Conflict Resolution

Game Theory
Agency Theory

© 2006 Pearson Education Canada Inc. 9-1

 Agency Theory
• A principal wants to hire an agent for
some specialized task
– Separation of ownership and control
• Principal and agent are rational. Agent is
risk-averse. Principal may be risk-averse,
but assume risk-neutral for simplicity
• Principal wants agent to work hard, but
– Agent is effort-averse

© 2006 Pearson Education Canada Inc. 9-2

 Moral Hazard Problem of
Information Asymmetry
• Principal cannot observe manager effort -
call it a
• Call manager’s disutility of effort V(a)
– More effort---> greater disutility
• Implies manager may shirk on effort
– E.g., if paid a fixed salary, how hard will the
manager work?

© 2006 Pearson Education Canada Inc. 9-3

Agency Contract Example 9.3
• Owner: rational, risk-neutral
– Wants to max. expected firm payoff x
• Manager: rational, risk-averse and
effort-averse
– Wants to max. expected utility of
compensation c, net of disutility of effort
V(a)
– To overcome shirking, why not give
manager a share of payoff?

© 2006 Pearson Education Canada Inc. 9-4

 Agency Contract Example 9.3
• A problem arises:
– Firm payoff not known until after contract
expires (single period contract). Why?
– Manager has to be paid at contract expiry
• A solution:
– Base manager compensation on a
performance measure (e.g., net income),
which is available at period end
© 2006 Pearson Education Canada Inc. 9-5
Timeline for Agency Example

© 2006 Pearson Education Canada Inc. 9-6

 Motivation of Manager Effort
• To motivate manager effort, give manager
a share of firm net income

• Concept of reservation utility, call it R

– If manager is to work for owner, must receive
expected utility of at least R

© 2006 Pearson Education Canada Inc. 9-7

 Assumptions for Agency
Contract Example 9.3
• Manager has 2 effort choices:
– Work hard (a1 )
– Shirk (a2 )
• If manager works hard, payoff is
x = 100 with prob. 0.6
x = 50 with prob. 0.4
• If manager shirks, payoff is
x = 100 with prob. 0.4
x = 50 with prob. 0.6
© 2006 Pearson Education Canada Inc. 9-8
 Assumptions, cont’d.
• Manager’s contract (linear): c = ky, 0 ≤ k ≤ 1, where y is
net income
• Manager’s reservation utility: R = 3

• Quality of net income y (noisy, but unbiased, e.g., fair value

accounting)
– If x is going to be 100
y = $125 with prob. 0.5
y = $75 with prob. 0.5

– If x is going to be 50
y = $62.50 with prob. 0.5
y = $37.50 with prob. 0.5

© 2006 Pearson Education Canada Inc. 9-9

 Assumptions, cont’d.
• Manager’s utility
EUm(a1) = 0.6[0.5(k × 125)1/2 + 0.5(k × 75)1/2]
+ 0.4[0.5(k × 62.50)1/2 + 0.5(k × 37.50)1/2] - 2
EUm(a2) = 0.4[0.5(k × 125)1/2 + 0.5(k × 75)1/2]
+ 0.6[0.5(k × 62.50)1/2 + 0.5(k × 37.50)1/2] – 1.7
• Owner’s utility (risk neutral)
EUO(a1) = 0.6[0.5((1 – k) × 125) + 0.5((1 – k) × 75)]
+ 0.4[0.5((1 – k) × 62.50) + 0.5((1 – k) × 37.50)]

© 2006 Pearson Education Canada Inc. 9-10

Formal Statement of the Owner’s
Problem
• Find k to maximize EUO(a)
Subject to:
• Manager wants to take a1 (incentive
compatibility)
• manager receives reservation utility of R = 3
• The result:
K = .326

