Chapters 10 and 18 (p ) –Incentive Conflicts and Contracts –eBay Case, P. 275 –Schmidt Brewing Company –Sarbanes-Oxley Review Assignment 3 Managerial Economics: Today’s Agenda

Managing with Economics “traditional managerial economics” Firm is a single profit maximizing decision maker “new managerial economics” Firm is a focal point for a set of implicit & explicit contracts between many decision makers Highlights the role of decentralized information

Full information management decisions –Maximizing profits Perfect Knowledge of Demand Perfect Knowledge of Costs Marginal thinking –Cost minimization Perfect knowledge of relationship between inputs and output Managing in a world of imperfect, asymmetric information –Making the best use of decentralized information –Decision rights –Incentives and evaluation Managing with Economics

Firm as focal point for set of contracts Contract is an agreement about obligations in a relationship

The role of contracts Costless contracting –ideal contracts would align interests (minimize incentive conflicts) at no or low cost Costly contracting and asymmetric information –contracts costly to negotiate, write, administer –parties to contract have asymmetric information on performance levels

The Story of the Chinese Junks (attributed to Steve Cheung) A refined British lady is taking a boat ride in China. A mean-looking man is yelling at the rowers and whips them when they fail to work hard. The lady comments to her guide that the British would not allow this cruel treatment of workers. Indeed, the owner of the boat would be put in jail for violating labor laws. The guide is amused by her statement and indicates that the people rowing the boat are the owners. The mean-looking man is an employee. Explain what is going on!

Precontractual information problems Bargaining failures –asymmetric information See recent the bus strike and NHL lockout Adverse selection –use of private information in manner detrimental to trading partner Insurance markets Valuable insurance markets fail to exist –No grade insurance

Postcontractual information problems Agency problems –principal contracts with agent for service –agent has postcontractual incentive to serve own perceived best interests Asymmetric information complicates resolution of agency problems –principal incurs monitoring costs and/or –agent incurs bonding costs Total agency costs = monitoring/bonding cost + any residual cost due to agency problem Incentives to economize on agency costs –sharing increased gains from trade

eBay, p How does eBay create value? 2.What potential contracting problems exist on eBay? 3.How does eBay address these problems? 4.What are the contracting costs at eBay? 5.eBay claims that it has only a small problem with fraud and misuse of the system. –Does this imply that it is overinvesting in addressing potential contracting –problems? Underinvesting? Explain.

Optimal combination of compensation and perks CEO utility function, C is compensation, P is perquisites: U=f(C,P) Owners have precise knowledge of profit potential:  p Realized profits are:  R =  p -P Therefore offer CEO compensation contract: C=S-(  p -  R )

Optimal perquisite taking

Value Maximization Principle Incentive problems generate costs that reduce value. It is in the interests of all parties to a contract to develop efficient solutions to agency problems. More value is created (gains to trade), which can be shared among the contracting parties. How does this apply to corporate governance?

Discussion Questions Describe an agency conflict in one of your organizations. What do you think is causing this conflict? What suggestions do you have for better controlling this conflict?

Schmidt Brewing Company Schmidt Brewing Company is family-owned and -operated. The family wants to raise some capital by selling 30 percent of the common stock to outside shareholders. The company has been profitable and the family indicates that it expects to pay high dividends to shareholders. The family will maintain 70 percent ownership of the common stock and continue to manage the firm. The rights of shareholders are specified in the company's corporate charter. The charter specifies such items as voting rights (procedures and items subject to a vote), meeting requirements, board size, rights to cash flows, and so on. Once adopted, a charter can only be changed by a vote of the shareholders. What types of provisions in the corporate charter of Schmidt Brewing might motivate minority shareholders to pay higher prices for the stock? Explain.

Sarbanes-Oxley What potential effects will the Sarbanes- Oxley Act of 2002 have on the legal form of organization? What potential effects will the Sarbanes- Oxley Act of 2002 have on the willingness of individuals to serve of corporate boards? What potential effects will the Sarbanes- Oxley Act of 2002 have the level of executive pay?

Assignment 3

Looking Forward Next Class: Managerial Economics and Organizational Architecture –Organizational Architecture, Ch. 11 –Kodak case from Chapter 11 –Ethics, Ch 21 Coursepack: Nordstrom Giving Until it Hurts, WSJ Recycling Corporate Responsibility, WSJ

Midterm Evaluations Please fill out Goes directly to instructor Feedback on what works; what could be improved – can allow adjustment of 2 nd half of course Thank you