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THE CONTRACTARIAN NATURE OF THE FIRM

THE CONTRACTARIAN NATURE OF THE FIRM. Session 1A Doctoral Seminar National Taiwan University June 27, 2011 Utpal Bhattacharya (Indiana University). Corporate Finance.

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THE CONTRACTARIAN NATURE OF THE FIRM

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  1. THE CONTRACTARIAN NATURE OF THE FIRM Session 1A Doctoral Seminar National Taiwan University June 27, 2011 Utpal Bhattacharya (Indiana University)

  2. Corporate Finance Corporate Finance is an investigation of the incomplete nexus or web of contracts that involve the providers of capital (bondholders and equity holders) and the controllers of this capital (managers).

  3. Neo-Classical Theory of Firm It is a constrained optimization problem: maximize the profit of the firm subject to constraints ILLUSTRATION 1 Advantages a. Useful comparative statics with respect to input and output prices b. Useful to study strategic interactions using game theory c. The firm can ignore the inter-temporal preferences of its owners – Fisherian Separation – which forms one basis for the NPV rule ILLUSTRATION 2 d. The firm can ignore the state preferences of its owners – Arrow-Debreu Securities – which forms the second basis for the NPV rule ILLUSTRATION 3

  4. Neo-Classical Theory of Firm(Contd.) c. and d. Basis for separation between the asset side and the liability side of the balance sheet (Modigliani and Miller, 1959, AER) e. As equity holders are residual claimants, maximizing shareholder value is equivalent to maximizing firm value Disadvantages a. Assumes that the firm is a “black box”; ignores the interaction between the various agents within a firm b. There is no definition of the boundary of a firm. The entire world could be one firm

  5. First Friction:Agency Theory Agency theory – also called Principal-Agent Theory or the Theory of Complete Contracts – recognizes the fact that different agents in the firm have different objectives, effort cannot be observed precisely, and incentives for each state have to be provided to align interests. Mirrlees (1976, BJE), Jensen and Meckling (1976, JFE) ILLUSTRATION 4 Advantage a. Opens up the black box Disadvantages a. Impossible to have complete contracts because no one can foresee all possible future stages b. There is still no definition of the boundary of a firm. The entire world could still be one firm

  6. Second Friction:Asymmetric Information Asymmetric information is when agents have private information about type/quality. This leads to Adverse Selection. Akerlof (1970, QJE). Note: Asymmetric information about effort leads to Moral Hazard. Discussed in Illustration 4. ILLUSTRATION 5 The solution to Adverse Selection is Signaling. Spence (1973, QJE) ILLUSTRATION 6 Advantage a. Further opens up the black box Disadvantage a. There is still no definition of the boundary of a firm. The entire world could still be one firm

  7. Third Friction:Transaction Costs Transaction costs were first introduced by Coase (1937, Economica) and formalized by Williamson (1979, JLE). Given that human beings have bounded rationality – Simon (1955, QJE) – it is impossible to predict all contingencies. So, contracts are incomplete. Second, given that contracts are incomplete, and humans are opportunistic, they will take advantage of this. They will try to renegotiate. Renegotiations cause transaction costs. A relationship will exist inside a firm if the transaction costs are lower than if it existed in the market.

  8. Third Friction:Transaction Costs (Contd.) Transaction costs are high for high frequency transactions and relationship-specific transactions because hold-up costs are high So such transactions will tend to be inside the firm rather than outside the firm(i.e. in the market) Advantage a. We now have a definition of the firm. Disadvantage • We do not know the hierarchy. Who will be the principal (the owner) and who will be the agent (the person who works for the owner)?

  9. Fourth Friction:Property Rights Hart (1988, JPE) added the notion of property rights. Definition of an owner: Given that an incomplete contract cannot and will not specify all contingencies, the owner is the person who has the right to decide what happens at the gaps. Explains why: • During solvency, equity holders are the owners. They get the residual income. So they take the risk and they decide. During insolvency, ownership transfers to debtholders • We have mergers and spin-offs • Why NTU has regular faculty and visiting faculty (free agents) like me. • Etc., etc.

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