Showing papers in "Journal of Law Economics & Organization in 1991"

Multitask Principal–Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design

Abstract: Introduction In the standard economic treatment of the principal–agent problem, compensation systems serve the dual function of allocating risks and rewarding productive work. A tension between these two functions arises when the agent is risk averse, for providing the agent with effective work incentives often forces him to bear unwanted risk. Existing formal models that have analyzed this tension, however, have produced only limited results. It remains a puzzle for this theory that employment contracts so often specify fixed wages and more generally that incentives within firms appear to be so muted, especially compared to those of the market. Also, the models have remained too intractable to effectively address broader organizational issues such as asset ownership, job design, and allocation of authority. In this article, we will analyze a principal–agent model that (i) can account for paying fixed wages even when good, objective output measures are available and agents are highly responsive to incentive pay; (ii) can make recommendations and predictions about ownership patterns even when contracts can take full account of all observable variables and court enforcement is perfect; (iii) can explain why employment is sometimes superior to independent contracting even when there are no productive advantages to specific physical or human capital and no financial market imperfections to limit the agent's borrowings; (iv) can explain bureaucratic constraints; and (v) can shed light on how tasks get allocated to different jobs.

The Shareholder Suit: Litigation without Foundation?

Abstract: Shareholder litigation is accorded an important stopgap role in corporate law. Liability rules are thought to be called into play when the primary governance mechanisms-board of directors (Williamson), executive compensation (e.g., Smith and Watts), and outside block ownership (Shleifer and Vishny)- fail in their monitoring efforts but the misconduct is not of sufficient magnitude to make a control change worthwhile. By imposing personal liability on corporate officers and directors for breach of the duties of care (negligence) and loyalty (conflict of interest), litigation is thought to align managers' incentives with shareholders' interests. The efficacy of shareholder litigation as a governance mechanism is hampered by collective action problems because the cost of bringing a lawsuit, while less than the shareholders' aggregate gain, is typically greater than a shareholder-plaintiff's pro rata benefit. To mitigate this difficulty, successful plaintiffs are awarded counsel fees, providing a financial incentive to the plaintiff's attorney to police management. There is, however, a principalagent problem with such an arrangement: the attorney's incentives need not coincide with the shareholders' interest. For instance, settlement recoveries in

Privatization and Incentives

Abstract: Is public or private ownership more likely to promote social welfare? This ancient and central question in economics has generated a fair amount of conventional wisdom on the benefits and costs of public production of goods and services. However, the arguments underlying this conventional wisdom are often delicate. The first goal of this exploratory article is to recast some of these arguments in the framework of modem agency theory. ] This article will remain almost as superficial as the conventional wisdom it criticizes and will only try to suggest that recent research in agency theory may start offering clues to a more satisfactory analysis of comparative ownership structures. The second goal of this article is to analyze a specific trade-off between a public enterprise and a private regulated firm. In order not to exogenously presume the superiority of one ownership structure, we trace differences in efficiency not to intrinsic taste differences of managers and supervisors of public and private enterprises, but rather to different institutional arrangements and incentives. In our model, the cost of public ownership is a suboptimal investment by the firm's managers in those assets that can be redeployed to serve social goals pursued by the public owners. While such a reallocation

Economic Institutions: Spontaneous and Intentional Governance

Abstract: Spontaneous governance has been the prevailing economic approach to economic organization since Adam Smith made perceptive reference to, and briefly described, the "invisible hand," according to which each businessman "by pursuing his own interest . . . frequently promotes that of society more effectively than when he really intends to promote it" (Smith:423). That formulation is properly regarded as a watershed event and has had a massive and continuing influence on economics. One of the most praiseworthy intellectual activities with which an economist can become engaged is to identify and explicate spontaneous control mechanisms through which hands-off governance operates. Not only does it take a powerful mind-or, usually, the combined efforts of many powerful minds-to discover and model the mechanisms of spontaneous governance, but the benefits are stupendous. The need to become knowledgeable about, much less engrossed in the study of, institutional details is relieved if not vitiated if spontaneous mechanisms are the main arena. That we appear to be subject to intentional governance structures everywhere we turn is thus misleading: the real action is largely invisible.'

