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Why do we need to have an objective function? So that we can use it
to make decisions.
The classical objective of maximizing firm value runs into problems
when we move away from an owner-manager who provides his own financing.
In other words, the separation of owners from managers, stockholders
from bondholders and suppliers of labor from suppliers of capital creates
difficulties.
Often, we end up with a stock price maximization objective as a way
of compromising between the interests of the different forces that are
brought under the umbrella of the corporation. The main reason for this
is that stockholders are the residual claimants of wealth in the firm.
As residual claimants, they also have more of an incentive to maximize
the value of the entire firm than any of the other claimants to the
value generated by the operations of the firm. And from a societal point
of view, maximizing the value of the firm, i.e. making optimal use of
society's resources is the correct objective. This is why it is optimal
for stockholders to have control rights to the firm.
Of course, there can be conflicts between stockholders and the other
stakeholders in the firm. This can lead to suboptimal use of social
resources. Under the right conditions, however, maximizing the stock
price is equivalent to maximizing firm value. This makes the manager's
job easier, because maximizing stockholder wealth is less ambiguous
than maximizing the value of the firm, and easier to justify to the
parties that control the firm, i.e. stockholders, and easier for the
manager to justify to himself. What are these conditions?
- Stockholders can design managerial compensation contracts so that
managers find it in their interest to maximize stockholder wealth.
(So that managerial actions also maximize stockholder wealth.)
- Bondholders can design bond contracts so that stockholders do not
take actions to transfer wealth from bondholders to themselves, and
injure firm value in the process. (So that stockholder actions also
maximize bondholder wealth, at least ex ante.)
- Financial Markets obtain all the information required to price securities
correctly. (So that maximizing stock price also maximizes stockholder
wealth.)
The objective function of maximing stockholder wealth is consistent
with maximizing social value as well, provided social costs are internalized
by the firm, explicitly or implicitly.
| Source of conflict |
Solution |
Difficulties |
| Between stockholders and managers |
Optimal contracts and takeovers; the annual meeting,
board of directors |
Collective action problems, greenmail, anti-takeover
devices such as golden parachutes and poison pills; imperfect information
problems, leading to the Winner's Curse. |
| Between stockholders and bondholders |
Covenants in Bond indentures and market discipline |
Imperfect monitoring |
| Between the firm and financial markets |
Action by concerned investor groups, market discipline
and governmental action |
Difficulty of entering into and enforcing implicit
multiperiod agreements (who acts on behalf of the market?) |
| Between the firm and society |
Governmental regulation, and boycotts by consumers
and investors |
Who controls the controllers? |
My interest in this note is to try and explain why firms tend to exhibit
certain organizational structures and not others. This will also
cast some light on the definition of a firm.
To begin with, let us go to an example of natural selection, taken
from Introduction to Evolutionary Biology by Chris
Colby (http://www.talkorigins.org/faqs/faq-intro-to-biology.html).
The species under consideration is a particular kind of finch, called
Geospiza fortis. "Geospiza fortis lives on the Galapagos
islands along with fourteen other finch species. It feeds on the seeds
of the plant Tribulus cistoides, specializing on the smaller seeds.
Another species, G. Magnirostris, has a larger beak and specializes
on the larger seeds. The health of these bird populations depends on
seed production. Seed production, in turn, depends on the arrival of
wet season. In 1977, there was a drought. Rainfall was well below normal
and fewer seeds were produced. As the season progressed, the G. fortis
population depleted the supply of small seeds. Eventually, only larger
seeds remained. Most of the finches starved; the population plummeted
from about twelve hundred birds to less than two hundred. Peter Grant,
who had been studying these finches, noted that larger beaked birds
fared better than smaller beaked ones. These larger birds had offspring
with correspondingly large beaks. Thus, there was an increase in the
proportion of large beaked birds in the population the next generation.
To prove that the change in bill size in Geospiza fortis was an evolutionary
change, Grant had to show that differences in bill size were at least
partially genetically based. He did so by crossing finches of various
beak sizes and showing that a finch's beak size was influenced by its
parent's genes. Large beaked birds had large beaked offspring; beak
size was not due to environmental differences (in parental care, for
example)."
