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ECON 20110 Fall 2013 - Lecture 2: Theory of the Firm — Transcript

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0:00okay so uh a firm is a bundle of
0:06individuals uh physical assets and
0:09technology that is used for production
0:12uh and that we will typically in this
0:14court of course treat as a coherent and
0:17profit maximizing individual now um it's
0:22useful uh to start off therefore by
0:25looking inside of the firm and thinking
0:28about the realism
0:30uh or relevance of this way in which we
0:33model firms as a coherent profit
0:36maximizing collection of things people
0:39uh individuals and Technology So today
0:42we're going to study the internal
0:43organization of firms and uh use that as
0:47sort of a launching off point for uh
0:50what we'll do in the rest of the
0:54course okay um so some of the questions
0:58we'll ask today
1:00are what are firms as legal
1:03entities uh what should and do firms
1:07maximize what are the conflicts that
1:09arise within firms that inhibit this
1:13maximization how uh firms should be
1:16governed and financed to deal with these
1:19conflicts why firms exist in the first
1:22place and why markets don't just
1:24organize all activity some of the
1:27theories of the answers to that question
1:29as well as contractual alternatives to
1:31firms and finally whether it matters
1:34exactly what we call a firm uh or you
1:37know what we should think of the term
1:39firm referring
1:42to so firms uh come in six basic legal
1:47varieties though there are uh variations
1:50on these the first are sole
1:53proprietorships uh these are mostly
1:56small businesses mom and pop stores
1:58franchise businesses that are part of a
2:01larger firm so like you know a local
2:03McDonald's franchise might be owned by a
2:05single individual even though it's part
2:07of the broad uh McDonald's firm these
2:11sole proprietorships are really just
2:13extensions of individuals and they have
2:16all the same responsibilities and rights
2:19that an individual have so it's
2:20basically just you going into
2:22business the second are
2:25Partnerships and these are groups of
2:27individuals who join together to take
2:30Joint responsibility for businesses
2:34every individual who's a member of a
2:36partnership is responsible for every
2:38action that is taken by the Partnership
2:41if the partnership incurs debt the
2:43debtors can come after any individual in
2:45the Partnership if the partnership
2:47commits uh you know uh some crime or is
2:50sued you can sue any of the individuals
2:52who are part of the
2:54partnership um usually Partnerships are
2:58professional groups uh groups of lawyers
3:01groups of accountants uh uh groups of
3:05doctors for
3:08example uh a third uh form of
3:11organization are privately held
3:14corporations so um the I'll talk more in
3:18just a moment about what it is that
3:20makes a corporation distinctive from
3:22other forms of business but the key
3:24difference between a private and
3:26publicly held Corporation is that a
3:28privately held Corporation is owned by a
3:30few numbers of individuals and there's
3:33no open and active market for um the
3:37shares or ownership or control of that
3:42Corporation the next category are
3:45publicly held corporations these are
3:47ones where the the stock the shares are
3:50traded on an open public market with
3:52many transactions occurring each
3:55day the fifth form uh is not for profit
4:01and that's closely related to another
4:02type of firm which is for profit but
4:04which is cooperative so a not for profit
4:08is a tax exempt organization that cannot
4:11disperse its profits any money it takes
4:13in has to be spent within the
4:15company and these are quite highly
4:18regulated uh another form of
4:20organization is a Cooperative which is a
4:22for-profit firm but we're the only
4:24people who are allowed to be
4:27shareholders are consumers or workers of
4:30that
4:31firm or some uh
4:35yeah and finally and this is less common
4:39in developed countries but uh another
4:42form of organization are state-owned
4:45firms which are run by the government
4:47for the benefit or with the subsidies of
4:51the public uh
4:53treasury okay so um we'll focus uh Prim
4:59primarily in the course on corporations
5:02and as a result I want to go into a
5:03little bit greater depth as to how
5:06corporations are run so is Julian here
5:11Julian uh what are the defining features
5:14of a corporation as opposed to another
5:16form of uh organization um so obviously
5:20it's not state owned it's owned by uh
5:22private individuals and um the
5:26corporation is a legal n of itself so
5:28that the shareholders aren't um aren't
5:32responsible for the actions like they
5:35can't the de debtors can't debt
5:38collectors can't go that's right that's
5:41right so the probably the most prominent
5:43uh feature of a corporation is that um
5:48they have the rights and
5:49responsibilities of an individual
5:51independent person they are chartered by
5:53States and as a result granted limited
5:55liability which means that creditors
5:58cannot pursue the the people who own the
6:00firm for the debts incurred by The
6:04Firm um and third as a result partially
6:09of that they have to pay What's called
6:10the corporation income
6:12tax um which is a separate tax that's
6:15assessed only on corporate forms of
6:17ownership now when the corporation pays
6:20out money to its owners they also have
6:23to pay taxes on that so effectively
6:25corporations are double taxed on their
6:27earnings okay now corporations are
6:30financed primarily in two ways uh is Su
6:35uh sorry yeah suel here I'm yeah yeah
6:39two ways are debt and Equity uh could
6:41you describe uh what What's the
6:43difference between debt and Equity or
6:44how they work sure yeah so um when you
6:47issue debt is generally issued um
6:50through bonds corporate bonds um and
6:53those have to be paid back um those
6:55definitely to be paid back and they have
6:57um first priority uhhuh so um
7:00whereas for Equity
7:02um um Equity
7:06is I meanes it's like a residual claim
7:10shareholders are residual claims in that
7:12they have an incentive they're kind of
7:14owners of the company yeah so they um
7:17have a St they make decisions for the
7:18company as well that's right yeah so
7:20debt is raised in two ways so one way is
7:23bonds as you mentioned the other way is
7:25uh Banks make loans to companies and
7:28they H the interest on those loans the
7:31cost of taking them on is deductible
7:33from the corporation's taxes as a cost
7:35of
7:36operation
7:37um and these typically come not with any
7:42right to control the actions of the firm
7:44but sometimes with legal restrictions on
7:47what the firm is allowed to do these are
7:48called
7:50covenants um equity on the other hand is
7:53tax disadvantaged because the payouts
7:57from the uh firm in as Dividends are
8:01taxed in addition H sorry there's
8:04they're not tax deductible in the way
8:06that the payments on the debt
8:08are but they receive um dividends voting
8:13rights and through their voting rights
8:16they have the right to choose the board
8:17of directors which then chooses the CEO
8:21and manages uh and thereby manages the
8:23corporation so they're the residual
8:25controllers as well as residual
8:27claimants on all the revenue that the
8:29company makes beyond what it has to use
8:31to pay back its debt
8:33holders now there are categories that
8:35are in between these like preferred
8:37shares which tend not to have voting
8:39rights but do have a claim on the
8:42dividends of the firm unlike debt uh but
8:46as you head towards bankruptcy they have
8:48some debt-like right uh to earn
8:52something even if the firm is going
8:55bankrupt
8:57okay so um shareholders own the company
9:02um but the question is exactly how do
9:04they maintain uh control over the
9:06company Jake do you have some thoughts
9:08about that
9:10um well uh shareholders that are
9:14residual right but how do they actually
9:17control the company how do they run it
9:19uh well they don't have
9:23uh that much control they just want to
9:25maximize profits since they're well but
9:28how do they make sure that the company
9:30does that how do they actually what what
9:32are their levers to control the company
9:34to make sure that it doesn't do
9:35something crazy that they have no
9:36interest in uh they can like buy and
9:40share so they can buy and sell shares
9:42but also they have voting rights right
9:48um uh they can choose the board of
9:51directors of the
9:53company
9:55um they uh there are protection
10:00of the rights of minority
10:02shareholders um so voting rights by the
10:05way they can use not only to choose the
10:07board of directors but also to vote on
10:08major issues of the company like the
10:10choice of the CEO sometimes or major
10:13transactions such as the acquisition of
10:16the company by another company or a
10:18decision to
10:19merge
10:22um the minority shareholders at the
10:26company uh can be protected from control
10:31by a majority that uh can vote them down
10:34in all the issues by various legal
10:38protections uh for example it may be um
10:42required that uh a majority of the
10:45minority approve certain types of
10:48transactions sometimes uh the there will
10:52be something called a poison pill where
10:55if you have a significant amount of
10:56equity in the company you're either not
10:58allowed to vote or other people have
11:00more weight in voting than you do um and
11:03these are to protect uh from abuse by
11:07the majority shareholders and we'll talk
