Lecture 1. Introduction
The corporation in the Neo-Classic model
- Sole Proprietorship
- Owner = firm
- Unlimited personal liability
- Partnership
- All partners are liable for debt
- Limited Liability Companies
- Firm as a legal entity with contractual rights and obligations
- Limited liabilities
- Separate ownership and control
- Joint-stock
Corporate profits flow to households
- Labor income ($0.25 per $1)
- Investment ($0.06)
- Tax ($0.04)
- Capital ($0.07)
- Suppliers ($0.58)
- Consumer surplus ($0.40)
- Positive spillovers (technology, health care etc)
- Negative spillovers (environment & social impact)
Adam Smith: It is not from the benevolence of the butcher, the brewer, or the baker that we
expect our dinner, but from their regard for their own self-interest.
The Company and its Stakeholders
In the perfect world;
- Complete contract specifies
- All rights and obligations of all parties
- In every possible future state of the world
- There is perfect information → no agency costs
Friedman Doctrine
- The responsibility is to conduct the business in accordance with their desires, which
generally will be to make as much money as possible while conforming to the
basic rules of society, both those embodied in law and those embodied in ethical
custom.
- He (the manager) is spending his own money or time or energy, not the money of his
employers or the time or energy he has contracted to devote to their purposes. If
these are “social responsibilities”, they are the social responsibilities of
individuals not of business.
,The Neo-Classic model
- Positive externalities: unintended positive effects arising from an action.
- Example: employee training increase productivity and employee loyalty, but
also benefits other employers
- Negative externalities: unintended negative effects arising from an action
- Example: Fertilizers from farming lead to ‘’dead zones’’ in the ocean.
Pigouvian Tax
Goals;
- Offset negative externalities with tax
- Encourage positive externalities with subsidy
→ The government plays a central role in welfare economics
Coase Theorem
- Producer purchases rights to pollute
1. The producer invests in new technology, or
2. Cleans up pollution, or
3. The community is compensated for the negative externalities
→ Government taxes the polluter and compensates the victims
→ If there are no transaction cost, parties can always find efficient solutions
Challenges of the Neo-Classic Model
Incomplete contract:
- Future generations and mother nature could not join the negotiation today
- Impossible to contract all possible future scenarios
- Hard to measure and quantify the externalities
- Accountability is quite a challenge
Information asymmetry
- Hard to quantify firms’ impact on the environment
- Hard to monitor and verify the firm’s clean-up activities
Shareholder maximization
,Corporate Governance System
, Lecture 2. Corporate Governance
Jensen & Meckling 1976
- Separation of ownership and control leads to agency problems
- Agency problems exist in all organizations and all cooperative efforts
- The corporation is a legal fiction that serves as a nexus of contracts among
individuals
Agency costs
1. Monitoring costs by the principal
- Board of directors to monitor managers and represent shareholder’s interest
- Large shareholders monitor management
- Shareholder activism to monitor and influence management
2. Signaling (Bonding) costs by the agent
- Managers pay dividends, signal to shareholders that the firm is profitable
- Timely and honest disclosure of crucial information to stakeholders
- Auditing of the financial and non-financial statements
3. Residual losses
- Managers pursue their own interests at the cost of the principals
“It is likely, that the most important conflict arises from the fact that as the manager’s
ownership claim falls, his incentive to devote significant effort to creative activities such as
searching out new profitable ventures falls.”
