The Theory of The Firm & Agency Theory: Pertemuan 2

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Pertemuan 2 :
The Theory of the firm

&
Agency Theory
Copyright 2006 – Biz/ed

http://www.bized.co.uk
Principal-Agent Relationships
• An agent has decision-making authority
that affects the well-being of the
principal.
• Examples of agents:
– Money managers
– Lawyers
– Corporate managers
• Examples of principals:
– Investors in a money market fund
– Clients of lawyers
– Stockholders of the firm
Agency Problem
• An agency problem arises when there is a
conflict of interest between the agents
and the principals.
• It can also arise due to asymmetric
information:
– The principal cannot monitor the agent’s
behavior perfectly.
• Moral hazard can occur when agents take
actions in their own best interest that are
unobservable by and detrimental to the
principal.
The Role of Monitoring

• The principal can monitor the agent’s
actions, but not perfectly.
• Costs are incurred in monitoring the
agent’s behavior.
• Perfect monitoring of all actions of the
agent can eliminate the agency
problem.
– This can be prohibitively costly.
• There is a trade-off between resources
spent on monitoring and the possibility
of agent misbehavior.

Alternatives to Monitoring
• Alternatives to monitoring include:
– Constraints on agent’s behavior.
– Incentives to align agent’s interests with the
principal’s interests.
– Punishments for agent misbehavior.
• Principal-agent contracts that eliminate
all agency problems cannot be designed.
– Thus, a residual agency problems remains.

Agency Costs
• These are costs incurred in an attempt
to push agents to act in the principal’s
best interest.
• They are the incremental costs of
working through others.
• They consist of three types:
– Direct contracting costs
– Monitoring costs
– Loss of principal’s wealth due to residual,
unresolved agency problems.
Direct Contracting Costs

• Transaction cost of setting up a contract.
– e.g. Legal fees
• Opportunity costs imposed by constraints
that preclude otherwise optimal decisions.
– e.g. Inability to take positive NPV projects due to
restrictive bond covenants.
• Incentive fees paid to agents to encourage
behavior consistent with the principal’s
goals.
– e.g. Employee bonuses.

Role of Financial Contracting

• To design financial contracts between
agents and principals that minimize total
agency costs.
• Perfect contracts that eliminate all agency
problems are not feasible.
– Periodic misbehavior may be less costly than the
cost of eliminating it.
• The optimal contract transfers decision-
making authority from the principal to the
agent in the most efficient manner.

Stockholder-Manager
Conflicts
• Created by the separation of ownership
and control of the corporation.
• Stockholders elect the Board of
Directors, who in turn appoint
managers.
• The self-interested behavior of
managers may be at conflict with the
interest of stockholders.

Stockholder-Manager
Conflicts
• Managers may favor growth and
larger size of the firm:
– Greater job security
– Larger compensation
– Greater prestige
– Larger discretionary expense
accounts

Stockholder-Manager
Conflicts
• Consumption of excessive perquisites.
– Direct benefits: use of company car, expense
accounts.
– Indirect benefits: up-to-date office decor.
• Shirking
– They may not put forth their best efforts.
• Non-Diversifiability of Human Capital
– Managers’ expertise is closely tied to the firm.
– This leads to a divergence of goals.

Non-Diversifiability of Human
Capital
• Capital Investment Choices
– Preference for low-risk projects even though their
NPV may be lower than other riskier projects.
– If the firm ceases to operate as a result of “bad”
outcomes of risky projects, managers lose their
jobs.
• Asset Uniqueness
– The more a manager’s human capital is closely
tied to the firm, the more unique the assets of
the firm are.

Non-Diversifiability of Human
Capital
• Capital Investment Choices
– Preference for low-risk projects even though their
NPV may be lower than other riskier projects.
– If the firm ceases to operate as a result of “bad”
outcomes of risky projects, managers lose their
jobs.
• Asset Uniqueness
– The more a manager’s human capital is closely
tied to the firm, the more unique the assets of
the firm are.

Debtholder-Stockholder
Conflicts
• This conflict can manifest in three
ways:
– Asset substitution
– Underinvestment
– Claim Dilution

Practical Contractual
Considerations
• Financial Distress
– Financial distress increases the conflicts
between the various stakeholders of the firm.
– Firms in financial distress have a greater
incentive to engage in asset substitutions and
underinvestment - they have little to lose,
and a lot to gain.
– Stakeholders may form coalitions to act in
their best interest, even though these actions
may conflict with shareholder interests.

Practical Contractual
Considerations
• Financial contracts are complex
because they involve imperfect
information.
• Agents may send “noisy” signals
so as not to reveal their hand.
• Well designed contracts can lead
to more credible signals.

Mitigating Stockholder-
Manager Conflicts
• Agents with good reputation can demand
higher prices for their products / services.
• Management contracts can include monetary
incentives:
– Stock options
– Performance shares
– Bonuses
• Threat of takeovers and replacement can
induce managers to act in shareholder
interests.

Mitigating Debtholder-
Stockholder Conflicts
• Debtholders may restrict wealth
appropriating behavior on the part of
stockholders through debt contracts.
• An indenture is the explicit legal contract
for a publicly traded bond.
• The indenture contains covenants:
– Negative covenants restrict certain actions of
the firm.
– Positive covenants require certain actions on the
part of the firm.

