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ECONOMICS 3200MLecture 4Ch. 2, 3

January 27, 2015

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Cost Minimization

• Inputs: labor, capital, other inputs, components, services– Availability, prices, trade-offs – some inputs available at lower

prices in some locations, while others available at lower prices in other locations (location decisions)

– Optimal combination of inputs depend upon relative prices, technologies, activities of company (where is the company located in the value-added chain, degree of vertical integration)

– Organization structure – mechanism for controlling production and other value added chain activities

• Outsourcing vs. insourcing– Incentives to maximize effort, minimize waste and defects –

hierarchical and control structure, internal rewards/penalties, reputation (invisible handshake/implicit contract)

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Cost Minimization

• Location decision– Transportation costs – inputs, outputs– Labor costs, availability of labor skills– Costs and availability of variety of qualities of other inputs – Property taxes, business taxes– Personal taxes impact location decisions because executives

concerned with after-tax income – agency problem– Exchange rates – currency risks– Access to specialized resources – capital equipment

manufacturers, research facilities, subcontractors (including advertising, finance)

– Regulations: environment, health and safety, product liability, employment standards, etc.

– Legal system: rent seeking, bribes

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Cost Minimization

• Human resources (cost cutting through layoffs and wage concessions)

– Labor costs and availability of skills – training costs, commitment to work, effort

– Productivity enhancing innovations recognized by employees• Loyalty and effort – work generates negative utility/welfare for

individuals (people work for the income that affords them the opportunities to buy desired goods/services)

– Incentives for encouraging loyalty and effort• Rewards (bonus, promotions, recognition)• Invisible handshake (commitment by employers to maintain

employment levels, offer training and upgrading of skills, and continually offer promotion opportunities)

• Golden handcuffs – job ladders and seniority, vesting in pensions, economic rents (above market compensation)

• Penalties (firing)• Job uncertainty, reneging on invisible handshake – impacts on

motivation, effort (longer-term cost implications)

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Efficiency• Production efficiency

– Minimize costs of production– With given state of technology (origins?) and factor prices, optimal

combination of factors of production and optimal organization structure to minimize shirking

– X-inefficiency– Agency problem and alignment of of interests – corporate jets vs. flying

on commercial airlines

• Allocative efficiency– Optimal allocation of scarce resources among products produced in

economy– Prices reflect social value of inputs at margin– Pareto efficient allocation – unable to reallocate factors so as to improve

one person’s welfare without reducing another’s

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Efficiency• Dynamic efficiency

– Productivity growth and improvements in real standards of living– Rate of innovation and rate of diffusion of innovation– Lower production costs because of reduced resource use (higher

productivity), higher quality products, new products more highly value by consumers

– Market structure required to maximize dynamic efficiency?

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Ownership and Control

Why go public?• Private companies – no separation of ownership and

control • Financing investment opportunities • Dual share structure to retain control• Diversification and estate planning• OPM and perks• Outliving the founder to enhance the value of brand

names and reputation• Attract management talent by offering equity stakes

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Ownership and Control

Agency• Definition • Problem – aligning interests• Compensation and incentives

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Objective of Firms

• Separation of ownership and control– Management and control by founder or founding family

(dual share structure)• Control/power• Maximize personal wealth• OPM

– Independent management, no controlling shareholder• Maximize personal wealth• Control/power

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Governance of FirmsAgency – executive compensation, ad agencies, investment

banks, lawyers, management consultants, etc.• Agency problem: separation of ownership and control –

why should management have objective to maximize shareholder value?– Objectives of senior management (agents) may differ from those

of shareholders (principals) – maximization of personal wealth vs. maximization of value (equity) of company

– Maximization of value of equity of company may not necessarily maximize value of debt of company – conflicts between equity holders and debt holders

– Agency problem may be non-existent with private companies where senior management owns company – possibility that different family members have different goals and objectives

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Objective of Firms

• Profit maximization/value maximization– Profit measure: total profits (operating profits, pre-tax

profits, after-tax profits, cash flows form operations), profit margin, profit per unit, rate of return on invested capital, rate of return on equity?

