Corporations McNamara Fall 2017
Ch. 1—Business and Risk
Julie & Ernst Hypo
Ernst becomes an employee
Julie’s cost: monitoring cost (agency cost), Julie is getting a good deal, if she has a good year, she just gives him a salary. She is assuming the risk of the success/failure of the business.
Most employees are risk averse people: assume you will just get your salary
Ernst leases the land (tenancy)
Julie bears less risk because she will get the profit either way. If it’s a bad year, E will make little
Long-term benefits and burdens
Third possibility: joint venture
Equal; they would share (each person would get part of the advantage) (pays less $, but gets 50% of profits)
Long-term benefits and burdens
Control issues: if E is working there on a day by day level he is going to want control
Risk Allocation: one of the key concerns in structuring any firm is how its risks are allocated
Two parties: one who supplies capital to the business/does little work and one who invests little but supplies expertise/does most of the work
General goal: Parties theoretically have a shared interest in agreeing on a structure that produces the largest total return to the venture at the lowest cost. This is difficult to achieve because each party wants to receive as large a share as possible of the venture’s total profits.
There is often a tension between: achieving the largest total return & an individual’s desire to obtain the greatest “piece of the pie”
Total return: you are trying to achieve the greatest good for economics as a whole (utilitarianism)
Piece of pie: trying to get the most money for themselves. You do not want someone to take a disproportionate amount
Prisoner’s Dilemma: The game theoretic “rational” strategy is for each person to betray the other, even though the ideal outcome would be for each prisoner to stay silent.
In real life humans are more cooperative that this game suggests. The prisoner’s dilemma however highlights difficulties coming to cooperative solutions in many contexts.
Cooperation: solution to the prisoner’s dilemma
Successful cooperation involves minimizing conflicting interests and maximizing the value of the venture to each party
There is however a tension between the two objectives: minimizing conflicting interests & distributing risks
Categories of Risk
Controllable risks
The parties to the venture have some ability to influence. The extent of their control depends on how well the parties make decision about the business/carry out assigned roles.
Types of grapes, amount/quality of work, amount spent on research, advertising/marketing
Uncontrollable risks
Risks over which the parties have no control over and the elements of the controllable risks that remain after the parties have taken all reasonable steps to control them.
Weather, demand for grapes, quality/quantity of grapes from other vineyards, economic variables
Risk ≠ uncertainty
Uncertainty is unquantifiable: A known risk is easily converted “into an effective uncertainty,” whereas true uncertainty “is not susceptible to measurement.”—Knight, Risk, Uncertainty, and Profit
Quantifying Risk—Expected Return
Expected Return: How much you think you will make from a venture; “the weighted average return based on the probabilities of events”
Calculation: multiplying the probability of each event happening by the return associated with that event, and adding up the results.
Example: If you have a 1/3rd chance of making $6 from a business and 2/3rds chance of making $3, what is your expected return?
1/3 x 6=2
2/3 x 3=2
expected return= 2 + 2= 4
NB: actual return in this scenario will always be either 6 or 3
Risk Preferences: (1) Risk averse, (2) Risk seekers, (3) Homo economicus: completely neutral person makes decisions based solely on expected returns
Allocating Risks
Uncontrollable risks
Insurance: When purchasing insurance, a person pays a fee (premium) in exchange for the right to payment if a specified event occurs. Allows private parties the ability to pool risk: spreads risk among all of the members of the insurance pool
Weather is an uncontrollable risk, pay insurance
Use financial markets (contracts such as futures and other options): Financial markets allow a business to “insure” against some types of risks
Examples: Purchasing future contracts that would be profitable if there was a drought, purchase product as a pre-established right that would be lower than when you need it.
Diversification: A person can diversify by participating in numerous ventures each of which involves different risks (being in more than one industry)
POV: Owner with/$: easier to diversify
Employee: human capital (investing time/effort) into one job so you are exposed to the fortunes of that company
Staying in a firm for a long time
Allocate the burden of the risk to the person who is best able to bear it.
Controllable risks
Agency cost: the costs of monitoring plus shirking
The party who bears the consequences of the risk will have a greater incentive to control the risk, but the
mp; Demsetz, Production, Information Costs, and Economic Organization: Emphasize information costs—in some situations the firm is a more efficient monitor than markets. The firm as a “centralized contractual agent in a team productive process.”
Jensen & Meckling, Theory of the Firm: The firm as a legal fiction that serves as the “nexus of contracting relationships.”
Contemporary “Law and Economics” view: the firm is viewed as a nexus of contracts, sees the various corporate forms themselves as “standard form contracts” entrepreneurs, investors, and other stakeholders can use to organize productive activities. State corporate (and other business entity) laws become default rules that set forth what most investors would want.
Posner’s Economic Analysis of Law:
The corporation exists to enable entrepreneurs to raise financing
An entrepreneur has a promising but risky business plan. She had 3 basic options to raise capital:
Bank loan
Find partners willing to invest
Receive portion of profit
Limitation is that it can be dissolved, automatic at death
Partnership wants to know likelihood of potential liability
Form a corporation and sell stock to investors
You do not need to give investors a lot of control, they don’t have to directly control it
Types of corporations
Public corporations: have stock listed on an exchange
Securities can be bought and sold
The governance structure of public corporation separates ownership from control
Shareholders do not play an active role
Close corporations: “closely” held, without publicly traded stock (usually a few people)
No market for the corporation’s securities
Overlap of ownership & management
Active management of the business
Non-profit corporations
Benefit corporations: an alternative, for-profit form which requires directors and managers to take into account the effects of corporate activity on non-shareholding stakeholders. Advocated by the “corporate social responsibility” movement to pursue social and environmental missions. Florida allows.