Politics and the Theory of Organization

Abstract: In some fashion or another, political scientists spend much of their time trying to understand organizations. They study public bureaucracies. They study legislatures. They study executive leadership. They study the courts. They study parties and interest groups. And because theory is the path to understanding, a central part of their task is to develop theories of organization. A similar story could be told for the other social sciences. Organizations are relevant, often crucial, to the traditional concerns of sociologists, psychologists, and economists, among others, and they too have strong reasons to pursue theories of organization. The difference is that scholars in these other fields have actually followed through. There is a sociology of organization, a psychology of organization, and, although it took economists a long time to get their act together, a fastdeveloping economics of organization. What we commonly refer to as organization theory is a combination of these, and thus a highly eclectic and interdisciplinary body of work (Perrow, 1986). Political scientists have not really been part of this. To the extent that they have paid attention to the field of organization theory at all, they have almost always been borrowers rather than contributors, relying on the nonpolitical theories of sociologists, psychologists, and economists to help them understand political organization. On those rare occasions when they have been active contributors to the field, moreover, they have typically not been concerned with developing theories of political organization anyway. Instead, they have chosen to pursue generic theories of organization: theories that,

Scale Returns in Communication and Elite Control of Organizations

Abstract: It seems to be a broadly valid generalization that in organizations of any size the central decisions are made by a relatively small number of individuals. Before World War I, there was a considerable literature, associated with such names as Vilfredo Pareto, Gaetano Mosca, and Robert Michels, which argued in one form or another that power in organizations tends to be concentrated in the hands of small elites. This is true regardless of the intended purpose of the organization. The most striking analysis is Michels's study of the German Social Democratic party. An organization devoted by its nature to spreading political power widely among the entire working class was itself run by a relatively small and self-perpetuating group. Michels referred indeed to an "iron law of oligarchy." I raise the question of to what extent is this phenomenon of elite control, as I shall call it, explainable in terms of rational organization theory. That is, is there some sense in which elite control economizes on some resources used in the processes of organizational decision-making. The article is exploratory in nature; I have no specific models, but rather raise the questions and suggest the issues that should be addressed in the future by more specific models. I do indeed suggest the possibility that elite control is connected with economies of scale in the process by which information is communicated. Hence, it will pay to reduce the number of individuals among whom information is to be communicated and have each transmit more. However, to the extent that this proposition is true, it calls for new models of optimal commu

Bargaining and the Division of Value in Corporate Reorganization

Abstract: This paper develops a sequential bargaining model of the negotiations in corporate reorganizations under Chapter 11. We identify the expected outcome of the bargaining process and examine the effects of the legal rules that shape the bargaining. We determine how much value equity holders and debt holders receive under the Chapter 11 process, and compare the value obtained by each class with the 'contractual right' of that class. We identify and analyze three reasons that the equity holders can expect to obtain some value even when the debt holders are not paid in full. Finally, we show how the features of the reorganization process and of the company filing under Chapter 11 affect the division of value, and in this way we provide several testable predictions.

On the Social Optimality of Liquidated Damage Clauses: An Economic Analysis

Abstract: The principle of freedom of contract rests on the premise that it is in the public interest to accord individuals broad powers to order their affairs through legally enforceable agreements that the courts will enforce without passing on their substance. Occasionally, however, a court will decide that the public interest in freedom of contract is outweighed by other considerations and will refuse to enforce the agreement or some part of it. In particular, contracting parties' power to bargain over their remedial rights is surprisingly limited. The most important restriction denies them the power to stipulate damages that are so large as to be characterized as penalties.'

Constraining Administrative Decisions: A Critical Examination of the Structure and Process Hypothesis

Abstract: Policy-making does not end with the passage of legislation. Congress may authorize a program, but responsibility for implementing it is usually delegated to another organization or institution (i.e., to some administrative body). Over the years Congress has developed a variety of techniques for supervising the decisions of these administrative bureaucracies. In order to avoid the high cost of formal, extensive, and systematic investigations, legislators use reauthorization hearings and personal exchanges with administrators as opportunities for oversight (Ogul). To further reduce the cost of oversight, legislators have developed a system of "fire-alarm oversight" in which interest groups and constituents monitor administrators and inform Congress of improper, inappropriate, or unsatisfactory decisions. Legislators then become involved only after their monitors have identified some problem or transgression. This system thus supplies legislators with the information required to maintain control over the bureaucracy without having to undertake systematic surveillance themselves (McCubbins and Schwartz). Congress uses these groups to do more than inform it of administrative errors. In a series of articles, McCubbins, Noll, and Weingast (1987, 1989)

Information and the Scope of Liability for Breach of Contract: The Rule of Hadley v. Baxendale

Abstract: According to the contract law principle established in the famous nineteenth century English case of Hadley v. Baxendale, and followed ever since in the common law world, liability for a breach of contract is limited to losses "arising ... according to the usual course of things," or that may be reasonably supposed "to have been in the contemplation of both parties, at the time they made the contract, ..." Using a formal model, we attempt in this paper to analyze systematically the effects and the efficiency of this limitation on contract damages. We study two alternative rules: the limited liability rule of Hadley, and an unlimited liability rule. Our analysis focuses on the effects of the alternative rules on two types of decisions: buyers' decisions about communicating their valuations of performance to sellers; and sellers' decisions about their level of precautions to reduce the likelihood of nonperformance. We identify the efficient behavior of buyers and sellers. We then compare this efficient behavior with the decisions that buyers and sellers in fact make under the limited and unlimited liability rules. This analysis enables us to provide a full characterization of the conditions under which each of the rules induces, or fails to induce, efficient behavior, as well as the conditions under which each of the rules is superior to the other.

