Jeremy I. Bulow

Durable-Goods Monopolists

Durable-goods monopolists face special problems because the sale of their products creates a secondhand market not controlled by the monopolist. To the extent the monopolist is able to rent his product rather than sell it, or to make binding promises about his future production, such problems are ameliorated. Given the inability to do the above, the monopolist is led to producing goods less durable than those produced by either competitive firms or monopolist returns. A reverse Averch-Johnson result--that monopolist sellers may invest less in fixed costs (including plant modernization and research and development) than would the renters--is shown. It is also shown that, even though sellers have less monopoly power than renters and nondurable-goods monopolists, it is possible that the seller will cause a greater deadweight loss than the other types of monopolies.

The Simple Economics of Optimal Auctions

We show that the sellers problem in devising an optimal auction is virtually identical to the monopolists problem in third-degree price discrimination. More generally, many of the important results and elegant techniques developed in the field of mechanism design can be reinterpreted in the language of standard micro theory. We illustrate this by considering the problem of bilateral exchange with privately known values.

Toeholds And Takeovers

Part ownership of a takeover target can help a bidder win a takeover auction, often at a low price. A bidder with a ‘toehold’ bids aggressively in a standard ascending auction because its offers are both bids for the remaining shares and asks for its own holdings. While the direct effect of a toehold on a bidder’s strategy may be small, the indirect effect is large in a common value auction. When a firm bids more aggressively, its competitors face an increased winner’s curse and must bid more conservatively. This allows the toeholder to bid more aggressively still, and so on. One implication is that a controlling minority shareholder may be immune to outside offers. The board of a target may increase the expected sale price by allowing a second bidder to buy a toehold on favourable terms, or by running a sealed bid auction.

The bankruptcy decision

This paper investigates the circumstances under which a firm will be forced into bankruptcy. The model developed can be viewed as part of a larger framework which would be necessary to address the question of optimal financial policy in a world of taxation, bankruptcy costs, investment and depreciation, uncertainty, etc. The model focuses on the conflicts of interest among various claimants to the assets and income flows of the firm (the stockholders, bond-holders, and bank lenders). We derive conditions under which the necessary funds for continuation will not be forthcoming and illustrate the importance of the liquidity of the assets and the maturity structure of the debt in staving off bankruptcy. Several examples highlight the major conclusions of the paper. The conditions for bankruptcy, which have some intuitive appeal, are more complex than those appearing in the previous literature. The latter part of the paper considers merger with a healthy company as an alternative to bankruptcy. We show that the tax system has an important effect on the choice between merger and bankruptcy.

A Note on the Effect of Cost Changes on Prices [Measurement of Monopoly Behavior: An Application to the Cigarette Industry]

In a recent article in this Journal, Sumner (1981) took an ingenious approach to estimating the level of monopoly power in the cigarette industry. He noted that differences in marginal costs exist in the industry due to varying levels of state taxes. The sales prices established will satisfy the equation p[I + (lIq)l = MR = MC, where p = price and -q = the elasticity of demand for the product in question. If elasticity is a constant, observing the change in marginal cost and the change in price enables one to infer the elasticity of demand perceived by the firm. Elasticity could then be used as a proxy for the firms market power. This technique turns out to be of very limited applicability, however, because it is extremely sensitive to the functional form assumed for the demand curve. Consider the general problem of a firm facing constant marginal costs of c. In maximizing profits the firm solves

What are Corporate Pension Liabilities

Analyses of corporate pension plans often make unstated assumptions about an implicit labor contract. An example of the effect of such an assumption is that many mistakenly believe that if a workers benefits are tied to final salary, he is protected against inflation until retirement. Also, the value of a workers claims is often considered to be independent of the status of the firms pension fund. These “implicit contract†assumptions are examined and questioned. The implications of analyzed pension liabilities in a manner consistent with the analysis of other corporate liabilities are explored.

The Taxation of Risky Assets

This paper reconsiders the effects of taxation on risky assets, recognizing the importance of variations in asset prices. We show that earlier analyses that assumed that depreciation rates are constant and that the future price of capital goods is known with certainty are very misleading as guides to the effects of corporate taxes. We then examine the concept of economic depreciation in a risky environment and show that depreciation allowances, if set ex ante, should be adjusted to take account of future asset price risk. Some empirical calculations suggest that these adjustments are large and have important implications for the burdens of, and nonneutralities in, the corporation income tax.

