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Business and managementLesson n°Types of goods: Essential Complementary Differentiable/ homogeneous Disposable/durable Industrial/consumer Public/private Sources of efficiency in groups: More diversified and complementary skills Easier to achieve risk-sharing Easier to accumulate resources Specialis...

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Business and management! Lesson n°1! Types of goods:! • • • • • •

Essential ! Complementary ! Differentiable/ homogeneous! Disposable/durable! Industrial/consumer! Public/private!

Sources of efficiency in groups:! • • • •

More diversified and complementary skills! Easier to achieve risk-sharing! Easier to accumulate resources! Specialisation economies!

Lesson n°2:! Partnerships: ! • partners equally entitled to the management and to an equal share of profits! • If a partner makes a decision, the other partners are bound to that decision.! • Partners are exposed to unlimited personal liability! • Responsibility for the misconduct of the other partner in connection with the partnership! Business firms: • Legal entity that engages in the production of economic goods or services.! • Predominantly economic objectives! • Many interests converge, but they do not necessarily come together spontaneously or congruously! • Often complex and bureaucratic.(not efficient)! Main features of a corporation:! • Legal personality! • Limited liability! • Transferability of shares! • Centralised management ! Advantages of corporations:! • Facilitate the accumulation of resources! • Survive as long as they have capital (independently of their shareholders)! • Limit risk!

• Facilitate larger operations: scale and scope economies!

Legal personality of corporations:! • Corporations recognised as legal entities distinct from their shareholders, executives etc. ! • May sue and be sued in ways distinct from the individuals involved.! • They own assets, have debt positions, and survive has long as capital is available (perpetual succession) !

Limited liability: Main principle is to separate what the corporation owns from what shareholders own (i.e. the equity capital they provide) ! If the corporation goes bankrupt, shareholders are not individually liable (usually) !

- Creditors will go after the assets of the company, not the owners’ individual wealth ! Transferability of shares: • Shareholders are free to buy and sell company shares ! • The identity of the corporation is independent from that of shareholders ! • Shares are transferred via financial transactions between buyers and sellers ! Stock markets for listed companies! - Private deals for unlisted or privately- held companies !

- While shares are tradable, their liquidity can be limited ! Centralised management: Shareholders own the equity capital of the corporation ! But its daily activities are often delegated to a few professionals (CEOs, top executives, managers) ! Separation between ownership and control – Makes decision-making more efficient% – Can bring about agency conflicts (more later) ! Firms’ organization is complex and problematic ! Markets vs firms: Can’t we just replace firms with contracts (and thus market transactions)? ! Price systems are great at generating information about what people want to buy and sell ! •

-& 'prices give producers incentives to shift production to products with high prices !

•

-& 'prices give consumers incentives to reduce quantity of products with high prices !

•

-& 'goods are rationed to those willing to pay %

Transaction costs: However, using market transactions entails costs beyond the simple market price ! – Search and information costs% – Bargaining and decision costs% – Policing and enforcement costs% – Opportunity cost of inefficient resource allocation ! Spot transactions vs. “incomplete” long-term contracts ! Conducting economic activities within firms minimises transaction costs

TCE (transaction cost economics) view of the firm: Firms have significant advantages over markets ! •

-& 'Fewer transactions !

•

-& 'Information specialization !

•

-& 'Reputational concerns !

•

-& 'Scale benefits (more in our strategy part) !

TCE perspective helps understand what drives firm size ! Transaction costs shape the ”boundaries” of markets vs. firms ! •

–& 'How many activities are carried out internally vs. being outsourced to contractors? !

•

–& 'When would a firm find it beneficial to integrate forward/backward activities of its value chain? !

Sources of finance: • Retained profit! • Equity (individuals or financial investors)! • Dept (individuals or financial institutions)! Financial stakeholders: • Equity providers! • Dept providers! Classification of stakeholders: Primary (or core) stakeholders% – Often, investors and employees% – They contribute to set firms’ objectives and strategies ! Obviously the importance of stakeholders vary across organizations (States, families, noprofits, firms) ! For business firms, it may vary also across industries or countries, and over time !

