Ch 03

Front 1

who can be thought as an Agent?

Back 1

frim's employees, american president, lawyers

Front 2

What agency problems can arise?

Back 2

-The objectives of principal and agents are different
-the actions taken by the agent or the information possessed by the agent is hard to observe

Front 3

how can a ceo boost short term earnings

Back 3

-cutting r&D costs will tend to pump up current earnings

Front 4

the hidden information problem?

Back 4

if shareholders coul deasily gain access to information about possible payoffs of firms investment they could hire or fire a ceo easily!
-example truck hiring in chicago

Front 5

where do coordinating problems come from?

Back 5

no one individulal holds all the information necessary to identify the best uses of a material or the uses for resources
(money, r&d, tin, time,..)

Front 6

how to combat agency problems?

Back 6

-monitor ceo's action through the corporate board!
adding a corporate board brings sometimes another agency problem between director and the principal
-performance based incentives
link the agents pay to the payoff the principal receives
(sales commision, grant stocks and stock options,empolyee of the month parking, vacation,...)

Front 7

key observations about performance-based incentieves:

Back 7

-it is the slope between pay and perfromance that provides incentives for effort, not the level of payment
-although the firms profit is a higher at the salery-plus-comission job, the employee has full ownership over the extra value, the firm can capture this extra value by reducing the salery
-it can help resolve hidden information problems

Front 8

problems with performance-based incentives are:

Back 8

they have to be balanced, as salesperson face multitasking jobs such as selling and post-sale-customer service task, which is hard to measure
-in developing complex products it is nearly impossible to give each employee full ownership over the extra value he creates

Front 9

bureaucracy?

Back 9

-rigid rules the limit employee discretion
-bureaucratic rules can help eliminating agency problems

discounts must be approved, etc

Front 10

centralized vs decentralized

Back 10

-case of communication in centraized companies is important (military)
-faculties with better knowledge decide according to a plan
-decentralized approach can cause coordination opportunities to be missed
-in reality there is a mixture
-centralized human resources, decentralized course fashion in business schools

Front 11

As firms grow large they face two problems:

Back 11

How to motivate the employees to take actions that further the firm’s goals
How to coordinate employees’ actions to achieve the best results for the firm

Front 12

When the principal hires an agent to take actions that affect the payoff to the principal, a principal-agent relationship occurs.
Agency problems arise when

Back 12

1. The objectives of the principal and the agent are different and
2a. The actions of the agent are not observable by the principal
or
2b. The information possessed by the agent is not observable by the principal

Front 13

Agency Problems:

Back 13

The differences in objectives between agent and principal will not matter if agent’s action/information was observable
The relationship can be structured to align the interests of the principal and agent

Front 14

Principal:

Back 14

Litigant, Shareholder, property owner

Front 15

Agent:

Back 15

Lawyer, CEo, real-estate agent

Front 16

Agency Problems in Corporations

Back 16

Separation of ownership and control (manager) is a key feature in a corporation (Berle and Means)
Owners (shareholders) want maximum profits while taking on a reasonable degree of risk
However, managers could be interested in
Enhancing their personal wealth
Limiting their personal risk or
Boosting their prospects for the next job

Front 17

Combating Agency Problems

Back 17

Firms can use several measures to combat the agency problems.
Monitoring
Pay-for-performance incentives
Bureaucracy

Front 18

Combating Agency Problems: (i) Monitoring

Back 18

Expending resources on monitoring the management/employees can mitigate the agency problems
But,
Monitoring can be expensive
Monitoring can be imperfect
Monitoring can add an extra layer in the agency relationship

Front 19

Combating Agency Problems: (ii) Pay-for-Performance Incentives

Back 19

Principal links agent’s pay to payoff from agent’s actions
Examples
Sales commissions
Stock options for executives
Non-monetary rewards (‘employee of the month’)

Front 20

Performance-Based Incentives: Illustration

Back 20

Let the dollar value of employee’s effort for the firm be h(e) where e = effort
Let c(e) = cost of effort for the agent
An employee will raise effort from e0 to e1 if there is an extra compensation of at least c(e1)-c(e0).
Furthermore, for the firm, it must be true that
h(e1)-h(e0) > c(e1)-c(e0)

Front 21

Performance-Based Incentives:

Back 21

Level of effort depends on marginal benefit and not the level of pay.
Firm can increase the commission rate and lower the base pay to increase profits.
Optimum base pay can even be negative (as in the case of franchises)

Front 22

Complexities in Performance-Based Model:

Back 22

Performance-based pay allows the employee to exploit his/her private information.
Sales persons can allocate their time and effort on most promising customers (using their private information)
Sales outcomes may be affected by factors not under the sales person’s control
With uncertainty, risk averse employees will demand risk premiums in contracts
If employee is engaged in multiple tasks he/she may focus on task that brings more reward.
Efficiency considerations may require employees to work in teams

Front 23

Combating Agency Problems: (iii) Bureaucracy

Back 23

Bureaucracy limits the set of actions an employee can take
An example is limits on discounting by the sales force
Discounting by one sales person may increase his/her compensation while lowering the overall profits for the firm.

Front 24

Coordination Problems

Back 24

Often the best action for one person may depend on
actions by others and/or
information held by others
It is important to coordinate the actions by individuals
Centralized organization
Decentralized organization

Front 25

Centralized Organizations?

Back 25

In centralized organizations, decision making authority is concentrated
Centralized organization may not be effective in responding to localized information.
While technology has enabled massive information processing, it may not substitute for human intelligence
As the organization becomes large, coordination problems become more severe.

Front 26

Decentralized Organizations

Back 26

In decentralized organizations, decision making authority is dispersed.
Agency problems may lead to coordination opportunities to be missed (resulting in agency costs)
As the organization becomes large, coordination problems become more severe.

Front 27

Influence Costs?

Back 27

Also influence costs become more substantial when an organization expands
Internal capital markets allocate scarce capital within the firm
Allocations can be favorably affected by influence activities
Resources consumed by influence activities represent influence costs.
In-house suppliers can use their influence with headquarters to shield against pressures to become more competitive.
Can explain the ‘conglomerate discount’: the value of the conglomerate is lower than the value of the separate divisions of the firm.