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Chapter 9

Chapter 9 Notes(Key takeaways from the chapter) - .docx

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Chapter 9 – An Analysis of Conflict Game Theory - Models a conflict situation between rational players (more than 1 player) - Takes into account any uncertainty arising from random realization of states of nature, taking into account the actions of other players - Two games include: o Cooperative binding agreement (e.g. cartel) o Non-cooperative (e.g. oligopolistic industry) Non-cooperative Game Model of Manager-Investor Conflict - Difficult to envision a binding agreement between manager and investor about what specific information is to be supplied - Nash equilibrium is the strategy choice where each player is content with his or her strategy (refer to Example 9.1 page 330) - Cooperative solution is the strategy that results in both parties being better off o Studies argue that it is not possible due to the one of the parties being able to receive a higher utility for a different option (Example 9.1 the cooperative solution is BH but manager would not accept this as they could receive a higher utility with BD) - Single-period game model relates to the accounting and auditing scandals o E.g. Why would Enron executives choose the cooperative solution BH when there is a higher payoff at BD - Multi-period game results in selecting BH as players need to consider o 5-period game where if parties do not trust each other, game unravels to single- period game o Manager reputation and ethical behaviour o Folk theorem Agency Theory - Studies the design of contracts to motivate a rational agent to act on behalf of a principal when the agent’s interests would otherwise conflict with those of the principal - Principal (owner) is rational and risk-neutral - Agent (manager) is rational, risk-averse, and effort-averse - Moral hazard problem of information asymmetry o Principal cannot observe agent’s effort, implies agent may shirk on effort - Direct monitoring o First-best – contract where direct monitoring is possible o Has risk-sharing properties, but in the case that there isn’t, manager will shirk if he/she bears no risk  Another example of information asymmetry (moral hazard) – manager knows the effort level, but the owner does not - Indirect monitoring o Moving support – possible payoffs is different depending on which action is taken o Does not work since we cannot rely on it to ensure that the first-best contract will be attained o Many contracting situations may be characterized by fixed support  Need to also consider legal and institutional factors that may prevent the owner from penalizing the manager sufficiently Chapter 9 – An Analysis of Conflict  How will the owner collect the money once the state is realized and the manager is already paid - Owner rents firm to the manager o Internalizing the manager’s decision problem o Since manager now bears all the risk, owner must sacrifice some utility to enable the manager to receive their reservation utility (agency cost) - Give the manager a share of the profits o Performance measure – some jointly observable variable that reflects the manager’s performance (generally use Net Income as the measure)  Net income is informative but not fully, noisy, and an unbiased message about the payoff o Results in higher utility than rentin
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