Managerial Economic 2

PART 11. Explain clearly what agency problem is. Focus your answer on why and how it may occur. Give several examples based on your experience or knowledge of its occurrence. Preferably, use local examples.

Agency problem is defined as conflicts of interest between corporate insiders, such as managers and controlling shareholders and outside investors such as minority shareholders which are central to the analysis of the modern corporation.

An agency problem occurs when the interests of shareholders and the management of the company are not perfectly aligned and associated when these entities are at a conflict. In the publicly held companies, there is a diversity of individuals with an interest in the performance of the company. The managers and executives who run the company on a day-to-day basis, the shareholders who possess the companys stock and the board of directors who administer the company's business development all may have different aims or ideas of how the business can be run.

Furthermore, an agency problem occurs when the incentives between the agent and the principal are not effortlessly affiliated and conflicts of interest might arise in between that situation. As a result, the agent may be interested to act in his or her own interest rather the principals interests. Conflicts of interest are almost unavoidable and inevitable. For example, the agent tolerates the full cost of putting effort into the task passed on by the principal, but usually the agent does not receive the full benefit which they supposed to receive and those results from these efforts. This may create an incentive for the agent to put in less effort into the task than he or she would do if acting on his or her own behalf. We will see some local examples which agency costs occur.

The agency problem typically denotes to a conflict of interest between a company's management and the company's stockholders. The manager who is acting as the agent for the shareholders or namely the principals, is supposed to make decisions that will maximize the shareholders wealth and minimize the companys risk of facing losses. Nevertheless, it will be in the manager's own best attentiveness and interest to maximize and exploit his own wealth.

There was a case where Chin Keem Feung, 46 years old and Shukri Abdul Tawad, 47 years old was the ex-directors of Transmile Group Bhd were caught under Section 122B (b) (BB) of the Securities Industry Act 1983. They had been locked up for issuing fallacious information of the income statement to the Bursa Malaysia Securities Bhd which were totalingRM989,191,000 in the fourth quarter and cumulative period of 2006, in a Transmiles quarterly report which was not examined consolidated results for the financial year ending Dec 31, 2006. The Sessions Court judge Datuk Jagjit Singh, had penalized RM300,000 for both criminal, in absence six month lockup and they were charged on November 14, 2007.Example of case studied by The Star (2010)

Malaysia Perwaja Steel Project face loss of RM2.56 billion, but actually losses RM10 billion. In year 2002, Prime Minister Dato Seri Dr.Mahathir had confessed that Perwaja had losses about RM10 billion. Stared with year 1982, Perwaja Steel as a government owned heavy industry Company Corporation with the Japanese Company Nippon Steel Corporation and invested a project with costs RM 1 billion in Terengganu in order to provide domestic demand for steel products. At that time, Perwaja Steel was faced by the production and bears a lot of debt in yen while interests of payment were more and more high. In 1987, Japanese Company Nippon Steel Corporation moved out the project invested in Terengganu. At the same time, Mahathir gave all the authority to Perwajas Principal Eric Chia. Eric Chia was services in Perwaja for seven years and successful to solve a problem of production and debt and took a leave in year 1995. after he leaved from Perwaja, all the deficit will be occurred, he draw from Bank Bumiputra which is RM 860 million and EPF which is RM130 million without discussions shareholder of Perwaja. Furthermore, he lead to Perwaja Steel losses from RM 1 billion increase to RM 2.49 billion and RM 5.7 billion on the additional debt crippled. The new principal of Perwaja had listed a report about Perwaja losses when services of Eric Chia are unauthorized contracts, unwise investment, misappropriation of funds, and poor management with broad of directors and manager, not accurate accounting record. When happened this case, Perwajas broad of director were take action to absence the meeting, bidding process, blatantly ignored, and not satisfied with the Eric Chia. This will be causes to the agency problem happen because conflict of broad of director and shareholders of Perwaja. In year 2004, Eric Chia was be charged with dishonestly authorization and paid of RM76 million but total loses was more than RM 10 billion.Example of case studied by Wain B. (2009)

2. Determine several agency costs firms may incur because of agency problems. Search for examples and explain.

Agency costs are known as intangible costs that are created from the conflict of shareholders and managers benefits and those of shareholders and bondholders. Behavior of agent can make the agency cost decrease in the firm value, which are difference with the owners. Agency cost includes principal monitor expenditures, residual loss, combined with a set of contract between the agent and conflict of interest and has been created since the separation of ownership and management of the corporation which was started by agency theory. Besides that, stockholders assign the administration of the corporate affairs to the management and if the management makes a decision contrary to the main objective of the corporation that is the maximization of shareholders wealth. This will cause the shareholders to undergo agency costs.