11:09a little bit about the types of abuse
11:10that would be possible in a
11:12minute a fourth uh uh way that they can
11:16control the managers are either by the
11:19Loyalty that the managers are instilled
11:22by codes of business ethics to field to
11:24them or by taking legal action against
11:28an abusive
11:29uh
11:30manager and we'll talk how well these
11:33work uh in the last class to to some
11:36extent um now there are also some legal
11:39protections that Bond holders have they
11:42can force a company into bankruptcy if
11:43it fails to make payments to them um and
11:47they can take assets from The Firm
11:49sometimes if the firm fails to uh make
11:52payments to
11:53them in the case of bank loans uh
11:56primarily the bank can force them to
11:58sign Covenant that restrict the sorts of
12:01actions the firms can take such as the
12:02risks that can take on
12:06okay so uh most of the course is going
12:09to focus on the assumption that firms
12:11are maximizing profits but a natural
12:14question is whether this is really what
12:15they do in fact or what they even should
12:17be doing so for the moment let's assume
12:21that owners want them to maximize uh
12:25profits uh because and this is the
12:28argument that Freedman gives in his
12:29article the shareholders could always
12:31take any money that was raised by the
12:33firm and use that themselves uh to
12:37donate to any charity they want or
12:39support any other cause so if the
12:41shareholders wanted to pursue a social
12:43goal they could just do that with the
12:45money that they got back from the
12:47company so a natural question is whether
12:51uh firms should try to accomplish this
12:53goal that shareholders want them to do
12:56now the corporate social responsibility
12:58uh debate has been largely about this
13:01question and some have claimed that
13:02corporations should not only look after
13:05the interests of their shareholders that
13:07they have a responsibility to society to
13:09deal with externalities uh and other
13:11social goals and Milton Friedman pretty
13:14forcefully argues against this view um
13:18Gum g oh he's not here
13:22today okay um does someone else want to
13:27uh describe fredman's argument
13:30uh go ahead remind me of your name uh
13:33Adam Adam well he argues that they're
13:36the uh agents of the company and they're
13:38not the principal so they uh don't have
13:41kind of the right to decide that their
13:44goal should be um the goals of the the
13:48shareholders which uh usually is profit
13:52and they they they don't have you know
13:54the right to tax in a sense either the
13:56shareholders or the customers or the
13:58employees
14:00for their own yeah so he argues managers
14:02are agents they choose they can choose
14:04the means to accomplish the goal but
14:06they can't really choose the goal the
14:07same way that If you hired someone to go
14:09buy you a sandwich and they gave that
14:11money to the beggar that was next to the
14:13sandwich shop you would have thought
14:15that they'd stolen your money right um
14:19and by pursuing social goals they're
14:21effectively
14:22imposing uh their views on the
14:25shareholders uh and if there are
14:27externalities it should be the role of
14:28the government and not of Corporations
14:31to solve those uh you know it shouldn't
14:34be the right of the manager to just
14:35decide what the externalities are um and
14:41if um if the shareholders themselves
14:45want to pursue a social goal why don't
14:49they just do that separately with the
14:50money that they get out right uh unless
14:54it's helpful to sell the goods to
14:56Consumers which it might be like for
14:57example Whole Foods has a whole image of
14:59being earthy crunchy that helps them
15:01sell their goods and maybe some social
15:04responsibility or green energy type
15:07Investments would further that now most
15:11economists are sympathetic to Fred men
15:13in particular they argue that unless the
15:16executives are willing to take a pay cut
15:18which is their you know right in order
15:20to pursue these social goals it's not
15:23really uh the job of them to judge
15:25what's in the social interests now some
15:29some people make a more modest
15:31claim um let me just give one Nuance to
15:35fredman's argument even though I'm to
15:37some extent sympathetic with
15:39it there are sometimes when a company is
15:42able to do inside of it things that
15:45would be very hard to do uh as
15:48effectively outside of the company
15:49charitably so for example Bell Labs was
15:53highly complimentary I don't know if you
15:55know what bell labs are Bell Labs was
15:57this these Laboratories that were run by
15:59AT&T when they were a monopoly and the
16:01thing is that a lot of people at Bell
16:03Labs produced things that were useful to
16:05AT&T and you had these researchers and
16:07if they hadn't been inside of AT&T they
16:10would have had a harder time actually
16:11making their ideas practical and
16:15conversely uh you know there wouldn't
16:17have been as much funding for research
16:19so many people have argued that you know
16:21having a function like that within a
16:22company actually makes possible a higher
16:25quality production than would have been
16:27uh of Charity than would be possible
16:28possible in any way that was fully
16:30separated from the company and therefore
16:32it's not really true that the
16:33shareholders could just as easily take
16:34the money back and do the charitable
16:36thing they wanted to do
16:38separately okay now some have made a
16:41more modest claim which is what they
16:42call the stakeholder society which is
16:45that
16:46stakeholders other than the shareholders
16:49should matter in the firm's decisions
16:50now what are stakeholders not just
16:52anybody or the environment or broad
16:55externalities but the direct
16:57stakeholders who interact with the firm
17:00like the workers and their cut consumers
17:03and in fact cooperatives try to achieve
17:05this goal by directly making these other
17:08stakeholders the owners and the
17:10stakeholder Society view argues that all
17:12firms even the ones that are not owned
17:15as Cooperative should act in this way
17:17now many if not most economists are
17:20skeptical even of this claim because
17:22there's a fundamental difference between
17:24a shareholder and a worker or consumer
17:27which is that the worker or consumer you
17:30know the firms might abuse them but in
17:33the end the worker or consumer can
17:36usually quit the firm whereas once
17:39someone has given money to the firm The
17:41Firm could just run away with all of
17:43their money right there's no ongoing
17:44relationship that they can use as
17:46leverage to stop the firm from screwing
17:48them right and without some ethical or
17:52legal protections For Those Who provided
17:54money to the firm uh it would be very
17:56easy for that to take place
18:00um and if you it may well be socially
18:03valuable to redistribute from those who
18:05own Capital to other people but
18:07presumably this should take place
18:09through some concerted social process
18:11like the tax system right where is the
18:14main role of corporate law and corporate
18:17governance is to ensure that firms can
18:19get financing right because if
18:22shareholders can't be guaranteed to get
18:24their money back they'll never invest in
18:27the first place um and in fact uh a
18:32really problematic thing that happens in
18:34many developing countries where there
18:36aren't many protections for uh
18:40shareholders is
18:42nepotism right if you can't be
18:44guaranteed to get back your money you
18:47want to hire someone uh who you know is
18:50your friend and therefore will look out
18:52for your interests so actually the
18:54failure to provide these sorts of
18:56protections even though many Corporate
18:58social responsibility people uh want to
19:02promote um the you know social interest
19:06if you really don't provide good
19:08protections to the investors then
19:11they're just going to hire people in
19:13their family and it can actually really
19:14reduce the ability to have a a society
19:18that offers opportunities to a wide
19:19range of people and that happens in many
19:23uh poor and developing
19:25countries okay so the naive defition
19:28definition of pro profits is just how
19:31much revenue you bring in minus all the
19:34costs that you have to
19:36expend uh and of course in a simple
19:39sense that's true but the problem is how
19:43you define all of these different uh
19:45objects in the right way so for example
19:49there can be an important difference
19:50between an economic profit and an
19:53accounting profit uh is Michael here
19:56Michael uh yeah go ahead
19:59what yeah what's an example of that like
20:00the cost of putting out your labor
20:03because you could work for someone else
20:05or you could work for yourself or you
20:06could rent your land something else
20:09whatever you're doing yeah that's right
20:11so
20:12um if a proprietor works at a store he
20:16shouldn't count all of the money that's
20:18made by the store as economic profit
20:20because he could as easily have worked
20:22at somebody else's store or done
20:24something else and he should count the
20:27wages that he could have earned
20:28elsewhere not as profit but as the
20:31opportunity cost effectively he's paying
20:33himself wages
20:36right um another example of this is that
20:40you know a company that's much larger
20:42will obviously earn greater
20:46profits but um in order to do that they
20:50might have to have uh say imagine
20:53they're currently a small company and
