Lecture 10 - Boundaries of the Firm 3 (From an Ownership POV)

Question 1

A governance structure is important in an incomplete contract setting, as it allocates decision rights in circumstances for which the contract has made no provisions

TRUE/FALSE

Answer 1

TRUE

A governance structure is only relevant when the contract is incomplete (costly to design contracts based on observable future variables)

Question 2

A governance structure adds value only when the following requirements are met: select all correct:
A) the relationship has to generate a quasi-surplus
B) when the contract is observable and verifiable to a third-party
C) the quasi surplus is not&raquo_space;completely&laquo_space;allocated ex-ante

Answer 2

WRONG:
B) when the contract is observable and verifiable to a third-party –> this is a complete contract where governance structure has no value-add

Question 3

One of the two requirements for a governance structure to add value is that the relationship has to generate a quasi-surplus - what does this mean?

Answer 3

If no quasi-surplus is generated, the competitive nature of the market ensures that the price is equal to the cost, resulting in no use for governance structure

Question 4

One of the two requirements for a governance structure to add value is that the quasi-surplus generated is not ex-ante completely -»allocated&laquo_space;- what does this mean?

Answer 4

If the quasi-surplus had been allocate completely (written down in a complete contract guarding against any hold-up), there is noting to bargain about, and governance structure has no value-add

Question 5

Because bargaining is assumed to be efficient in the Coase Theorem, there is no need for governance structures

TRUE/FALSE

Answer 5

TRUE

Question 6

In reality, there are often inefficiencies in the bargaining process. A governance has an impact on the nature and size of these inefficiencies, because it has consequences for …. (select all correct):

A) Information asymmetries between parties
B) Coordination costs
C) Financial restrictions on the parties
D) Alignment between parties
E) Complexity in the relation

Answer 6

A) Information asymmetries between parties
B) Coordination costs
C) Financial restrictions on the parties
D) Alignment between parties

Question 7

______ rights delineate the rights and duties in circumstances which are verifiable. These are the rights that one has in the contractual relationship.

______ rights determine who has the decision-making power in circumstances not foreseen and not described in the contract. These are the non-specified rights.

Fill in the blank spaces

Answer 7

[Specific] rights; [Residual] rights

Question 8

According to Michael Jensen perspective on ownership, the ownership gives the right to _____ income. That is, an owner is a _____ claimant of the profit.

Fill in the blank spaces

Answer 8

According to Michael Jensen’s RESIDUAL INCOME perspective on ownership, the ownership gives the right to RESIDUAL income. That is, an owner is a RESIDUAL claimant of the profit

Question 9

Hart introduced the residual rights perspective on ownership. Which of the following statements hold true for his view? Select all correct

A) Hart’s perspective on ownership entails that ownership gives the right to make residual decisions
B) residual decisions are those not stipulated/ specified in a contract
C) Hart believed that Michael Jensen’s view was far from the complete picture, and argues that ownership goes beyond claim on residual income

Answer 9

ALL ARE CORRECT:
A) Hart’s perspective on ownership entails that ownership gives the right to make residual decisions
B) residual decisions are those not stipulated/ specified in a contract
C) Hart believed that Michael Jensen’s view was far from the complete picture, and argues that ownership goes beyond claim on residual income

Question 10

A car owner rents his car to a counterparty, giving him the right to drive the car. However, the contract does not mention the right to change the color of the car. This is a decision that is for the owner of the car to make – not the renter.

What is this an exemplification of?

Answer 10

Hart’s residual rights perspective

Question 11

Following the property rights approach perspective on ownership, following statements hold true (select all correct)
A) PRA highlights assets in an incomplete contract setting
B) it argues that right to control an asset in the relation shall be allocated to one party
C) by allocating the decision-right of control of the asset, hold-up risk is eliminated due to no need for bargaining
D) possession of the residual rights of control constitutes “ownership”
E) such delegation of decision-right helps resolve any asset-use-related conflicts in events of unforeseen contingencies

Answer 11

All options are correct

Question 12

Transaction cost economics argue that asset specificity in face of incomplete contracting and opportunism will lead to hold-up problem (underinvestment) and an inefficient outcome - which can be solved if the firm engaged in vertical integration.

One of the critiques of the Property Rights Theory is targeting this specific argument. What is this critique?

