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models a conflict situation between rational players
non-cooperative vs. cooperative |
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| maximize expected utility |
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In game theory,it is a solution concept of a non-cooperative game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only their own strategy. they're content
- not the best solution bc if manager knows that the investor will buy, they will distort and if investor knows manager will distort, investor wont buy |
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| What is a cooperative game model? Give examples of cooperative behavior |
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binding agreement. a branch of game theory based on contracts and relationships
employment contracts
debt contracts |
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branch of game theory that studies design of contracts to motivate a rational agent to act on behalf of a principal when the agent's interest would otherwise conflict with those of the principal
optimize own utility vs. firm wealth |
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| Basic assumptions of agency theory |
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principal wants to hire agent
principal and agent are rational
agent is risk averse, principal is risk neutral
principal wants agent to work hard but agent is work averse |
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part of info asymmetry
principal cannot observe manager's effort
agent has disutility of effort (harder you work, the less utility you have)
agent may shirk (do less work) |
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| Characteristics that make managers want to shirk |
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fixed salary
indirect monitoring |
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| how to motivate managers through the agency theory |
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direct monitoring
manager rents firm from owner- manager bears all risk, requires low rent for manager to attain reservation utility
give manager a share of profits |
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| Problem with profit sharing and solution |
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payoff is not known until after the contract expires
some manager effort will not pay off in future years (R&D)
manager is paid at contract expiration
Solution: base compensation on jointly observable performance measure |
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| The minimum level of utility that must be guaranteed by a contract to make it acceptable to an agent |
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| Manager's information advantage |
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managers can observe unmanaged net income but owner cant
one-period-game: rational manager will shirk and report highest net income but owner utility will fall (biased reporting) |
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| How to prevent shirking from manager's info advantage? |
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-design contract for manager to report truthfully
-revelation principle (example 9.7)
- restrict earnings management to point where manager must work hard to attain reservation utility (example 9.8) |
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| conflicts with manager/lender contracts |
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moral hazard problem cuz manager has more info
manager may act in own or company's best interest
lender will be rational, raise interest rate on loan, use debt covenants |
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| Beatty, Weber, and Yu (2008) RQ, focus, and hypothesis? |
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RQ: under what conditions will contracting over GAAP be less costly than modifying contracts?
- focus on debt covenants
- income escalation clause in net worth covenant
hypothesis: expect stronger debt covenants when lenders are faced with more serious agency issues (agency cost related to agency theory and moral hazard) |
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probability of income escalator is increasing in agency costs and financial reporting conservatism
interest rates are lower when debt covenants are strengthened |
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| needs multiple performance measures |
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| Holmstrom: What must net income have to be an informative performance measure? |
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sensitivity and precision
- What type of accounting would managers prefer?
o Flexible accounting (can’t anticipate everything)
o Few changes in GAAP (contracts are hard to change)
- What about owners?
o Happy with whatever the managers want
o They don’t have a preference either way
o Not a consistent expectation |
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| accounting and contracting |
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Definition
| performance is measured using accounting based measures...... |
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| what type of accounting would managers prefer? |
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| flexible accounting, few changes in GAAP (bc contracts are hard to change) |
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| parties are on their own. there is a manager and investor in the Nash equilibrium. not common in real life |
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| 1.What is the difference between a cooperative and non-cooperative agreement? |
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| 2. What are examples of cooperative behavior? |
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- Employment contracts
- Lending Agreements |
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| 3. With respect to contracting, why are managers opposed to changes in GAAP? |
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| Contracts are hard to change |
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| 4. What is the impact of debt covenants on loan interest rates? |
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| Interest rates are lower when debt covenants are strengthened |
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| 5. Identify and discuss the based assumptions of agency theory. |
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Principal wants to hire agent
o Principal and agent are rational
o Agent is risk-averse & principal is risk- neutral
o Principal wants agent to work hard, but agent is work-averse |
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| 6. Why does moral hazard exist? |
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Definition
a. Principal cannot observe manager’s effort
b. Agent has disutility of effort
c. Agent may shirk |
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| 7. What may happen when managers have an information advantage? |
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| Earnings Management, shirking |
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| 8. What is the primary finding of Beatty Weber and Yu (2008)? |
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o Probability of income escalator is increasing in
• Agency costs (consistent with lenders’ demand for more conservative accounting)
• Financial reporting Conservatism
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o Interest rates are lower when debt covenants are strengthened
o Greater the agency costs, lenders will….
1. Increase debt covenants
2. Increase interest rates |
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| Is the point of being content the best solution? |
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| Why do Multi-period game increases the chances of BH? |
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| LIMITATIONS of Game Theory: |
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| Problems with Agency Theory |
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aa. Moral Hazard Problem
a. Principal cannot observe manager’s effort
b. Agent has disutility of effort
c. Agent may shirk |
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| Posner and the Residential Real Estate Market: |
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- Principal – homeowner
- Agent – real estate agent
Agent’s effort cannot be observed- Limited to behavior at open house, listing in the newspaper, ect.
Agent is risk averse & effort averse (who wants to work???) |
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