Problem Set 2, Spring 1996 -- Solutions
1. In Jensen and Meckling's model, managers who own less than 100% of the firm are unable to guarantee shareholders that they will make the same decisions they would if they were sole owners. Why is this costly? What individual or group of individuals bear these costs? What assumption concerning individuals' foresight drives this result?
Managers will make decisions toward maximizing their own utility. If they are full owners, they reap the full benefits and bear the full costs of these decisions. Therefore, these decisions will be value maximizing. These decisions may be different, and therefore not value-maximizing, when they do not bear the full costs of the decisions they make. Not being able to guarantee shareholders that they will make the decisions they would if they were sole owners means that some decisions will not be value-maximizing. Thus, this is costly.
The entrepreneurs/managers themselves bear these costs, because shareholders will only be willing to pay the value of the equity under the new ownership structure. This assumes that shareholders can see through entrepreneurs/managers' private incentives and understand how they will behave under the new ownership structure.
2. Firms often find it difficult to monitor their workers' use of telephones. For example, when I worked for the Council of Economic Advisers in Washington, there was no monitoring whatsoever. Furthermore, there was no accounting system to track the location, length, and cost of long distance telephone calls. As a result, my coworkers and I frequently made lengthy long distance phone calls from office phones. There were even instances where individuals came into work on the weekends for the sole purpose of making long distance calls.
What is the moral hazard problem? Who is the principal(s) and who is/are the agent(s)? How do their objectives differ? Is there an incentive conflict?
The principal(s) could be taxpayers, the Federal Government, the CEA, or the head of the CEA, etc., depending on how you look at it. The agents are the workers. Their objectives differ because everything that enters positively into workers' utility does not contribute to bureaucratic output, and things that contribute to output enter negatively into workers' utility. The incentive conflict arises because private telephone calls are contribute to positively workers' utility but negatively to the value of whatever the CEA produces. A moral hazard problem arises because prinicpals cannot costlessly observe or monitor agents' phone usage.
Suppose the press got wind of this, and in the ensuing media uproar, the Federal Government announced that it was going to implement a new system to monitor telephone usage. At the end of each day, individuals would receive a print-out of describing each telephone call they made. Unless they could provide evidence that a call was for legitimate government business, the cost of the call would be deducted from their (after tax) pay.
Would this likely reduce telephone usage? Are agency costs lower than before? Why or why not?
Closer monitoring would likely reduce telephone usage, because making a private call is now more costly in some way to agents (even if it is just in having to figure out how to explain away phone calls). Agency costs are not necessarily lower, because agency costs include the costs of monitoring, which are undoubtedly higher in this new situation.
3. According to the theory presented in class, what group is most likely to gain the most from successful hostile takeover bids: incumbent management, incumbent shareholders, new management, or new shareholders? Why?
Incumbent shareholders, from the increase in the value of the stock they hold. This is particularly the case because if they know their firm is the object of a bidding war among potential new owners, and they know the value of their shares under new management, they will generally not sell shares for any amount less than their post-takeover value. This theory would predict that shareholders of acquiring firms are unlikely to gain much when their firm takes over another -- because they are forced to pay the full post-takeover value.
4. Suppose a risk-neutral firm pays each of its workers a function of the output they produce rather than a fixed wage. Suppose workers' output is separable, but is affected by circumstances outside of their control (such as the weather) as well as their effort.
What are the costs associated with compensating workers in this way? That is, what is its main disadvantage relative to fixed wages? Suppose the firm is able to exactly measure the effect of outside circumstances on each worker's output. Does this potential disadvantage disappear? Why or why not?
Because it shifts risk from parties for whom risk is not costly to parties for whom it is, this compensation scheme is costly. This is its main disadvantage. If the firm were able to exactly measure the effect of outside circumstances, this disadvantage disappears. The workers' compensation is no longer based on circumstances outside of their control, and therefore they bear no risk.
5. Entrepreneurs seeking financing for start-up companies have several options, including commercial banks and venture capitalists. Commercial banks generally finance more traditional projects where both the entrepreneur's mission and the means by which he or she will accomplish it is well-defined and well-understood by all interested parties. Venture capitalists often finance projects where the entrepreneur's mission and the means by which he or she will accomplish it are less well-defined. The entrepreneur has to initially present a business idea that the venture capitalist believes is promising, but the agreement usually allows entrepreneurs considerable leeway. The advantage of this is that is presents entrepreneurs incentives to take advantage of business opportunities that were not initially foreseen.
Suppose you read in the Wall St. Journal that commercial banks tend to provide entrepreneurs capital by lending them money, and venture capitalists generally do so by exchanging cash for shares of entrepreneurs' projects. Applying what you have learned in class, provide a theoretical explanation for this stylized fact.
This can be explained using what we learned from Jensen and Meckling. Debt financing is costly because managers have an incentive to undertake risky projects -- riskier than if they were 100% owners. When there is a potentially broad spectrum of projects -- from safe to risky -- from which managers can choose, this problem is particularly acute, and the agency costs of debt are potentially large. When this spectrum is narrower, the agency costs of debt are likely small.
When "both the entrepreneur's mission and the means by which he or she will accomplish it is well-defined and well-understood by all interested parties," this spectrum is narrow, so debt financing is more likely. It is therefore not surprising that the projects commercial banks tend to finance are these ones. When entrepreneurs have "considerable leeway," the agency costs of debt are probably much larger, and the equity financing is probably less costly. It follows that the projects financed by venture capitalists are financed with equity.
The key to answering this question -- and it was quite a tough one -- is to focus on differences in the transactions, not the firms. Ask: what is the efficient arrangement through which this transaction should be organized? Explaining the stylized fact becomes much easier.