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2. Compensation and management incentives. The compensation of managers can be structured to bring the interests of managers more into harmony with those of
shareholders. Corporations usually tie the compensation of managers to the market success of the business. The salary increases and bonuses of most high-level managers are directly related to the firm’s profitability and the price of its shares.
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Costs, Competition, and the Corporation 175
How important are these in- centives? In recent years, salaries have constituted only about 10 percent of the compensation of chief executive officers (CEOs).
The other 90 percent has been in the form of bonuses, often stock awards and stock options (the right to buy shares at a certain price). Both forms of payment have a “vesting period,” which means they will be granted only if the CEO stays with the firm for a certain amount of time and meets specific goals. Policies like these encourage corporate managers to maximize the the firm’s profits- and, not coincidentally, the value of its shares-both strongly in the interest of shareholders. Managers who develop a good track record
of adding value to the firm gain not only more pay and greater job security, but also better job offers should they later decide to switch firms.
Incentive pay brings with it another unwanted incentive for managers, though: the incentive to gain personally by manipulating the firm’s accounting records to make its financial performance look better than it really is. (See the accompanying Applications in Economics feature: “Cooking the Books.”) However, stockholders and portfolio managers, and especially investors who specialize in selling stocks short when they think the firm is overvalued, will be scrutinizing the records to detect phony accounting designed to mislead investors.
3. The threat of corporate takeover. Managers who do not serve the interests of their shareholders leave the firm vulnerable to a takeover. This is a move by an outside person or group, noticing the bad management, to gain control of the firm. As we previously noted, shareholders who lose confidence in the firm’s management can exit the arrangement by selling their shares. When a significant number of shareholders follow this course of action, the market value of the firm’s stock will decline. This will make it an attractive prospect for takeover specialists shopping for a poorly run business, the value of which could be substantially increased by a new and better management team.
Consider a firm currently earning $1.50 per share. At present, the market value of the 5rm’s stock is $15 per share. If the firm’s earnings are low because the current manage- ment team is pursuing its own objectives at the expense of profitability. then a corporate takeover could lead to substantial gain for someone. Suppose outsiders belie\e the? can restructure the firm, improve the management. and double the firm‘s earnings. The! then
“tender” a takeover bid-make an offer to buy the shareholders‘ stock or persuade them to xessure the board of directors to sell out. Suppose the) offer S20 per share. This is more ihan the current market value of the firm, so shareholders and the board will be tempted to accept the offer and gain wealth from the sale. If the takeover team gains control of the firm. improves its performance, and increases its earnings to $3 per share, then the stock value of the firm will rise accordingly (to $30 per share).
Of course, the current managers have an incentive to resist the takeover. After all, they are likely to lose their jobs if the potential new owners are successful. Unfortunately for :hcm. though, the shareholders or their board of directors will ultimately decide whether axnot to accept the offer. The takeover threat helps keep current managers from straying bm far from a strategy to maximize profit. Some corporate managers have instituted policies to help defend their firms against takeovers. However, limiting the power of shareholders this way can significantly lower the stock price of a badly managed
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Corporate managers are more likely to serve the interests of customers and stockholder because of the following: competition for investment funds and con- sumer sales, the threat of a takeover, and managerial compensation packages based on stock and stock options.
176 C H A P T E R 8 Costs and the supply of Goods
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Cooking the Books: How t Criminal Behavior
Coorc,r-,g the books” refers to the practice of using accounting procedures in an intentionally misleading way.
books, a corporation’s profits-or at least be its profits-can be increased. Stockhold- ers are always looking for shares of high-profit firms, so a recent record of high profits will increase the demand for the corporation’s stock shares and drive up their price.
Cooking the books can be artificially encouraging to share- holders in the short term, but it can conceal problems and
Enron, the energy-trading company, is a dramatic ex- ample. High-level executives in the firm used misleading accounting procedures to make Enron look highly profitable when, in fact, it was not. Moreover, Arthur Andersen, a highly respected accounting firm, audited Enron’s books and certi- fied their accuracy, knowing there were irregularities. As a result, Enron’s stock price climbed, along with the value of its managers’ stock options-even though the c
able to cash in on their stock options to enrich while the company lay on the path to ruin.
When Enron made some of its accounting procedures public in November 2001, market participants took quick action, selling their shares. The stock price then plum- meted. In light of its true financial position, Enron filed for bankruptcy less than a month later. A t the beginning of the year, its stock had been worth $60 billion. By the end of the year, it was nearly worthless. By July 2004, Enron was e ploying about 9,000 workers, down from 32,000 at peak, and its bankruptcy plan had been approved by a fed- eral judge. The Justice Department had filed crimin charges against thirty-one members of Enron’s manag ment, including its chief executive.
