Economics 174

Problem Set 2 -- Solutions

1. Why would entrepreneurs voluntarily enter into agreements which limit their discretion on matters such as which types of new products to develop?

Apply Jensen and Meckling. Consider an entrepreneur seeking outside financing (debt or equity) for a project. Entrepreneurs may have an incentive to expend resources ("bonding costs") such that total value is maximized given the new organizational form. The reason is that the price that they will get for debt or equity they sell in their firm will reflect its value in the new ownership structure. So if an entrepreneur is able to ensure outsiders that his activities will be value-increasing (rather than toward activities which maximize his own utility but decrease total value), outsiders will be willing to pay more for the debt or equity shares.

In general, assuming no wealth effects and no transactions costs, it is in all parties' interest that the value-maximizing institutional structure be chosen. Therefore, if the value-maximizing structure includes monitoring, it will be in the interest of those being monitored that be chosen, given the right side payments.

2. Some economic studies use the fact that stock prices rise after hostile takeovers as evidence that takeovers are efficiency-enhancing. Do Shleifer and Vishny believe that one can always use stock prices as evidence in this way? If so, what is their reasoning? If not, describe a circumstance where a hostile takeover might be efficiency-decreasing but where the stock price would increase.

No. Shleifer and Vishny imply that in some cases the stock holders' gains from hostile takeovers are the result of transfers from other parties such as the firm's workers or trading partners -- not efficiency gains. Suppose that after a hostile takeover, the new management decides to break existing contracts with their unions or their suppliers and renegotiate more favorable terms. This would transfer value from workers or suppliers to stockholders and cause the stock price to increase, but would not necessarily increase total value.

(It may be a part of an overall strategy which increases total value, but it may not.)

3. Read the following two Wall Street Journal articles about Ben and Jerry's Homemade, Inc. and answer the following questions.

Company Background. News Story.

a) How are the stated objectives of Ben and Jerry's different than most firms'?

Ben and Jerry's clearly maximizes more than profits or the value of their own firm. Evidence for this is that it values the well-being of Vermont farmers, whether they sell their ice cream to countries (such as France) who have policies to which they object, etc.

b) Considering only the interests of Ben and Jerry's employees and shareholders, are Ben and Jerry's policies likely to have been value-maximizing before the firm went public in 1984? After the firm went public? Explain.

Ben and Jerry were the only residual claimants. Like the 100% owner in Jensen and Meckling's article, they bore all the costs associated with activites which diverged from profit-maximization. If they took an action (such as using high-price suppliers) which decreased profits, the value of their shares in the company went down. Since B and J fully bore the costs and benefits of these decisions, they may well have been efficient.

They may not have been efficient after the firm went public, assuming that their shareholders do not receive utility from promoting B&J's social agenda. B&J did not bear the full cost of non-profit maximizing decisions.

c) Discuss Ben and Jerry's management problems since then in light of moral hazard. Be sure to state within your answer: who the principal(s) and agent(s) are, how their objectives differ, and on which types of decisions conflicts of interests arise.

The new CEO was an agent; the shareholders (including Ben and Jerry) were the principals. CEO maximizes his own utility. Shareholders maximize theirs. Most shareholders probably did not receive utiltiy from anything but the value of their investment. Clearly, the shareholders/founders Ben and Jerry do. The CEO was caught in a bind due to the conflict of interest among the shareholders. He was a agent to more than one principal, and these principals' objectives differed. Conflicts of interest arose when decisions that would increase the price of the firm's shares did not coincide with the founder/shareholders' social agenda -- such as whether to move into sorbets and away from ice cream, or whether to sell products in France.

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.

Assuming that each of the workers is risk-neutral, is this compensation scheme likely to be efficient? Why or why not?

Each worker is risk-neutral -- therefore, there are no costs in shifting risk from the firm to individual workers. There are benefits in the form of stronger work incentives.

The efficient compensation scheme is to "sell the firm to the workers" in this case. Pay them full commissions. This makes them work the same amount as if they owned the firm themselves. In fact, in a way they do own the firm, because they are full residual claimants with respect to their own output.