First World Governments and Third World Debt

FIRST MEXICO, THEN Asia, then Russia and Brazil. Now Argentina and Turkey. As always when financial, crises occur, questions arise about whether first world governments should change their role in the restructuring of third world debt, by restructuring the multilateral international financial institutions (IFIs), creating an international bankruptcy court, or adopting one of the many other proposals for reforming the international financial architecture. (1) Kenneth Rogoff and I wrote a series of papers addressing these and related issues between 1988 and 1992: (2) --In 1988 we argued that the existence of the official creditors led to increased emerging-market and developing-country debt, because private creditors would be able to count on the official creditors to pay back part of their loans. (3) In 1990 we further claimed that the existence of the official creditors made debt renegotiation more difficult and complex, by hardening the positions of debtors and creditors. --In 1990 we argued that the legal infrastructures of the industrial countries were being used to lend developing countries more money than the underlying economics warranted. We maintained that it would be better if creditors were forced to rely much more on debtor-country legal structures to create a level playing field for equity and foreign direct investment. --In 1988 and 1992 we argued that official creditors, defined broadly as a group, are at best equal in seniority and possibly even junior to private creditors. (4) These arguments underlay the reform proposals that we made in our 1990 paper. Rogoff reiterated many of these views shortly before becoming chief economist at the International Monetary Fund (IMF). Similarly, my views have not changed. The proposals we made then still make sense today: --Multilateral loans should largely, and in some cases completely, be replaced by aid. --The United States should repeal the relevant portion of the Foreign Sovereign Immunities Act of 1976, and the United Kingdom the part of the 1978 State Immunity Act, that allows developing countries to waive their immunity when they borrow money abroad. That is, to the extent possible, jurisdiction over a sovereigns debts should be in its own courts. This would include the debt of banks that are nationalized during debt crises. --The IFIs should be kept out of the international bailout business. (5) --The aid should be disbursed through an International Citizenship Fund and focused on issues that involve externalities, such as environment and education, rather than on macroeconomic structural adjustment. In the context of our 1990 proposal, I would be extremely cautious about proposals for either a real or a metaphorical international bankruptcy court. Such proposals run the risk of moving some sovereign obligations from debtor-country courts to external jurisdictions, making it even harder for industrial-country governments to avoid getting enmeshed in resolving these crises. Proposals to coordinate creditors through collective action clauses, such as those suggested by Under Secretary of the U.S. Treasury for International Affairs John Taylor or already existing in U.K. law, or through mechanisms that also coordinate different classes of creditors, as suggested by the IMFs First Deputy Managing Director Anne Krueger, have some appeal in simplifying the renegotiation bargaining problem. Countries may well want to adopt such provisions within the context of their domestic restructuring laws. But the key step is to coordinate as much of the bargaining as possible under the auspices of the debtors own legal system. Whereas in 1990 our proposals were treated as quite radical, they no longer seem so today. The Meltzer Commission has now advocated aid in place of loans, and the White House and the Treasury have called for dramatically increasing the proportion of aid in official financing for developing countries, particularly the poorest. …

Accounting for Stock Options

Employee stock options differ substantially from traded options. Most expire within 90 days of the termination of employment, and are forfeited if the employee leaves before vesting. The major accounting standards boards are in agreement that options should be expensed, but companies have legitimate complaints about the proposed methods. For example, the proposals create accounting incentives for firms to lay off employees who hold unvested and nearly worthless options. We propose a simple accounting system, based on 90 day option prices, that addresses these legitimate objections. The system produces objective, transparent, and decision-relevant information. Firms are given significant flexibility regarding the amortization of unvested option expense. This flexibility is created, without distorting incentives, by our use of market-based prices whenever an option expense is recognized.

Multilateral Negotiations for Rescheduling Developing Country Debt: A Bargaining-Theoretic Framework

A dynamic bargaining-theoretic framework is used to analyze multilateral negotiations for rescheduling sovereign debt. The analysis illustrates how various factors, such as the debtors gains from trade and the level of world interest rates, affect the relative bargaining power of various parties to a rescheduling agreement. If creditor-country taxpayers have a vested interest in maintaining normal levels of trade with debtor countries, then they can sometimes be bargained into making sidepayments. The benefits from unanticipated creditor-country sidepayments accrue to both lenders and borrowers. But the benefits from perfectly anticipated sidepayments accrue entirely to borrowers.