1. In Jensen and Meckling's piece, debt financing serves to provide entrepreneur/managers incentives toward non-value-maximizing behvior.
2. What is the winner's curse?
This refers to the tendency for those with the most optimistic signals about an objects value to win the object when bidding against other buyers, but pay a price which is greater than what the object is truly worth.
Suppose there is a single object up for sale. Potential buyers do not know the exact true value of the object. Each of them has some private information ("a signal") concerning the object's value. On the average, these signals reflect the object's true value. But across individual buyers, some have information which makes the object look more valuable than it really is, and some have information which makes it look less valuable than it really is. If they bid according to their signal, the buyer with the most optomistic signal will win the object, but will pay more than its true value. This phenomenon is known as the winner's curse.
How does this phenomenon affect the market for corporate control?
Bidders, realizing this phenomenon, will discount particularly optimistic information and shade their bid down. It also provides incentives to acquire better information about target firms.
Does it tend to make this market work better or worse?
In retrospect I am not sure that this is all that good a question. Define "working better" as improving the efficiency of who wins the object -- or which management team obtains control. The winner's curse affects how bidders incorporate private information into their bid. But because it affects all bidders in the same way, it does not change who will win the bidding -- so it has no efficiency implications. It only affects how much the winner bid (and pays).
Hard question. Don't worry too much if your answer is different than this.
3. You are the owner of a small trucking firm in LA. You employ several similarly risk averse drivers who value both income and leisure. The firm's output, and thus profit, is a function of your drivers' effort -- high effort levels mean that your firm is able to serve more customers because your trucks are on the road and moving more of the time. Effort, however, is costly to drivers.
Assume that individual truck drivers' output is observable (the number of "hauls" he makes, how long they are, etc.) to you. Output is a function of driver effort and of factors outside of his control, such as traffic. Assume that you can directly observe only output and not effort.
Your drivers run two types of routes. One goes back and forth between West LA and Bakersfield. On the average, there is very little traffic, and not much difference in the traffic from day to day. The other goes back and forth between West LA and Pomona. Because it goes through Downtown LA, this route tends to have a lot of traffic, and a lot of variablility in traffic.
You are trying to design optimal compensation contracts for drivers on these different routes. Compensation consists of a fixed wage plus a per-mile rate. Assume that the market for truck drivers is perfectly competitive -- truck drivers' utility from working for you is the same as that in their next best opportunity.
Both types of drivers will be no better off than their next best opportunity by assumption. The Bakersfield-bound drivers are earning higher commissions on the average. It is therefore likely that they will be paid lower fixed wages. (This holds as long as drivers are not very risk averse. One needs to make stronger assumptions about their degree of risk aversion for this to be strictly true from the theory.) With respect to fixed wages, either "Bakersfield is lower" or "ambiguous" are acceptable answers.
4.. 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.
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.