Agency costs in the corporate world
Ceo pursuing self-interests;
- Shirking
- Even talented managers may find themselves slacking if not disciplined
properly
- Extremely hard to monitor someone with unique skills & knowledge
- Management perks
- Executives tend to over-spend on perks
- Tunneling
- Managerial theft of corporate assets
- Favoring companies owned by themselves / relatives
- Excessive compensation
- Limiting Shareholders’ voting rights
- Management entrenchment
- Management could protect their control rights in the following anti-takeover
mechanisms;
- Poison pills: allow existing shareholders to purchase extra shares at a
discount → to dilute shares
- Golden parachute: to give generous payments to executives after the
acquisition
- Staggered board: classify board to prevent the board being replaced at once
- Require supermajority for shareholders to amend a corporate charter
The corporation in the Neo-Classic model
- Sole Proprietorship
- Owner = firm
- Unlimited personal liability
- Partnership
- All partners are liable for debt
- Limited Liability Companies
- Firm as a legal entity with contractual rights and obligations
- Limited liabilities
- Separate ownership and control
- Joint-stock
Corporate profits flow to households
- Labor income ($0.25 per $1)
- Investment ($0.06)
- Tax ($0.04)
- Capital ($0.07)
- Suppliers ($0.58)
- Consumer surplus ($0.40)
- Positive spillovers (technology, health care etc)
- Negative spillovers (environment & social impact)
Adam Smith: It is not from the benevolence of the butcher, the brewer, or the baker that we
expect our dinner, but from their regard for their own self-interest.
The Company and its Stakeholders
In the perfect world;
- Complete contract specifies
- All rights and obligations of all parties
- In every possible future state of the world
- There is perfect information → no agency costs
Friedman Doctrine
- The responsibility is to conduct the business in accordance with their desires, which
generally will be to make as much money as possible while conforming to the
basic rules of society, both those embodied in law and those embodied in ethical
custom.
- He (the manager) is spending his own money or time or energy, not the money of his
employers or the time or energy he has contracted to devote to their purposes. If
these are “social responsibilities”, they are the social responsibilities of
individuals not of business.
,The Neo-Classic model
- Positive externalities: unintended positive effects arising from an action.
- Example: employee training increase productivity and employee loyalty, but
also benefits other employers
- Negative externalities: unintended negative effects arising from an action
- Example: Fertilizers from farming lead to ‘’dead zones’’ in the ocean.
Pigouvian Tax
Goals;
- Offset negative externalities with tax
- Encourage positive externalities with subsidy
→ The government plays a central role in welfare economics
Coase Theorem
- Producer purchases rights to pollute
1. The producer invests in new technology, or
2. Cleans up pollution, or
3. The community is compensated for the negative externalities
→ Government taxes the polluter and compensates the victims
→ If there are no transaction cost, parties can always find efficient solutions
Challenges of the Neo-Classic Model
Incomplete contract:
- Future generations and mother nature could not join the negotiation today
- Impossible to contract all possible future scenarios
- Hard to measure and quantify the externalities
- Accountability is quite a challenge
Information asymmetry
- Hard to quantify firms’ impact on the environment
- Hard to monitor and verify the firm’s clean-up activities
Shareholder maximization
,Corporate Governance System
, Lecture 2. Corporate Governance
Jensen & Meckling 1976
- Separation of ownership and control leads to agency problems
- Agency problems exist in all organizations and all cooperative efforts
- The corporation is a legal fiction that serves as a nexus of contracts among
individuals
Agency costs
1. Monitoring costs by the principal
- Board of directors to monitor managers and represent shareholder’s interest
- Large shareholders monitor management
- Shareholder activism to monitor and influence management
2. Signaling (Bonding) costs by the agent
- Managers pay dividends, signal to shareholders that the firm is profitable
- Timely and honest disclosure of crucial information to stakeholders
- Auditing of the financial and non-financial statements
3. Residual losses
- Managers pursue their own interests at the cost of the principals
“It is likely, that the most important conflict arises from the fact that as the manager’s
ownership claim falls, his incentive to devote significant effort to creative activities such as
searching out new profitable ventures falls.”
Agency costs in the corporate world
Ceo pursuing self-interests;
- Shirking
- Even talented managers may find themselves slacking if not disciplined
properly
- Extremely hard to monitor someone with unique skills & knowledge
- Management perks
- Executives tend to over-spend on perks
- Tunneling
- Managerial theft of corporate assets
- Favoring companies owned by themselves / relatives
- Excessive compensation
- Limiting Shareholders’ voting rights
- Management entrenchment
- Management could protect their control rights in the following anti-takeover
mechanisms;
- Poison pills: allow existing shareholders to purchase extra shares at a
discount → to dilute shares
- Golden parachute: to give generous payments to executives after the
acquisition
- Staggered board: classify board to prevent the board being replaced at once
- Require supermajority for shareholders to amend a corporate charter
