Problem Set 2, Fall 1995-- Solutions
1. Shareholders of large corporations appoint boards of directors to monitor managers. Why might such monitoring be ineffectual?
It may be ineffectual because, in general, there remain significant agency problems between the board and managers. Although boards may be in a better position than individual shareholders to monitor -- they can more readily obtain information about the firm, for example -- it remains difficult for them to monitor managerial performance. Managers can hide information from them, and cast their reports in light that make them look particularly good.
There is also the problem of "who will monitor the monitor." It is costly for shareholders to monitor the board's actions, and since each individual shareholder would bear all the costs but receive only part of the benefits of monitoring, free rider problems lead to lower than optimal monitoring levels. This is especially a problem because boards are agents of both shareholders and managers. Managers can attempt to align the boards incentives with their own, by lavishing them with perquesites in exchange for their suppport. Shareholders must not only over come the free rider problem, but compete with additional principals (managers) to induce boards to act in their interest.
2. True or false: Agency costs are manifested solely in the amount by which the agent's choice of actions differs from that which would be chosen if their actions could be perfectly and costlessly observed by the principal. Support your answer.
False. Agency costs equal monitoring costs plus bonding costs plus residual losses. The question only refers to residual losses.
3. According to Jensen and Meckling, who bears the costs of agency that result from owners financing projects by issuing equity? Why is this the case?
The manager/entrepreneur bears the agency costs of equity, according to Jensen and Meckling. Prospective shareholders foresee the incentive effects of reducing the manager's share in the firm. Knowing that the manager will act less in shareholders' interest once his/her holdings are diluted, they will be willing to pay less for the equity than if there did not exist agency problems. So agency costs are fully reflected in the price of the equity. The manager/entrepreneur thus receives a lower price than he/she otherwise would for this new stock.
4. How does a deductible in insurance (a provision in which individuals are not covered for small losses) align the incentives of the insured and the insurer? What economic problem are deductables a response to?
Deductables are a response to moral hazard, or post contractual opportunism. By making the insured bear part of the losses, it provides him/her an incentive to avoid them. The socially efficient action is that which the insured would take were he/she not insured. Deductables induce them to take more efficient actions than they would under full insurance. This increases the total value of the contract they have with their insurer, compared to one in which they are fully insured.
5. When a workers' effort is not directly observable, it may be desirable to pay them on the basis of output rather than their labor, particularly when output can be attributable to individual workers. While this may provide performance incentives that lead them to work harder, this may have drawbacks. Describe at least two.
There are many answers. These include:
-- It may inefficiently load risk on workers to whom it is costly. -- By providing incentives for output, it diverts their attention on other value-increasing activities, such as maintaining their machines, being nice to customers. -- It may divert them from cooperating with other individuals. For example, suppose it would be efficient for an individual to help someone else -- it would increase this other individual's output a great deal. Individual performance incentives may discourage this. (Of course, workers may be able to contract on their own -- you may be able to pay someone else within the firm to help you...) -- Measuring output is costly. If costs are high enough, this can preclude performance incentive schemes.