Gerald T. Garvey

The economics of corporate governance: Beyond the Marshallian firm

It is now customary to view the corporation as nexus of explicit and implicit contracts. Governance determines how the firms top decision makers (executives) actually administer such contracts. We survey recent theory and evidence on executive behaviour and incentives and reject the standard assumption of shareholder-wealth-maximisation, either in its strict sense or in the sense implied by standard principal-agent models. Explanations for this state of affairs as an inefficient, rent-seeking outcome are contrasted with efficiency explanations, particularly those that explicitly consider the diverse claims of employees, customers, and suppliers as well as those of investors.

Why reputation favors joint ventures over vertical and horizontal integration A simple model

Abstract This paper investigates the effect of reputation in a model where two parties make noncontractable contributions to an economic undertaking. It is shown that the optimal allocation of ownership between the parties is more similar in a repeated than in a one shot version of the model. This implies that unified ownership and reputation are substitutes . Low discount rates and repeated investment decisions thus favor subcontracting and joint venture arrangements of the type commonly observed in Japanese industry, while full integration is more likely to be optimal when reputational forces are weak.

A collective tournament

Abstract Traditional tournaments among workers yield suboptimal levels of helping efforts, while collective incentives generate free-riding or lack incentive compatibility. We confront these problems using a tournament between workplaces. Under fairly restrictive conditions, the collective tournament is first best and incentive compatible.

How Brokers Facilitate Trade For Long-Term Clients in Competitive Securities Markets

In adverse-selection models of security market microstructure, a market maker could enhance efficiency if he or she were willing to sustain short-term trading losses. We show that this desirable activity can be supported as a self-enforcing agreement between broker-dealers and long-lived clients. An implication is that brokers who sustain such losses should charge higher fees to long-term clients for trades where the broker merely receives a commission. This prediction is supported by an analysis of brokerage rates on the Australian Stock Exchange. By contrast, market makers who make trading profits charge lower agency fees to large, long-term clients. Copyright 1995 by University of Chicago Press.

Managerial Objectives, Capital Structure, and the Provision of Worker Incentives

Worker incentive schemes are invariably assumed to be administered by an owner-entrepreneur who has an incentive to understate worker performance after the event. While tournaments can overcome this problem, they discourage cooperation between workers. We show that a professional manager concerned with equality between workers and with avoiding bankruptcy rather than maximizing shareholder wealth will conduct a tournament that preserves individual effort incentives while promoting cooperation between workers. The theory predicts lower debt levels and more compressed pay scales as cooperation becomes more important. In the limit this becomes a group bonus scheme, supported by blue-chip debt.

The interaction between financial and employment contracts: A formal model of Japanese Corporate Governance

Abstract Decision making in large Japanese corporations traditionally gives substantial weight to the interests of employees and of main bank investors, but not to those of small shareholders. This paper shows how such a governance system is uniquely suited to provide employees with incentives both to exert individual efforts and to cooperate with one another. The critical element of the system is shown to be a substantial concern for the welfare of workers and of creditors, with relatively little involvement by shareholders. The potential for overwork due to performance measurement error is also highlighted.

The principal--agent problem when the agent has access to outside markets

Abstract Principal-agent models assume that the agent must consume the payments he receives under the incentive contract. This paper shows that if the agent can trade his payments on frictionless state–contigent markets, only a flat-wage or a full residual claim for the agent are viable.

Agency Theory and “Management Research†A Comment

The application of agency theory to management research issues such as organisational design, strategic management and corporate policy is becoming increasingly common (Lyles 1990). Within this broad suite of topics, corporate governance issues have become the focus of increasing concern. Relevant issues include “appropriate” board structures (i.e., independent versus executive directors) as well as the separation of the chief executive officer (CEO) and chairperson’s (chair) rôles (i.e., the “duality” question).1 Donaldson and Davis (1991) address the latter issue, comparing the relative merits of what they call the agency perspective to one they term “stewardship theory”. In addition to serious problems with their methodology (Whittred 1993), their analysis is based on a misunderstanding of agency theory. Donaldson and Davis characterise the agency perspective in a relatively simplistic and misleading fashion, such that natural conflicts of interest between widely dispersed owners (i.e., shareholders) and professional managers preclude managers acting in shareholders’ best interests. Modern agency theory argues to the contrary: that firms create long-term wealth for their owners because those owners are relatively diverse and cannot intervene, while managers motivated by (among other things) debt and capital structure are put in charge. In contrast, Donaldson and Davis present stewardship theory as a stark alternative which gives due recognition to managers’ “desires” to perform satisfactorily. We contend that

A Theory of the Optimal Cost Barrier to Corporate Takeovers

This paper characterizes financial and employment contracts in the presence of both worker moral hazard and the threat of opportunistic takeovers. Firms in which worker efforts or specific investments are of greater importance are shown to exhibit a greater degree of deferred compensation, supported by governance structures that allow managers to resist hostile takeovers more vigorously. This effect is most pronounced in firms where workers pay for their job by accepting low wages early in their careers. Firms in which large deferred payments cannot be offset by low starting wages will offer less resistance to a hostile bidder. Copyright 1997 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Optimal Capital Structure for a Hierarchical Firm

This paper analyzes the optimal financial structure for a firm in which the top manager must provide incentives to a subordinate in addition to exerting directly productive efforts. Optimal capital structure is shown to involve a moderate level of debt with a substantial penalty for default, and passive shareholders. In a twoor three-layer hierarchy, optimal leverage is shown to decrease as either the number of hierarchical levels or the importance of agents further down the hierarchy increases. This and other implications of the model square well with existing evidence and suggest new directions for empirical work. Journal of Economic