Using Auction Theory to Inform Takeover Regulation

Abstract: 1The Delaware courts’ preference for auctions follows from two premises. First, a firm’s managers should maximize the value of their shareholders’ investment in the company. Second, auctions maximize shareholder returns. The two premises together imply that a target’s board should conduct an auction when at least two firms would bid sums that are nontrivially above the target’s prebid market price. Legal commentators generally share the Delaware courts’ preference for auctions. According to these commentators, the state should pursue efficiency, which here requires a target’s assets to be sold to the highest-valuing possible acquirer at the least cost. An auction is thought best to achieve the efficiency goal (Gilson, 1982). Also, auctions reduce the target shareholders’ collective action problem. This problem may prevent atomized shareholders from getting the highest price (Bebchuk). The broad preference for auctions in the legal community does not rest on serious study of the properties of the typical “takeover auction.” Rather, auction proponents implicitly suppose that takeover auctions are similar to classic English auctions, in which the bidders gather in a room and bid in ascending order until all but one of them drops out. In equilibrium, the winner has the highest valuation for the auctioned object, so English auctions do ensure that the right buyer wins. These auctions also generate high prices because the winner is able to pay the most. Actual takeover auctions differ in material respects from this auction model that dominates legal thought. The desirable properties of English auctions obtain when three assumptions hold. Potential bidders (a) know what, when, and where objects are offered for sale, (b) can costlessly acquire information about the value of the objects being sold, and (c) can bid as often as they like. More formally, bidders have zero search, investigation, and bidding costs. These assumptions imply that the bidder with the highest valuation for the auctioned object always buys it, but none of these assumptions hold in the takeover context. Instead, (a) search costs are positive—it is expensive to find possibly desirable acquisition partners; (b) investigation costs are positive; (c) bidding costs are positive because the forms in which bids must be cast are subject to extensive legal regulation. 2

State Takeover Legislation: The Case of Delaware

Abstract: The rise in hostile takeover attempts in recent years has apparently motivated many states to pass antitakeover legislation, often after lobbying by the management of targeted firms. At least 39 states have passed some sort of antitakeover legislation. In 1988, Delaware, the state of incorporation of almost half of the firms listed on the New York Stock Exchange, enacted its own antitakeover legislation. How did investors in Delaware firms react to news of the progress of this particular law? Since shareholders typically enjoy rapid price gains when their firms are successfully acquired (see Jensen and Ruback, Jarrell et al.), laws reducing the probability of a takeover may also reduce the value of a potential target. Such value reduction may be mitigated as antitakeover laws may also have the effect of raising takeover premiums. Critics also argue that takeover protection makes management less accountable to shareholders, which may lead to corporate decisions not in the best interest of shareholders. Firm value may not be maximized, however, when management feels vulnerable to a takeover. The threat of takeover may lead management to focus unduly on short-term results, holding costs down by deferring R&D and

Equilibrium Enforcement and Compliance in the Presence of Tax Practitioners

Abstract: We develop a game-theoretic model in which taxpayers, tax practitioners and a tax agency all interact to determine the extent of tax compliance. The model focuses exclusively on the service aspects of third-party assistance. We characterize four types of equilibria, depending on whether taxpayers prefer to use tax practitioners and whether the tax agency prefers them to use tax practitioners. In the empirically relevant case, which occurs when tax practitioner penalties for noncompliance are sufficiently low and the efficiency gains from using practitioners are sufficiently high, the tax agency prefers taxpayers to prepare their own returns, but taxpayers prefer to use a tax practitioner. In this case, the use of a tax practitioner is associated with lower compliance and higher audit rates.

Constructed Organization: First Principles

Abstract: A major change in the structure of society occurred with the emergence, beginning about the thirteenth century, of a new form of corporate body. Otto von Gierke in Germany and Frederick Maitland in England have traced the growth of this new corporate form. In contrast to the old corporate bodies, the new corporate bodies came to be regarded as legal persons (called for a time

Private Versus Socially Optimal Provision of Ex Ante Legal Advice

Abstract: This article considers whether the demand for legal advice about potential liability for future acts is socially excessive. using the standard model of accidents, we find that the answer depends on the type of advice and the form of liability. When advice provides information about properly determined liability, the demand for advice is socially optimal under strict liability but is socially excessive under the negligence rule. When advice identifies errors the legal system is expected to make, the demand for advice is socially excessive under both liability rules.(This abstract was borrowed from another version of this item.)