Answer 12

Critique by PRT: it seems unrealistic to assume that people who behave opportunistically as an independent entity will behave fully aligned with the firm once they become employees (after VI)

Question 13

Transaction cost economics argue that the same result is obtained whether the downstream firm owns upstream firm, if if upstream investor owns downstream firm

One of the critiques of the Property Rights Theory is targeting this specific argument. What is this critique?

Answer 13

Critique by PRT: if parties are affected differently by integration, then the form of integration and ownership structure matters –> e.g., weaker ownership share post M&A leads to weaker incentives of the target

Question 14

Ownership of assets matters because?
Hint: something about bargaining power - explain how and why

Answer 14

Ownership gives you bargaining power from the ability to pull assets out of a relation, eliminating the counterparty’s ability to do business (recall McD example)

Question 15

Why does ownership matter with respect to efficiency and value creation (bigger pie)?

Answer 15

Ownership of assets –> higher bargaining power –> higher value appropriated by owner –> stronger incentive to invest in relation –> value creation (efficiency)

Question 16

Which of the following statements does/do NOT hold true wrt. appropriate governance structure, ownership and asset value?

A) the efficient allocation of ownership rights depends on who has the most important asset in the relationship
B) if upstream firm has the most important asset, it makes sense for him to forward integrate (acquire downstream firm)
C) if upstream firm has the most important asset, it makes sense for him to be acquired by downstream form (backward integration)
D) if upstream firm has the most important asset, and acquires downstream firm, 100% of quasi-surplus goes to upstream party
E) when the asset of each party is equally important to the relation, they should choose market rather than integrating

Answer 16

WRONG:
C) if upstream firm has the most important asset, it makes sense for him to be acquired by downstream form (backward integration)

Option B is the opposite of this argument, which is correct

Question 17

It makes a difference who owns the asset, because (select all correct options)

A) the bargaining power of the parties varies accordingly
B) the allocation of quasi-surplus varies accordingly
C) to exemplify ownership effect: in a forward integration, the upstream party gets 100% of bargaining power and 100% of quasi-surplus
D) to exemplify ownership effect: in a forward integration, the upstream party gets almost most of the bargaining power and almost 80% of the quasi-surplus

Answer 17

A) the bargaining power of the parties varies accordingly
B) the allocation of quasi-surplus varies accordingly
C) to exemplify ownership effect: in a forward integration, the upstream party gets 100% of bargaining power and 100% of quasi-surplus

Question 18

If each firm owns an asset each that is equally valuable to the relation, then they should engage in ______ with upstream firm getting ___ % of quasi-surplus and downstream firm getting ___% of quasi-surplus

Fill out the blank spaces

Answer 18

If each firm owns an asset each that is equally valuable to the relation, then they should engage in [MARKET TRANSACTION] with upstream firm getting [50]% of quasi-surplus and downstream firm getting [50]% of quasi-surplus

Question 19

If upstream firm owns the asset most valuable to the relation, then they should engage in ______, with the upstream firm getting ___ % of quasi-surplus and downstream firm getting ___% of quasi-surplus

Fill out the blank spaces

Answer 19

If upstream firm owns the asset most valuable to the relation, then they should engage in [FORWARD INTEGRATION], with the upstream firm getting [100]% of quasi-surplus and downstream firm getting [0]% of quasi-surplus

Question 20

If downstream firm owns the asset most valuable to the relation, then they should engage in ______, with the upstream firm getting ___ % of quasi-surplus and downstream firm getting ___% of quasi-surplus

Fill out the blank spaces

Answer 20

If downstream firm owns the asset most valuable to the relation, then they should engage in [BACKWARD INTEGRATION], with the upstream firm getting [0]% of quasi-surplus and downstream firm getting [100]% of quasi-surplus

Question 21

If sunk cost/ asset specificity, k= 0, which of the following governance structures will lead to an efficient outcome?

A) backward integration
B) forward integration
C) market

Answer 21

A) backward integration
B) forward integration
C) market

All three leads to efficient outcome, since this situation appropriates the Coase Theorem assumptions

Question 22

If sunk cost/ asset specificity is low, k = (0;40), which of the following governance structures will lead to an efficient outcome?

A) backward integration
B) forward integration
C) market

Answer 22

B) forward integration
C) market

Backward integration is no longer viable, because the upstream supplier will suffer a loss

Question 23

If sunk cost/ asset specificity is high, k >40, which of the following governance structures will lead to an efficient outcome?

