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Chapter 15

EC260 Chapter Notes - Chapter 15: Downside Risk, Call Option, Root Mean Square


Department
Economics
Course Code
EC260
Professor
Olivia Ozlem Mesta
Chapter
15

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Chapter 15: Principal-Agent Issues and Managerial
Compensation
Principal-Agent Issues
-Principal-agent issues arise when managers (agents) make decisions that affect the
wealth of shareholders (principals) and the interests of the principal and agent
diverge
-To understand this better we have to consider the roles of uncertainty and asymmetric
information
-Shareholders do not know the degree of effort that managers are exerting on their
behalf since they cannot monitor this perfectly
-Since managers gain utility from their leisure time, there is a conflict between how
much time and effort they spend working on the shareholders’ behalf and how much
time they spend on personal pursuits
-One way to mitigate this conflict is to link the agents’ compensation to the
performance of the firm — interests are better aligned (now what is good for the
agent is also good for the principal)
The Diverging Paths of Owners and Managers
-Shareholders are concerned with the value of their shares
-While managers share the goal of maximizing share value, a number of other goals
exist for managers that may conflict with them always acting to maximize firm value:
1. Minimizing effort — managers experience disutility from working and would prefer to
have more leisure time
2. Maximizing job security — managers will be discouraged to undertake high risk/high
reward projects that could jeopardize their employment situation
3. Avoiding failure — managers are more likely to avoid projects with a high risk of
failure even if the potential rewards are high because they would rather be
associated with successful projects
4. Enhancing reputation and employment opportunities — sometimes managers may
make decisions that hurt firm value because these decisions make them look good
to others they wish to impress
5. Consuming perks — managers may use their positions to exploit opportunities such
as engaging in luxury travel, making corporate donations to their favourite charities,
hiring friends and family, etc.
6. Pay — the structure of a manger’s pay and compensation package may create
conflicts with shareholder goals
The Effect of Risk, Information, and Compensation
Managerial Behaviour and Effort
-The principal-agent problem can be represented algebraically through the firm’s
expression for profit
Profit = Revenue - Costs

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Profit = Revenue - Managerial Compensation - Other Costs
-We can also define the variable e to represent managerial effort
-The revenue (R) the firm earns will be a function of this effort as will profit (π)
-We can define managerial compensation as S, which for now we assume is a flat
salary unrelated to effort, and other costs can be represented by C
π(e) = R(e) - (S + C)
-Profit before deducting the manager’s salary is equal to R(e) - C and profit after
deducing the manager’s salary is R(e) - S - C
-Because managers experience disutility from expending effort on behalf of the firm,
we can define this disutility as u(e)
-As effort increases, the manger’s disutility of effort rises
-Although the manager experiences this disutility, they also earn a flat salty, S, for their
work at the firm
-This means they experience a net benefit B(e): B(e) = S - u(e)
-When S and u(e) are equal, the manager experiences a net benefit of zero
-For all levels above this point, the managers net benefit is negative — this shows
that the manager bears all the cost but no reward, while the firm earns higher profits
as the manger’s level of effort increases
Resolving the Incentive Conflict If Effort Is Observable
-Owners want managers to maximize effort and thus firm profits, while managers
experience no benefits from increasing effort and in fact experience a falling level of
net benefit

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-As a result, managers working under this type of pay structure (flat) will be inclined to
exert less effort
-It is possible to resolve this incentive by making effort observable
-In this case, the salary of managers is altered to provide rewards for increased effort
-We assume there is still a fixed component to the managers salary, K
-We also define U(e) as the component of the managers salary that varies with effort
-When U(e) = u(e), the manager is being fully compensated
S(e) = K + U(e)
-Substituting the last equation into our profit equation yields:
π(e) = R(e) - [K + U(e)] - C
-The figure above shows that with this new method of compensating managers, firm
profit has a definite maximum
-This occurs at effort level e* where the marginal benefit from effort, dR(e)/de, is equal
to the marginal cost of compensating managers for their efforts, dU(e)/de
-This condition is obtained by maximizing profit with respect to effort:
Profit maximizing condition:
dπ(e)/de = dR(e)/de - dU(e)/de = 0
dR(e)/de = dU(e)/de
-At e*, the manager’s net benefit becomes:
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