MANAGERIAL ECONOMICS:
THEORY, APPLICATIONS, AND CASES
W. Bruce Allen | Keith Weigelt | Neil Doherty | Edwin Mansfield
Chapter 17
Principal-Agent Issues and Managerial
Compensation
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Information asymmetries
Problems before a contract is written:
◮
◮
Adverse selection
i.e. trading partner cannot observe quality of the other partner
⋆
Use signaling or screening
Problem after contract is written:
◮
◮
◮
Moral hazard
Principal-agent problems
i.e. trading partner cannot be sure if the other is behaving ok after
contract is written
Nobel prize in economics 2001 for informational asymmetries
(Akerlof, Spence and Stiglitz)
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Contracts
Contract is economic jargon for agreements that modify behavior in
ways that are mutually beneficial. This may encompass sorts of
actions, payments, rules/procedures and behavior.
The term contract does not necessarily have to refer to the legal
status; they can also be implicit and unarticulated.
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Complete contracts
The parties foresee all relevant contingencies (and can describe
these);
Agree upon an efficient course of action for each contingency;
Abide to the terms of the contract (no desire to renegotiate and are
able to determine violation).
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Contracts are often incomplete
Information problems:
◮
limited foresight
◮
imprecise language of contract
◮
costly calculations and costly contracting
Further, not everything can be verified and enforced (notice: there is a
difference between observability and verifiability)
◮
(observability vs. verifiability: a cartel observes that the price is not at
the cartel price anymore, but may not know whether someone has
deviated or demand has dropped)
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Private information
Bargaining: a buyer and a seller bargain over a price
Value maximization principle: efficient transaction should occur if
value to buyer is higher than value to seller
With private information one party does not know the other party’s
payoff (see also auctions)
With private information it is typically not possible to reach the same
level of efficiency as under complete information, because both buyer
and seller will have strategic incentive to misrepresent her real
valuation.
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PRINCIPAL-AGENT ISSUES
Principal-Agent Issues: When managers (agents) make decisions that
affect the wealth of shareholders (principals)
◮
Conflict of interest: Personal utility of decision maker (agent) conflicts
with the objectives of the principal.
◮
Issue vanishes when principal and agent have identical objectives.
⋆
Manager is the business owner.
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PRINCIPAL-AGENT ISSUES
Factors
◮
Uncertainty is a factor when the effects of an agent’s decisions are not
deterministic. Outcomes may be bad when decisions are good.
◮
Information asymmetry: Agents and principals do not have the same
information sets.
⋆
Noncooperative game
⋆
The principals determine compensation rules for the agents.
⋆
Agents’ actions are not directly observable by principals.
⋆
The consequences of decisions made by agents are not entirely
predictable.
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PRINCIPAL-AGENT ISSUES
Managers can anticipate issues associated with the principal-agent
problem and devise incentive compensation strategies that will help to
minimize the problem.
◮
Product liability laws provide incentives for agents (product
manufacturers) to produce safe products for the principals (consumers).
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THE DIVERGING PATHS OF OWNERS AND
MANAGERS
Shareholder goals
◮
Maximize value of the firm
Alternative management goals
◮
Minimizing effort
◮
Maximizing job security
◮
Avoiding failure
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Enhancing reputation and employment opportunities
◮
Maximizing perquisites
◮
Maximizing pay
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THE PRINCIPAL-AGENT SITUATION
Example: Choice of distribution channel by managers at a life
insurance company
◮
Existing channel: Low risk, low expected profit
⋆
◮
Managers may prefer this choice because of low risk.
New channel: High risk, high potential profit
⋆
Stockholders may prefer this choice because of the high potential profit
and because they can reduce risk by holding a diversified portfolio.
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THE EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Managerial Behavior and Effort
◮
Disutility of effort: A measure of the cost to the manager of supplying
effort
◮
Effort imposes personal costs on managers, who therefore prefer to
exert less effort.
◮
Effort contributes to increasing the value of the firm, so stockholders
prefer managers to exert more effort.
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THE EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Procedure
◮
Incentive conflict: What is the issue?
◮
Find the optimal contract when effort is observable
◮
Find the optimal contract when effort is not observable
◮
Find the optimal contract when effort is not observable and profits are
risky
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EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Model
◮
π = π(e)
⋆
◮
π is profit and e is manager’s effort.
π(e) = R(e) − (S + C )
⋆
R(e) is revenue as a function of manager’s effort, S is manager’s
compensation, and C is other costs.
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EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Model (Continued)
◮
Figure 14.2: The Principal-Agent Problem with Flat Salary
⋆
u(e) is the disutility of effort for the manager, represented as linear
with a positive slope.
⋆
Net benefit to the manager is B(e) = S − u(e).
⋆
Utility maximizing level of effort by manager is (in this case) where
e = 0.