20:54they spend a huge amount of money buying
20:58uh another another company that then
20:59generates profits well they should C uh
21:02count against that the cost that they
21:04incurred in buying that other company in
21:06the first place right so it's not just a
21:08big company is always more profitable
21:11the real question is profit per current
21:13shareholder of the
21:15firm right okay so a second issue is
21:19time and discounting so profits um today
21:24are worth more than profits later
21:26because you can take those profits today
21:27and invest them in the stock market or
21:30in other projects and they'll generate
21:32more money but on the other hand um many
21:36things in the long run uh that the fir
21:39that might help the firm make more
21:41profits in the long run might actually
21:43hurt its profits today because it as to
21:44make an investment in improving its
21:46reputation in building plant Etc and so
21:48it shouldn't just think about the
21:49absolute most short-term profit so
21:51there's a right way to balance the
21:53long-term and the shortterm that's an
21:56important issue in thinking about uh
21:58profit ability of a
21:59firm a third issue is
22:02uncertainty so um if the firm doesn't
22:07know what is going to produce the most
22:09profits all it can do is maximize its
22:12expected profits it doesn't know exactly
22:15uh what it's going to do there so you
22:16can't just really instruct the firm to
22:18maximize profits it has to maximize
22:20expected profits but in fact that's not
22:22even the right thing to do necessarily
22:24right because if you care about risk
22:26it's not just the average of profits you
22:27care about it's some risk weighted
22:30average profits right you might uh
22:33disfavor actions that the firm could
22:35take that would be extremely risky uh
22:37but would generate profits and in fact
22:39these May matter to different people
22:41differently for example uh if a firm is
22:45undertaking a project that will make a
22:48lot of money if and only if I get
22:50incredibly sick and I'm the owner of the
22:52firm I might actually like that sort of
22:54risk because it would ensure me against
22:56how costly it would be to me if I set
22:59right and so different owners of the
23:02firm may actually have different
23:04valuations of different types of risk
23:07The Firm takes and so it's not a
23:09completely uh straightforward way even
23:12once you uh realize that there's risk to
23:15figure out how you should weight all
23:17these different things now A solution
23:20that people have offered to this is that
23:23firms rather than maximizing profits
23:25should maximize the stock market value
23:27of their firm and this obviously also
23:29has problems right first of all it's not
23:31even possible for privately valued firm
23:34privately owned firms because there is
23:35no going stock market value the stock
23:39market value doesn't always reflect the
23:42long-term value of the company because
23:43stock markets can get confused and
23:45messed up in all sorts of ways right so
23:48the real ideal for a firm is to maximize
23:52the value to the original people who
23:55took the company public but how exactly
23:59one does that uh through all the future
24:01decisions of the firm thinking back to
24:04the original value to the IPO uh people
24:07is is quite complicated yeah philli well
24:10once the firm lets in a new shareholder
24:13doesn't the firm uh have a
24:17responsibility to and also an incentive
24:20through the new shareholders power in
24:23the voting process to uh treat him as
24:26well as any other IPO shareholder
24:29like the value to the current
24:31shareholders could be the important
24:33thing yeah but the thing that you have
24:34to think about is that actually the
24:36reason why you want to give some rights
24:38to the current shareholder is because
24:41that will make him have been willing to
24:45pay more to the original IPO people so
24:47you can sort of Trace everything back to
24:49that you can think what actions in the
24:51future will
24:52lead as you trace back the line of
24:55causation the original IPO people to get
24:58the most money and that may well be
25:00committing to respect the interests of
25:03the future
25:06shareholders it's like you know it might
25:09not be in my interest to uh give you a
25:14good product once we've already signed a
25:15contract and I know how much money
25:17you're going to pay me but unless I
25:19commit to give you a good product you're
25:20not going to be willing to pay me that
25:22much up front
25:25right okay so this this is almost an
25:29impossible goal uh to achieve and we
25:33really don't have any way of governing
25:36corporations that aims at achieving
25:38exactly this goal because there's lots
25:41of uh conflicts that end up coming so
25:43one is just of profits versus other
25:46goals like we talked about in the
25:47corporate social responsibility
25:49debate but um another issue that comes
25:54up is that different uh shareholders may
25:57have different evalu
25:59of Notions of risk even among those
26:01initial people who went for the IPO uh
26:04and Florence could you describe uh why
26:06that's the case and and what problems
26:08that might cause
26:11uh if you have
26:14sorry if you have different attitudes to
26:17risk you might have different attitudes
26:21towards different actions and um
26:25Associated possible gain or loss yeah
26:28exactly so when the company goes public
26:32initially some people may want things to
26:35pay off in certain situations and not
26:37others others may feel the reverse
26:40Others May value risk more or less and
26:42you have to find some way to make a
26:43compromise among all those different
26:45things that the shareholders uh want or
26:47don't want Yeah Austin it's kind of a
26:49empirical question you know with the
26:51rise of like high frequency trading and
26:54stuff people are looking at you know
26:55time Horizons under milliseconds has
26:57there been any significant shifts in how
27:00you see companies priced because of this
27:03uh because the incentives have changed
27:04so rapidly so yeah I mean many people
27:06have argued that day trading and
27:08short-term trading has distorted the way
27:11in which companies make decisions
27:13there's a recent paper by Christian
27:14Hellwig about that um I think it's an
27:17open question I don't think we know for
27:18sure because I don't think we have
27:19definitive evidence but there's some
27:21arguments you might make that that that
27:23would happen yeah yeah philli isn't a
27:26limitation on maximizing in the
27:28interests of the original IPO
27:31shareholders as that the original
27:32shareholders have a finite lifespan
27:35while there's no bound on the lifespan
27:37of a corporation so that isn't really a
27:39useful way to think once the not
27:44necessarily because the thing is that
27:45the original shareholders might set up
27:47rules which will uh maximize their
27:51payoff and then you know of course they
27:55can't write everything they want down in
27:56the rules right but you want people they
27:59want as much as possible to write down
28:01the rules that will maximize the amount
28:02of money they get so they because they
28:06can't write down all the rules we want
28:08ideally those rules to be interpreted in
28:10the way with where if people expected
28:12them to be interpreted that way it would
28:14maximize the payoff of the original
28:16shareholders so that's sort of the way
28:18that a lot of this stuff uh in corporate
28:20governance works is you try to think
28:22about how would the original
28:24shareholders have wanted the rules
28:26around corporate governance to work work
28:28so that in anticipation of that people
28:31would have been willing to pay the most
28:32to buy the shares from those people
28:35that's sort of the way that we think
28:36about it yeah go ahead so isn't that
28:38basically saying the goal is to Maxim
28:40maximize long-term share share value in
28:42some sense yeah
28:44yeah yeah yeah so when you know when
28:47people talk about whether the chairman
28:49of the company should be the same as the
28:50CEO and whether those two ropes should
28:53be embodied by the same person how does
28:55how does how does that kind of play out
28:57when we talk about these deferring
28:59perspectives on on risk and um these
29:01conflicts of interest well I think we're
29:03going to talk a little bit more of that
29:04in a moment because that's really an
29:05issue of how so right now we're talking
29:08about like what objectives should the
29:09firm as a whole try to do and then we're
29:11going to talk about how that's
29:13implemented by the various people that
29:14are employed by The
29:16Firm um okay so another conflict can
29:21come from different classes of
29:22shareholders so not all classes of
29:24shareholders may have the same interests
29:27and this is a small problem at most
29:29companies because at most companies most
29:30of the shareholders are common
29:32shareholders but in principle there
29:34could be you know preferred shareholders
29:36who have different preferences from you
29:38know uh other
29:40shareholders okay another problem can
29:42come from there being a single uh large
29:45shareholder and sual uh why might that
29:47be a problem
29:50um a lot of times like if you have a
29:52single large shareholder um a lot of
29:54activist investors sometimes Force
29:56corporations to do things that may not
29:58be in their best interest sometimes they
30:00don't have the best information um like
30:02or the same amount of information as the
