chapter 9

Question 1

Whats game theory

Answer 1

attempts to model and predict outcome of conflict between rational individuals. Frequently in presence of information asymmetry. Each player expected to max own utlity.
-forced to take into account action of other player
cooperative (binding) or non-cooperative (nonbinding)

Question 2

nash equilibrium

Answer 2

only strategy pair such that given the strategy choice of the other player, each player is content with his/her strategy.

Question 3

How is a multi-period game different

Answer 3

Manager can choose to be honest and establish a reputation. Investors will choose B and agree to the cooperative solution. The mutual threat is that if one party deviates from the cooperative solution, the other will also do the same in the coming round and nash equilibrium will occur again.

Question 4

WHY is DR important in game theory

Answer 4

DR must not be too high or the immediate payoff of being dishonest exceeds punishment

Question 5

how can govt deal with managers choosing dishonest option to get immediate payoff?

Answer 5

change the payoff matrix through new regulation or penalty? Increase in penalties may lower management payoff for dishonest outcomes so BH becomes nash equilibrium.

Question 6

Agency theory

Answer 6

branch of game theory. Design of contracts to motivate a rational agent to act on behalf of a principal when agents interests would otherwise conflict with those of the principal.

Question 7

reservation utility

Answer 7

compesnation offered must at least equal opportunity cost (utility that could be attained in the next best employment opportunity)

Question 8

Describe agency theory with regards to owner and manager.

Answer 8

rational owner wishes to max payoff net of manager compensation. Manager can either work hard or shirk and this choice affects the probability of payoffs. Managers are effort averse. greater disutility if more effort.

Question 9

5 options owners can deal with agency theory issues.

Answer 9

1) direct monitory: First best. gives owner max attainable utility and manager doesnt bear risk of random payoff (no compensation risk). unattainable because its impossible to establish if manager is working hard.
2) Put up with low manager effort
3) Indirect monitoring: assumes moving support. move payoff for x2, a2 and owner would know when manager chose a2. (amend salary lower). impossible, cant be sure if payoff resulted form low effort or firm risk
4) rent firm to manager: high agency cost because of lost utility. Manager is risk adverse but now takes all the risk while risk neutral owner takes no risk. inefficient
5) give share of profit: most efficient alternative. base on a jointly observable performance measure. still some agency cost because manager must bear some risk.

Question 10

What are the 3 stages of opportunity for E management

Answer 10

1) pre-contract information: have info about payoff before entering contract
2) pre-decision info: obtain payoff info before choosing an act (a1,a2)
3) post devision: learn about what payoffs are before reporting to owner.

Question 11

Revelation Principle

Answer 11

for contract under which manager has incentive to lie, equivalent contract can be designed that motivates truth telling. Raise compensation if low net income is realized to the point where same compensation is received whether NI is high or low. manager will report low income if it is realized (truthful)

Question 12

3 conditions that must be met if revelation principle is to be held. (problems)

Answer 12

1) owner must be able to commit that truth telling wont be used against manager
2) Must not be any restrictions on contract (i.e. required level of performance before bonus given)
3) no restriction on manager communication: loss of reputation or legal liability if manager doesnt meet its own forecasts

–> may be more efficient to allow some upwards earnings management

Question 13

How to deal with E management?

Answer 13

1) strengthen corp governance: audit/compensation committee
2) GAAP + competent audit. GAAP limits ability to manage earnings
3) Revelation principal

Question 14

Describe relationship between lender & firm.

Answer 14

1) manager can either offer high or low dividends while loan is outstanding
2) manager is indifferent between the 2 because remuneration is unaffected by choice.
3) higher div increases risk of bankruptcy
4) mgr has inventive to lower risk to lower interest: may commit to low div covenant.

Question 15

What 2 characteristics do performance measures need to have to contribute to efficient compensation contracts?

Answer 15

1) sensitivity: rate at which expected value of a performoance measure changes as manager works harder. STrengthens connection between mgr effort and perf measure
2) precision: in predicting payoff from current management effort (reciprocal of variance of noise in perf measure)

must be traded off.

Question 16

How can 2nd best contract be made more efficient?

Answer 16

By basing it on 2 perf measures instead of 1. NI and share price

Question 17

Why does rigidity of contract lead to intervention by managers in the standard-setting process

Answer 17

Contracts tend to be rigid once signed. Contract incompleteness makes it difficult to anticipate all contingencies when entering a contract (i.e. changes in GAAP)
This incompleteness lead to managers intervening in the standard setting process to prevent changes that are not in favour of their interests.