There is an agency relationship between employees of a firm and its owners. Suppose that to conduct normal business, an employee must travel necessitating the expenses associated with a hotel stay. If the owners of the organization allow the employee to arrange his or her own travel itinerary, an agency problem can occur if the employee spends more on the hotel than is necessary to conduct business. For example, if the employee books a 5-star hotel in a major city, takes advantage of expensive hotel services, and orders room service several times a day, the equity of the companys owners is diminished because these high-cost expenses are not a necessary expenditure.

Agency problems are possible because of asymmetric information between the principal and agent. One of the results of the corporate structure is separation of control and ownership. Separation is the direct cause of asymmetric information. With an inability to monitor agents, the principle of self-interest suggests that agents will act in their own self-interest whenever possible.

Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and often to share value in particular. For example, managers are frequently given the option to buy stock at a bargain price. The more the stock is worth the more valuable is this option. In fact, options are often used to motivate employees of all types, not just top managers. For example, in 2001 Intel announced that it was issuing new stock options to 80,000 employees, thereby giving its workforce a significant stake in its stock price and better aligning employee and shareholder interests. Many other corporations, large and small, have adopted similar policies.

The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, managers who are successful in pursuing stockholder goals will be in greater demand in the labour market and thus command higher salaries.

In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, the best-paid executive in 2005 was Terry Semel, the CEO of Yahoo!; according to Forbes magazine, he made about $231 million. By way of comparison, Semel made quite a bit more than George Lucas ($180 million), but only slightly more than Oprah Winfrey ($225 million), and way more than Judge Judy ($28 million). Over the period 20012005, Oracle CEO Larry Ellison was the highest-paid executive, earning about $868 million. Information about executive compensation, along with lots of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started.

Control of the firm ultimately rests with stockholders. They elect the board of directors, who in turn hire and fire managers. The fact that stockholders control the corporation was made abundantly clear by Steven Jobs's experience at Apple. Even though he was a founder of the corporation and was largely responsible for its most successful products, there came a time when shareholders, through their elected directors, decided that Apple would be better off without him, so out he went. Of course, he was later rehired and helped turn Apple around with great new products such as the iPod.

An important mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else's stock. A proxy fight develops when a group solicits proxies in order to replace the existing board and thereby replace existing managers. For example, in early 2002, the proposed merger between Hewlett-Packard (HP) and Compaq triggered one of the most widely followed, bitterly contested, and expensive proxy fights in history, with an estimated price tag of well over $100 million. One group of shareholders, which included Walter B. Hewlett (a board member and heir to a cofounder of HP), once opposed the merger and launched a proxy fight for control of HP. Another group, led by HP CEO Carly Fiorina, supported the merger. In a very close vote, Ms. Fiorina prevailed, the merger went through, and Mr. Hewlett resigned from the board.

Another way that managers can be replaced is by takeover. Firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests. For example, in April 2006, the management of Arcelor SA was attempting to fight off a bid from rival steelmaker Mittal Steel Co. Arcelor's management undertook several steps in an attempt to defeat the 20.4 billion ($24.8 billion) bid. First, the company transferred its lucrative Canadian operations to a Dutch foundation. Next, the company increased its dividend and promised a special dividend to shareholders when Mittal dropped its bid or the takeover failed. These payments to shareholders meant that remaining with current management or siding with Mittal would be financially equivalent.

PART 21. Develop a simple regression model with paint sales (Y) as the dependent variable and selling price (P) as the independent variable.

a. Show the estimated regression equation.

CoefficientsStandard Errort Stat

Intercept390.37644.28.8

price -14.263 2.9-4.9

Therefore, the estimated regression equation will be;

Y= 390.376 14.263X2

b. Give an economic interpretation of the estimated intercept (a) and slope (b) coefficient.

The estimated intercept value of 390.376 indicates that sales (Y) will be equal to 390.376 (X1000) = 390,376 gallons when the selling price (X2) is equal to zero.

This value of X2 which lies far separate from the range over which the regression line was estimated (recall that the lowest selling price in the sample was $12.00 in sales region (9) and the sales estimate has no practical economic significance.

The estimated slope coefficient of 14.263 indicates that expected sales (Y) will decrease by 14.263 (X1000) = 14,263 gallons for each additional $1.00 increase in the selling price (X2).

c. Test the hypothesis (at the 0.05 level of significance) that there is no relationship (i.e., = 0) between the variables.

H0: 2=0 Ha: 2 0b2= 14.263 sb2 = 2.909Therefore, t = (14.263 0)/2.909 t = 4.903

Since the calculated t-value is less than the t-value from the table (t.025,8 = 2.306), one rejects the null hypothesis at the 0.05 significance level that there is no relationship (i.e., 2=0) between paint sales and the selling price.

d. Calculate the coefficient of determination.

The coefficient of determination is also known as the R-square, whereby the R2 = 0.75 for this particular regression.