• Covenants benefit the bondholders by
lowering the risk of the bonds.
• They also benefit the stockholders since the
reduced risk of the bonds implies lower
interest rates.
• Covenants can be costly to the
stockholders:
– Reduces the firm’s operating flexibility.
– Monitoring costs must be paid to ensure that the
covenants are adhered to.

• Convertible Bonds
– These can be exchanged for a pre-
specified number of shares of the
firm’s common stock, at the
bondholder’s option.
– Bondholders can benefit from the up-
side potential of successful risky
investments.

Monitoring Devices
• New External Financing
– When a firm seeks new external
financing, it is subject to special scrutiny.
– The willingness of investment bankers to
underwrite the issue acts as a
certification device.
– Firms that frequently raise capital from
external sources are monitored more
efficiently.

Monitoring Devices
• New External Financing
– When a firm seeks new external
financing, it is subject to special scrutiny.
– The willingness of investment bankers to
underwrite the issue acts as a
certification device.
– Firms that frequently raise capital from
external sources are monitored more
efficiently.

The Theory of the Firm

Production Function

Production Function
• States the relationship between inputs and
outputs
• Inputs – the factors of production classified as:
– Land – all natural resources of the earth – not just
‘terra firma’!
• Price paid to acquire land = Rent
– Labour – all physical and mental human effort
involved in production
• Price paid to labour = Wages
– Capital – buildings, machinery and equipment
not used for its own sake but for the contribution
it makes to production
• Price paid for capital = Interest

Production Function
Inputs Process Output
Land
Product or
Labour service
generated
– value added
Capital

Analysis of Production Function:

Short Run
• In the short run at least one factor fixed in supply
but all other factors capable of being changed
• Reflects ways in which firms respond to changes
in output (demand)
• Can increase or decrease output using more or less
of some factors but some likely to be easier
to change than others
• Increase in total capacity only possible
in the long run


Short Run
In times of rising
sales (demand)
firms can increase
labour and capital
but only up to a
certain level – they
will be limited by
the amount of
space. In this
example, land is
the fixed factor
which cannot be
altered in the short
run.


Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.


Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example, it
reduces its labour
and capital but
again, land is the
factor which stays
fixed.

Analysing the Production

Function: Long Run
• The long run is defined as the period of time taken to vary all
factors of production
– By doing this, the firm is able to increase its total
capacity – not just short term capacity
– Associated with a change in the scale of production
– The period of time varies according to the firm
and the industry
– In electricity supply, the time taken to build new capacity
could be many years; for a market stall holder, the ‘long
run’ could be as little as a few weeks or months!


Long Run
In the long run, the firm can change all its factors of production thus
increasing its total capacity. In this example it has doubled its capacity.

Production Function
• Mathematical representation
of the relationship:
• Q = f (K, L, La)
• Output (Q) is dependent upon the
amount of capital (K), Land (L)
and Labour (La) used

Costs

Costs
• In buying factor inputs, the firm
will incur costs
• Costs are classified as:
– Fixed costs – costs that are not related
directly to production – rent, rates,
insurance costs, admin costs. They can
change but not in relation to output
– Variable Costs – costs directly related
to variations in output. Raw materials
primarily

Costs
• Total Cost - the sum of all costs
incurred in production
• TC = FC + VC
• Average Cost – the cost per unit
of output
• AC = TC/Output
• Marginal Cost – the cost of one more
or one fewer units of production
• MC = TCn – TCn-1 units

Costs
• Short run – Diminishing marginal
returns results from adding
successive quantities of variable
factors to a fixed factor
• Long run – Increases in capacity
can lead to increasing, decreasing
or constant returns to scale

Revenue

Revenue
• Total revenue – the total amount received
from selling a given output
• TR = P x Q
• Average Revenue – the average amount
received from selling each unit
• AR = TR / Q
• Marginal revenue – the amount received
from selling one extra unit
of output
• MR = TRn – TR n-1 units

Profit

Profit
• Profit = TR – TC
• The reward for enterprise
• Profits help in the process of
directing resources to alternative
uses in free markets
• Relating price to costs helps a firm
to assess profitability in production

Profit
• Normal Profit – the minimum amount
required to keep a firm in its current line
of production
• Abnormal or Supernormal profit –
profit made over and above normal profit
– Abnormal profit may exist in situations where
firms have market power
– Abnormal profits may indicate the existence of
welfare losses
– Could be taxed away without altering resource
allocation

Profit
• Sub-normal Profit – profit below
normal profit
– Firms may not exit the market even if
sub-normal profits made if they are
able to cover variable costs
– Cost of exit may be high
– Sub-normal profit may be temporary
(or perceived as such!)

Profit
• Assumption that firms aim to
maximise profit
• May not always hold true –
there are other objectives
• Profit maximising output would be
where MC = MR

Profit
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100 101 102 103 104 Output

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http://www.bized.co.

The Theory of the firm

Copyright 2006 – Biz/ed

The Role of Monitoring

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Direct Contracting Costs

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Role of Financial Contracting

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The Theory of the Firm

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Inputs Process Output

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Analysis of Production Function:

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Analysis of Production Function:

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Analysis of Production Function:

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Analysis of Production Function:

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Analysing the Production

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Analysis of Production Function:

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100 101 102 103 104 Output

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