⋆
Profit maximizing level of effort is where ∂R/∂e = 0, which is higher
than the manager’s utility maximizing level of effort.
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EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict If Effort Is Observable
◮
Model: S(e) = K + U(e)
⋆
S(e) is compensation as a function of observable effort, K is the fixed
component of compensation, and U(e) is the portion of compensation
that depends on effort.
⋆
π(e) = R(e) − S(e) − C = R(e) − [K + U(e)] − C
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EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict If Effort Is Observable
◮
Model: S(e) = K + U(e) (Continued)
⋆
Profit maximizing compensation:
∆π(e)/∆e = ∆R(e)/∆e − ∆U(e)/∆e = 0
⋆
Manager net benefit: B(e) = S(e) − u(e) = K + U(e) − u(e)
⋆
If U(e) − u(e), then B(e) = K and managers will be willing to supply
any desired effort level (net benefit is always positive so long as K is
positive). The stockholders just need to communicate the optimal level
of effort to managers and they will provide it.
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THE EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict If Effort Is Observable (Continued)
◮
Figure 14.5: The Principal-Agent Problem with Pay as a Function of
Effort
◮
In practice, managers have better information than shareholders and it
is too costly for shareholders to perfectly monitor managerial effort.
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EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict If Effort Is Not Observable
◮
If effort is not observable, then it is difficult to reward or penalize effort
levels.
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THE EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict (Continued)
◮
Model
⋆
Assume that the firm’s revenue R(e) is riskless and determined solely
by e, the effort put forth by the manager
⋆
The level of managerial effort can be inferred from R when revenue is
riskless, but this does not ensure that the optimal level of effort, e*, is
selected by managers.
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THE EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict (Continued)
◮
Model
⋆
This problem is resolved by replacing K with a bonus; a share, α, of
profits that is selected by owners.
⋆
Compensation = S(e) = Salary + Bonus = U(e) + απ(e)
⋆
Profit = π(e) = R(e) − U(e) − C
⋆
Net benefit to manager = B(e) = S(e) − u(e) =
U(e) + απ(e) − u(e) = απ(e)
⋆
Managers’ and owners’ incentives converge. Both seek to maximize net
profit.
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THE EFFECT OF RISK, INFORMATION, AND
COMPENSATION ON PRINCIPAL-AGENT ISSUES
Resolving the Incentive Conflict (Continued)
◮
Incentive compatibility: When the agent and the owners share in the
profit of the firm; and the agent’s effort maximizes the principal’s profit
⋆
The manager chooses a level of effort to maximize profit.
⋆
The owners choose α such that the compensation package is
competitive.
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RESOLVING THE INCENTIVE CONFLICT WHEN
OUTPUT IS RISKY AND EFFORT IS NOT
OBSERVABLE
When output is risky, owners cannot infer the level of managerial
effort from observed profits.
Bonus plans
◮
Contribute to efficiency by aligning managers’ incentives with owners’
objectives.
◮
Impose risk on managers in that performance measures that determine
bonuses are not entirely under managers’ control.
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RESOLVING THE INCENTIVE CONFLICT WHEN
OUTPUT IS RISKY AND EFFORT IS NOT
OBSERVABLE
Risk Sharing
◮
Risk premium: minimum difference a manager requires in compensation
to be willing to take a risk
◮
Owners can reduce risk by portfolio diversification. Managers are averse
to risk in their compensation plan. This suggests that owners should
absorb all risk.
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RESOLVING THE INCENTIVE CONFLICT WHEN
OUTPUT IS RISKY AND EFFORT IS NOT
OBSERVABLE
Risk Sharing (Continued)
◮
Model
⋆
Revenue = R(e) = R1 (e) + R2
⋆
Revenue consists of two components. R1 (e) is determined by manager
effort and R2 outside of the manager’s control.
⋆
Compensation should consist of a fixed component, K , which is
independent of effort, and a bonus, απ(e), that depends on profit.
⋆
Profit = π(e) = R1 (e) + R2 − K − C
⋆
Net benefit is the expected utility of compensation minus the disutility
of effort B(e) = EU[K + απ(e)] − u(e)
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RESOLVING THE INCENTIVE CONFLICT WHEN
OUTPUT IS RISKY AND EFFORT IS NOT
OBSERVABLE
Risk Sharing (Continued)
◮
Elements of the principal-agent conflict in this example
⋆
Principal: Sets incentive compensation to align manager and owner
interests
⋆
Agent: Given the compensation plan, selects a level of effort to
maximize expected utility
⋆
Result: When profit is determined, manager receives compensation and
principal keeps residual profit.