A) backward integration
B) forward integration
C) market

Answer 23

B) forward integration

Backward integration is no longer viable, because the upstream supplier will suffer a loss

Market breaks down and no longer leads to efficient outcome

Question 24

Contracts and internal legal systems are necessary due to the existence of opportunism and moral hazard under integration

TRUE/FALSE

Answer 24

TRUE

Question 25

Incentives for opportunism, moral hazard, and holdup also exist within companies - employees do not necessarily act in the interest of the firm –> vertical integration does not fully eliminate cooperation problems

TRUE/FALSE

Answer 25

TRUE

Question 26

Which of the following are implications of ownership? (Select all correct)

A) the party that invests in relationship-specific assets will have a poorer ex-post bargaining position, reducing incentive to invest. To solve this, one shall allow that party to have sufficient bargaining strength, to make them confident that their investment will be recouped
B) the higher degree of specificity of the investment (higher K), the more bargaining power should the investing party get
C) incentives for the investing party can be strengthened by providing more control over assets (benefit of ownership) - but only at the expense of weakening the incentive of the other party giving up ownership (cost of ownership)
D) those parties whose investments matter the MOST to value creation should own the asset

Answer 26

All options are correct

Question 27

Those parties whose investments matter the MOST to value creation should own the asset - because increasing incentives for that party should be prioritized

TRUE/FALSE

Answer 27

TRUE

Question 28

According to Hansman, who are the “best” owner of an asset/firm?

Answer 28

“Best owner” refers to the party who is able to realize the highest degree of efficiency

Question 29

Hansman put forth what the “best” owner entails. In doing so, he proposes a definition of ownership - which?
A) Ownership is the possession of residual decision rights
B) Ownership is the possession of residual decision rights of the firm and residual income rights
C) Ownership is the possession of residual income rights

Answer 29

B) Ownership is the possession of residual decision rights and residual income rights

Question 30

Hansman introduces some unusual terminology, one being a term denoting the entities that transact with the focal firm. What is this term?

A) patrons
B) cooperatives (coops)
C) capital suppliers

Answer 30

A) patrons: those who transact with the firm, which can be capital suppliers (stockholders), but may as well go beyond

Question 31

Which of the following are examples of “patrons”? (Choose all correct options)

A) capital suppliers
B) input suppliers
C) customers
D) employees
E) government

Answer 31

A) capital suppliers: lenders/ stockholders
B) input suppliers: milk supplier to cheese factory
C) customers: as in Brugsen/ Coop
D) employees: e.g., partner-owned companies
E) government: not explained why - but remember that this is the case for the exam:)

Question 32

Hansman argues that regardless of what class of patrons owns the firm, the ownership structure is equivalent - and can be thought of as cooperatives

TRUE/FALSE

Answer 32

TRUE

Question 33

According to Hansman, how should one decide on which group of patrons constitute the “best” owners?

A) there must be a balance between the cost of contracting (with non-owning patrons), and cost of ownership (how good the given patrons at owning?) - The patron group for which the sum of the two costs (cost of contracting and ownership) is lowest, is the efficient owner group
B) the patrons that supplies the most valuable asset to the firm should in theory constitute the “best” owners, since their incentive to “own well” is maximized

Answer 33

A) there must be a balance between the cost of contracting (with non-owning patrons), and cost of ownership (how good the given patrons at owning?) - The patron group for which the sum of the two costs (cost of contracting and ownership) is lowest, is the efficient owner group

Question 34

With respect to a class/ group of patrons, which of the following statements DO NOT hold true (multiple may be correct)

A) one shall consider a class of patrons rather than individual patrons
B) one type of patrons typically have very different interests than other types –> risk of interest misalignment among the patrons group is smaller than across groups
C) we seldomly see that workers are owners of a firm alongside with lenders
D) the relative homogeneity within a patrons group/ class is assumed to imply that interests are completely aligned

Answer 34

WRONG: D) the relative homogeneity within a patrons group/ class is assumed to imply that interests are completely aligned

Question 35

Often within cooperatives (a group of patrons owning the firm), we observe an issue of diverging interests between members relating to priorities. When such divergence concerns whether to pursue long-term growth or short-term stockholder wealth, this specific issue is referred to as____

Answer 35

Time-horizon issue

Question 36

Following Hansman and the basic transaction cost economics idea, who should own the firm?

