Managerial ownership with rent-seeking employees

Brackets, “[ ]” are added by the present author. From the passage, Smith (1776) clearly thought joint-stock companies were flawed, relative to owner-managed firms.

Risk neutrality facilitates 100 percent ownership because it allows the manager to be unconcerned about diversification. Lack of credit constraints allows the best manager to buy the firm from its original owners. These assumptions are sufficient for the optimal incentives, 100 percent ownership, to be transferred to the best manager without forcing the original entrepreneur to sell the firm at any discount. (One could also argue that symmetric information would be also necessary for such an ownership sale to be always efficiently consummated.) Other scholars such as Bagnoli et al. (2011) have pointed out the conflicts between maximing firm value and the value of the equity stake.

While there may be rational mechanisms or institutional features that may obstruct managerial monitoring, behavioral factors may also come into play. Seniority based firing and formal grievance procedures may make the firing of unproductive workers more difficult. Nevertheless, Baumol (1986, p. 13), for example, believes that fairness and envy are embraced in society even when such norms lead to disastrous consequences such as contributing to the Irish potato famine. He writes, “...laws against unfair pricing by speculators in times of severe shortages, which presumably are designed to protect the interests of the poor, in fact make it likely that those poor will be exposed to enormous hardships—possibly famine and starvation.”

The standard predictions of non-cooperative game theory are often overturned in laboratory settings. There appears to be a much stronger tendency towards equal division of surplus than economic theory would predict. The dictator game allows a proposer to split a pie with another participant. The other participant actually has no role in the game, yet Forsythe et al. (1994) found the most likely outcome was that a dictator would give 30 percent of the pie to the passive participant. Bolton et al. (1998) find this result in other studies. In less extreme games where the receiver can destroy the pie if it rejects the proposer’s settlement, Andersen et al. (2011) finds that across many studies the receiver rarely is offered less than 20 percent of the pie. Yet, game theory would predict that such dictator or ultimatum games would result in 100-0 splits of the economic pie.

Diversification motives would only strengthen the results of this paper—that low levels of CEO ownership are optimal.

There are a few papers that explore how managerial biases can be commitments that ultimately increase firms’ value under different environments. One strand of literature pursues how managerial biases improve project selection when rewards for successful innovation are fixed. Empathy for lower level managers in Rotemberg and Saloner (1993), narrowness of firm scope in Rotemberg and Saloner (1994) and managerial vision in Rotemberg and Saloner (2000) can improve incentives for innovation in this incomplete contracting setting. The other approach of Van den Steen (2005) looks at how managerial biases or “vision” influences the recruitment of employees. In contrast to both these approaches, the present paper is concerned less with project selection than cost minimization. Further, the present paper looks to design compensation to change managerial objectives. In contrast, the papers in this footnote focus on exogenous managerial traits that make them the “right man” (or woman) for the job.

The \(\textit{IC}_{U}\) constraint is much like an efficiency, or non-shirking wage, as proposed by Calvo and Wellisz (1978) or Shapiro and Stiglitz (1984). Here we have focused on how the monitoring of slack work affects employees’ wages. From the \(\textit{IC}_{U}\) lower levels of monitoring are associated with higher efficiency wages. Shapiro and Stiglitz (1984) point to other factors which increase efficiency wages. Higher levels of voluntary turnover by employees can increase wages. Work situations that make voluntary turnover more likely will

also be more highly paid workforces. Thus, there are other ways than raising monitoring costs that could lead to a boost in workers’ wages.

Further, \(\hat{{\alpha }}=1\) is not a corner solution because a 100 percent share maximizes the value of the firm in the unconstrained problem. Higher percentages, \(\alpha >1\), even if they would be feasible, would strictly decrease the value of the firm.

It is equivalent to envision the entrepreneur selling the firm to an outside manager. The price of the sale to the outside manager would be \(V_{M}\).