GAME THEORY - Attempts to Model and Predict the Outcome of Conflict Between Rational Individuals

MODULE 7 - AN ANALYSIS of CONFLICT

UNDERSTANDING GAME THEORY

GAME THEORY - attempts to model and predict the outcome of conflict between rational individuals.

Characteristics: - models interaction of 2 or more players - occurs in presence of uncertainty and information asymmetry - each player is assumed to maximize his/her expected utility

Contrast to: * Decision theory that has single player, playing a game against the states of nature * Market theory that has many players in which no one player's actions can influence the market

In game theory 1 player does influence the other player(s)....leads to conflict aspect.

Co-operative game - parties can enter into a binding agreement (ex cartel) Non co-operative game - no binding agreements to control actions of parties

NON –COOPERATIVE GAMES OF MANAGER- INVESTOR CONFLICT

Conflict occurs because investors & managers have differing objectives: * Investors want relevant & reliable F/S * Managers want to present firm in best light (could bias or manipulate F/S)

Typically considered a non-cooperative game since difficult to have binding contract:  costly to prepare contracts (negotiating diff contracts w/ diff investors)  costly & difficult to enforce (audit req'd for each user)

Nash Equilibrium - the only strategy pair such that given the strategy choice of the other player, each player is content with his/her strategy (both chose same strategy pair).

Initial choice of a non-cooperative solution is “unconstrained maximization”.

Other options to move towards a more satisfactory outcome (ie more co-operative): 1. Enter a binding agreement to choose that outcome 2. Change payoffs by introducing severe penalties for a specific choice 3. Develop sufficient trust that both parties are willing to choose the more cooperative outcome

Moral principles could be applied to enable parties to commit to a co-operative solution.  Help players realize the benefits of playing the moral strategy as well as the costs of deviating  Encourage transparency to generate trust between contracting parties i.e. develop sufficient trust that both parties are willing to choose the more cooperative outcome”

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Per Danielson:  Initial choice of a non-cooperative solution is “straight forward maximization”.

Moral principles could be applied to enable parties to commit to a co-operative solution. Leads to:  Constrained maximization - recognition of a longer term benefit (give up short term benefits)

CO-OPERATIVE GAME THEORY MODELS

AGENCY THEORY - a version of game theory which models the process of contracting between 2 or more persons. This involves conflict since each party in the contract wants the best deal for him/herself.

Most common contracts for business firms: 1. Employment contracts - between the firm & its managers (firm is principal and managers are agents) 2. Lending contracts - between the firm and its lenders (lender is principal and firm manager is agent)

Contracts typically depend on reported NI: * Employment contracts - managerial bonuses based on NI (incentive for managers) * Lending contracts - inclusion of covenants (protection for lenders)

Co-operation comes in to play in a game situation when players enter agreements they perceive as being binding. (Ex. employment contract; lending contracts)

Note that agency theory contracts have both cooperative and non-cooperative characteristics: - both parties choose their actions non-cooperatively - but need to be able to commit to the contract

The action of the agent affects the distribution of the payoffs in that: Greater effort put into the operation => higher probability of high payoff => lower probability of low payoff

Effort considered to be a range of activities that could include:  work longer and harder  be responsible for running firm prudently  motivate employees and supervise them conscientiously  not take advantages of opportunities at expense of firm

Note: payoff must be observable to both parties (onus on accountants to report info fully & accurately so both players are willing to accept reported NI as measure of the payoff).

Reservation utility - mgr has alternative opportunity for use of his/her time (this represents the utility of the alternative opportunity. (Utility from remuneration must be higher or the mgr goes elsewhere).

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Effort averse - dislike of effort. Harder one works, the more one dislikes it.

Disutility of effort - dislike of effort reduces utility by X. The amount of this reduction is the disutility. (Subtract the disutility from the utility derived from remuneration)

Moral Hazard - tendency of agent to shirk.

Agency Theory works to control manager shirking by basing manager compensation on a performance measure that is correlated with manager effort.

MANAGERS’ INFORMATION ADVANTAGE

EARNINGS MANAGEMENT

Managers frequently engage in earning management as predicted by Positive Accounting Theory. Net income does have a role as a performance measure but we need to recognize that the manager could bias or otherwise manage reported earnings.

Manager information advantage:  Manager could have information about the payoff prior to signing the compensation contract (pre-contract information)  Manager could obtain payoff information after signing the contract but prior to choosing an act (pre-decision information)  The manager receives information after the act is chosen (post-decision information)

Typically means that the manager is more likely to shirk, having knowledge of the payoff, and the owner’s expected utility will reflect the lower expected payoff.

Earnings management is possible since the manager controls the firm's accounting system. When net income is the performance measure, the owner can only observe an earnings number reported by the manager, which could be different than the earnings number resulting from application of accounting policies that best inform investors.

Revelation Principle

Definition: for any contract under which a manager has an incentive to lie about his/her private information, an equivalent contract can be designed that motivates truth-telling.