Indentured Prostitution in Imperial Japan: Credible Commitments in the Commercial Sex Industry

Abstract: So interpreted, the song makes no more sense in Japanese' than in English. But in its first two lines are two puns: "win" also means "buy," and "flower" can mean "girl." Thus the song can also mean "I'm glad we bought a girl for a dollar." As in Mother Goose, the macabre is historical: Peasant families in pre-20th-century Japan [like peasants in medieval Europe (Engerman, 1973:44)] bought and sold children. "I'm glad my parents bought for me," the child sings, "a sister for a dollar."

Reward Systems and the Distribution of Wages

Abstract: Output-related payment systems, such as piece rates, production bonuses, and commissions, are common in many jobs and are typically thought to serve two primary purposes: first, to induce workers to expend more effort; second, to allocate some or all of the risks at the point of production to the workers. In the literature on agency problems, the first purpose is referred to as the incentive purpose (see, e.g., Stiglitz); whereas in the Marxist labor-process literature, it is referred to as the purpose of extracting labor power (e.g., Burawoy:chaps. 3-4; Lazonick:chaps. 1-2). In terms of wages, workers employed under an output-related payment system tend on the average to earn more than workers paid by the hour. This is so because incentive-rated workers in part are compensated for working harder and in part they are compensated for the risks they have to carry. One part of the expected pay differential between the two groups is due to effort compensation and another to compensation for risks. Against this background, the article has two goals. The first is to assess the extent to which, and the magnitude by which, incentive-rated workers on the average earn more than time-rated workers. This analysis provides an assessment of the role of output-related payment systems in generating wage in-

Premerger Notification and the Incentive to Merge and Litigate

Abstract: The original Clayton Act's (15 U.S.C. 18) prohibition of certain mergers was intended to be preventive in nature. Mergers having the potential to reduce competition were to be challenged prior to consummation. Historically, however, most of the complaints brought by the Department of Justice (DOJ) or the Federal Trade Commission (FTC) were initiated after mergers had been consummated. Failure to challenge mergers prior to consummation was not, however, deliberate. Obstacles to obtaining preliminary injunctions were high. Moreover, once an illegal merger had taken place, it often took five to six years to resolve the case. The inability to secure what was considered adequate postacquisition relief led to the belief that the government had achieved only Pyrrhic victories.1 In response to these conditions, the Congress passed the HartScott-Rodino Antitrust Improvement Act of 1976 (HSR).2 A major objective of the Act was to provide antitrust authorities with the means to handle illegal mergers expeditiously by establishing premerger notification requirements. To that end, Title II of the Act facilitates premerger investigations and enhances

Imports and Domestic Wages: Is the Relationship Consistent with Expense Preference Behavior?

Abstract: The relatively recent emergence of strong import competition has dramatically altered the employment relationship in a wide variety of industries. While previous analysis of imports has frequently been limited to effects on employment levels, it is inappropriate to presume that other job conditions remain unchanged. This study joins a growing number that examine the association between domestic wage levels and the degree of import penetration. As such, it can be considered part of a larger literature examining the influence of product-market structure on wages. Unfortunately, this literature is largely bereft of satisfactory theoretical underpinnings and has not convincingly explained why more monopolistic firms pay higher wages for otherwise equal workers. My agenda is threefold. First, I will present a theory for the association between market structure and wages that integrates two disparate literatures: "expense preference behavior" and notions of an "efficiency wage." Second, I will demonstrate that import penetration (as one element of market structure) behaves roughly as predicted and in tandem with other elements of market structure. Third, I will suggest, and to the extent possible test, other rationales

Bargaining Costs, Bargaining Benefits, and Compulsory Nonbargaining Rules

Abstract: In thin markets, resources are usually allocated by bargaining. In bargaining, potential trading partners have two contradictory incentives. Each wants to know the attributes of the items the other offers and seeks. Transaction costs are lowered by quick and easy discovery of the terms of trade. Hence, each trader has an incentive to transmit some information expeditiously. But although economists' usual interest in thin markets concerns whether traders will reach the contract curve, a goal furthered by trader cooperation, a trader is interested only in reaching a higher indifference curve individually, a goal often furthered by strategic noncooperation (Raiffa). The cost of trading is increased directly by uncooperative behavior-each party expends resources to conceal or distort information, then each expends more resources trying to unmask the other's deception. Indirectly, opportunity costs are increased also. First, some exchanges will be missed altogether when parties' strategies create an erroneous belief that no gains from trade exist. Second, even if some deal is made, strategic bargaining can obscure the