Fama, Eugene. (1980). “Agency Problems and the Theory of the Firm,” The Journal of Political Economy 88(2): Group 3: Jason Franken Prasanna Karhade Hsiao-Ching Lee Jennifer Shen Marko Madunic The firm is viewed as a team or a nexus of contracts.

2 “Agency Problems & the Theory of the Firm” Motivation: Classical property rights literature: Holds entrepreneur to be manager & risk bearer. Neglects separation of the actions in modern corps.Purpose: To present an argument for his thesis: “Separation of security ownership and control can be explained as an efficient form of economic organization within the ‘set of contracts’ perspective.”

3 “Agency Problems & the Theory of the Firm” Irrelevance of Ownership of Firm Concept: Firm is a “nexus of contracts.” Assume firm rents all factors of production! Each factor in the firm is owned by somebody. Managers own their labor & rent it to the firm. Their role – “decision-making” – coordinating activities of inputs & carrying out contracts. Risk bearers own capital & technology. This does not make risk bearers owners of the firm.

4 “Agency Problems & the Theory of the Firm” Separation of Managing & Risk Bearing: Managing and risk bearing are separate functions, with markets providing alternative opportunities to their suppliers, and motivation for managers to perform. Who should control the firm? Though risk bearers are residual claimants, their investment portfolios imply little personal interest in the operation of a particular firm. Managers should have seats on the board of directors, as their market value depends on the firm’s success. Including outside directors (as referees) deters collusion by managers to expropriate security holder wealth.

5 “Agency Problems & the Theory of the Firm” Managerial Incentive Problem: Managers that are not a security holders benefit from shirking & on-job consumption. Resolved by Managerial Labor Markets if: Settle ex post by wage revision – requires: 1.) Manager’s talent & taste for on-job consumption uncertain. 2.) Managerial labor markets efficiently revise wages. 3.) Weight of wage revision is sufficient to resolve problem. Marketable Human Capital Example – Managers perceive the market for their services to vary by unbiased assessments of security holders’ wealth changes due to managers’ deviant behavior … perpetuity nets out, deterring opportunism.

6 “Agency Problems & the Theory of the Firm” Managerial Incentive Problem (cont.): Stochastic process for marginal products (MP): (1.) Manager’s period t wage is his expected MP, with risk bearers accepting ex post measurement noise. Optimal for risk-neutral risk bearers. Not necessarily optimal for risk-averse managers. The inverted form yields: (4.) Wage revision smoothing process requires 0<Ф <<1 Expected MP follows random walk White noise random error

7 “Agency Problems & the Theory of the Firm” Managerial Incentive Problem: More complicated models (equations 5-7): ( are general conditions for full ex post settling up ) Sum of weights = 1 if expected MP nonstationary and differences in MP stationary. If risk bearers are risk averse: Fixed discount on wage each period to compensate risk bearers, which managers wish to avoid. Manager avoids this by contracting to receive ex post measured MP and “smoothing” his MP in capital markets.

8 “Agency Problems & the Theory of the Firm” Conclusions: If the weight of the wage revision process at least equals full ex post settling up, managerial incentive problems – attributed to separation of ownership & control – are resolved … this is an empirical issue. Accumulated expected wage changes may fall short. Full ex post settling up is not the upper bound. Weights of wage revision ≥ full ex post settling up are likely part of the explanation for the survival of modern corps. with diffuse security ownership that is separate from control. Full ex post settling up Weight of wage revision