Core stakeholder: Decide objectives, strategies and policies ! Select the people who contribute to the economic activity of the organization ! Design and implement governance/control structures ! Monitor the economic viability of organizations ! Stakeholders: individuals or group of individuals who provide contribution to a company in exchange of a reward! Institutional model:% Set of core stakeholders (contributions/rewards) ! Governance mechanism that allocates power and wealth among them% Fundamental goal of the organization (?) !

Lesson n°3:! shareholder views: Shareholder view ! – Property notion of the firm (seen as a nexus of contracts) according to which shareholders (principal) own the firm and managers/directors are agents of the shareholders ! Stakeholder view ! – Social-entity notion of the firm according to which capital providers must be rewarded properly but the corporation has broader purposes ! Shareholder view of the firm: Executives are employees of the owners. Their responsibility is to run the business in accordance with owners’ desires (generally to make as much money as possible in a legal way) ! If executives pursue social responsibility, they are spending the money of company owners for general interest, i.e. imposing taxes ! Executives who impose taxes are like civil servants. But then they should be chosen through an election. And what do they know about the general interest? ! Stakeholder view of the firm: Separation fallacy: No firm decision has only economic consequences. Always a mix of economic and social impacts ! No shareholder primacy: Each stakeholder has voice and rights. Their claims on residual value can vary across time and context in relation to their contribution to the firm ! Competitive advantage: Financial capital is diffused and fungible, and thus a weak source of competitive advantage !

Milton’s hypothesis response: Separate money-making from ethical activities – Firms make money% – Individuals deal with problems ! But separability assumption not often satisfied: profit-making and damage-making are intertwined ! – Often hard or impossible to find reversible project that counteract the social costs of corporate actions ! Let the government deal with externalities! ! Makes sense in theory, but.. ! – Lobbying ! – Government failures ! – Sometimes government cannot intervene due to constitutional boundaries !

Usefull link on Firedmand and Freeman: https://www.smartsheet.com/what-stakeholder-theory-and-how-does-it-impact-organization Firm objectives: o Should be consistent with the preferences of their investors o Closely-held firms, or firms with a single investor solve easily this problem o Coordination problems and difficulties in aggregating preferences in listed firms o Potential solutions – Voting by shareholders on corporate policies – Polling investors on specific issues Non profit organisations: • Are perfectly allowed to make net earnings! • However, they cannot distribute net earnings to stakeholders (no dividends) ! • Instead, they should reinvest them in the organization to pursue its goals ! Rationales for nonprofits • Due to nonexcludability, a private for-profit firm may find it not profitabile to provide a good ! • Due to asymmetric information, a private firm may exploit consumers ! • More generally, when a good or service is not adequately provided by firms (i.e. inefficient market allocation) !

How do nonprofits get resources

• • • •

Donations from firms etc. (fundraising campaigns) ! Membership fees (do not depend on the actual use of the service) ! Voluntary work from members and nonmembers o Favorable loans ! Tax and administrative advantages!

Classification of nonprofits • Closed associations - Members cover the costs and enjoy the benefits ! • Open associations - Members engage in their activities but are not the only one enjoying the benefits. Costs covered wore widely ! • Providers of healthcare or educational services - Self-restriction on prices; costs covered by customers/ donors ! • Charities - Engaged in the collection and redistribution of resources to donors (who do not cover the costs) ! • Private providers of public goods - Costs usually covered by donors and states! Lesson n°4:! Patagonia case study! Lesson n°5:! Completeness

For any x' and x", either x' ≥ x" or x' ≤ x”! In other words, the options can be compared and the individual knows how to choose! Transitivity For any x', x'' and x''', if x' > x'' and x'’ > x''' then x' > x''' ! Imagine you are given x'' and are willing to pay some money to get x' (since x' > x''). If x' > x''' does not hold, then you are willing to pay to get x'''. But afterwards you are also willing to pay to get x'' (since x'' < x'''). You end up from where you started but with less money!