With the regression equation shown above, with the selling price as the independent variable, it has explains that 75 percent of the variation in paint sales are in the sample.

e. Perform an analysis of variance on the regression, including an F-test of the overall significance of the results (at the 0.05 level).

The regression output gives the ANOVA or analysis of variance as:

dfSSMSF

Regression16489.816489.8124.03

Residual82160.19 270.02

Total9 8650

H0: 2=0 Ha: 2 0

Therefore, F = MSR / MSE F = 6489.812 / 270.024 F = 24.03

Since the calculated F-value is greater than the F-value from the table (F.05,1,8 = 5.32), one rejects the null hypothesis at the 0.05 significance level that there is no relationship between selling price and paint sales. Therefore, there is no relationship between selling price and the sales of paint for the company.

f. Based on the regression model, determine the best estimate of paint sales in a sales region where the selling price is RM14.50. Construct an approximate 95 percent prediction interval.

The Excel regression gives the following information on R2 and the standard error of estimate:REGRESSIONSTATISTICS

Multiple R0.87

R Square 0.75

Adjusted R Square0.72

Standard Error16.432

Observations10

Xp = $14.50 se = 16.432

Therefore, Y' = 390.376 14.263 (14.50) Y' = 183.563, which can be written as 183,563 gallons.

Y' - 2se = 183.563 2(16.432) Y' - 2se = 150.699 Y' + 2se = 183.563 + 2(16.432)Y' + 2se = 216.427

Therefore, the estimate of paint sales in a sales region where the selling price is RM14.50 are from 150,699 gallons to 216,427 gallons.

g. Determine the price elasticity of demand at a selling price of RM14.50.

ED = (dY / dX2) (X2 / Y)ED = 14.263 (14.50 / 183.563)ED = 1.13, which is elastic.

2. Suppose one is interested in developing a multiple regression model with paint sales (Y) as the dependent variable and promotional expenditures (A) and selling price (P) as the independent variables.

a. Show the estimated regression equation.

Dependent variable: SALES N: 10Multiple R: 0.874 Squared multiple R: 0.764Adjusted squared multiple R: 0.697Standard error of the estimate: 17.062

VariableCoefficientStandard errorStandard CoefficientT

CONSTANT344.58584.24504.09

PROMEXP0.1060.1640.1770.648

SELLPR-12.1124.487

SourceSum-of-squaresDFMean-squareF-ratioP

Regression6612.20323306.10211.3570.006

Residual2037.7977291.114

The answer is, Y = 344.585 + 0.106X1 12.112X2

b. Give an economic interpretation of the estimated slope (bs) co-efficient.

b1 = 0.106 whereby, a one-unit (if $1,000) increase in promotional expenditures, it will increases the expected sales by 0.106 (x 1,000), which is 106 gallons of paint with all the other things being equal.

b2 = -12.06 whereby, a one-unit (if $1,000) increase in the selling price, it will decreases the expected sales by 12.112 (x 1,000) which is 12,112 gallons of paint with all the other things being equal.

c. Test the hypothesis (at the 5 percent level of significance) that there is no relationship between the dependent variable and each of the independent variables.

The computer output indicates that only selling price (X2) is statistically significant at the 0.05 level. The t-value for significance is t (0.25, 7) = 2.365.

d. Determine the coefficient of determination.

R2 = 0.764 whereby the model explains about 76.4 percent will be the variation in paint sales for the company.

e. Perform an analysis of variance on the regression, including an F-test of the overall significance of the results (at the 5 percent level).

At the 5 percent level, the F variables of variance on the regression are very useful in explaining the sales of paint for the company.

f. Based on the regression model, determine the best estimate of paint sales in a sales region where promotional expenditures are RM80(000) and the selling price is RM12.50.

Y' = 344.585 + 0.106X1 - 12.112X2Y' = 344.585 + 0.106(80) - 12.112(12.50) Y' = 201.665Therefore, the answer is 201,665 gallons of the estimated of paint sales.

g. Determine the point promotional and price elasticity at the values of promotional expenditures and selling price given in part (f).

EA= (Y / X1) (X1 / Y) at the base level in section (f). EA = 0.106 (80 / 201.665) EA = 0.0420 EL= (Y/X2)(X2/Y) EL= 12.112 (12.50/201.665) EL = 0.751

PART 3

The Lumins Lamp Company, a producer of old-style oil lamps, estimated the following demand function for its product:Q = 120,000 10,000Pwhere Q is the quantity demanded per year and P is the price per lamp. The firms fixed costs are $12,000 and variable costs are $1.50 per lamp.

a. Write an equation for the total revenue (TR) function in terms of Q.