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SOME REFINEMENTS TO MANAGERIAL
COMPENSATION
Motivating the Manager with Profit Sharing
◮
Figure 14.7: The Effect of Compensation Schemes on Managerial Effort
⋆
Utility of flat salary B = U(B) with low effort
⋆
With high effort, EU = (0.4)U(A) + (0.6)U(C ) = U(B)
⋆
Risk premium plus disutility of high effort = D − B
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SOME REFINEMENTS TO MANAGERIAL
COMPENSATION
Motivating the Manager with an Income Guarantee and Stock
Options
◮
Figure 14.8: Reducing Managerial Risk with Stock Options
⋆
Manager is guaranteed a salary of E plus stock options that will pay F
with probability 0.35 and nothing with probability 0.65.
⋆
EU of compensation is the same as in Figure 14.7, but there is a
guaranteed minimum income.
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Indexed Stock Options
A call option is a contract that gives the holder the right (but not the
obligation) to purchase a given number of shares of stock in a firm at
a pre-agreed price from the counterparty (the seller of the option)
The fixed price is called the striking or exercise price
◮
Example: you have the right to buy x shares in six months’ time
(maturity) at a striking price of 50$ per share
The call option allows you to make a profit if the stock price raises
above the striking at maturity
Indexed stock options have a striking price that is linked to an index
of stock prices. They reward performance relative to the market that
is indexed.
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Composition of CEO Pay
CEO payment: fixed salary, bonus, long-term incentive payments
(stock options)
Composition is changing with an increasing focus on incentive
payments
Long-term incentive payments have increased dramatically already in
the 1990s, but also b/w 2000 and 2008
b/w 1994 and 1999: fixed payment decreased from about 50% to
37% in US firms
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CEO Pay over time
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Backdating scandal
Backdating options is the practice of issuing options contracts on a
later date than which the options have listed
Academic researchers had long been aware of the pattern
◮
share prices of some companies rising dramatically in the days following
grants of stock options to senior management
Backdating stock options is not necessarily illegal; it becomes illegal
when a company’s shareholders are misled
◮
can be misleading to shareholders in the sense that it results in option
grants that are more favorable than the shareholders approved in
adopting the stock option plan.
◮
quarterly and annual financial reports to investors may be misleading
As of 17 November 2006, backdating has been identified at more
than 130 companies, and led to the firing or resignation of more than
50 top executives and directors of those companies
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Running the family farm
Assume:
◮
you inherit the family farm halfway through your MBA program and
would like to employ a manager for the time being
How much should you pay?
◮
Pay a flat salary of about $ 50,000 a year
◮
Or: maximize the profits of the farm
Manager relies only on this income and maximizes her utility
◮
Low effort: U = sqrt(W )
◮
High effort: U = sqrt(W ) − u(e) = sqrt(W ) − 46.3
◮
(disutility of 46.3 corresponds to $2143.69;
46.3 = sqrt(W ) → W = $2143.69)
Flat salary
◮
Utility with low effort: sqrt(50, 000) = 223.6
◮
Utility with high effort: sqrt(50, 000) − 46.3 = 177.3
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Running the family farm
Profit-related compensation
◮
Assuming a competitive labor market for managers, it has to be at
least 223.6 in expected utility terms → What proportion x of profits
would achieve this?
Profit and managerial effort
Low effort
low grain price (.5)
$ 50,000
high grain price (.5)
$ 150,000
High effort
$ 100,000
$ 200,000
x should satisfy
◮
◮
◮
◮
expected utility with flat salary and low effort = expected utility with
bonus of x profit and high effort
223.6 = .5sqrt(100, 000∗x)+.5sqrt(200, 000∗x)−46.3 → . . . → x = .5
→ expected compensation .5 ∗ [.5 ∗ 100, 000 + .5 ∗ 200, 000] = 75, 000
extra 25,000 compensates the manager for both the disutility of effort
and risk
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Running the family farm
Will the managers provide the effort?
◮
EU with high effort:
EU = .5 ∗ sqrt(.5 ∗ 100, 000)] + .5 ∗ sqrt(.5 ∗ 200, 000) = 223.6
◮
EU with high effort:
EU = .5 ∗ sqrt(.5 ∗ 50, 000)] + .5 ∗ sqrt(.5 ∗ 150, 000) = 216
Are you better off?
◮
Your expected net profits will be
◮
Flat salary: E (profit) = .5 ∗ 50, 000 + .5 ∗ 150, 000 − 50, 000 = 50, 000
◮
Earnings related:
E (profit) = .5 ∗ 100, 000 + .5 ∗ 200, 000 − 75, 000 = 75, 000
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The good and bad of incentive payments
Example: Sears - auto repair centers - offered incentive payments to
auto technicians
Intend: to increase productivity
What happened actually?