Rational preferences • Satisfy both the completeness and transitivity principles! • Allows to operationalize economic preferences with utility functions – if x' > x'' and x'' > x''' then we can use u( x' )=3, u( x'' )=2 and u( x''' )=1, i.e. greater utility index for more preferred options! Homo oeconomicus • Common assumptions used in economic models to characterize decision-making – Rational preferences – Ability to use all the information available – Utility maximization ! • Significant advantages – Allows formalization of individual behavior in theoretical models – Provide a benchmark of individual behavior useful e.g. to understand the effect of certain policies!

Framing Example:

The role of framing • Easy to see that the two cases are identical ! • Only difference: in the 1st case the outcomes are framed using lives saved whereas in the 2nd case using lives lost – A is equivalent to C and B equivalent to D, only the framing differs – People do not exhibit complete preferences due to violation of description invariance!

Decision-making in groups • Often firm-level decisions are made by groups: – Top management teams, boards of directors, shareholder assembly, work-groups – We studied the benefits of groups in terms of specialization economies! But do groups make more rational decisions as compared to stand-alone individuals?! • Drawbacks of group decision-making • • • • •

Social pressure impairing individual capabilities! Conformity and imitation of bad practices ! Excess risk-taking due to dilution of responsibilities ! Small amounts of irrationality which trigger large aggregate effects! time consumption of these decisions!

Herding behaviour • Two restaurants A and B next to each other: the prior probabilities are 51% for A being better and 49% for B being better ! • People arrive at the restaurants in sequence, observe the choices made by those before them, and decide ! • Apart from knowing the prior probabilities, each of these people also got a signal saying that either A or B is better (of course the signal could be wrong) ! • Each person's signal is of the same quality! • Of the 100 people, 99 receive signals that B is better; the one person whose signal favors A chooses first. Clearly, she will go to A ! • The second person will know that the first had a signal favoring A, while her own signal favors B. Signals of equal quality cancel out: the second person follows prior probability and go to A regardless of her signal ! • The third person's situation is exactly the same as that of the second person… ! • Everyone ends up at restaurant A even if, given the aggregate information, it is certain that B is better! Contracting • Principal and agent sign a contract that specifies what the manager does with the funds and how to divide the returns ! • The contract should be complete, i.e. should cover all states of the world ! • Most contingencies are hard to descrive and foresee (contract incompleteness) ! • Whatever contract they write, the manager ends up having a significant discretionary power! Contracting in more depth • Elaborate a (incentive) contract where the manager is paid according to his/her actual effort • Managerial effort is unobserved – and that generates the key problem • Use performance as a (crude) proxy of managerial effort – When the company does well (net of industry effect, business cycle etc) the manager must have done a good job – If the manager invest in wasteful projects, the company will underperform – The contract will align the interests of principal and agent Managerial discretion • Plain expropriation ! • Schemes to take the cash out, e.g. setting up a company and then engage in related party transaction (more in the Parmalat case) ! • Use company funds to engage in activities that generate personal benefits (perks, pet projects) o Entrenchment: CEOs who make themselves irreplaceable! Other symptoms of bad governance • • • • •

Excessive risk-taking usually stemming from distorted CEO incentives ! Extremely long CEO tenures ! Little or absent shareholder or board dissent ! Over-investment ! Dissipation of cash holdings!

Efficient contracting! • – Outside options for managers have increased enormously! • – Larger firms are in constant search of the right manager: higher return on managerial skills! Managerial power – CEOs have been found to be paid for “luck” (e.g. increase in pay due to increase in performance, such as oil price, which is not attributable to them) ! – Entrenched managers set the pay package for themselves! Increasing the number of principles • Companies (esp. listed ones) are held not just by one investor but by a myriad of shareholders ! • Investors often small and uninformed about the corporate decisions => they won’t exercise the control rights they actually have! • They could actively engage in monitoring the agent. But remember the problem of freeriding with public goods – Monitoring under-provided in equlibrium! The board of directors • Shareholders elect a group of specialized individuals to deal with the management on their behalf ! • Main tasks – Appointment and replacement of CEOs – Provide skills and specialized knowledge – Monitor the CEO!