30:04managers Force the company to go so
30:06that's one reason uh but there can be
30:09something even more extreme that can
30:11occur yeah sorry remind me of your name
30:14yeah they could act in their own
30:16interest and not necessarily the
30:17interest of the firm give can you give
30:19me an example of
30:20that
30:22um as in
30:24like they could uh try to sell it um
30:30because that would maximize profits to
30:32them yeah but not necessarily
30:35maximize the firm's profit yeah so a
30:37particularly extreme example of that is
30:39they could set up a shell company that
30:42they completely own and they could get
30:4451% of the shares and then instruct the
30:47company to sell itself for one cent to
30:48the Shell company that they completely
30:50own so that's a way where by buying 51%
30:53of the shares they effectively get 100%
30:55of the
30:56company right
30:58uh and that happened a lot in Russia and
31:00other countries that have poor minority
31:03shareholder protections but in less
31:05Extreme Ways it happens all over the
31:08place uh so like in um Korea right now
31:12there's these companies called chable
31:14and they're very powerful family
31:16controlled companies and the families
31:18usually have only about five or 6% of
31:20the cash flow rights like the right to
31:22actually get payments but they have a
31:23lot of the voting shares because they'll
31:26control 51% of aan that controls 51% of
31:29a company that controls 51% of a company
31:31of the eventual thing and that will
31:33allow them to like you know through
31:35layers and layers and layers end up
31:37controlling most of the uh final uh
31:41company and then what they'll do is
31:43they'll have a logistics company and
31:45this logistics company will be
31:46completely owned by the family and will
31:49just move stuff around the country like
31:50you know truck all the goods around and
31:53then that company will charge a th%
31:56markup on the cost uh and that will be
31:59their way of sucking the profits out of
32:01the downstream company um now minority
32:06shareholder protections are the way that
32:08these are usually dealt with so there
32:10will usually be some way in which like
32:11the majority or the large shareholders
32:13don't have all the power like you know
32:15you might need majorities of minorities
32:17to uh approve related transactions like
32:21this or you might have uh something
32:23where if you get above certain threshold
32:25you have to declare that and then other
32:28people can buy votes against you at a
32:30better rate or something like this right
32:33A system that I've actually proposed and
32:35that we'll talk about in the last
32:36question for solving this does it in a
32:38much smoother way rather than having
32:40these like fairly arbitrary rules you
32:42would just get to vote rather than the
32:44number of shares you have the square
32:46root of the number of shares you have so
32:48that would dramatically reduce the power
32:49of the large holders of the company um
32:53and there's some arguments that we'll
32:54talk about in the last class about why
32:56that's like sort of the best way to do
32:57it yeah go ahead so you say you use
32:59square root voting assuming that's
33:01because it's a smooth function no
33:03there's a very particular reason why the
33:04square root is the right thing and we'll
33:06talk about that in the last class but
33:08anyways we I proposed this in front of
33:10the Korean National
33:12Assembly uh a few few months ago so um
33:17okay so these are all uh imperfect
33:23Solutions uh to um the problem
33:28uh because voting is not really an
33:33efficient way to govern uh a company uh
33:37there's really no way around that unless
33:38you come up with a more efficient way
33:39and that was the goal of square root
33:41voting another solution that can be used
33:44sometimes is that um someone if a
33:47company badly can come and buy out the
33:50whole company right and that can be a
33:53way to um that can be a way to make sure
33:58that the compan didn't run too badly but
34:00of course that requires someone raising
34:01a bunch of money uh and therefore is not
34:05that constant of a threat uh and
34:07probably doesn't deal with most of the
34:08day-to-day problems of governing the
34:10company yeah philli um AR there also
34:14some protections that are sometimes
34:17planted into a company that make it very
34:19hard for an outsider to take over that's
34:22well but that's part of like these
34:25minority
34:26protections uh right because you don't
34:28want an outsider to come and buy 51% and
34:30then loot the remaining people those are
34:32called Poison pills so that's like if
34:34you get 15% of the company then usually
34:36everybody else can buy shares at like
34:38half the rate that you can or something
34:40like
34:41that um yeah and you can see that those
34:44give more power back to the management
34:46which is another problem so like you
34:48know the square root voting it smoothly
34:50downgrades all the large holders and
34:52puts more power in the hands of the
34:53small holders
34:54so um Okay so so um so much for the
35:00normative side now I'm going to actually
35:02think about what companies do in
35:04practice okay so nonn for-profit
35:07corporations are a small but actually
35:10growing part of the
35:12economy and even if they don't maximize
35:15profit that doesn't mean that they
35:17aren't interested in in some sense
35:19maximizing the income they get because
35:20this may allow them to pursue other
35:22goals that they have so for example micr
35:24finance companies do want to make money
35:26so they can make more loans
35:28um they also might be interested in
35:29maximizing income in order to uh pay
35:33their workers more uh because even
35:36though they can't take out profits they
35:37can ALS they can pay salaries
35:40cooperatives uh May partially
35:43incorporate uh the value that consumers
35:45and workers have however because they're
35:49you know uh highlevel managers may want
35:51to make more money they may actually do
35:54something closer to maximizing the
35:55income that they're bringing in state
35:58owned uh State ownership uh is
36:02legendarily inefficient and loss making
36:05because it has to serve the interests of
36:07the majority of Voters right and the
36:09whole political process um but sometimes
36:14when the uh political process really
36:16demands profits it can work quite well
36:19so for example the car companies and the
36:22banks that the government basically
36:23nationalized during the crisis actually
36:25were quite profitable because there was
36:27such pressure from the public for them
36:29to make profits and not just to serve
36:31other political
36:32goals
36:35um other uh shareholders may have other
36:39goals than profit as well like some
36:42shareholders may be part of socially
36:45responsible uh investing organizations
36:48and want the corporation to prefer to uh
36:51follow corporate social responsibility
36:53but I think the most important reason
36:55why companies fail to maximize profits
36:57is because managers will try to serve
37:00their own interests rather than
37:02Faithfully serving the interests of
37:04Corporations um and uh we're going to
37:08talk a lot about that today but I think
37:10an important thing to keep in mind is
37:12even then managers may try to get the
37:14company to maximize income because if
37:16they're going to steal income from the
37:19uh shareholders they have to make that
37:21income first right okay so the principal
37:26agent problem is the problem of a
37:31shareholder or anyone trying to manage
37:34someone who works for them so that they
37:36serve the interests of the principal
37:39rather than the interests uh of that
37:41agent that they hire so I think uh a
37:45funny example is you going off to
37:47college your parents want you to go off
37:49to college and during college accomplish
37:52who knows X Y and Z right you they want
37:54you to become uh a successful
37:56professional now you might want to do
37:59that to some extent but you also might
38:01want a party and they might not want you
38:03to do that uh so they might want to give
38:06you some incentive to try to do well in
38:08school like uh paying you for your
38:11grades and you might want to hide from
38:13them some of the information that would
38:15help them realize whether you're doing
38:17or not achieving that goal like for
38:19example if they want you to major in uh
38:22if they want you to become an investment
38:23banker you might tell them that some
38:25course called money in society is really
38:28an economics course uh that will teach
38:30you about Finance rather than some
38:31anthropology course which is really
38:33critical of all moneymaking right um so
38:38uh maybe you want to study a different
38:41subject than they want you to study uh
38:44maybe be so you might make them think
38:47that it's really just too hard for you
38:49to study economics when in reality
38:52economics is really easy and you're
38:54studying uh some other field like
38:57sociology not because it's easier but
39:00just because uh you think it's more
39:02interesting and you know serves what you
39:05want rather than what they want you to
39:07do um maybe you want to go to graduate
39:12school and they want you to go to some
39:14sort of professional school because they
39:16think it will be more lucrative so you
39:18might take classes that prepare you for
39:21graduate school but that you can
39:22convince them uh are actually uh useful
39:26for making money um so the question is
39:30how can they persuade you to act in