/E = {/PQ}*{PQ/K}*{K/E} = {P-AC}*Q• Increasing K/E increases bankruptcy risk• Miller-Modigliani theorem, and optimal capital

structure – covenant and restrictions on decision making

– Short-term, long-term – definition of time concepts

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Governance of Firms

• Principal-agent– Board of Directors (principal) – functions, fiduciary

responsibilities, compensation, liability– CEO (agent) – functions, compensation

• Alignment of interests of owners and managers• Importance of incentive (compensation) contracts

to align objectives of senior management and shareholders

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Governance of Firms• Compensation contracts

– Mix of salary, bonuses, long-term compensation (including post-retirement benefits)

– Duration of contracts – Fixed endpoint problem: weak incentive for senior managers to

perform as they near end of contract– How many years to learn whether senior managers better than

average or worse than average in ability? – Information requirements to assess talent of management – how

long a contract? How long a track record? Luck or talent?– Firing senior officers when record indicates below average talent

becoming more common – Type I and Type II errors – re-hiring below average senior officer;

firing above average senior officer

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Governance of Firms• Nature of bonus: measurement problems linked to

aggregate profits; profit rate (what rate? operating margins, return on assets, return on equity); growth in profits; value of company; thresholds– Problems in multi-divisional enterprises – basis for bonus,

incentives to ensure synergies among divisions realized– Re-coupment of bonuses if performance falters in future time

periods• Payment of bonus

– Short-term vs. long-term payoffs– Annual cash payments– Partial payments in equity

• Low interest loans to acquire shares and forgiveness of loans owing to company (restricts diversification if acquisition of equity is mandatory)

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Governance of Firms

Stock options• Pricing of stock options – indexing of exercise price to

reward holders of options for superior relative performance only (selection of companies to comprise index?)

• Meet performance targets and have right to exercise options at original strike price or some pre-set premium over the original strike price

• Re-pricing of options that are underwater – argument that such options no longer provide incentive; threat of losing talented senior managers

• Magnitude of stock option grants; scope of eligibility for stock options

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Governance of FirmsAre incentives required?• Market for managers: super stars

– Free agency and signing bonuses– Information requirements to determine whether a manager is a

super-star– Incentive to perform to maximize value in free agency market

• Nature of signing bonuses – cash, salary, stock options• Younger managers – ability to declare free agency again• Older managers – no further opportunity for free agency,

important to link signing bonus to performance of company

• How to motivate losers? – economic rents and threat of losing jobs

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Governance of FirmsMarket for corporate control: takeovers• Outsiders (raiders, private equity firms, hedge funds) acquire poorly

performing companies (potentially undervalued companies) and replace senior management with good management to increase value of company

– Pershing Capital and Canadian Pacific – Carl Icahn

• Outsiders also acquire companies to engage in financial engineering (increasing debt to equity and selling off divisions and/or assets) to create value and then spin off companies (IPOs) to realize value – why doesn’t management do these things?

• Fear of losing job (and associated economic rents – value of reputation reduced) sufficient incentive to perform and achieve best results for shareholders

• How effective – poison pills (new shares available to existing shareholders at bargain prices if bid made for company), scorched earth policy (sell crown jewels), golden parachutes

• Managerial myopia to prevent takeovers

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Compensation in Multi-Division Firms

• Synergies from cooperation– Sharing value created through cooperation– Compensation linked to increase in value – how?– Compensation linked to performance of division –

bonuses – Long-term incentives paid in company shares (options,

SARs)– Front-line employees – wealth of information and

critical for execution of strategy

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Corporate Governance

Boards of Directors• Whom does a Board represent?

– Shareholders, but which ones?

• Reasons for monumental failure in 2008• Externality

– Confidence in the equity markets and the financial system in general

– Responsibility to ensure that there are no blow-ups which threaten the macroeconomy

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Corporate Governance

Should the CEO be allowed to bet the company?• Consider VC model• Major investors are institutions• Stock picking or industry picking?

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Corporate Governance

Possible Reforms• Role of Boards

– Hiring a CEO and negotiating the employment contract; – Supervising the strategic planning process and approving the plan; – Monitoring the performance of the CEO– Risk management

• Independence• Training in risk assessment and management• Full-time job• Term limits• Compensation

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Mergers & Acquisitions

• Objective: Maximize shareholder wealth– Benefits (advantages) must outweigh premium paid to

acquire control of assets

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Mergers & Acquisitions• Increase market power

– Eliminate competitor benefits all surviving firms in industry– Long-run possibility of reducing competition given Schumpeterian

competition?• Cost improvements – economies of scale, scope, internalization,

access to lower cost inputs, getting rid of overhead• Bargaining leverage with suppliers, distributors (complete product

offerings)• Acquire superior talent• Undervalued assets because of poor management, limited distribution

capabilities – leverage competitive advantage• Internalization – Microsoft and Nokia, steel companies and resource

companies (iron ore, coal)

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Mergers & Acquisitions• Diversification to reduce business risks

– Ability of shareholders to diversify at lower cost and more completely

– Hedging against various types of business risks – economic shocks, interest rates, currencies, commodity shocks

• Eliminate excess capacity– Benefits all competitors – why not wait for company’s assets to be

liquidated?– Does capacity disappear when companies eek bankruptcy

protection?

