to become promoted.

The management is not a fixed group. People die, leave, get fired, etc.

If you are a good manager, you will self-select yourself into a firm which will recognize your quality. “How do you identify superior performance and how is it rewarded?”

Tournament theory – What if the CEO is overpaid? Wouldn’t stock prices go down? Why is it that when these increases in pay are announced, stock prices go up?

When people see higher gains to being CEO, they work harder. This decreases monitoring costs.

Efficiency wage theory – overpaid workers so that absenteeism was decreased. Monitoring by coworkers was high.

Gains from overpaying workers is high.

Living wage laws – by overpaying janitors, do monitoring costs go down? This is an application of efficiency wages where it should not be applied.

Board of directors – monitors top managmeent. Outside board members monitor

How do you monitor these members? The better work they do, the more boards you can be on.

How do you monitor older board members? S tock options.

German forms do not take much risk, because they boards are dominated by bondholders.

(pp. 61-62) Settling up is equivalent to capitalization.

Ex post and ex ante settling up.

How much of these mechanisms are present?

Crawford, Alchian, Klein

Read the footnotes to see applications of the principles.

Best place to start (p. 301, footnote 6) – appropriable quasi-rents

If you are my only supplier, you can take advantage of me. If I am your only buyer, I can take advantage of you.

Printing presses. L.A. Times has an enormous printing press. Couldn’t the press owner hold up the L.A. Times?

Ex post appropriable quasi-rents

Large newspapers tend to vertically integrate (purchase your own printing press)

Book publishers don’t own their own presses since the appropriable quasi-rents are much smaller.

Competition does not take care of this hold-up problem.

Solutions to this:

Explicit contracts enforced by courts.

Vertical integration

Implicit contracts.

Post contractual opportunistic behavior

Competition to enter the relationship doesn’t solve this.

(p. 297) Small numbers

Bilateral monopoly

(p. 298) As assets become more specific and appropriable quasi-rents increases, cost of contracting increases by more than costs of vertical integration. Then we would expect to see vertical integration.

Implicit contracts are “easier to write.”

(pp. 298-299) Quasi-rents: difference in value between users in the same use. Rents: difference in value between uses.

Oil tankers versus oil pipeline example

(p. 299) “Market power” will exist in situations other than monopolies due to these locked-in relationships.

Footnote 4: Vertical integration does not completely solve the problem.

(p. 301) As complexity of contracting increases, explicit contracts work less well. More likely to have vertical integration.

What happens if production function changes? Appropriable quasi-rents will change cost curves.

Standby facilities help lower cost of being ripped off. This will increase costs.

I might pick more generalized assets to protect myself. This will increase costs.

Similarly with larger inventories.

Just-in-time production: substitute for inventories. Huge amount of trust required.

(p. 303) Explicit vs. implicit contracting

Implicit contracting enforced by present-value of future profits market mechanisms.

Implicit contracts are seen a lot more in the real world than explicit contracts.

Footnote 16: Exclusive territories increases benefits of implicit contracting

Other examples. Coors beer example.