39:34their interests rather than your own
39:35interest right that's basically the
39:37principal agent problem well the problem
39:41they face is they need to give you quite
39:42a lot of freedom because they just don't
39:44know what courses are what they don't
39:47know what uh you know clubs you should
39:50be in what things would actually achieve
39:52the goals they want you to achieve if
39:54they knew all those things right then
39:55they could micromanage every moment of
39:57your life right but they don't so they
39:59have to give you freedom but on the
40:01other hand they want to take have some
40:03control give you some rewards Etc to
40:07make sure that you're not just
40:08completely abusing the money that
40:10they're spending to send you to school
40:13right and this is a problem that's
40:15crucial for companies as well because
40:18managers usually have their own
40:20interests in mind rather than having in
40:23mind the interests of the firm right and
40:26the people that the manager employees
40:28have their own interests in mind rather
40:30than having in mind the interest of the
40:32firm and the people employed by those
40:35employees have their own interests in
40:37mind rather than having in mind etc etc
40:39I don't know if you guys have ever heard
40:41this story about its Turtles raise your
40:43hand if you've heard the story about its
40:44Turtles all the way down so there
40:46there's this story that uh you know
40:48someone goes to a great sage and says
40:50you know why doesn't the Earth fall like
40:53why is the earth you know just sitting
40:54there and the sage says well it's
40:55sitting on top of a turtle
40:58and they says well but what's that
40:59turtle sitting on top of and they said
41:01well he's sitting on top of two other
41:02Turtles it's like well what are those
41:03turtles standing on top well they're
41:05Standing On Top of three other Turtles
41:07and and he says you know but what are
41:09those Turtles and he's like Lady it's
41:11Turtles all the way
41:13down yeah so that's the way that
41:15principal agent problems are within
41:16firms right um and so this naturally
41:19leads to all sorts of suboptimal
41:21behavior on which we'll talk about more
41:23in a minute now the ideal situation from
41:26the perspective of the principal agent
41:28problem is when the person who runs the
41:31firm is also its owner and why would
41:33that be the case
41:35Wesley yeah so uh is that the
41:40possibility theorem where the uh the
41:43only way to get optimal proper
41:46maximization when is a dictatorship yeah
41:48I mean so that that's definitely one way
41:50to think about it it's basically just
41:51because um it's usually so because the
41:56person who owns The Firm right uh is
42:00also the person who's interested in
42:01maximizing its profit so if that's for
42:03the person who manages the firm then
42:04there's no conflict of interest but the
42:06problem is this is almost always
42:09impossible because usually the person
42:11who has the money to fund a company is
42:14not the same person who has the idea or
42:16the talent to fund that company and that
42:18separation between
42:20ownership between talent and capital
42:22makes it usually impossible for the
42:24owner to also be the manager
42:27now the owner the person who has the
42:29capital could try to make the manager
42:30residual claimant what does that mean
42:32that if the company loses any money you
42:35still have to pay me right but again
42:38that sort of is impossible if people are
42:40risk averse or have limited liability
42:44right if they're if you can't just come
42:45after them for an infinite amount of
42:47money right now in countries where
42:52institutions that help ensure that the
42:55manager acts in the interest of the
42:56company are not well developed as we
42:58discussed earlier it's very common that
43:01you will hire people in your family to
43:02run the company instead because um this
43:06ensures that the managers uh have some
43:09familial interest or some caring for the
43:12person who's giving the money so the
43:14lack of formal incentives uh can make
43:17nepotism a very attractive way to run a
43:19company and this is a very general
43:22problem in economics the problem of
43:23principles and agents and you'll see
43:24that in various forms it will come up uh
43:27throughout throughout the
43:29course okay so today I'm going to give
43:32as a result a relatively brief and
43:34informal introduction to the
43:37um principal agent problem okay so there
43:42are lots of different types of
43:47incentives that um firms give to their
43:51workers uh very very diverse
43:54incentives um so let me just go through
43:57some of those examples the ones that are
43:59most classic that economists talk about
44:02are ones involving money so uh equity in
44:07The Firm stock options other financial
44:11instruments that link directly the
44:12financial interests of the individuals
44:14to the firm but you should understand
44:16that those are a very very small part of
44:18the total incentive because um it's been
44:22estimated that for every dollar that a
44:25company makes in profits this CEO ends
44:27up on average getting something like one
44:301,000th of a dollar one uh tenth of 1
44:33cent so that just can't be most of
44:36what's driving uh the CEO's effort to uh
44:40make the company work well right
44:43um some things that are a little bit
44:47more uh exotic than this is that
44:50sometimes the companies uh these these
44:53shares that the that the uh owner gets
44:57might be vesting over time so then
44:59unless the firm does well consistently
45:01over years the the uh individual won't
45:04be able to cash out their shares or this
45:07compensation might be deferred in
45:08another way or they'll only get the
45:11compensation contingent on something
45:12occurring so that's another way to try
45:14to align the interests of the
45:16shareholders and the uh managers another
45:19version of this is that there could be
45:21personal liability if something goes
45:23really badly at the company if there's
45:24like an accounting fraud you could make
45:26the manager personally responsible for
45:29that even though the company has limited
45:31liability or you could be able to claw
45:33back some of their compensation if they
45:35do something really
45:38egregious um a third uh way of aligning
45:42the interest of shareholders and uh
45:45managers is um just directly
45:49monitoring uh or just uh aligning the
45:53interest at any level of the hierarchy
45:56is directly monitoring someone making
45:58sure that they're doing something and if
45:59not forcing them to do something else uh
46:02or providing very explicit instructions
46:05and that is what some micromanagers do
46:08but for obvious reasons uh it's not
46:11always the best way to manage people it
46:13can lead people to not be able to do
46:15their job very well and not be able to
46:17add very much over what the manager
46:19would have done themselves so a lot of
46:21people said that Jimmy Carter ran a very
46:22bad administration because he was
46:24constantly micromanaging the people
46:26beneath him
46:29um lawsuits or audits for bad behavior
46:33can be helpful as well so if if things
46:35are going on badly in the company you
46:37might have someone from the outside come
46:39in and audit all the books to see if
46:41there was anything funky going on uh or
46:44you could bring a lawsuit against the
46:45company if they do something really
46:47egregious another thing another
46:50incentive scheme is called Efficiency
46:51wages this is the idea that you make the
46:53job really cushy and lucrative so people
46:56are scared of getting fired right and if
47:00you do that uh then they'll be very
47:03paranoid uh and they'll try to do a good
47:06job because they're afraid of getting
47:08fired another thing you can do like this
47:10is you can promote people only if
47:13they've done a good job and that can
47:15lead people to be worried about
47:16maintaining their career and if the
47:18promotion is to a position that's
47:20desirable uh that can also help align
47:23the interest bonuses can also be helpful
47:27and these can be paid either based on
47:29some objectively good thing that you did
47:32like making a sales quota uh making some
47:34sort of a Target or based on just the
47:37subjective evaluation of the
47:41manager another way of providing
47:43incentives is reputation or concerns for
47:47your career not just for promotion
47:48within the firm but outside of the firm
47:50so people might want to do a good job uh
47:53or get a good reputation so that they
47:56can get jobs elsewhere right then the so
47:59we're gradually moving towards softer
48:01and softer types of incentives all play
48:03an important role in incentives and
48:05while economists tend to emphasize the
48:07stuff up at the top all these other
48:09things play very important roles as well
48:11so identity professionalism and
48:15corporate culture are a little bit
48:17softer things so for example we saw in
48:19the movie last night that um people
48:22might have it in their heads that their
48:24job is a Salesman and their as a result
48:27their job is to you know do a good job
48:29with sales you might try to indoctrinate
48:30someone with that idea or like a you
48:32might hire a hacker who has this culture
48:35that he wants to make things incredibly
48:37secure because that he just feels good
48:39about that right like that's how he
48:41thinks of himself is that he's really
48:42good at achieving that uh
48:44professionalism plays that role as well
48:46doctors take this oath the hypocritic