A) ownership should be tied to transactions (whether suppliers of milk or capital)
B) balance should be reached between the cost of contracting with non-owning patrons and the cost of ownership by that group of patrons
C) the patrons group for which the sum of the two costs is the lowest is the efficient owner group
D) all of the above

Answer 36

D) all of the above

Question 37

With respect to cost of contracting with non-owners, which of the following is/are NOT sources of such cost?

A) transacting with a monopolist with large market power
B) contractual lock-in, where relationship-specific assets are involved and give rise to hold-up problem (underinvestment)
C) risk-bearing: if there is high supply risk related to transacting with the counterparty due to their prioritization of other clients
D) asymmetric information: the supplier may have specialized knowledge that can be used to exploit the focal firm

Answer 37

WRONG:
C) risk-bearing: if there is high supply risk related to transacting with the counterparty due to their prioritization of other clients

Even though this actually makes sense, it is not presented as one of the contracting costs causes by Hansman

Question 38

If the costs from transacting with a monopolist; contractual lock-in; and asymmetric information are very high, it makes sense to make the supplier an owner all else equal

TRUE/ FALSE

Answer 38

TRUE - all else equal. But one must also take into account cost of ownership for owning patrons

Question 39

With respect to cost of ownership for owning patrons, which of the following is/are NOT sources of such cost?

A) monitoring (agency) costs: patrons who are able to monitor at lowest cost are the most efficient owners (e.g., they know more about the company)
B) collective decision-making: the degree to which the interests of the patrons class are aligned/ homogeneous - the higher the alignment, the lower the cost
C) risk-bearing: which patrons group is best able to bear risk? The higher the ability to bear risk
D) network: the patrons group able to offer the most advantageous network for the firm will lead to lower cost of ownership

Answer 39

WRONG:

D) network: the patrons group able to offer the most advantageous network for the firm will lead to lower cost of ownership

Question 40

With respect to worker-owned firms, which of the following statements are true?
A) proletarian coops are rare: unskilled workers are seldomly made owners
B) most worker-owned firms are within professional service industries such as law, medicine, consulting

Answer 40

B) most worker-owned firms are within professional service industries such as law, medicine, consulting

Question 41

Most worker-owned firms are within professional service industries such as law, medicine, consulting. Why is this?
A) low-skilled workers are easy to monitor by other patron groups - making it unnecessary to appoint them as owners
B) high-education professional service workers are difficult to monitor by other patron groups - but are better monitored by other professionals in the same group
C) high-skilled workers are expensive to hire, making the cost of contracting higher than the cost of ownership
D) little physical capital is needed in such knowledge-dominant firms, making it unnecessary for lenders/ capital providers to own

Answer 41

C) high-skilled workers are expensive to hire, making the cost of contracting higher than the cost of ownership

This is BS

Question 42

Milton Fried man argues that: (multiple may be correct)

A) managers should make decisions so as to increase the market value of the firm - prioritizing shareholder value
B) managers may invest in CSR, but this is provided that they have been given this permission by shareholders
C) managers should make decisions so as to take into account the interests of all stakeholders

Answer 42

A) managers should make decisions so as to increase the market value of the firm - prioritizing shareholder value
B) managers may invest in CSR, but this is provided that they have been given this permission by shareholders

Question 43

Ed Freeman argues that: (multiple may be correct)

A) managers should make decisions so as to increase the market value of the firm - prioritizing shareholder value
B) managers may invest in CSR, but this is provided that they have been given this permission by shareholders
C) managers should make decisions so as to take into account the interests of all stakeholders

Answer 43

C) managers should make decisions so as to take into account the interests of all stakeholders

Question 44

Why is Hansman’s view on ownership closer to that of Friedman than Freemand?

A) Freeman’s perspective implies that different patrons groups (stakeholders) are to be made owners of the firm
B) Catering to too many different groups of stakeholders/ patrons will increase the ownership costs
C) an ownership structure with too many different groups of patrons will decrease firm profitability
D) Hansman and Friedman agree on that managers should only make decisions that increase the market value of the firm
E) all of the above

Answer 44

E) all of the above

Question 45

As one moves from Friedman’s perspective of maximizing shareholder value to Freeman’s perspective of maximizing stakeholder value, the ownership costs ______
INCREASES/ DECREASES

Answer 45

As one moves from Friedman’s perspective of maximizing shareholder value to Freeman’s perspective of maximizing stakeholder value, the ownership costs INCREASES