Arthur Andersen, Enron’s accounting firm, faced similar consequences. Many of the auditing firm’s clients quickly stopped doing business with it. One of its partners was subsequently convicted of obstructing justice, and the firm announced it would no longer audit public companies in the U.S. Its reputation as a trusted accounting company w
ally on its way to bankruptcy. These executives
company.2 Moreover, managers thought to be doing a bad job will have to make it extraor- dinarily difficult for a takeover to occur in order to avoid being ousted.
Perhaps history provides the best answer to this question. If the corporate structure were not an effective form of business organization, it would not have continued to survive, nor would it be so prevalent today. Rival forms of business organization, including proprietorships, partnerships, consumer cooperatives, employee ownership, and mutually owned companies can and do compete in the marketplace for investment funds and cus- tomers. In certain industries, some of these alternative forms of business organization are dominant. Nonetheless, in most industries, the corporate structure is the dominant form of business organization (see Exhibit 1). This is strong evidence that, despite its defects, the corporation is generally a cost-efficient, consumer-sensitive form of organization.
*Economists Paul Gompers, Joy Ishii, and Andrew Metrick, in “Corporate Governance and Equity Prices” (NBER working pa- per 8449, released Augurt 2001), find that “firms with weaker shareholder rights earned significantly lower returns, were valued lower, had poorer operating performance, and engaged in greater capital expenditure and takeover activity.” However, some of the same actions that favor managers-large “golden parachute” retirement plans, for example-can also be guarantees that in- crease the ability of a company’s directors to hire or retain good managers, as shown by Dino Falaschetti, “Golden Parachutes:
Credible Commitments or Evidence of Shirking?,” Journal of Corporate Finance 8 (2002): 150-78.
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-.The Econonirc Role of Costs 177
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Consumers would like to have more economic goods, but resources to produce them are scarce. How much of each desired good should be produced? Every economic system must balance consumers’ competing desires. When decisions are made in the political arena, the budget process performs this balancing function. Legislators, a central planning committee, or a monarch decide which goods will be produced and which will be forgone.
Taxes and budgets are set accordingly.
In a market economy, though, consumer demand and production costs are central to performing this balancing function. The demand f o r a product represents the voice of consumers instructing firms to produce the good. On the other hand, a firm’s costs represent the desire of consumers not to sacrifice goods that could be produced
if
the same resources were employed elsewhere. A profit-seeking firm will try to produce only those units of output buyers are willing to pay full cost for. Proper measurement and interpretation of costs by the firm are critical to both the firm’s profitability and the effi- cient use of resources.We can reasonably assume that business firms in a market setting, regardless of their size, are concerned first with profit. Profit is simply the firm’s total revenue minus its total costs. But to state profit correctly, costs must be measured properly. Most people, includ- ing some who are in business, think of costs as amounts paid for raw materials, labor, machines, and similar inputs. However, this concept of cost, which stems from accounting procedures, excludes some important components of the firm’s costs. When cost is miscalculated, so, too, is profit because it is merely revenue minus cost. Bad economic decisions can result from miscalculating cost and profit.
The key to understanding the economist’s concept of profit is to remember the idea of opportunity cost-the highest valued alternative forgone by the resource owner when the resource is used. These costs may either be explicit or implicit. E x p l ~ c i t costs result when the firm makes a monetary payment to resource owners. Money wages, interest, and rental payments are a measure of what the firm gives up to employ the services of labor and capital resources. These are relatively easy to track. But firms also incur i r n p ~ ~ ~ ~ t costs-those associated with the use of resources owned by the firm. For example, the owners of small proprietorships often work for their own businesses, for little or no pay. These businesses incur an implicit cost-an opportunity cost- associated with the use of this resource (the owners’ labor services). The highest valued alternative forgone in this case is the maximum amount of money the owners could have made doing something else. The total cost of production is the sum of these explicit and implicit costs incurred by the employment of all resources involved in the production process.
Accounting statements generally omit the implicit cost of equity capital-the cost of funds supplied by the firm’s owners. If a firm borrows financial capital from a bank or other private source, it will have to pay interest. Accountants properly record this interest sxpense as a cost. In contrast, when the firm acquires financial capital by issuing stock.
accountants don’t record this as an expense. Essentially. this is because the stockholders
tire the firm’s owners. Either way, acquiring capital has an opportunity cost. People who .upply capital to a firm expect to earn at least a normal rate of return-a return compara- ble to what they could have earned if they had chosen other imestment opportunities.
Banks will demand interest payments, for example. Stockholders will demand a share of rhe company’s profits, or dividends. Or they might expect the price of the stock they purchase to rise measurably, thereby enhancing their wealth.
When calculating the normal rate of return, economists use the normal return on financial capital as a basis for determining the implicit opportunity cost of e capital. If the normal rate of return on financial capital is 10 percent, equity investors
\\ ill refuse funds to firms that persistently fail to earn a 10 percent rate of return on capi-
131 assets.
licit c o ~ ~ s Payments by a firm to purchase the services of productive resources.