48:48oath and they're told over and over
48:49again you're not allowed to harm your
48:51patients that's you know your job is to
48:53save your lives of your patients and you
48:56can imuse them with that sort of an idea
48:58corporate culture uh can do that as well
49:02you can set up a culture within a
49:03company like apple has a culture of
49:05creativity where people feel like in
49:07order to be a really good person at
49:08Apple in order to like you know feel
49:11like you're a member of uh the group you
49:14need to uh you know be very creative and
49:17come up with great new
49:19ideas uh leadership uh pressure and
49:23people's emotions are another way to
49:24manage people so p pressure can uh make
49:28people feel that they need to do
49:29something uh an inspirational speech by
49:32a leader can make you feel that um you
49:35know uh or or seeing that they do
49:38something really well and aspiring to be
49:40like them can be another way to
49:42incentivize
49:43people another way is just intrinsic
49:45motivation you might hire people who
49:47just really love doing something and
49:50therefore just want to be are excited to
49:52be given the opportunity to do it and in
49:55those contexts it can be great to give
49:57those people a lot of freedom because if
49:58they feel they're being micromanaged
49:59they won't want to do anything but if
50:00you leave it open to them and they're
50:01intrinsically motivated they'll uh
50:03really want to do things um and a sense
50:06of mission in a company can be useful in
50:08that way as
50:09well uh reciprocity or family ties and
50:14teamwork can be very useful as well so
50:17uh if you have a bunch of people who are
50:20good friends with each other working
50:22together they may work hard just in
50:24order to help the other people and the
50:26group do well and that's one of the most
50:28powerful ways the military tries to
50:30motivate people so a lot of people in
50:32the military say that they fight not
50:34because they believe in the cause but
50:35because they want to save their buddies
50:38and in fact you can build relationships
50:40like that by putting people into very
50:41stressful difficult situations where
50:43they have to rely on each other and
50:45that's why military a lot of people say
50:47is so sort of brutal in training because
50:50all these people get the sense that like
50:52their higher ups are brutalizing them
50:54and the only people they can rely on are
50:56each other
50:57right and that forces them to form these
50:59really really close
51:02relationships so while economists
51:04usually emphasize and love all these
51:07incentives up at the top What You
51:08observe is all the time companies use
51:10all these different types of incentives
51:12if you look at the way that companies
51:13are run they're using mixes of all these
51:16things and given that those are the
51:18companies that are successful in the
51:19marketplace we should think as
51:21economists if we believe in the power of
51:22the market that they must have some
51:24value as well right
51:27okay so um these incentives are used to
51:33address a wide range of incentive
51:38problems
51:41um and let me give you uh an example of
51:44some of the problems these incentives
51:46are used to solve so one is just plain
51:48embezzlement right someone at the
51:50company could just secretly be stealing
51:52all sorts of money than the from the
51:53company and while that sounds extreme
51:55it's actually common
51:57especially uh at the uh low levels of uh
52:02companies so the primary reason for
52:06security cameras is actually not people
52:08stealing from the store or at Le not
52:10outside people stealing from the store
52:12it's people stealing from the cash
52:13register so that's the main thing that
52:16companies use uh security Camas to
52:19monitor um and another reason why
52:22companies uh require so much bookkeeping
52:25and receipts and so forth is to make
52:27sure that the employees aren't stealing
52:29from the company and in the developing
52:31world this is an even bigger problem
52:33another problem is shirking so just like
52:37coming to work and not doing anything
52:39right or not even showing up for work at
52:41all right but also it could be not
52:44focusing on your work uh not doing
52:47outside work mentally or literally to
52:51prepare uh another issue that comes up a
52:54lot is excessive or insufficient risk
52:57taking this was the excessive
52:59risk-taking was obviously a huge problem
53:00at Wall Street banks that people lower
53:03down the company if they group did
53:05really well would get a huge payoff but
53:07if the group did poorly they wouldn't
53:09they would at worst lose their job right
53:13um so uh this can come from the fact
53:16that employees get the upside but not
53:18the downside risk um or they uh might
53:22actually be more risk averse than the
53:24principal so for example if someone is
53:26really terrified about losing their job
53:29right then they um then the and the CEO
53:34just wants to make a bunch of money from
53:36all the different groups and doesn't
53:37care whether someone loses a job right
53:39and someone might be way too risk averse
53:41not take enough risk on
53:43right and this comes up all the time in
53:46companies because very often employees
53:48need to choose how ambitious the
53:49projects the company takes on
53:51on
53:53similarly uh there might be uh workers
53:57who are too shortterm they might only
53:59benefit from the very short-term things
54:01but the long-term consequences of their
54:02actions might stick with the company
54:04forever right now there are other less
54:08traditional incentive problems that have
54:10been really the focus of a lot of
54:12Economics literature recently so one is
54:15Empire building Empire Building is where
54:18a manager is seeking their personal
54:21Glory or their long-term fame or
54:25something like that and therefore tries
54:26to build a really big but not
54:28necessarily all that profitable company
54:30because if they're the CEO of a
54:32profitable you know really famous
54:34company they're going to do well and you
54:36know have all sorts of prer
54:37opportunities even if they weren't uh
54:41actually making that much money for the
54:43shareholders right so they might acquire
54:45what's often called
54:47diversification I don't know if anyone's
54:49ever heard of that so like
54:50diversification is when you buy a bunch
54:52of companies to diversify your portfolio
54:54diversification is when you buy bunch of
54:56crappy companies just to have more
54:59things that you're in charge of right um
55:03many many studies show this is a major
55:05problem and that many mergers are
55:07actually
55:08wasteful
55:11um so
55:13um uh is Michael here Michael
55:17fosco yeah yeah um yeah sorry I remember
55:22um so which of the incentives that we
55:25discussed do you think would work well
55:26or work poorly against for for this
55:29issue for Empire yeah corporate culture
55:31if you don't want an Empire that's
55:33terrible live in corporate culture where
55:35it's all about professionalism yeah and
55:38class and set that standard in the
55:39workplace or you can micromanagement so
55:42that you don't have that happening yeah
55:44so cor well but I mean the thing is
55:46actually corporate culture could be
55:47quite bad for this if you have like
55:49imagine you have a company like apple
55:51right where there's this whole idea of
55:53the image of apple and people are so
55:55proud of Apple that's actually something
55:57that would lead the manager to be like
55:59oh man I'm going to get a ton of press
56:01if I just like take over all the areas
56:03you know of the world and populate it
56:06with apple symbols right so in some ways
56:08actually corporate culture can be quite
56:10corrosive and can actually make the
56:11Empire Building problem worse in many
56:14ways I think you see what I'm saying so
56:17like actually having a distinctive image
56:18and culture for the company often can
56:20make the Empire Pro building problem a
56:23real issue do you have a thought
56:26can't most of the incentives actually
56:28work to uh prevent Empire Building yeah
56:32so the more you like narrowly align the
56:34material interests of the company with
56:36the interests of the firm of the manager
56:38the more you're going to help deal with
56:40the Empire Building problem and actually
56:42more of these soft incentives can make
56:44the Empire Building problem worse sorry
56:46what's your name Dake Dake yeah d d okay
56:53great um another issue oh yeah what's
56:57your name Jo Joan yeah since Empire
57:00Building the problem is kind of caused
57:02more by Soft incentives yeah it's better
57:04Sol by Harden symptoms with the opposite
57:06side were too like if the Harden
57:08symptoms cause the problem better solv
57:11by well I mean yeah so in general I
57:13think that that's true but you can get
57:16much more subtle than that as we'll see
57:18that there's some things where like some
57:20types of soft incentives work well other
57:21types of soft incentives work poorly
57:23it's really quite detailed and I think
57:26think that you know you can use some of
57:27this incentive Theory when you guys
57:29maybe eventually go in the business
57:31world to think through some of the
57:32trade-offs that you face as managers uh
57:35yeah go ahead bar um on the previous
57:37slide you mentioned that like a lot of
57:39these incentives are supposed to um
57:42reduce risk risk aversion or increase
57:45some of them could be used to increase
57:46risk aversion yeah like um just like
