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Chapter 9

Analysis on ConflictSummary and Quiz

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Chapter 9

ANALYSIS OF CONFLICT

9! " #A$% T&%O'Y

#ame Theoryattempts to model and predict outcomes of conflict between rational

individuals. It models the interaction between two or more players in the presence of

uncertainty and information asymmetry. Game Theory requires that players formally takethe actions of the other players into account, making it more complex than decision

theory and theory of investment. The number of players in a game theory is sufficiently

small that the actions of one player do influence the other players. One way to classifythese games is as cooperati(eparties enter into a binding agreement! and non)cooperati(e.

9* " NON)COO+%'ATI,% #A$% $O-%L OF $ANA#%')IN,%STO'

CONFLICT

"hen making decisions, investors are aware that managers do not always reveal allinformation. It is too difficult and costly to provide each investor with desired

information about the company. Game Theory assumes each player chooses a strategy

without knowing the strategy choice of the other. Strate.y +airis a statement of thestrategy taken by each party. Nash %/uili0riumis the only strategy pair, such that given

the strategy choice of the other player, each player is content with their strategy and does

not wish to depart from their choice. #ash equilibrium is the predicted outcome of a non$cooperative game.

In single$person decision theory, nature is an impartial force that does not think and the

strategy chosen by an investor does not affect these probabilities of nature. This theorybreaks down when the payoffs are generated by a thinking opponent a manager! rather

than by nature, which leads us to the game theory.

91 " COO+%'ATI,% #A$% T&%O'Y

%layers engage in a game situation when entering into agreements they perceive asbinding i.e. contracts!. There are two important contracts&

'. %mployment contracts$ between firm and its managers

(. Lendin. contracts$ between the firm and its lender

In these contracts, one party is the principal and the other is the agent. A.ency theoryis

a branch of game theory that studies the design of contracts between two or more people.It motivates a rational agent to act on behalf of a principal when the agent)s interests

would otherwise conflict with those of the principal. It has characteristics of both

cooperative and non$cooperative games. Two parties do not specifically agree to takecertain action but rather the actions are motivated by the contract itself.

91! " A#%NCY T&%O'Y2 %$+LOY$%NT CONT'ACT

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It assumes the payoffs are observable by both parties. It puts onus on firm)s accounting

policies to report information fully and accurately, so both parties in the game are willingto accept reported net income as a measure of the payoff.

'eser(ation utilityis the minimum utility a manager will accept before deciding to goelsewhere. One player will not choose an act desired by another player because that

player says so. *ach player chooses the act that maximi+es his or her own expected

utility. tility maximi+ing behaviour by all parties is one of the important anddistinguishing characteristics of positive accounting theory and economic theory of

games.

%ffort)Ad(erse$ the manager dislikes effort- the greater the level of effort, the greaterthe dislike. This disutility of effort by the agent is subtracted from the utility of

remuneration of the agent. s a result, the agent will choose to shirk instead of work hard

and this creates a moral ha+ard situation.

Options available to control moral ha+ard&

'. /ire manager and accept the shirk work 0 unlikely to occur

(. 1irect monitoring First)3estcontract!

Ex. manager is paid $25 if alt. 1 is chosen and $12 if alt.2 is chosen Gives the owner maximum attainable utility and gives the agent reservation

utility.

'is4)sharin.properties 0 risk$neutral owner bears all the risk- if owner isrisk$adverse, manager and owner share risk.

2irst$best contract often unattainable 0 difficult to determine effort of

manager.

3. Indirect monitoring

1oes not work for fi5ed support cases $ possible payoffs is fixed regardlesswhich action is taken

$o(in. support0 the set of possible payoffs differ depending on the actions

taken

4annot ensure first$contracts will be attained because many contracts usefixed support

If the moving support holds, legal5institutional factors prevent owner from

penali+ing manager sufficiently to force a better alternative.

6. Owner rents firm to manager

Owner guaranteed fixed rent no matter what and does not care about theactions of the manager this is called internalizin.the manager)s decision

problem!

7anager bears all the risk

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8. Give manager a share of the payoff most efficient alternative after first$best!

7anager given a certain percentage of the payoff

4ontract motivates the manager to choose the best alternative for the principalcalled incenti(e)compati0ility because manager)s incentive is compatible

with owner)s interests! 0 interests are ali.ned

9isk is shared Second)0est ) most efficient contract short of first$best

:ummary

gency theory studies how to design the optimal contract with the lowest possible cost.4ontracts can only be written in terms of performance measures that are ;ointly

observable by both principal and agent.

$ If the agent)s effort can be observed, directly or indirectly, a fixed salary is theoptimal solution when the principal is risk neutral. Effort is the performancemeasure!

$ If effort cannot be observed, but payoff can, the optimal contract will give the

agent a share of the payoff. gent will be motivated but is second 0estbecause of the additional risk imposed on the agent. Payoffis theperformance measure!. %ayoff is usually measured in terms of net income.