Now, the interesting aspect of this is how Geospiza fortis came to
have larger bill sizes. This did not occur because some finches
realized that larger bills were advantageous and proceeded to somehow
grow larger bills. Rather, birds with larger bill sizes survived
the drought better and transmitted larger bill sizes to their progeny.
In other words, natural selection led to the larger bill size of Geospiza
fortis. This is particularly interesting to us because in talking
about organizational structures, we are not talking about entities that
have volitions and objectives. Rather, we are talking about a
set of relationships between other entities that do have volitions and
objectives. These entities are suppliers of capital (bondholders
and stockholders), suppliers of labor (employees), suppliers of raw
materials (suppliers), etc. However, it is difficult to argue
that these groups sat down and worked out the best way of setting up
their relationships; the main argument against this is that these groups,
generally, have conflicting objectives, more or less, in the same way
that any buyer and seller have competing objectives. Buyers want
the lowest price possible for their goods, while sellers want to sell
at the highest price.
Agency Costs
The term agency costs is often used to refer to the costs incurred
by the firm due to the conflicts referred to above -- conflicts between
management and shareholders, conflicts between shareholders and bondholders,
etc.
These costs are of three varieties:
- Costs that are incurred by the principal directly to monitor the activities
of the agent
- Costs that are incurred by the agent to comply with the restrictions
imposed by the principal, who is attempting to ensure that the agent
acts as he, the principal wishes.
- Costs due to suboptimal actions that the agent might take because
of these conflicts. These can be of two kinds:
- suboptimal actions that the agent is able to take because the
monitoring by the principal is not effective.
- suboptimal actions that the agent is forced to take because of
the restrictions imposed by the principal.
Agency costs of debt
Agency costs of outside equity
One of the agency problems that occur when managers are also not owners
is that they have an incentive to take excessive perquisites.
Here are some examples of executive perks. Of course, these perks
are portrayed as necessary for employee retention and/or increased productivity,
but such claims are difficult to verify.
Staff-hungry tech firms cast exotic
lures Pet insurance, BMWs, day care are among perks
USA Today; Arlington; Feb 1,
2000
PALO ALTO, Calif. -- High-tech firms and recruiters are ratcheting
up the outrageous and creative incentives they're dangling to fill the
346,000 highly skilled technology jobs that have gone begging.
"The market is hotter than hot, so employers are doing everything
to stand out," says Lance Choy, a recruiting director at Stanford
University, which graduates more than 1,000 engineering students a year.
- Interwoven, an e-commerce software maker in Sunnyvale, Calif., hopes
to lure engineers with flashy BMW Z3s. The firm will cover a two-year
lease, auto insurance and other costs, worth more than $60,000. "It
introduces them to the spirit of our culture," says Jack Jia,
an Interwoven executive.
- 2Wire, a Silicon Valley start-up that makes products for home networks,
opened an office in the rolling foothills of Grass Valley - - just
to hire 10 top engineers at a nearby 3Com facility who didn't want
to move from the area. "If you want world-class people, you've
got to go to great lengths," 2Wire's Roy Johnson says.
- L.L. Bean, the big retailer in Freeport, Maine, attracts Web site
engineers to its rural headquarters by selling the gorgeous New England
wilds.
Techies who join the company get five "outdoor days" to borrow
L.L. Bean camping gear for backpacking, kayaking and other activities.
And it doesn't count against vacation.
The most desirable hires, such as e-commerce software developers, are
juggling several offers. They command up to $120,000 salaries, $15,000
signing bonuses and stock options worth nearly $1 million after an IPO,
says Craig Silverman of Hall Kinion, a technology staffing firm in San
Francisco.
But recruitment tricks and cash only go so far, notes Dave Van De Voort,
a compensation expert at William Mercer.
Firms must sell workplace culture and lifestyle perks, such as flextime,
telecommuting, fitness centers, day care, even health insurance for
pets. "Organizations must offer the total work experience to attract
talent," Van De Voort says.
To keep talent from leaving, 1,000 high-tech firms surveyed last year
by Mercer say they offer workers more challenging jobs and training,
more family-related benefits and better management supervision.
The nation's high-tech regions have been hit equally hard by the talent
shortage. Unemployment last year sank to record lows in Silicon Valley
(2.7%); Austin, Texas (2.1%); Boston (2.6%); and Fairfax County, Va.
(1.6%), according to the American Electronics Association.
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