57:50glancing at them yeah it seemed as
57:53though they could have the counter
57:54effect of like you know do in anying
57:58situation yeah I mean I think an
58:00important thing to keep in mind is that
58:03what I and what I'm trying to show you
58:04through this is that companies don't
58:06face one incentive problem they face
58:08tons of different incentive problems and
58:11they have to use millions of different
58:14instruments in complex combinations in
58:17some situations and not in others to try
58:19to adjust those problems so you know you
58:22can get the impression from economics
58:23that there's just this simple incentive
58:24problem you know of like you want them
58:27to work harder but it's really much more
58:29subtle than that and there's all these
58:31different aspects of the problem um
58:34another issue is uh overstaying your
58:38welcome so uh a manager might like to
58:43stay in his job right and stay in
58:47control of the position that he's in
58:50right because he doesn't want to have to
58:52go look for work um and so they may try
58:55to make themselves valuable like they
58:56might try to do some project where
58:58nobody really understands it except for
59:00them so that you can't fire them right
59:04uh yeah Philip just a comment I've heard
59:07that this can be a thing among computer
59:11coders too yeah of a computer coder who
59:14writes programs in an entirely
59:16nonstandard fashion will either be fired
59:19almost immediately because the company
59:22doesn't like that he's trying to
59:24entrench himself or he'll get entrenched
59:26and be very difficult to dislodge I see
59:30yeah so that's that's an interesting uh
59:32issue um I not so what which types of
59:36incentives do you think would work best
59:38for overstaying the uh welcome uh Joan
59:41do you have any thoughts
59:45um probably more of a hard thing because
59:49think that's
59:50do so if overing the actually decreases
59:55the graphs
59:56um do you do something like vesting or
59:59contingent compensation that well I I
1:00:02actually think vesting and contingent
1:00:04compensation are could well be very
1:00:06counterproductive here's the reason if
1:00:08the person's going to make the money
1:00:10only if they stay with the company or if
1:00:13you're giving a lot of material
1:00:14incentives for working there then
1:00:16they're going to be worried about losing
1:00:18the job right because they're going to
1:00:19want to make all that money
1:00:24the
1:00:54e
1:01:24e
1:01:54for
1:02:24e e
1:03:17TR off right
1:03:21um imagine that like you know you have
1:03:25an difference
1:03:27curve uh between so imagine there's like
1:03:32a um production possibilities
1:03:37Frontier between the number of militants
1:03:46killed and civilians spared
1:03:57without providing that incentive for
1:04:00killing people you might be inside of
1:04:03this Frontier right you might be sparing
1:04:07a fair number of civilians but you
1:04:09really might not be killing as many
1:04:10people because people are being too lazy
1:04:12right they're not like working hard
1:04:15enough as soldiers but then you might
1:04:17end up moving to some point over here uh
1:04:21by and killing a lot more civilians but
1:04:23maybe killing also more militants right
1:04:26and so the question is depending on what
1:04:29your preferences are how much you care
1:04:31about innocent people dying versus uh
1:04:34mil killing militants you might or might
1:04:36not want to give that type of an
1:04:38incentive so I thought the Margin Call
1:04:41movie was a really cool um area where
1:04:46some of these issues played out so um
1:04:50for
1:04:51example
1:04:53um uh we're um Mike uh did we see in um
1:05:02in the movie uh reputation and career
1:05:06concerns coming in um there are
1:05:08questions of for example if you sell off
1:05:11like this whole company a matter of a
1:05:13few hours nobody will ever trust you
1:05:15again or nobody will ever like buy stock
1:05:17or invest that's right uh that's right
1:05:20and um so uh they had to try to give
1:05:25people these giant uh
1:05:28payoffs uh in order to try to get them
1:05:31to overcome the uh career concerns and
1:05:34reputation that they had assembled and
1:05:36they had assembled that in order to
1:05:37maintain the relationships with their
1:05:39clients because absent they're having
1:05:42that reputation they wouldn't have been
1:05:44able to sell so there were like two
1:05:46different layers of incentives
1:05:47conflicting with each other uh in the
1:05:49movie right um how about feeling of uh
1:05:55serving a higher good or Society where
1:05:58did that come in in the
1:06:00movie uh yeah so that that scene with
1:06:03there remind me of your name one more
1:06:05time aab yeah on that scene one I forgot
1:06:08who the actors were but you know they
1:06:10were in the car um and they looked out
1:06:13and they looked at all these people and
1:06:14they were kind of wondering about how
1:06:16our actions would um spill over um onto
1:06:20citizens yeah I think another good
1:06:22example was the Bridge Building guy
1:06:24right like obviously a lot of what had
1:06:26motivated him in his old job which he
1:06:28had then left uh was that right
1:06:36um uh how about oh yeah Christian what's
1:06:39up oh see didn't the company try and
1:06:41like minimize any feeling of society I
1:06:44think so I mean that's sort of what he
1:06:46did at the end you know in that
1:06:47conversation that he had with like all
1:06:49the dates and stuff like oh this happens
1:06:51all the time and then the blonde British
1:06:52guys saying oh they deserved it exactly
1:06:54seems like trying to kind of hide that
1:06:57Michael um what about teamwork and
1:07:00loyalty where did that come in in the
1:07:01movie they gave the huge payoffs for you
1:07:03hit 93% if you sell everything off and
1:07:06we're in this together and we'll be
1:07:07completely honest with you and that
1:07:08whole speech yeah and everything yeah
1:07:11yeah exactly exactly that's right um how
1:07:15about uh which financial in which cases
1:07:20were like the actual direct Financial
1:07:23incentives uh most important
1:07:31yeah exactly that's what kept Him uh
1:07:34working the job right
1:07:37um and uh what about an example of
1:07:40golden parachutes where did those show
1:07:41up in the movie uh go ahead okay Adam
1:07:46Adam Adam um well there's that example
1:07:49where they the I forget the the actors
1:07:52but there was the one woman and the one
1:07:54guy who built
1:07:56come and both know they're going to be
1:07:59fired but they're doing it for the uh
1:08:02the large pay out and kind of and they
1:08:04say there there never really is a choice
1:08:06yeah
1:08:07right um okay let me just see where we
1:08:12are uh I'm going to try to get through
1:08:15these two things and then maybe I'll
1:08:16take some more questions this last part
1:08:18if the lecture is not that important um
1:08:21okay so um there are a bunch of
1:08:23different ways to fund a company
1:08:26uh which also relate to these incentive
1:08:28problems so one way is personal Capital
1:08:32so this is the main source of financing
1:08:34for small companies very small companies
1:08:37and also common among very rich
1:08:39individuals the second method is friends
1:08:41and family financing and most startups
1:08:44at least at some stage have this as a
1:08:47initial Source the third is Venture
1:08:50Capital uh or Angel Investing is really
1:08:53uh some stage in between these where
1:08:55there are private investors who take
1:08:56equity in the firm uh and eventually
1:08:59hope to cash out through the public
1:09:01markets um and usually the Venture
1:09:05capitalists are experts in the sector
1:09:07who can do a particularly good job
1:09:08evaluating whether the opportunity is
1:09:11desirable a fourth uh form of financing
1:09:15is bank loans a fifth one is public
1:09:19equity and this usually requires some
1:09:21sort of an intermediary to float it to
1:09:24do an IPO and is therefore very costly
1:09:27and corporate bonds are also quite
1:09:29costly because you usually need somebody
1:09:30to float those on the
1:09:32market okay now each of these different
1:09:36incentive uh financing schemes has some
1:09:39incentive benefits and costs personal
1:09:42Capital has the pro that there's no uh
1:09:45principal agent relation problem as we
1:09:47discussed but the problem is it requires
1:09:48an individual to take on very large
1:09:50risks and offers you a small pool of
1:09:53capital um friends and family financing
1:09:56gives you a little bit more Capital um
1:09:59and because of your sort of reputation
1:10:01with your friends and your desire to
1:10:03preserve uh their money uh can give a
1:10:07strong incentive for you to work hard
1:10:09the problem is that it um usually still
1:10:13only off offers a relatively small pool
1:10:15of capital and a larger risk Venture
1:10:19Capital uh has the benefit that the
1:10:21person who's monitoring you is an expert
1:10:23in the area and is really good at
1:10:25evaluating your project can often
1:10:28establish a personal relationship but
1:10:30the problem is that it's uh still
1:10:33relatively high risk and a relatively
1:10:36small pool of capital so you see as we
1:10:37go out of these stages we're getting
1:10:39less and less ability to monitor less
1:10:41and you know more and more principal
1:10:43agent problems but a broader and broader
1:10:45pool of capital right um there's also
1:10:49issues of whether to look at to use debt
1:10:52versus equity and that's on one of the
1:10:54previous problems sets that you can take
1:10:56a look at it's on the uh econ uh
