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Analysis on Conflict
Summary and Quiz
Chapter 9
ANALYSIS OF CONFLICT
9.2 GAME THEORY
Game Theory attempts 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 take
the 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 classify
these games is as cooperative (parties enter into a binding agreement) and noncooperative.
9.3 NON-COOPERATIVE GAME MODEL OF MANAGER-INVESTOR
CONFLICT
When making decisions, investors are aware that managers do not always reveal all
information. 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. Strategy Pair is a statement of the
strategy taken by each party. Nash Equilibrium is 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. Nash equilibrium is the predicted outcome of a noncooperative 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 theory
breaks down when the payoffs are generated by a thinking opponent (a manager) rather
than by nature, which leads us to the game theory.
9.4 COOPERATIVE GAME THEORY
Players engage in a game situation when entering into agreements they perceive as
binding (i.e. contracts). There are two important contracts:
1. Employment contracts - between firm and its managers
2. Lending contracts - between the firm and its lender
In these contracts, one party is the principal and the other is the agent. Agency theory is
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 agents 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 take
certain action but rather the actions are motivated by the contract itself.
9.4.2 AGENCY THEORY: EMPLOYMENT CONTRACT
It assumes the payoffs are observable by both parties. It puts onus on firms accounting
policies to report information fully and accurately, so both parties in the game are willing
to accept reported net income as a measure of the payoff.
Reservation utility is the minimum utility a manager will accept before deciding to go
elsewhere. One player will not choose an act desired by another player because that
player says so. Each player chooses the act that maximizes his or her own expected
utility. Utility maximizing behaviour by all parties is one of the important and
distinguishing characteristics of positive accounting theory and economic theory of
games.
Effort-Adverse - the manager dislikes effort; the greater the level of effort, the greater
the dislike. This disutility of effort by the agent is subtracted from the utility of
remuneration of the agent. As a result, the agent will choose to shirk instead of work hard
and this creates a moral hazard situation.
Options available to control moral hazard:
1. Hire manager and accept the shirk work unlikely to occur
2. Direct monitoring (First-Best contract)
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.
Risk-sharing properties risk-neutral owner bears all the risk; if owner is
risk-adverse, manager and owner share risk.
First-best contract often unattainable difficult to determine effort of
manager.
3. Indirect monitoring
Does not work for fixed support cases - possible payoffs is fixed regardless
which action is taken
Moving support the set of possible payoffs differ depending on the actions
taken
Cannot ensure first-contracts will be attained because many contracts use
fixed support
If the moving support holds, legal/institutional factors prevent owner from
penalizing manager sufficiently to force a better alternative.
4. Owner rents firm to manager
Owner guaranteed fixed rent no matter what and does not care about the
actions of the manager (this is called internalizing the managers decision
problem)
Manager bears all the risk
5. Give manager a share of the payoff (most efficient alternative after first-best)
Manager given a certain percentage of the payoff
Contract motivates the manager to choose the best alternative for the principal
(called incentive-compatibility because managers incentive is compatible
with owners interests) interests are aligned
Risk is shared
Second-best - most efficient contract short of first-best
Summary
Agency theory studies how to design the optimal contract with the lowest possible cost.
Contracts can only be written in terms of performance measures that are jointly
observable by both principal and agent.
-
If the agents effort can be observed, directly or indirectly, a fixed salary is the
optimal solution when the principal is risk neutral. (Effort is the performance
measure)
If effort cannot be observed, but payoff can, the optimal contract will give the
agent a share of the payoff. Agent will be motivated but is second best
because of the additional risk imposed on the agent. (Payoff is the
performance measure). Payoff 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 for
the owner (hard income).
If neither payoff nor effort can be observed, the optimal contract is a rental
contract, where the principal rents the firm to the manager for a fixed rental
rate, thus internalizing the agents effort decision (no performance measure)
Share price is another way to measure firms performance and most efficient payoff
depends on firms organizational structure and environment.
9.4.3 AGENCY THEORY: BONDHOLDER-MANAGER LENDING CONTRACT
Even in lending contracts, there exists a moral hazard problem where the managers may
act contrary to the best interests of the lenders. Rational lenders will raise their interest
rates and managers may commit not to act against the lenders interests by entering into
covenants. The manager agrees to limit dividends, or limit additional borrowing while
loan is outstanding. With these covenants, a firm is able to lower the interest rates
charged by the lender.
9.5 IMPLICATIONS OF AGENCY THEORY FOR ACCOUNTING
Chapter 9
Analysis Of Conflict
Multiple Choice (18 minutes)
INVESTOR
MANAGER
Honest (H)
Distort (D)
12, 8
4, 16
7, 4
7, 6
1. For the non-cooperative game model above, which strategy pair represents the Nash
Equilibrium?
a.)
b.)
c.)
d.)
BH
RD
BD
RH
Direct Monitoring
Hire the manager and put up with the shirking
Rent the firm to the manager
Give the manager a chare of the payoff
Risk Premium
An Audit
Internalizing
GAAP
Covenants
Complete
Incomplete
None of the Above
Credibility
Information
Volatility
Completeness
Cooperative games
Binding Games
Non-Cooperative games
Both a and b
2. Briefly define the two important types of contracts of Cooperative game Theory.
(4 minutes)
3. There are different contracts that can be designed to control moral hazard; one option
is to use direct monitoring, which formulates a First-best contract. Briefly explain
First-best contracts. (6 minutes)
Chapter 9
Analysis Of Conflict
(Solution Key)
Multiple Choice (18 minutes)
INVESTOR
MANAGER
Honest (H)
Distort (D)
12, 8
4, 16
7, 4
7, 6
1. For the non-cooperative game model above, which strategy pair represents the Nash
Equilibrium?
a.)
b.)
c.)
d.)
BH
RD
BD
RH
Direct Monitoring.
Hire the manager and put up with the shirking.
Rent the firm to the manager.
Give the manager a share of the payoff.
Direct Monitoring
Risk-Premium
An Audit
Internalizing
GAAP
Covenants
Complete
Incomplete
None of the above.
Credibility
Information
Volatility
Completeness
Cooperative Games
Binding Games
Non-Cooperative Games
Both (a) and (b)