© 2006 Pearson Education Canada Inc. 9-11

 Check
• Manager’s utility
EUm(a1) = 0.6[0.5(.326 × 125)1/2 + 0.5(.326 × 75)1/2]
+ 0.4[0.5(.326 × 62.50)1/2
+ 0.5(.326 × 37.50)1/2] – 2
=3
EUm(a2) = 0.4[0.5(.326 × 125)1/2 + 0.5(.326 × 75)1/2]
+ 0.6[0.5(.326 × 62.50)1/2
+ 0.5(.326 × 37.50)1/2] – 1.7
= 2.96
Manager will work hard, (i. e., incentive compatible)

© 2006 Pearson Education Canada Inc. 9-12

 Check, cont’d
• Owner’s utility
EUO(a1) = 0.6{100 – [0.5(.326 × 125)
+ 0.5(.326 × 75)]}
+ 0.4{50 – [0.5(.326 × 62.50) +
0.5(.326 × 37.50)]}
= 53.92

© 2006 Pearson Education Canada Inc. 9-13

 A More Efficient Contract,
Example 9.4
• Retain previous assumptions,
except
– Quality of net income y (less noisy, still
unbiased)
• If x is going to be 100
y = $110 with prob. 0.5
y = $90 with prob. 0.5

• If x is going to be 50
y = $55 with prob. 0.5
y = $45 with prob. 0.5

© 2006 Pearson Education Canada Inc. 9-14

A More Efficient Contract,
cont’d.
• Then
k = .322 (compared with .326 in previous contract)

EUm(a1) = 0.6[0.5(.322 × 110)1/2 + 0.5(.322 × 90)1/2]

+ 0.4[0.5(.322 × 55)1/2 + 0.5(.322 × 45)1/2]
–2
=3
EUm(a2) < 3 can be verified

EUO(a1) = 0.6{100 – [0.5(.322 × 125) + 0.5(.322 × 75)]}

+ 0.4{50 – [0.5(.322 × 62.50) +
0.5(.322 × 37.50)]}
= 54.24
Owners utility greater than previous contract

© 2006 Pearson Education Canada Inc. 9-15

 Implications of Agency Theory
For Financial Accounting
• Net income matters
• The agency relationship is a contract.
Contracts are rigid
• Implies accounting policy choice and changes
to accounting policy matter
• Manager will usually object to new
accounting standards that:
– Lower reported net income (why?)
– Increase its volatility (why?)

© 2006 Pearson Education Canada Inc. 9-16

 Implications, Cont’d.

• Net income must be jointly observable

(i.e., by manager and owner)
– Role for GAAP, audit

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 Implications, Cont’d.
• Holmström’s agency model
– Basing manager’s compensation on 2
variables is better than on 1 variable, unless
the 2 variables are perfectly correlated
– This implies that net income is in
competition with share price performance
for “market share” in compensation
contracts

© 2006 Pearson Education Canada Inc. 9-18

 Implications, Concl.

• To maintain market share, net income

should be highly informative about
manager effort
– Properties net income needs to be highly
informative
• Sensitivity
– Net income responds to changes in manager effort
• Precision
– Net income has low noise re effort

© 2006 Pearson Education Canada Inc. 9-19

 Implications, Concl.
• Unfortunately, sensitivity and precision must be traded
off
– Historical cost accounting
• Low sensitivity due to recognition lag
• High precision since relatively unaffected by market-wide factors
– Fair value accounting
• High sensitivity due less recognition lag
• Low precision since affected by market-wide factors

• Fundamental problem of financial accounting theory

– Most useful net income for investors is not necessarily the most
informative about manager effort

© 2006 Pearson Education Canada Inc. 9-20

 Multi-Period Considerations
• Manager reputation and resulting value
of manager on managerial labour market
motivates effort
• Net income provides information to
market about manager value
• Is agency contract still needed?

© 2006 Pearson Education Canada Inc. 9-21

 Multi-Period Considerations,
Concl.
• Answer: yes
• Reason: managerial labour market does
not fully operate properly, due to
information asymmetry (moral hazard)
• For example, manager may disguise
shirking by earnings management

© 2006 Pearson Education Canada Inc. 9-22