Economics of the Firm
Risk
o Non-Controllable Risk -that the parties to a business cannot control
· They may affect businesses differently, but they cannot be completely eliminated
§ Ex – a vineyard owner cannot control the weather or consumer demand
§ Risk can be good – to a weapon maker, the risk of armed hostilities is a good thing
o Controllable Risk – can be influenced
· Ex – a vineyard owner can chose what type of grape to use
o Preferences Generally
· Risk v Uncertainty – risk can be quantified, uncertainty cannot be
§ Risk is a “quantifiable uncertainty”
§ Expected Return – the weighed average return based on the probabilities of events, after a business has quantified risks
· Risk Averse: the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff
§ People are risk averse with respect to gains, but risk seekers with respect to losses
· Risk Neutral: s used to describe an individual who values risk at a constant value. Risk neutral is in between risk aversion and risk seeking, and a risk neutral individual will accept exactly the same interest rate for all assets
§ Would take a risk anytime it would benefit on average
· Risk seeking: Such an individual would willingly (actually pay a premium to) assume all risk in the economy and is hence not likely to exist.
§ Go for the greater expected value and risk getting nothing
Managing Risks
o Insurance
· In purchasing insurance, a person pays a fee upfront – a premium – in exchange for the right to payment if a specified event occurs
· By using insurance to pool risks, each member of the pool bears a pro rata share of the pool’s total loss, which is easier to predict than the loss to any particular member
§ Hedging- commodity exchanges in Chicago offer contracts that permit parties to bet on what the temp will be in a given month or how much rain
o Diversification
· A person or business can diversify by participating in numerous ventures, each of which involves different risks
· Diversification will not completely eliminate the risk of loss in any given stock, it will reduce the total risk because the performance of the entire portfolio is more likely to be balance between gains and losses
§ Thus, the diversified portfolio will offer a more certain return than can be obtained from any particular stock
o Allocating Risks
· Parties to a business venture might allocate risks to the person who is most willing or best able to bear those risks – perhaps because he is in a better position to insure or diversify
§ Or, a more sophisticated party with superior information might allocate risks to the person who is least likely to understand the risks
· Problems in Allocating Risks to an Agent
§ Motoring costs
· Shirking problems
§ Discipline
§ Contracting ex ante
§ Resolving disputes from an ex post perspective
· Two sources of rules for parties to use in structuring their business relationship:
§ Contract – through private agreement
§ Business Org – by choosing a particular legal regime
· Allocating Risks to the Principal
§ Some risks are more efficiently borne by the principal
· If the principal is less risk averse than the firm’s agent, the principal will be more willing to bear the non-controllable risk of business success or failure
· The agent, on the other hand, would prefer fixed compensation
§ If the agent does not bear the risks of the business, but receives a fixed compensation, there arises the controllable risk that the agent will be lazy or even corrupt
· The risk of the agent shirking will lead to the principal wanting to monitor and discipline the agent
· First, the principal must decide what constitutes optimal performance by the agent – an ex ante task
· Second, having decided this, the principal must determine whether the desired level of performance is occurring – an ex post perspective
§ How should the principal monitor?
· Direct supervision – agreement on optimal standards an punishments
· Employment contract – specify duties and sanctions (“best efforts” clause)
· What about long term contingencies?
· Contracting is costly – info, negotiations, drafting, and enforcement
· Allocating Risks to the Agent:
§ The risk of shirking is completely on the agent – reduces P’s monitoring costs
§ Agent is self-monitoring
§ If A works less hard, it is because he values his non-work activities more than the fruits of his work
§ But, if shirking is really P’s concern, he could tie A’s salary to the size or quality of his work
· When an agent becomes a risk-bearer, he becomes more interested in operating the business as he sees fit, without interference
· Monitoring can still be hard i
o it has recorded
· Third – “accounting” stage: the company classifies and analyzes the audited info and presents it in a set of financial statements
§ There are opportunities to be dishonest and manipulative at every level
§ Private companies do not always go through all three steps
§ If you are considering buying a private company, you would want to know who prepared the financial statements and whether any third party reviewed them
o A balance sheet is only a snapshot of a companies finances at a particular moment
Assets
o Assets are listed in the balance sheet in order of liquidity
o Current Assets: include cash or other assets which in the normal course of business will be converted into cash in the reasonably near future (one year of the balance sheet
· Cash – money in the till and money in demand deposits in the bank
· Marketable Securities – securities purchased with cash not needed for current operations
§ Usually very liquid securities – commercial paper and treasury bills (interest income)
§ GAAP requires securities to be reported at their fair market value, not their cost
· This is know as “mark to market” because securities are marked on the balance sheet to their market price
§ Financial instruments used to hedge against prices also need to be marked to market
· If a market price can’t be determined > good faith estimate
· Accounts Receivable – Amounts not yet collected from customers to whom goods have been shipped or services delivered
§ GAAP required that AR be adjusted by deducting reserve for bad debts
§ Firms compute bad debt allows on the basis of past experience
§ When a firm increases its allowance for bad debts, GAAP require it to record to increase as a charge against income – “bad debt expense”
Notes or Loans Receivable – somewhat analogous to accounts receivable and represent a very large portion of the assets of firms engaged in
