Class 04

Econ 243 Class 04 of September 18, 2015

• “Lerner & Lastic”

= but we didn’t get to the Lerner Rule and only waved our hands about elasticities

= instead we spent class reminding ourselves of the modeling process:

→ SIMPLIFY

• goals of firm

= we assume firms maximize profits

→ that’s bullshit. in fact firms are run by people who have complex motives and constraints. most executives care about their firms, but they aren’t going to sacrifice their first-born to the Baal of Profits, or work for minimum wage because that will raise profits (but pay lower than that would not be legal).

» writing on the separation of ownership and management dates back to an influential book by Berle & Means in 1932. they attributed this to the growth of large firms and the rise of professional managers, replacing owner-managers and partnerships or closely held corporations in which shareholders were well-informed had “voice” over enterprises. their research spawned a large literature in corporate finance and corporate law.

» general incorporation laws date to the late 19th century. earlier they required special state-level legislation, and even when a legal framework was set up, it intially varied from state to state. the research of Berle & Means relied upon NYSE records from the 1910s and 1920s. recent work by Hilt, who went into state archives, found that in fact even closely held companies where major shareholders sat on the Board suffered from the same challenges of (excessive) managerial independence.

Berle, Adolf A., and Gardiner C. Means. 1932. The Modern Corporation and Private Property. New York: Macmillan; [Harcourt, Brace & World].

Hilt, Eric. 2014. “History of American Corporate Governance: Law, Institutions, and Politics.” NBER Working Paper #20356.

→ so in fact executives “satisfice,” doing well enough to keep Boards off their backs and bonuses in their pockets. such behavior is very complex to model and tends to give the same qualitative predictions, such as a firm facing higher costs will engage in some combination of higher prices (which implies less output) plus internal adjustments to costs consistent with lower output.

→ shareholders don’t “own” a firm, they merely have the right to vote on specific actions (composition of the Board, certain types of reorganization). in particular they aren’t given a choice over profit retention versus dividend payments [more profits today and lower growth next year]. they aren’t asked for approval over “bet the company” investment projects. they aren’t given special access to inside information. all they can do is stay or sell: they have no “voice” over management decisions.

» takeovers are a blunt tool. they entail very high transaction costs. they tend to occur only when financial markets make raising funds easy [hence we see “waves” of mergers with peaks and troughs]

• modeling: demand curves flat and not

= our key analytic distinction: firms in “competitive” markets (by which economists mean markets with very large numbers of homogenous producers) don’t employ strategic behavior. undermining (or helping) a rival doesn’t lead to a shift in price. advertising doesn’t shift demand. R&D doesn’t pay. p = MC and econ π = 0.

→ think wheat farmers. they accept prices as given. they share know-how with neighbors: no skin off their teeth. they don’t advertise. they let Federal Land Grant institutions do their R&D (one in each northern state, two dating back to “separate but equal” in the south). in short, they don’t engage in strategic behavior.

= all that changes once demand slopes down. then p > MR and p > MC while π > 0