Typical board in a listed firm • Average number of directors 8-10 ! • Around 2/3 independent directors (i.e. no conflict of interest with the management ! • Three main committees, with monitoring role (auditing, compensation) or advising role (strategy)! • In some contexts (e.g. Germany), boards have a “dual” or “two-tier” structure: supervisory and management board with distinct roles! Do boards really work • Board capture – Directors have incentives to be loyal to the CEO to get promotion in other companies or other sorts of favors ! • Busy board – Directors are often appointed in so many companies (40% in 2 or more firms) which do not give them the time to work effectively ! • Tokenism – Board appointments often for symbolic management reasons!

Questionable board practices • Demographic homogeneity leading to conformity in group-thinking ! • Weak independence criteria in turn weakening monitoring ! • CEO-board chair duality again weakening monitoring! Shareholder activism • Mostly mutual funds, pension funds, hedge funds and other investors! • Use their equity shares to put pressure on the management! Areas of intervention • • • • •

Issues related to anti-takeover defences (e.g. poisson pills, golden parachutes) ! Issues related to board independence ! Executive compensation ! Voting issues (confidential voting, multiple voting shares etc) ! Ownership and capital structure issues!

Legal protection of shareholders • Minimum share of ownership to call for extraordinary shareholder meetings, (the lower the percentage required, the more rights the shareholders have). ! • Proxy vote by mail ! • Direct representation on the board (via cumulative voting or quotas). In other words, if an investor gains, for example, more than 5% shares of the company, he directly gets a seat on the board.! • Presence of a judicial venue to challenge the management ! • Preemptive rights in equity issuances (allows the current shareholders to buy new shares when the company Is diluted to a higher number of shares)! Institutional owner: Investment funds! Exit as governance • Blockholders who sell a firm’s stock based on private information impose downward pressure on prices ! This effect hurts management through its equity investment in the firm ! • • Management increase productive effort to increase firm value and dissuade blockholders from exiting ! Governance mechanism comes from threat of blockholder exit, not actual exit o In order • for the threat to be credible, the stock should be highly liquid! Liquidity of stocks How easily stocks are sold! Product market competition • Monopoly is a great enemy to good management (Adam Smith 1776) !

• Competition forces firms to minimise costs: inefficient firms due to lazy management wont survive in the long-run ! • Takeover mechanism – Managerial inefficiency is detrimental to market value – A bidder makes an offer to the shareholders of the firm – If once it acquires control, what’s the first thing it will do?! • To work well as governance device, it requires a liquid market for corporate assets or Acquisitions may be the manifestation rather than the cure of agency problems ! Takeovers are often regulated by law and firms have the opportunity to introduce legal • obstacles to the likelihood of being acquired ! • When can takeover protection be good for the firm?! Anti takeover protection (ATP) and innovation

To promote innovation, some degree of managerial entrenchment may be needed to protect the management from short-term failures.!

Lesson 7:! Larger shareholders as principals: (when there is a majority shareholder e.g. he owns 80%) • Can better coordinate to monitor the management (lower risk of free riding)! • Have power and influence (are widely represented in the board, and may even influence the management directly)! • Often are themselves the managers of the firm (no separation ownership and control)!

Sources of cross-country differences • Rule law:! Family ownership less frequent in countries with common law legal origins (better protection of minority shareholders, which in turn facilitates equity financing)!

• Cultural value! Family ownership more prevalent in countries where the role of family is culturally stronger and where social capital is weaker.! • Institutional characteristics! Family ownership works best in context that are connection-centric, more entrenched with the political system and less accountable! Extraction of private benefits • Intrinsic private benefits incurred from controlling a family firms! Family majorities may be better off, even talking into account the potential lower profitability. (e.g. hiring a family member as CEO despite there being better CEO on the market)! • But this may not always be the best choice in terms of managerial efficiency! Minorities would bear the cost without enjoying any benefits! Propping • Use of private resources by family members to support the company! Remember that families manage companies for the long run! Propping is often used to rescue the legacy of the family business! • Minority shareholders benefit at the expenses of the majority shareholders! Performance Implications • Theoretically unclear whether agency and resources advantages of family control should outweigh its co...