Problem Set 2

Due May 4, 1998

1.    Define "greenmail."  Discuss the role greenmail plays in the market for corporate control.  Be sure to discuss whether it is likely efficiency-enhancing or not, and why.

Greenmail refers to a class of takeover defenses in which managers use the resources of their own firm to  pay off  either those making outside offers or blocks of their own shareholders.  Greenmail is generally considered to hinder the operation of the market for corporate control.  If takeover attempts are symptoms that target firms are organized inefficiently, and greenmail prevents firms from reorganized in a more efficient way, greenmail would not be efficiency-enhancing.

2.    The compensation packages received by many CEOs and other upper-level managers include stock options.  One example of a stock option would give the holder the right to buy 100 shares of Microsoft stock at a price of $120/share if exercised before June 1, 1998.  This is valuable because if Microsoft's share price, sitting at about $95 (as of 4/24/98), were to increase above $120 before June 1, the holder to exercise the option and turn around and sell the stock at a profit.  The option becomes worthless, however, after June 1.  Until then, all else equal, the option price is an increasing function of the firm's stock price.

[See for a discussion on option pricing, if you are interested in this kind of stuff.  This is not at all important for the purposes of this class, however.]

In light of some well-publicized, large exercises of options which provided several CEOs (most notably Michael Eisner of Disney) millions of dollars, several commentators have recommended that stock options be used to compensate lower-level employees as well.  Part of the underlying idea is that incentive schemes that work well for CEOs should work well for lower-level employees too.

Comment on this recommendation.  Would paying lower-level employees stock options likely be efficient? Why or why not?  For simplicity, assume that labor markets for such employees are competitive.

Using an efficiency criterion implies that we are only concerned with the manner in which employees are compensated, not the level.  "Manner" in this context means how much to base employees' compensation on options versus a fixed wage.  Using options means that the performance statistic one is using is (a function of) the value of the firm.  The value of the firm is likely very weakly correlated with an individual lower-level employee's effort.  Basing the individual's pay on this would shift a lot of risk on the employee because it would base his compensation almost entirely on factors outside of his or her control, but would not provide the individual very strong incentives.  Therefore, paying lower-level employees in stock options would likely be inefficient.

[In the framework discussed in class, if the performance statistic is based on the value of the firm, "V" would be high.  Therefore, the optimal "beta" would be very low.  It would not be optimal to base very much of an individual's compensation on the value of the firm.]

This, of course, is different in the case of CEOs, whose decisions have a large effect on the value of the firm.  There is, therefore, an efficiency explanation why one would pay CEOs stock or stock options.

3.    The form of truck drivers' compensation differs systematically according to the length of the haul.  Truck drivers who make local deliveries are generally paid fixed wages.  Truck drivers who make long-distance hauls are generally paid by the haul.  Long-haul drivers are generally paid a function of the length of the haul.

Truck drivers receive job assignments from their dispatcher at the start of the day.  They generally telephone in after finishing each haul to receive further instructions.  At this time, dispatchers often change drivers schedules' or add hauls to their schedule.  Local drivers return to their base at the end of the day.  Long-haul drivers generally do not.

Long haul drivers are effectively paid piece rates, which are a form of performance incentives.  They are paid according to much work they do -- the more quickly they finish one haul, the faster they can move on to another.  Short haul drives are not paid performance incentives.  They are paid the same, no matter what. Stronger performance incentives induce higher effort levels and hence more output.  However, they shift risk from an individual (or individuals) to whom it is not costly to individuals to whom it is costly. How valuable driver effort is at the margin -- perhaps how important it is to deliver the cargo promptly (pi-prime).  How risk averse the driver is ("r").  How closely the performance measure one uses to evaluate drivers tracks their effort (this determines "V").  How onerous effort is at the margin to the driver (C").  The latter determines how responsive drivers are to incentives. One reason may be that it is more difficult to construct a good performance measure for local drivers than long distance drivers.  Local drivers operate mostly on surface streets and make a lot of stops per day.  Long-distance drivers are mostly out on the open road and make fewer stops.  Local drivers probably have to deal with more variable traffic conditions, and measures of their productivity would probably be affected by things like whether shippers and receivers were ready to load and unload trucks when they arrived.  If this is the case, "V" would tend to be higher for local drivers than long distance drivers.  One would then set the performance incentive higher for long-distance drivers.

This is by no means the only possible explanation.  It is, however, a theory that explains the difference.  The theory, admittedly, is somewhat suspect.  To wit, why aren't firms better able to identify the factors outside of drivers' control which affect measures of their productivity when drivers operate close to home?  If this were the case, one might expect short-haul drivers to be paid stronger performance incentives.

More about this later in the class.

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.

See also Ben and Jerry's web site at, if you wish.

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

Most firms do not place as much weight on social objectives as Ben and Jerry's.

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 shareholders before they went public.  Assuming that Ben and Jerry agree on their social agenda and how much weight it should get relative to productive and organizational efficiency, Ben and Jerry's policies may have been value-maximizing before they went public.  [This begs the question, of course, why B&J did not instead run their firm to maximize profits, then pursue their social objectives by distributing the profits to subsidize Vermont farmers, etc.  It must be the case that B&J care not just about helping certain individuals and businesses, but the way in which they do so.]

They are less likely to have been value-maximizing after they went public.  After Ben and Jerry's went public, Ben and Jerry only owned part of the shares of the firm.  They probably benefited disproportionally from the pursuit of social objectives relative to shareholders.  Sacrificing profits for the sake of social objectives to the same degree or more would not have been value maximizing.

Remark 1: Note that this does *not* imply that the "after public" organizational form was inefficient.  Because it is costly to mitigate incentive conflicts, efficient arrangements can allow non-value-maxmizing decisions.  But the question did not ask whether the organizational form was efficient -- it asked something simpler -- whether decisions were non-value-maximizing.

Remark 2: Note that the value-maximizing level of social objective pursuit is likely *not* zero, even if shareholders other than B&J do not care at all about social objectives.  B&J's utility count -- so this means that social objectives do.  They would just tend to be pursued excessively relative to the "first best" when there are outside shareholders.

c) Discuss Ben and Jerry's management problems since then in light of moral hazard. Be sure to state within your answer: who theprincipal(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.