The higher the correlation between net income with effort, the closer the

second$best contract is to first$best contract and the lower the agency costs forthe owner

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/olmstrom)s gency 7odel

ssumes the agent)s effort is unobservable by the principal, but payoff is ;ointly

observable. %ayoffs can be measured through net income, but principal may not believe

net income is creditable because the manager controls the accounting system and policies

used- thus, G% and auditing play a role in contracting. G% limits a manager)sincentive to influence reported net income and auditing adds creditability.

4ontracts based on payoff are less efficient than first$best- raising questions of whethersecond$best can be made more efficient by biasing it on a second variable such as share$

price. >oth net income and share price can be used to reduce agency costs provided both

variables are observable and conveys information about manager)s effort. nalysisshows that no matter how noisy the second variable is, as long as it can be used to

increase efficiency of the second$best contract, it contains some additional information

about effort.

96! " 'I-#ITY OF CONT'ACTS

4ontracts tend to be rigid once signed. It is impossible to anticipate all contingencieswhen entering a contract. 4ontracts that do not anticipate all possible state realisations are

called incomplete. Things that are hard to predict include a change in the way net income

or covenant ratios are calculated. 9enegotiations are possible for incomplete contracts butall or ma;ority of bondholders would need agreement because bondholders need to be

compensated to positive changes in net income. nforeseen state reali+ations impose

costs on firm and5or manager.

98 " '%CONCILIATION OF %FFICI%NT S%C7'ITI%S $A'%T T&%O'Y

:IT& %CONO$IC CONS%Q7%NC%S

#et income and other financial statement numbers matter to managers because manager)s

remuneration depends on net income and usually long term lending contracts involve

covenants where manager commits not to take certain actions that may be contrary tolender)s interests. #othing in the theory of efficient securities markets conflicts with

managerial concern about accounting policies. 4onsidering both theories helps us see that

managers may well intervene in accounting policies even though these policies wouldimprove the decision usefulness of financial statement to investors. gency theory is not

the only explanation for economic consequences, but also managers do not accept

securities market efficiency, believing that investor reaction and cost of capital are

affected by accounting policy choice irrespective of any impact on cash flow. 7anagersbelieve that accounting policies are a way to communicate inside info to the market.

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Chapter 9

Analysis Of Conflict

$ultiple Choice;

se the following utility table to answer question '

IN,%STO' $ANA#%'

investor, manager! &onest ;&> -istort ;->

3uy ;3> '(, ? 6, '@

'efuse to 3uy ;'> A, 6 A, @

'. 2or the non$cooperative game model above, which strategy pair represents the #ash*quilibriumB

a.! >/

b.! 91

c.! >1d.! 9/

(. "hich one of the following statements about Game Theory is falseB

a.! Game theory models the interaction of two or more players, frequently in the

presence of uncertainty and information asymmetry.b.! The number of players is sufficiently small that the actions of one player do

not influence the other players.

c.! The conflict aspect of a game is where the players take the actions of the other

players into account.d.! gency theory is a version of game theory that models the process of

contracting between two or more persons.

3. One way of classifying game theory is cooperative. cooperative game is one&

a.! "here players in a game can enter into agreements that they perceive as

binding.b.! That is concerned with two types of contracts, employment and lending

contracts.

c.! "here it is difficult to envisage a binding agreement between managers andinvestors about what specific information is to be supplied.

d.! >oth a! and b!

6. "hen a manager is said to be *ffort$adverse, this means&

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a.! The manager is indifferent to the effort he or she must contribute.

b.! The manager likes effort and the lower the effort level, the greater the dislike.c.! The manager dislikes effort and the greater the level of effort, the greater the

dislike.

d.! #one of the above.

8. n example of moral ha+ard is when a manager shirks. There are several ways to

control moral ha+ard, which option is an owner most likely will not chooseB

a.! 1irect 7onitoring

b.! /ire the manager and put up with the shirking

c.! 9ent the firm to the managerd.! Give the manager a chare of the payoff

@. CCCCCCCCC is needed as a cost$effective way to put limits on the manager)s incentive

to influence reported income by selecting from alternative policies.

a.! 9isk %remiumb.! n udit

c.! Internali+ing

d.! G%

A. It is generally impossible to anticipate all contingencies when entering a contract.

4ontracts that do not anticipate all possible state reali+ations re termed&

a.! 4ovenants

b.! 4omplete

c.! Incompleted.! #one of the bove

?. uditing is needed to add CCCCCCCCCCC to the reported net income number.

a.! 4redibility

b.! Informationc.! Dolatility

d.! 4ompleteness

E. gency theory contracts have characteristics of which of the following&

a.! 4ooperative gamesb.! >inding Games

c.! #on$4ooperative games

d.! >oth a and b

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Short Ans?er Questions ;

'. "hat is agency theoryB (2 minutes)

(. >riefly define the two important types of contracts of 4ooperative game Theory.

(4 minutes)

3. There are different contracts that can be designed to control moral ha+ard- one option

is to use direct monitoring, which formulates a 2irst$best contract. >riefly explain

2irst$best contracts. (6 minutes)

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Chapter 9

Analysis Of Conflict:olution Fey!