~ ~ p i i c ~ t costs
The opportunity costs associ- ated with a firm’s use of r e sources that it owns. These costs do not involve a direct money payment. Examples in- clude wage income and inter- est forgone by the owner of a firm who also provides labor services and equity capital t o the firm.
Total cost
The costs, both explicit and implicit, of all the resources used by the firm. Total cost in- cludes a normal rate of return for the firm’s equity capital.
QpportMnity cost of eqMity c a ~ i t ~ l
The rate of return that must be earned by investors to in- duce them to supply financial capital to the firm.
178 c H A P T E R 8 Costs and the Siipply of Goods
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Economists include both explicit and implicit costs when they measure total cost.
i c ~ r o ~ t is total revenues minus total costs, including both the explicit and implicit cost components. Economic profit will be positive only if the earnings of the business exceed the opportunity cost of all the resources used by the firm, including the opportunity cost of assets owned by the firm and any unpaid labor services supplied by the owner. In contrast, economic losses result when the earnings of the firm are insuffi- cient to cover explicit and implicit costs. That is why the normal ~ rrate ~is zero ~ t economic profit, yielding just the competitive rate of return on the capital (and labor) of owners. A higher rate would draw more competitors and their investors into the market; a lower rate would cause competitors and their investors to exit the market.
Remember, zero economic profits do not imply that the firm is about to go out of business. On the contrary, they indicate that the owners are receiving exactly the normal profit rate, or the competitive market rate of return on their investment. They are earning no more and no less than they could earn elsewhere on what they use in the firm.
Whenever accounting procedures omit implicit costs, like those associated with owner- provided labor services or capital, the firm’s opportunity costs of production will be under- stated. This understatement of cost leads to an overstatement of profits. Therefore, the r o ~ t s of a firm are generally greater than the firm’s economic profits (see the in Economics feature on accounting costs). For most large corporations, though, omitting the implicit costs of services provided by an owner isn’t an issue. In this case, the accounting profits approximate the returns to the firm’s equity capital. High ac- counting profits (measured as a rate of return on a firm’s assets), relative to those of other firms, suggest that a firm is earning an economic profit. Correspondingly, a low rate of ac- counting profit implies economic losses. Either positive or negative economic profits, of course, call for a change in output. Such a change, however, will take time.
Economic profit
The difference between the firm’s total revenues and its total costs. including both the explicit and implicit cost com- ponents.
Normd profit rate Zero economic profit, providing just the competitive rate of return on the capital (and labor) of owners. An abovenormal profit will draw
m eentry into the market, whereas a below-normal profit will lead to an exit of investors and capital.
The sales revenues minus the expenses of a firm over a des- ignated time period, usually one year. Accounting profits typically make allowances for changes in the firm’s invento- ries and depreciation of its assets. No allowance is made, however, for the opportunity cost of the equity capital of the firm’s owners, or other implicit costs.
Short run (in production) A time period so short that a firm is unable to vary some of its factors of production. The firm’s plant size typically can- not be altered in the short run.
A time period long enough to allow the firm to vary all of its factors of production.
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A firm cannot instantly adjust its output. Time plays an important role in the production process. All of a firm’s resources can be expanded (or contracted) over time, but for specialized or heavy equipment, expanding (and contracting) availability quickly is likely to be very expensive or even impossible. Economists often speak of the s ~ o r ~ ~~n as a time period so short that the firm is unable to alter its present plant size. In the short run, the firm is typically stuck with its existing plant and heavy equipment. These assets are “fixed” for a given time period, in other words. The firm can alter output, however, by applying larger or smaller amounts of “variable” resources, like labor and raw materials. In this way, the ex- isting plant capacity can be used more or less intensively in the short run.
How long is the short run? The short run is thatperiod of time during which at least one factor of production, usually the size of the firm’s plant, cannot be changed. The length varies from industry to industry. A trucking firm might be able to hire more drivers and buy or rent more trucks and double its hauling capacity in a few months. In other industries, particularly those that use assembly lines and mass-production techniques (for example, the automotive factory supplying trucks), increasing production capacity might take a year or even several years.
The long run is a time period long enough for existing firms to alter the size of their plants and for new firms to enter (or exit) the market. All of the firm’s resources are variable in the long run. In the long run, firms can expand their output by increasing the sizes of their plants-perhaps by adding on to them or by constructing entirely new facilities.
An example might help you understand the distinction between the short- and long- run time periods: If a battery manufacturer hired 200 additional workers and ordered more raw materials in order to squeeze more production out of its existing plant, it would be making a short-run adjustment. In contrast, if the manufacturer built an additional plant (or expanded the size of its current facility) and installed additional heavy equipment, it would be making a long-run adjustment.