1:11:00201100 problem Set uh my first year here
1:11:03uh the 2011
1:11:04one there's also an issue of whether you
1:11:07take bank loans versus public loans so
1:11:09the benefits of bank loans is it's much
1:11:12easier for a bank to monitor your
1:11:13behavior to restrict to put covenants on
1:11:16it Etc and it can often also save people
1:11:19from bankruptcy because it's much easier
1:11:21for the bank to negotiate a good
1:11:23settlement uh afterwards
1:11:26but because it's easier to save people
1:11:28from bankruptcy it makes people less
1:11:30paranoid about going through bankruptcy
1:11:32and therefore might reduce the incentive
1:11:35uh to make sure that uh that doesn't
1:11:38happen Okay um I could go through this
1:11:43stuff so there's a there's just a broad
1:11:45issue of like you know why don't
1:11:47companies just Outsource everything to
1:11:49other firms why do they keep things
1:11:51inside of the firm and there are
1:11:53different theories of this
1:11:56um but in the end my basic view is that
1:12:00um firms like putting something into a
1:12:03firm rather than Contracting out for it
1:12:06is really more of a spectrum than it is
1:12:11um a discrete choice and it happens for
1:12:13a variety of different reasons at any
1:12:16time so one reason why you might you
1:12:18know keep things inside of the firm is
1:12:20it's like you know firms tend to be
1:12:22physically close to one another so if
1:12:24it's important that people be working
1:12:25physically close with one another it's
1:12:27more likely you'll put them together
1:12:28into the same firm it might be easier to
1:12:31communicate for various legal reasons
1:12:32within a company than setting up you
1:12:34know a separate entity um it could be
1:12:38that
1:12:39um that you want to establish a sense of
1:12:42culture and it's easier to have a
1:12:44coherent sense of culture if you're
1:12:46within one company with each other than
1:12:48if you're a subcontractor to my company
1:12:51now of course almost all these things
1:12:54can be overcome in some uh way there's
1:12:57contracts that you could write or
1:12:59Arrangements you could set up that would
1:13:01allow for this cluster of things
1:13:03together uh but it's quite costly to do
1:13:07each one of those individual things uh
1:13:10and within a company all those things
1:13:12are sort of packaged together the
1:13:14relationship that we have when we're in
1:13:16a company is a set of things that we're
1:13:18used to having uh physical closeness
1:13:22close communication uh exclusive
1:13:24relation relationships Etc and um really
1:13:28the choice between putting something
1:13:30outside and inside of a company is
1:13:31whether that Baseline of us having this
1:13:33tight relationship or having this loose
1:13:35relationship is a better starting point
1:13:38from which we can start to change things
1:13:41so that's really how I think about um
1:13:45firms okay uh so really I think of firms
1:13:49as being sort of a convenient fiction
1:13:50firms are not just one thing uh firms
1:13:54are incredibly heter genius they may
1:13:55have looser or tighter relationss than
1:13:57different governance within them and
1:14:00they may have looser or tighter
1:14:01relationships with people they contract
1:14:03with it's really just that uh on average
1:14:07the people who call themselves a legal
1:14:09firm have more of those things together
1:14:12and really what we should think of when
1:14:14we Model A firm in economics is not just
1:14:17what's legally called a firm but
1:14:18whatever is a reasonable coherent entity
1:14:21that we can think of as maximizing The
1:14:23Joint profits of within that group so
1:14:26that's sort of how I think of firms so
1:14:28we have about 5 minutes left and I know
1:14:29there were a lot of questions so I just
1:14:30wanted to take some of the questions
1:14:32Jake I in terms of intiation and and
1:14:37social
1:14:38responsibility because it seems like
1:14:40when like at least for some of the
1:14:42techniques that one can
1:14:44employ employees they sort of they
1:14:47create some sort of false consciousness
1:14:48where like what the employees want is
1:14:52constructed as opposed to what they they
1:14:55naturally want to have manager the um
1:14:59the administration sort of actions that
1:15:02want yeah and so my question is like
1:15:04when when uh well that's sort of the
1:15:07whole point of management right the
1:15:09whole point is to create Desires in the
1:15:11employee that align their interests with
1:15:14the employer right and they can use
1:15:16money and they can use all these
1:15:17different things but they're all ways of
1:15:18sort of manipulating the employee to
1:15:21serve the interests of the employer but
1:15:23then my question is that when Freeman
1:15:24uses like he says like the CEO shouldn't
1:15:27take actions in terms of social
1:15:29responsibility because of the uh the
1:15:32rest of like you know the rest of the
1:15:33company wanted to do that they done it
1:15:35on their own if you create like a
1:15:37culture of of like a corporate culture
1:15:39of like success and competition that
1:15:42you're you're like they're not going to
1:15:45desire that because you're creating the
1:15:46desire yeah in fact I think exactly the
1:15:48point of the Freedman article is to try
1:15:50to brainwash CEOs into thinking that way
1:15:55in other words he views himself and I
1:15:57think he views the business ethics
1:15:59classes that build on his perspective as
1:16:02ways of creating helping companies to
1:16:05create exactly that sort of a
1:16:10culture um in fact one of the 24210
1:16:14problem sets that um that they're doing
1:16:17this this week is sort of about
1:16:20ideology and like the role that it might
1:16:23play and that the role that economists
1:16:24might play in creating various
1:16:26ideologies that serve the economy and
1:16:29so sort of related to what you're
1:16:32saying yeah um another question on
1:16:35overstaying your your name is Dake again
1:16:38right yeah yeah um overstaying welcome
1:16:40that a problem yeah why if the company
1:16:43knows that this manager is overseeing
1:16:45their why can't they simply fire the
1:16:47manager because the manager's done
1:16:49things to make it hard to fire him
1:16:52because only he knows how the code works
1:16:55or only he you see what I mean I see so
1:16:57that's almost a necessary prerequisite
1:16:59in order for over exactly yeah so
1:17:03there's some way that they can entrench
1:17:04themselves yeah um so in terms of uh I
1:17:09guess like examples like one Philip
1:17:11brought up of programmers perhaps like
1:17:15programming in ways that only they can
1:17:17understand people studying precedence
1:17:18with mic management just be the best way
1:17:20to prevent those things like just making
1:17:21rules that you can't like programs or
1:17:24that has to be transparent or that you
1:17:26know you could have rotation within the
1:17:28company where you work on one project
1:17:30and then you move to another project so
1:17:31people know that they're not or you know
1:17:33forcing people to leave at a certain age
1:17:36or I mean all those are techniques that
1:17:38companies can use yeah related to this
1:17:41idea of scope and bound um has been any
1:17:45kind of substantive research carried out
1:17:47on why certain things like consultancy
1:17:50um have gained such a kind of large um
1:17:53Outsourcing um kind of of notion I mean
1:17:57corporate and strategic departments can
1:17:59exist within firms that serve the same
1:18:01kind of purposes right but yeah there so
1:18:03many like consultancy firms that you
1:18:05know that specialize in Outsourcing
1:18:07those so why you know I mean I I don't
1:18:10really know I don't think there's been
1:18:11that much research but I you know one
1:18:12conjecture that you could have is that
1:18:14like the culture of consultancies and
1:18:16the way that Consultants interact with
1:18:17one another and move across different
1:18:19companies makes them gives them like an
1:18:21outside perspective that makes them
1:18:22particularly useful and it would be hard
1:18:24to have that just within a company I
1:18:27mean that that's just a conjecture but I
1:18:28have but you know I have no idea really
1:18:32uh Christian I remember hearing a lot
1:18:34about during the financial crisis
1:18:35hearing a lot about retention bonuses Y
1:18:37where would those fit in on the
1:18:38incentive SCH maybe like retention
1:18:40bonuses are basically just fixed pay
1:18:42that's really all they are they're just
1:18:43like ways of like getting you to stay so
1:18:46could that be like it's a way of
1:18:47separating out and it's really just like
1:18:49a base salary that's all that a
1:18:51retention bonus really
1:18:52is yeah yeah
1:18:55um remind me of your name reishi Rishi
1:18:57yeah uh in response to the Consulting
1:19:00question I think what you were saying
1:19:03yeah um about getting the fresh
1:19:05perspective is also really useful
1:19:06encountering like um the you know the
1:19:10social
1:19:16culture can bring a fresh
1:19:19perspective maybe break up the incentive
1:19:21and the same thing yeah so like you can
1:19:23deal with group things type issues that
1:19:25could arise as a result of the teamwork
1:19:28in you see all these incentives you know
1:19:30they help with one thing they hurt with
1:19:31another and you need to balance them out
1:19:33and that's sort of how it works anyways
1:19:34I should let you guys go but I'm happy
1:19:36to take questions after class so

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