Principles of Agents

Any Introductory Business course will teach you that shareholders are the owners of the firm. The shareholders elect the Board of Directors to oversee the firm on their behalf. The Directors appoint the company President and the other members of the executive team who are responsible for the day-to-day operations. The Directors and executive team are the agents of the principal owners of the company.

Economists have long studied a situation known as the Principal-Agent problem. This inefficiency occurs when the objectives of the principals, the shareholders, differs from the agents, the executives. Finance theory suggests that individual investors want to maximize returns and minimize risk. This implies using the equi-marginal principle to strike a balance between the two.

The Board and executive may have an objective of maximizing their own income or their own power. Agents typically share in profits by way of bonuses, but not in losses. A company that has negative net income does not require the company president to pay back salary or previous bonuses, nor do they encumber future bonuses. This is just one example of how the Principal-Agent problem can manifest itself.

Evidence of the Principal-Agent problem appeared in several places this week. The first, as related in a Reuters article, involves the investment bank Goldman Sachs (GS). There is currently a proposal to split the role of Board Chairman and the role of CEO between two people.  The idea is that the Chairman oversees the activity of the CEO which is a management position. This may prevent the risk taking activity that lead to the banking collapse of 2007-2008. The company, however, has put forward a legal challenge to prevent a vote on the motion. Essentially, the company is using shareholders’ money to the detriment of shareholders.

JP Morgan Chase (JPM) is also fighting a legal battle in an attempt to prevent shareholders from voting on a motion to break up the company. See the American Banker article for the details. The rationale is similar to the Goldman Sachs situation.  JP Morgan has four distinct businesses, some of which are vastly riskier than others. This not only puts the whole company at risk, but affects the optimal pricing of the firm. In the finance world, they refer to the plan to break up the company as “unlocking value”. Again, the company is using shareholders’ money to their detriment.

Perhaps the most troubling revelation this week was something that was not reported. Apple (AAPL) has $136 billion in cash and marketable securities on its balance sheet that it refuses to return to shareholders. (Source: SEC filing) Apple is currently showing Owners’ Equity of $127 billion which means the entire book value of the company, plus some, is being held in cash. The problem with this is that cash earns less than 2% on average. For example, if that money were returned to shareholders they could purchase shares of Altria Group (MO), that currently pays dividends of 5.3%. Returning half of the $127 billion would double Apple’s return on equity without hampering their ability to operate.

Goldman Sachs, JP Morgan and Apple are just three examples of the Principal Agent problem that caught our attention this week. There will be more next week and the week after that. We can’t help but wonder if the Principal-Agent problem would exist if agents had principles.

 

Sticky Buns and Sticky Wages

One explanation often found in textbooks for the relatively slow pace of price adjustment in the macroeconomy is ‘sticky wages’. The idea is that, due to long term contracts and other structural impediments, firms cannot reduce wages when the demand for their product falls. 

Microeconomic theory tells us that firms will hire workers up to the point where the marginal product of labour is equal to the real wage rate. When the demand for a firm’s product falls, the price of their product falls and the real wage rises. In order to restore the cost minimizing solution, firms must either cut nominal wages or increase the marginal product. Increasing marginal product of labour requires using less labour. So firms must cut jobs or cut wages. Both of these can prove difficult to accomplish in the short run. 

This is the unfortunate circumstance that Hostess Brands was facing late last year. A Reuters article in the Montreal Gazette tells of the demise of the Twinkie. As people have become more health conscious the demand for the 150 calorie high-fat snack has decreased. At the same time, droughts and agriculture policy have increased the price of the flour used to produce the Twinkies. Both of these circumstances have led to a decrease in the production of Twinkies, and Hostess was faced with either laying off employees or reducing wages. 

Faced with a staggering 300 different labour contracts, the company had no success in reducing wages. The article quotes one baker as saying he would rather be unemployed than take a wage cut. This is consistent with an upward sloping labour supply curve. With no opportunity to cut labour costs and no control over flour prices, Hostess decided that the only way to preserve its cash was to shut down production. This is what our theory suggests will happen if price falls below the average variable cost of production.  

Hostess has now filed for bankruptcy protection in the United States and has ceased production of the infamous Twinkie. While Hostess could not profitably produce Twinkies, it may be possible for another company, with lower labour costs, to do so. Hostess still owns the rights to the Twinkie and is currently seeking a buyer for the recipe and brand name. If and when the Twinkie returns to the US, there is no doubt that it will be manufactured and shipped by workers with lower wages than those that worked at Hostess. 

Sticky wages in the sticky bun business. Result: unemployment.

Hunting: Market Style

Teddy Roosevelt was credited by the NY Times recently as saying that ‘wildlife belongs to all, and not just to those with land and wealth’. Of course Mr. Roosevelt was president of the United States from 1901 to 1909 when the population was around 90 million and there were only 46 states (New Mexico and Arizona joined in 1912 and Alaska and Hawaii in 1959). In Mr. Roosevelt’s time, wildlife was not terribly scarce.

Now, with 50 states, 320 million people and an estimated 223 million firearms held by individuals, there is not enough wildlife for everyone to shoot. When a shortage occurs, the most efficient allocation method usually involves a market.

This is the approach that Utah has taken. Some licenses are available for $35 in a blind draw, the method used in most jurisdictions. The supply of licenses is determined to conserve wildlife which, for most species means there will be an excess demand.

Some of the licenses are given to non-profit organizations that support conservation. These licenses are auctioned off to the highest bidder; and that will be the market equilibrium. Still others are given to private land owners willing to open their land to hunters. These tend to be the most expensive licenses. Landowners that participate in this program have a profit incentive to create an environment that is conducive to the survival of wildlife. As such, the likelihood of ‘bagging’ an animal is higher on private land and thus the price is higher. This further increases the incentive for land owners.

The primary objection to this profit-maximizing program is that ‘money’ is being used to determine who gets to hunt. This is true, but it is also a tried and true method of allocating scarce resources in an efficient manner. When a resource is scarce, efficiency dictates that it should be used I the most ‘valuable’ endeavor.

One may argue that wildlife is a social resource, as President Roosevelt did, and this implies that hunting should maximize ‘social welfare’. I’ll admit that I am not a hunter, but as a member of the society that ‘owns’ an elk, I would hope that that elk would be ‘sold’ for the highest possible price.

The NY Times article quotes a dentist from Utah that is complaining about the market allocation of game. We can’t help but wonder if the dentist uses something other than the price mechanism to allocate his services. Perhaps he treats patients for a nominal fee and then schedules his appointments by lottery. Somehow, we doubt that.