$ultiple Choice;

se the following utility table to answer question '

IN,%STO' $ANA#%'

investor, manager! &onest ;&> -istort ;->

3uy ;3> '(, ? 6, '@

'efuse to 3uy ;'> A, 6 A, @

'. 2or the non$cooperative game model above, which strategy pair represents the #ash

*quilibriumB

a.! >/0> '-

c.! >1

d.! 9/

(. "hich one of the following statements about Game Theory is falseB

a.! Game theory models the interaction of two or more players, frequently in the

presence of uncertainty and information asymmetry.

0> The num0er of players is sufficiently small that the actions of one player

do not influence the other players

c.! The conflict aspect of a game is where the players take the actions of the other

players into account.

d.! gency theory is a version of game theory that models the process ofcontracting between two or more persons

3. One way of classifying game theory is cooperative. cooperative game is one&

a.! "here players in a game can enter into agreements that they perceive as

binding.

b.! That is concerned with two types of contracts, employment and lendingcontracts.

c.! "here it is difficult to envisage a binding agreement between managers and

investors about what specific information is to be supplied.

d> 3oth ;a> and ;0>

6. "hen a manager is said to be *ffort$adverse, this means&

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a.! The manager is indifferent to the effort he or she must contribute.

b.! The manager likes effort and the lower the effort level, the greater the dislike.

c> The mana.er disli4es effort and the .reater the le(el of effort@ the .reater

the disli4e

d.! #one of the above.

8. n example of moral ha+ard is when a manager shirks. There are several ways to

control moral ha+ard, which option is an owner most likely will not chooseB

a.! 1irect 7onitoring.

0> &ire the mana.er and put up ?ith the shir4in.

c.! 9ent the firm to the manager.d.! Give the manager a share of the payoff.

e.! 1irect 7onitoring

@. CCCCCCCCC is needed as a cost$effective way to put limits on the manager)s incentiveto influence reported income by selecting from alternative policies.

a.! 9isk$%remium

b.! n udit

c.! Internali+ing

d> #AA+

A. It is generally impossible to anticipate all contingencies when entering a contract.

4ontracts that do not anticipate all possible state reali+ations re termed&

a.! 4ovenants

b.! 4omplete

c> Incomplete

d.! #one of the above.

?. uditing is needed to add CCCCCCCCCCC to the reported net income number.

a> Credi0ility

b.! Informationc.! Dolatility

d.! 4ompleteness

E. gency theory contracts have characteristics of which of the following&

a.! 4ooperative Gamesb.! >inding Games

c.! #on$4ooperative Games

d> 3oth ;a> and ;0>

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Short Ans?er Questions

'. "hat is agency theoryB (2 minutes)

A.ency theory is a type of .ame theory It studies the desi.n of contracts tomoti(ate a rational a.ent to act on 0ehalf of a principal ?hen the a.ents

interests ?ould other?ise conflict ?ith those of the principal

(. >riefly define the two important types of contracts concerned with 4ooperative game

Theory. (4 minutes)

The t?o types of contracts concerned ?ith cooperati(e theory are employment

contracts and lendin. contracts

%mployment contract is 0et?een the firm and its top mana.er The mainconcern of employment contracts is moral hazard due to shir4in. The .oal here

is to ali.n the interests of 0oth the o?ner and the mana.er

Lendin. contract is 0et?een the firm and the 0ondholder $ana.ers may act

contrary to the 0est interest of the lenders@ ?hich causes rational lenders to

increase interest rates Co(enants are inserted into lendin. a.reements to .et

mana.ers to act in the 0est interest of the lenders

3. There are different contracts that can be designed to control moral ha+ard- one option

is to use direct monitoring, which formulates a 2irst$best contract. >riefly explain

2irst$best contracts. (6 minutes)

7nder direct monitorin.@ a mana.ers contract ?ould 0e amended to pay a

salary that depends on the closeness of the mana.ers decision to the interest of

the o?ner For e5ample@ payin. a salary of B!6 for choosin. to ?or4 hard or B

for shir4in.

The o?ner ;principal> recei(es a ma5imum attaina0le utility and .i(es the

mana.er ;a.ent> the reser(ation utility A ris4)sharin. property arises ?here the

mana.er 0ears no ris4 0ecause a fi5ed salary is recei(ed@ re.ardless of the

payoff If the mana.er is ris4)ad(erse@ this option is desira0le The o?ner@ on

the other hand@ 0ears all the ris4 of the random payoff If the o?ner is ris4)

neutral@ he or she does not mind 0earin. all the ris4s

7sually@ first)0est contracts are unattaina0le 0ecause it is unli4ely the o?ner

could monitor the a.ents effort in a mana.erial settin. As ?ell@ information

asymmetry plays a factor due to the fact the o?ner is una?are of the mana.ers

effort le(el only the mana.er 4no?s the amount of effort he puts in