CHAPTER 1 – ECONOMICS OF THE FIRM
What is a sensible way of allocating the risk of an enterprise? (to increase its value)
o controllable risks – to the party better able to control them
o uncontrollable risks – to party who can better bear risk(i.e. more diversified, richer, risk lova/neutral)
o Hard when that falls on 2 diff people. Can draw distinction in K but theres problems:
§ You may not know what specifically needs to be controlled
§ Requires supervision to enforce (Agency Costs)
· Reputation is an alt to enforcement – repeat biz often ensures compliance but doesn’t work when person is older/on last legs/ + isn’t accurate
What causes different attitudes towards the uncertainty of risk?
o Short vs. Long term investment – guy w/ LT investment is better able to take loss 1 yr b/c he knows it’ll be better in long run
o Diversification – enables u to bear risk better. inscos-spreads risk among many – can diversify
o Wealth – rich folks are likely to be more risk neutral w/ respect to risk of a given number of $
o For controllable risks u want the upside & downside risk to be balanced to provide the right incentives – this isn’t necessaryily the case for uncontrollable risks
o Maybe the party better able to foresee risk should bear it – makes sense for controllable risks so u can control & if uncontrollable maybe u can insure against or at least prepare for it- risk is calculable, uncertainty is nebulous- the latter are more frightening to bear
Most of the time, most people are risk averse – Why?
o DMUI – Diminishing marginal utility of income- as u get richer, the marginal utility – (the incremental increases in utility from an extra dollar) diminishes (u need $ less to thrive)
o This is relevant to insurance – loss in utility from paying premiums is smaller than the gain in utility in the scenario you are protecting yourself against
o People will not insure against certain kinds of events like P+S, b/c when someone is in P&S $ likely has no marginal utility. – if anything a person gets less utility out of $1 when theyre in P&S than when theyre normal. So people insure against pecuniary losses b/c theyre the kind of losses where $ helps to restore the lost utility.
Employment vs. Tenancy – Possible structures are agent gets a salary or agent rents land as a tenant & principal receives a fixed rent. HOW BEST TO ALLOCATE BOTH TYPES OF RISKS?
o IN an employment sit, employer bears controllable risks – doesn’t make sense in hypob/c optimally Edward will bear those risks here
o In an employment sit, employer also bears uncontrollable risks – makes sense here b/c Julia probably has more $ & might be more diversified or educated
o We want to put controllable risks on ernest& uncontrollable on Julia. How do you do that?
§ Spell out K where everything controllable must be done & salary is dependent on that. (Problem – its hard to spell out whats necessary to control risks + to enforce K)
§ Profit sharing K? (not ideal b/c some controllable risk is borne by Julia & some uncontrollable risk is born by earnest)
§ *Middle(to combat shirking/agency costs)-imperfect risk sharing arrangement that puts some risk for each. (i.e. sharecropping arrangement – pay someone a fixed rate + a % as compromise AS OPPOSED TO employment –bad for controlling agency costs problem + tenancy which puts all risk on tenant which is bad for allocating risk)
o Corporate Laws – Both state & federal but most corporate law is state law. (DE, CA, RMBCA)
o AOI – spells out the rules specific to a corp (like const).- trumped by corp law.
o Bylaws – Technical details for corp governance/mgmt (cant do anything contrary to AOI).
CH 2 – CORP LAWINTRO /CHOICE OF ORGANIZTNL FORM
– General Partnership – FUDDS traits
o fid duties (good faith + loyalty that parties owe each other)
o decentralized mgmt – every partner is an agent w/ auth to act on behalf of firm.
o Dissociation (if u cease to be partner, ur interest
rability of shares –fellow SHs can sell to who they want. (unlike partnership – partner cant sell his partnership to someone else)
o Limited liability –SHs aren’t liable for co debts.Worst case is SH’s investment is worthless
o Sep entity – can sue + be sued, it can hold prop. Sep from any individuals involved.
§ Tax– corps pay tax as sep entity. Partnership doesn’t (profits imputed to indiv partners).
– Problem 132 -Stern & Star – Current owners/mgrs; Jessica – 30 yr old. Writer for biz pub. Will invest $200k but doesnt know technical aspects; M – Technical guy, has $100k to invest. Married w/ kid; B – semi-retired, $600k to invest, doesn’t want to be actively involved. How best arrange co?
o GP – Bernie doesn’t want to be general partner – he doesn’t want his assets to attach to biz
o LLP is not an option in CA b/c only a limited # of industries can do it
o Limited Partnership – Bernie could be a LP & the others GPs. This is a possibility but would Bernie butt in enough that ct might find he is participating in biz & is thus liable?
§ Some attys get around liability by making a corp GP. (maybe unnec now w/ LLC’s)
§ WOuldn’t really want this b/c the general partners have liability
o LLC –plausible here. They can organize it centralized or decentralized, choose tax conseqs too. From tax pov they want partnership – losses can be deducted from their personal income. This is useful b/c individual may have other sources of income.
o Corp is also plausible but not as good b/c u can’t get partnership tax (S Corp may fix this)
So Corp + LLC are the best options