• Tax advantages – tax losses, transfer pricing across countries with different tax rates

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Mergers & Acquisitions• Gold companies – acquiring reserves (timing)• Internet companies – using shares; VC model• Valeant – serial acquirer

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Mergers & Acquisitions: Money for Nothing

• Serial acquirer – growth company: higher P/E• Target – low growth: lower P/E• Acquirer offers 25% premium over market ($10 per share

for target)• Acquirer pays for transaction using own shares issued

from Treasury – 0.67 of acquirer shares for each share of target

• Assume aggregate net profits unchanged• 1+1>2

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Mergers & Acquisitions: Money for Nothing

Pre-acquisition

Post-acquisition

Acquirer Target

Shares 10,000,000 10,000,000 16,700,000

Net income $10,000,000 $10,000,000 $20,000,000

EPS $1.00 $1.00 $1.20

P/E 15 8 15

Share price $15 $8 $18

Mkt. value $100M $80M $300M

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Mergers & Acquisitions• Preventing mergers – why?

– Supermajority– Greenmail– Poison pills

• Should shareholders approve of management’s recommendations?

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Competition• Carlton & Perloff : “Even though perfect competition is rarely, if ever,

encountered in the real world, we study the perfect competition model because it provides an ideal against which to compare other models and markets.”

• Assumptions:– Homogeneous, perfectly divisible product– Perfect information (consider Internet again)– Price takers– Zero transactions and search costs (eBay)– No externalities– Free entry and exit– No entry barriers– U-shaped ATC– No advantage– Equilibrium: no economic profits, D/S– Entry/exit process

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Competition• Price determination

– Some degree of market power for each firm because of search costs– High degree of substitutability – firm elastic demand curve– How is initial price point established?

• Long-run equilibrium– Economic profits or losses as signal for entry/exit – definition of

economic profits– Rate/speed of adjustment – how long does it take to get from short-run to

long-run?– Perfect information, zero transactions costs and free entry and exit

• Incentives to innovate – technological change– Perfect information, zero transactions costs and free entry and exit

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Competition• Contestability

– “If there is free entry into and exit from a market instantaneously (no sunk costs), firms have an incentive to enter whenever price exceeds average cost. Markets with free instantaneous entry and exit are called perfectly contestable.”

– Assumes no sunk costs, zero entry/exit costs, reactions of incumbents, possible competitive advantages of incumbents, speed/number of entrants

– Solid waste collection – competitive bids every year• Relocation costs, experience, lobbying

– Airline industry – city-pairs assumed to be contestable• Start-up costs, competitive advantages of incumbents’ networks• Porter Air and Billy BishopAirport

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Competition• Barriers to entry

– Absolute cost advantages of incumbents– Access to customers – access to distribution channels, switching

costs– Access to inputs, technology – role of patents– Product differentiation – importance of reputation, brand names– Scale of entry and capital requirements– Exit costs– Strategic behavior of incumbents – reputation of incumbents– Number of potential entrants– Strategic actions of incumbents

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Competition• Scale, speed of entry

– Information re. economic profits– Information re. production, distribution, consumer tastes, etc.– Access to inputs at same prices as incumbents, including access to

capital and management talent– Start-up costs – sunk costs– Time required to enter – develop strategies, acquire facilities and

resources– Actions of other potential entrants– Actions of incumbents– Willingness of external investors to finance entry– Expected growth– Excess capacity

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CompetitionSchumpeterian competition and dynamic efficiency• Competition that counts is not price competition, but competition from

new products, new technology, new sources of supply, new types of organization

• Dynamic change and efficiency gains result of strategic behavior and risk-taking (decision-making under uncertainty – absence of full information) – technological change, productivity growth

• Pursuit of economic profits (above-average returns on investment) motivates risk-taking

• Investments anticipate payoffs commensurate with the risks (probability of failure) – VC model– Small number of winners in each time period/round– Monopoly power short-lived because of dynamic nature of competition– Strategic behavior to solidify monopoly position