Several conditions must be met for this to hold:  The owner must be able to commit that the truth will not be used against the manager  There must be no restrictions on the form of the contract  There must not be any restrictions in the manager’s ability to communicate his/her information

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Overall – means we cannot rely on the revelation principle to assure us that the most efficient compensation contract involves truth telling. It is unlikely that the revelation principle can eliminate earnings management.

Note that GAAP (when accompanied by a credible audit) also fulfills a corporate governance role. GAAP does allow some discretion in choice of accounting policies but there is a structure to GAAP and it does limit the amount by which earnings can be managed.

AGENCY THEORY: OWNER- MANAGER EMPLOYMENT CONTRACT

Separation of ownership & management; running organization requires skills.

Owner's options are:

1.Hire manager and put up with manager putting in less than desired effort

2.Directly monitor manager First best - gives the owner the maximum attainable utility and meets the agent's reservation utility; no risk imposed on agent 3.Indirectly monitor manager (changing payoffs - moving support)

4.Owner rents firm to manager (mgr internalizes the owner’s decision problem)

5.Manager gets a share of payoff Second best - ie best that can be achieved under the circumstances but provides less utility to the owner than the first best contract; imposes some risk on agent and agency costs on principal

Fixed Support - possible payoffs are fixed regardless of the action chosen

Moving Support - set of possible payoffs is different depending on which action is taken.

Incentive compatibility - agent's incentive to take a specific action is compatible with the owners’ best interests.

Agency Cost - represents cost to the owner of the information asymmetry b/w owner & mgr (owner cannot observe mgr effort)

Note: if owner can observe manager’s effort, then the optimal compensation contract is to pay a fixed salary (cost of manager compensation is typically lowest under this option).

AGENCY THEORY: BONDHOLDER- MANAGER LENDING CONTRACT

Lending contracts - binding commitments in terms of debt covenants (legally binding) where mgrs commit not to act in a manner that is against the lender's interests.

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Covenant is inserted into the lending agreement (ex limit dividends; additional borrowing; maintain specific F/S ratios which relate to liquidity)

Lender changes the assessed probabilities of acts; thus firms are able to borrow at lower rates.

IMPLICATIONS OF AGENCY THEORY FOR ACCOUNTING

Net income and key balance sheet ratios have desirable properties for contracting -> correlation with effort

To use reported NI and balance sheet ratios as a basis for contracting owners/lenders must have confidence that the number has not been biased or manipulated. Hence, use of GAAP (provides structure to calculation of net income) and auditing (adds credibility).

Use of two performance measures in a compensation contract Given payoff observability, a contract based on payoff is less efficient than first best.

Holmström Agency Model (1997) Holmström’s study asked whether the second best contract could be made more efficient by basing it on a second variable in addition to payoff. (Does basing the contract on both net income and share price reduce the agency costs of the second best contract?)

Yes – if the second variable is also jointly observable and conveys some info about mgr effort beyond that contained in the payoff measure itself. (This will be the case for share price.)

Implies that both net income and share price can be useful payoff measures in employment contracts, since each reveals different information about the manager’s effort. Even if the second variable is noisy (ex. share price can be quite volatile) it can increase efficiency of the second best contract if it does contain some additional effort info.

(Implication is that net income also competes with other info sources for motivating managers under agency theory.)

Characteristics of good performance measures

Sensitivity - strengthens the connection between manager effort and the performance measure (makes it easier to motivate that effort).

Precision - reflects the probability that the performance measure will differ from the payoff -> high precision means low probability of difference (precision reduces manager’s compensation risk).

There is a trade-off between these two desirable characteristics.

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Investors' interests are best served by earnings information that represents a trade- off between relevance and reliability.

Managers' (and owners') legitimate interests are best served by earnings information that represents an efficient trade-off between sensitivity and precision.

Note: earnings information that best meets investor interests does not always best meets manager and owner interests – hence conflict between the interests of manager and investors.

CONTRACTS – RIGID & INCOMPLETE

Contracts tend to be rigid once they are signed. This is a concern if a new accounting standard impacts key calculations in the contract. Typically, a manager cannot simply renegotiate affected contracts (hence accounting policies do matter)

It is generally impossible to anticipate all contingencies when entering into a contract - thus would be an incomplete contract if it does not anticipate all possible state realizations (hence will result in economic consequences.)

Reconciliation of Efficient Securities Market Theory with Economic Consequences

* Agency theory enables a reconciliation of efficient market theory & economic consequences. Economic consequences are rational result of constraints resulting from binding contracts

* Financial statement variables (e.g. net income, balance sheet ratios) haev desirable properties for contracting purposes

* Agency theory implies that GAAP & auditing are important in providing credibility to NI (basis for contracting)

CALCULATIONS TO KNOW:

 Be able to identify Nash Equilibrium(s)  Be able to calculate Owner Manager utility comparisons - fixed support; moving support; rent; share of payoffs  Be able to calculate Bondholder Manager expected returns