Lesson 3.2 Flashcards
what do we assume managers goal is?
to maximize value for shareholders
define principal agent issues
when managers (agents) make decisions that affect the wealth of shareholders (principals)
what is another way to explain principal agent issues
Managers may face situations where personal utility function conflicts with that of being an agent of the firm
when do we not worry about principal agent issues
When interests of principal and agent are identical
one form of uncertainty in principal agent issue
One form of uncertainty occurs because outcomes of agents actions are not linked in a totally deterministic way with their effort. Knowledge of results does not necessarily imply anything about effort. This is caused by info asymmetry
2 asymmetrical info issues
hidden action or moral hazard
most common hidden action issue
determining effort of agents
explain effort value to principal and agent
Effort has a disutility to agent but has a value to the principal because it increases probability of a favorable outcome
6 goals that may prevent managers from always taking actions to maximize firm value
1) minimizing effort
2) maximizing job security
3) avoiding failure
4) enhancing reputation and employment opportunities
5) consuming perquisites
6) pay
explain manager goal - minimizing effort
There is disutility to work given the opportunity cost of leisure
explain manager goal - maximizing job security
Managers may be disinclined to make risky choice that could jeopardize employment but risky projects are characterized by high potential reward or large potential loss
explain manager goal - avoiding failure
If risky project is undertaken, managers are rewarded if results are favourable and penalized if results are unfavourable
explain manager goal - enhancing reputation and employment opportunities
Sometimes reputation is promoted by doing things that benefit shareholders however this is not always the case. He may lower prices or give another firm that might be a potential employer a good deal.
explain manager goal - consuming perquisites
Luxury travel, expensive art in office, etc
explain manager goal - pay
Level and structure of compensation package becomes important parts of principal-agent story
what does level of output depend on?
Level of output depends on quality and quantity of effort provided by agent
why can effort not be directly rewarded?
Effort cannot be perfectly monitored by the principal and therefore cannot be directly rewarded
what happens because effort cannot be perfectly monitored?
Since the principal cannot observe and therefore cannot reward effort, the agent tends to shirk or reduce effort which in turn reduces output for principal
explain what effort mean
Achieving a target level of profit requires that managers incur some personal cost, which we call effort.
cost to manager of effort
value of time
profit formula when S is flat salary
profit(e) = R(e) - (S+C)
what does S mean
managerial compensation
what does C mean
other costs
when S is flat salary - profit(e) graph
upward curve with decreasing slope