Economics of the Firm
– Risk: quantifiable uncertainty
o Non controllable risks: risks that the parties to a business venture cannot control
o Controllable risks: risks parties might be able to influence
o Expected return: the weighted average return based on probabilities of events
§ If a business can quantify the risk associated with a particular decision, it can determine the expected return of that decision
o Risk aversion: people who avoid risk, usually risk averse with respect to gains
o Risk seekers – usually with respect to losses
o Risk neutrality: a risk neutral person makes decisions based solely on expected returns, and would be happy to take on a risk any time it will generate a benefit
– Mgmt. of Risk
o Insurance: when purchasing insurance, a person/business pays a fee upfront in exchange for the right to payment if a specified event occurs
o Diversification: a person or business diversifies by participating in numerous ventures, each of which involves different risks
§ Will offer a more certain return for balance between gains and losses
o Allocation: allocation of the risk may be to the person most willing or able to bear risk
– Roles in business
o Agency: a fiduciary relationship that results when one person consents to act on behalf of another and subject to his control
o Principle: the investor/owner
§ Will want to maximize return
§ Will want agent to use as much effort as possible
§ Will want bulk of products
o Agent: mgner/employee
§ Interst in maximizing return on his effort
§ Will want compensation
§ Will want to expend as little energy as possible
o Agency costs
§ Agent shirking, monitoring
o Relationship must address
§ Term of relationship
§ Allocation of financial rights/obligations (profits and losses)
§ Discretion and responsibility of agent
§ Supervisory powers of principal
§ Ability of either to terminate
§ Means by which relationship can change
– Rules for parties
o Contract
§ Parties can specify the allocation of risk through private agreement
§ Principles and agent can affect controllable risks by acting or not acting
· Controllable risks can be reduced by monitoring and discipline devices to alight agent’s incentives with interest of principle
o Shirking: when a person does less than is optimal to control a risk
o Law
§ Parties can allocate risk y choosing a particular legal regime
– Allocation of risk to the principle
o If the principal is less risk averse he will be more willing to bear the uncontrollable risks
§ When there is a risk of agent shirting the principle will have to incur monitor/discipline costs
· The principle must decide what constitutes optimal performance
· The principle must dete
the parties can choose them or not
· Enabling rules significantly lower the costs of entering into a firm relationship by providing the rules that the parties presumably would have identified and negotiated for themselves
§ Default rules for corporations:
· If you do nothing more than file the articles of incorporation
· Default rules cut down on agency costs
· Designed to allow more people to get into business
– In a large corporation shareholders elect members of the board of directors
o Mgmt. and power of the corp. is in the board
§ This is a greater delegation of authority
· There is a greater need for monitoring
· There is a greater fiduciary duty owed by agents to principles
Introduction to Corporations
– Corporation: a legal entity that can own property, enter into contracts, sue and be sued
o A team of people working for a return on investment
o Web of contracts
o Investment vehicle
– Key Characteristics of the Corporation
o Separate Entity
§ EVERY CORPORATION IS A LEGAL ENTITY THAT IS SEPARATE FROM INVESTORS AND THE PEOPLE WHO MANAGE THE BUSINESS