P = (120,000 - Q) / 10,000 P = 12 Q / 10,000Q = 120,000 10,000P

Total Revenue, TR = Price (P) x Quantity (Q) TR = (12 Q / 10,000) x (120,000 10,000P) TR = 12Q - Q^2 / 10,000The answer is, The Total Revenue, TR = 12Q - Q^2/10,000.

b. Specify the marginal revenue function.

Total Revenue, TR = 12Q - Q^2 / 10,000Marginal Revenue, MR = 12 (2 x Q^2-1 / 10,000)MR = 12 Q 5,000The answer is, the Marginal Revenue, MR = 12 5,000Q.

c. Write an equation for the total cost (TC) function in terms of Q

Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x Quantity (Q) ] TC = FC + VC (Q)TC = 12,000 + 1.5QThe answer is, the Total Cost, TC = 12,000 + 1.5Q.

d. Specify the marginal cost function.

Marginal Cost Function (MC) = TCTC = 12,000 + 1.5QMC = 0 + (1 x 1.5Q^1-1)MC = 1.5The answer is, the Marginal Cost Function, MC = 1.5.

e. Write an equation for total profits () in terms of Q. At what level of output (Q) are total profits maximized? What price will be charged? What are total profits at this output level?

Profits () = Total Revenue (TR) Total Cost (TC) = 12Q - Q^2 / 10,000 - 12,000 - 1.5Q = -Q^2 / 10,000 + 10.5Q - 12,000Total profits () in terms of Q is = -Q^2 / 10,000 + 10.5Q - 12,000.

Total profits will be maximized when;Marginal Revenue (MR) = Marginal Cost (MC)MR [ 12 Q 5,000 ] = MC [ 1.5 ]12 Q / 5,000 = 1.5Q / 5,000 = 10.5Q = 10.5*5,000 Q= 52,500 unitsTotal profits maximized at the quantity of Q at 52,000 units.

To find the Price of every unit that will be charged;Q = 52,000 unitsP = 12 Q / 10,000

P = 12 - 52,500 / 10,000 P = $6.75The price will be charged at, $6.75 per unit.

To find the total profit at this output level;Q = 52,000 unitsProfit, = -Q^2 / 10,000 + 10.5Q - 12,000 = -52,500^2 / 10,000 + 10.5*52,500 - 12,000 = $263,625The total profit at this output level is $263,625.

f. Check your answers in Part (e) by equating the marginal revenue and marginal cost functions, determined in Parts (b) and (d), and solving for Q.

Q = 52,000 unitsMR = 12 - Q/5,000MC = 1.5

MR= MC12 Q / 5,000= 1.512 Q / 5,000 = 1.5- Q / 5,000 = 1.5 12- Q / 5,000 = -10.5Q = 52,000Therefore, the answer is, 12 Q/5,000 = 1.5

g. What model of market pricing behaviour has been assumed in this problem?

As the Price of the product is $6.25 and is higher than MR = MC = 1.5, this is a monopolistic market or the market of monopolistic competition whereby it is hard for any other competitor to enter the market and make them theirs. When the company is in the monopolistic market, therefore, they can easily grab the market demand just on their own.

PART 4a. Develop a payoff matrix for this decision-making problem.

The payoff matrix for Toshiba and Hitachi is:

TOSHIBA

Limited Advertising CampaignExtensive Advertising Campaign

HITACHILimited Advertising Campaign$7.5; $7.5(Million Dollar)$4.0; $9.0(Million Dollar)

Extensive Advertising Campaign$9.0; $4.0(Million Dollar)$5.0; $5.0(Million Dollar)

b. In the absence of a binding and enforceable agreement, determine the dominant advertising strategy and minimum payoff for Hitachi.

The dominant advertising strategy for Hitachi is an Extensive Advertising Campaign. It yields a guaranteed minimum profit for example, the security level of $5.0 million, regardless of which strategy Toshiba chooses to use in the business strategy which is the Extensive Advertising Campaign.

c. Determine the dominant advertising strategy and minimum payoff for Toshiba.

The dominant advertising strategy for Toshiba is also the Extensive Advertising Campaign because this strategy yields a guaranteed minimum profit of $5.0 million, regardless of which strategy Hitachi chooses to use in the business strategy which is the Extensive Advertising Campaign.

d. Explain why the firms may choose not to play their dominant strategies whenever this game is repeated over multiple decision-making periods.

The firms may decide to engage in limited cooperation, such as a "tit-for-tat" strategy, when the game is recurring over multiple decision-making periods.

By selecting such a strategy it may be possible for the firms to earn profits 50% above the guaranteed minimum payoff.

If in the first period, each cooperate, both are better off. If either violates the trust by engaging in extensive advertising in a subsequent period, the other reacts by also using extensive advertising.

The thought that the stream of $7.5 million is cut down to $5 million if either violates the collusive agreement helps firms in repeated games to decide to cooperate.