We have stated that the objective of the firm is to maximize its net worth in expected- present-value terms. By “the firm” we really mean the owners or shareholders of the firm, whose interests presumably lie in the maximization of their personal net worth. However, the owners of the firm are typically not the decision makers. The shareholders are most often excluded from the day-to-day process of making decisions, having delegated the authority to trained managers whose job is to make these decisions. As absentee owners, shareholders are unable to observe perfectly whether or not the managers’ decisions are always consistent with the shareholders objectives. Consequently, managers may pursue their own personal objectives, to some degree, rather than as siduously seek the maximization of net worth. Only in the case of owner-managed firms can we expect the objectives of the owners and the managers to coincide perfectly.
This difficulty has been called the principal-agent problem. 11 The manager is an agent of the shareholders (the principals), making decisions on their behalf. Although the principals may monitor the agents’ actions, monitoring involves information- search costs, and it will not be taken to the ultimate degree, with the result that there remains an asymmetry of information—the actions of the agent are not perfectly ob-
Table captionTABLE 1-6. The Decision Criteria for Maximization of the Firm’s Net Worth under Four Scenarios
|
The State of |
THE FIRM'S TIME HORIZON FALLS WITHIN THE |
|
|
Information |
Present Period |
Future Period |
|
Certainty |
Maximize short- run profits |
Maximize present value of profits |
|
Uncertainty |
Maximize expected value of profits |
Maximize expected present value of profits |
"See A. A. Alchian and H. Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review, 57 (December 1972), pp. 777-95; M. C. Jensen and W. H. Meckling, “Theory of the Firm; Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics, 3 (October 1976), pp. 305-60; E. F. Fama, “Agency Problems and the Theory of the Firm,” Journal of Political Economy, 88 (April 1980), pp. 272-84; and G. M. MacDonald, “New Directions in the Theory of Agency,” Canadian Journal of Economics, 17 (August 1984), pp. 415-40.
served by the principal. Thus managers may make decisions that do not best serve the firm’s (owners’) objectives.
The manager may not select the decision alternative that maximizes EPV if another alternative better serves the manager’s own objectives. These may include rapid promotion (served by highly visible decisions that make the decision maker look good), personal enrichment (served by allocating contracts to higher-cost suppliers who give kickbacks, or by channeling business to family members), aesthetics (served by choosing an alternative that has pleasant, rather than profit-maximizing, consequences), or avoidance of stress and competitive conflict both within the firm and in the firm’s product markets (served by avoiding decision alternatives that may generate conflict or threaten job security).
A means of helping to ensure that the manager’s efforts will serve the firm’s objectives is to offer the manager an “incentive contract” that relates the manager’s total compensation package to the profit performance of the firm. 12 Thus the manager would be offered a bonus equal to some share of the firm’s profits. To encourage decisions that best serve the expected present value of net worth, the current year’s bonus is often related to profits over the past several years. Such incentive contracts do not guarantee the manager’s unflagging pursuit of shareholder objectives, however, because the problem of asymmetric information remains. Managers may continue to exert less than maximum effort (known as “shirking”) and take nonmonetary benefits (known as “perks,” or more correctly, perquisites), with the result that net worth is not maximized, and the shareholders may not be aware of these problems.
In this book we shall continue to speak of the firm’s objectives, but it must be kept in mind that managers’ objectives may be at variance with those of the firm and that decisions may be made that do not maximize the firm’s net worth, to the extent that shareholders remain unaware of the divergence or are unable to discipline management effectively (through the board of directors).