◮
Some Sears technicians decided to increase their compensation by
doing repairs that were unnecessary
◮
Consumers were e.g. told that the brakes are near failure; risk averse as
most of the consumers were they authorized a repair
◮
When the practice was exposed, it caused great embarrassment to
Sears
Stock option plans may increase the incentive to misstate the firm’s
financial situation
Stock option plans may also induce managers to take to much risk
◮
Managers do not face the negative side of a risky undertaking
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PRINCIPAL-AGENT ISSUES IN OTHER CONTEXTS
Moral hazard: When a party insured against risks behaves differently
from the way it would behave if it were uninsured against these risks
◮
Ex-ante moral hazard: Tendency of insured entities to take less care to
prevent future losses
◮
Ex-post moral hazard: Tendency of insured entities to attempt to
minimize the cost of their losses
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PRINCIPAL-AGENT ISSUES IN OTHER CONTEXTS
Examples
◮
Health insurance
⋆
Insured ⇒ more willing to take risks
⋆
Doctors ⇒ more willing to prescribe costly treatment
◮
Car insurance ⇒ more risk taking
◮
Home insurance ⇒ less effort in taking care
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Further examples
U.S. Savings and Loans industry
◮
Banks make too risky investments because of deposit insurance
Similar problem with equity holders and creditors in general:
◮
Equity holder (residual claimant) wants investment with higher mean
return but also higher risk
Employees shirking behavior
In all cases: agent does not get the full reward of her effort/activity
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PRINCIPAL-AGENT ISSUES IN OTHER CONTEXTS
Asset Substitution: Example
◮
Shareholders have control over the decisions of managers through the
compensation scheme, but creditors do not.
◮
A drug company is exposed to risk. Expected future earnings could be
100 or 200 with equal probability. Expected value of the firm is 150.
The firm has 100 in debt. Hence, after paying off the bonds, there is 50
in expected equity.
◮
The drug company has an opportunity to invest in a new drug.
Formula A is relatively risk free and Formula B is potentially more
profitable and more risky. Capital cost of the new drug is 200.
◮
Certain value of A = 220 − 200 = 20
◮
Expected value of B = (0.5)(20) + (0.5)(310) − 200 = −35
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PRINCIPAL-AGENT ISSUES IN OTHER CONTEXTS
Asset Substitution: Example (Continued)
◮
Firm Value if Project A Is Chosen: Equity = 70(= 370 − 100 − 200)
◮
Firm Value if Project B Is Chosen: Equity = 80
⋆
Value of the firm = .25 ∗ (120 + 220 + 410 + 510) = 315
⋆
Old debt = 100 and new debt = .25 ∗ (20 + 120 + 200 + 200)
⋆
Equity = .25 ∗ (0 + 0 + 110 + 210) = 80
◮
Firm is better off with Project B because, if the project fails, the firm
will go bankrupt, bondholders won’t get paid, and stockholders walk
away. If the project succeeds, then stockholders will reap the rewards.
◮
Bondholders, recognizing the optimal action of the firm, will refuse to
provide financing above the 135 amount, which is what bondholders
would receive if Project B is selected and it is unsuccessful.
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Controlling Moral Hazard
Monitoring
Explicit incentive contracts
Bonding
Ownership changes
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Monitoring
Costly
There might be a problem with the credibility of the punishment (if
the punishment is too severe)
Problem of moral hazard of the principal: supervisor might claim that
agent did not do his job in order to save wages/bonuses
Maybe competitors can provide independent sources of information
which can be used
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Explicit incentive contract
Agent is directly rewarded for her effort - in most cases effort not
directly observable, but outcome is ⇒ output-related pay ⇒ exposes
the agent to uncontrollable risk.
Use Value-Maximization principle: design contract such that joint
value of the parties is maximized.
What if agent is risk-averse?
◮
If no-wealth condition is fulfilled, i.e. necessary compensation is
independent of the decision makers’ wealth ⇒ agent can be
compensated for the risk she is taking
Tradeoff between incentive and insurance
◮
Incentives are highest if agent bears all the risk
◮
If she is risk-averse, incentive should be not so strong because of
insurance.
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Bonding
A bond is a sum of money - the agent has to deposit - which is lost if
the agent misbehaves
Examples: trainees have to repay training costs if they leave the firm
early
Problem: in many cases the no-wealth condition does not hold
◮
(The necessary compensation amount is independent of the decision
makers’ wealth.)
One solution:
◮
seniority pay (pay rises disproportionately with stay in the firm) or big
payment at end of stay (e.g. “Abfertigung”)
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Ownership changes
Eliminate principal and agent by merging firms
Problems
◮
P-A problems also within firms, or departments of firms
◮
Influence activities within firms will increase especially after merger
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Moral hazard in the financial market
rescue of the investment bank Bear Sterns
in 2007, Bear Stern’s stock was trading at $170
by mid March 2008 the price were down to $30
in addition there was the danger of a failure and its impact on the
financial system
rescue plan
◮
JPMorgan bought Bear Sterns at $10; too high??
◮
If the bailouts is too attractive, owners will expect them in future as
well and won’t be prudent anymore
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