Economics 174

Problem Set 2 -- Due Wednesday, April 24

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?

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?

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?

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?

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?

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.