Microeconomics for MBAs 46

Second, studies indicate that a corporation’s stock price generally increases when the corporation announces increased spending on investment, and generally decreases when a reduction in

Consider a decision facing you as a manager on whether to commit to an

expensive research and development project that will reduce profits over the near term

but which is expected to more than offset this loss with higher profits in the future

Should you be fearful that investing in this project will, because of the reduction in

current profits, drive the price of your stock down, making your corporation more

vulnerable to a hostile takeover? The answer is probably no, especially if your estimate

of the long-run profitability of the R&D project is correct There are two good reasons

for believing this First, the obvious fact that price-earnings ratios vary widely between

different stocks provides compelling evidence that stock prices reflect more than current

profits Second, studies indicate that a corporation’s stock price generally increases when the corporation announces increased spending on investment, and generally decreases

when a reduction in investment spending is announced.19 A study by Brownyn Hall

found that, over the period 1976-85, the firms taken over by other firms did not have a

higher R&D to sales ratio than did firms in the same industry that were not taken over.20 There is no reason for managers to become short sighted because of the threat of a hostile takeover Indeed, the best protection against a takeover, hostile or otherwise, is to make decisions that increase the long-run profitability of the corporation, even if those

decisions temporarily reduce profits

What about the fact that once a corporation is taken over it is sometimes broken

up as the acquiring firm sells off divisions, often profitable divisions? Isn’t this

disruptive and inefficient? There is no doubt that takeovers are disruptive, particularly

when they result in parts of the acquired firm being spun off But disruption is not

necessarily inefficient Indeed, any economy that hopes to be efficient has to motivate

rapid responses to changing circumstances, and those responses are necessarily

disruptive Making the best use of resources in a world of advancing technologies,

improved opportunities, and global competition requires continuous disruption The

alternative is stagnation and relative decline

Many of the mergers that took place in the 1960s and 70s created large

conglomerate structures that, even if efficient at the time, soon ceased to be efficient

Increased global competition began rewarding smaller firms with quicker response times

to changing market conditions Technology reduced the synergies that might have existed

at one point by having different products produced within the same firms It became less costly for firms to buy inputs and components from other firms, thus increasing the

ability to specialize in their core competencies (in the vernacular of earlier chapters,

transaction costs fell)

In many cases these changes made the divisions of the corporation worth more as separate firms than as parts of the whole Many managers, however, prefer to be in

charge of a large firm than a small one and are reluctant to divest divisions that are worth

more by themselves or as part of another organizational structure This extant managerial reluctance of the 1960s, 1970s, and into the 1980s was partly responsible for the

depressed stock prices that corporate raiders were able to take advantage of by buying a

19

John J McConnell and Chris J Muscarella, “Capital Expenditure Decisions and Market Value of the Firm,” Journal of Financial Economics, vol.14 (1985), pp 399-422

20

Hall’s study is discussed by the Jensen article cited in footnote 3

controlling interest in conglomerates and then increasing their total value by spinning off

some of their divisions.21

Another complaint about the spinning off of divisions and downsizing that often

accompanies takeovers is that workers are laid off The claim is made that while

stockholders may come out ahead, they do so at the expense of workers who lose their

jobs There is evidence that hostile takeovers do result in reductions in the work force

But the questions we want to consider are the following

• Is this a valid criticism of takeovers?

• Which workers are most likely to be laid off and how big is the cost to the

workers when compared against the gain to shareholders?

The fact that workers are laid off after hostile takeovers is consistent with the

view that these takeovers promote efficiency The most natural thing in the world for

managers to do when sheltered against the full rigors of competition is to let the

workforce grow larger than efficiency requires This is most evident in what are often

referred to as “bloated government bureaucracies” (a fact that is partially attributable to

the absence of the takeover option) But the same thing can and does happen in private

corporations, though generally to a lesser degree

Economic progress occurs most rapidly when there are strong pressures to

produce the same output with less effort, to lay off workers when they are no longer

needed This often causes dislocations in the short-run, but in the long run it increases

the availability of the most valuable resource (human effort and brainpower) to expand

output elsewhere in the economy So a strong case can be made that one of the

advantages of the market for corporate control is that it increases the pressure on

managers to keep the size of their workforce under control If there were an active

market for the control of government bureaucracies, where bureaucracy raiders could

profit from the savings realized by eliminating redundant government jobs, does anyone

doubt that these agencies would be run more efficiently – with far fewer workers?

Some of the efficiencies derived from hostile takeovers (and therefore some of the benefits to corporate shareholders) are the result of workers losing their jobs But what is the extent of this loss, and which workers are most likely to be laid off? To address this

question, 62 hostile takeover attempts (50 of which were successful) from 1984-1986

were examined.22 According to this study, layoffs were common, but seldom exceeded

10 percent of the workforce, and were typically far less than that Also, it was estimated that the probability of being laid off was 70 percent higher for white-collar workers than

for blue-collar workers The jobs of managers, not those of workers on the line, were

21

Others have explained the advantages of moving toward more smaller and more focused firms in terms

of improved, more efficient capital markets that have made it attractive for firms to substitute reliance on external capital markets for internal capital markets, which favor multi-division firms See Amar Bhide,

“Reversing Corporate Diversification,” Journal of Applied Corporate Finance, Summer 1990, vol 3

(Summer 1990), pp 70-81

22

See Sanjai Bhagat, Andrei Shleifer, and Robert W Vishny, “Hostile Takeovers in the 1980s: The Return to Corporate Specialization,” pp 1-72 in Martin N Bailey and Clifford Winston (eds.) Brookings Papers on Economic Activity (Washington, DC: Brookings Institution; 1990)

most at risk In addition, layoffs at targeted firms that were not taken over were greater

(as a percentage of the workforce) than those in firms that were taken over This suggests that the threat of a takeover provides a strong incentive for efficiencies even when no

takeover actually occurs

Takeover Defenses

Even if it is accepted that hostile takeovers are generally efficient, it doesn’t follow that

there should be no corporate defenses against such takeovers Ideally there should be

some resistance to takeover offers, but not “too much.” Neither efficiency nor the

interest of stockholders would be enhanced if the managers of a corporation simply

acquiesced to the first takeover bid that offered more for the corporation’s stock than the current price The first bidder is not necessarily the one best able to improve the

performance of the target corporation, and therefore the first bidder is not necessarily the one who can make the best offer By being able to mount some defense against hostile

offers, corporate managers can stimulate an aggressive auction that results in a winning

bid that more accurately reflects the value of the corporation

On the other hand, efficiency and the interests of shareholders can be harmed if

the defenses against takeover bids are too impenetrable If a takeover looks impossible,

no one will make the effort to acquire control of even the most poorly managed

corporation Also, a significant investment is involved on the part of an outsider to

determine the potential for improving the management of a target corporation and the

maximum price that can be paid for its stock and still make the takeover pay There is

little motivation to incur the cost of this investment unless it gives those who do so a

bidding advantage So takeover defenses that go “too far” in requiring the initial bidder

to make his information generally available can discourage takeover efforts to the point

of reducing the amount of the winning bid

No one can know exactly what is the best defense against a hostile takeover from the perspective of efficiency Obviously the most efficient defense will vary from

situation to situation But some types of defenses that managers can mount seem to be

more efficient than others

Interestingly, there is evidence that bringing litigation against bidders increases

the amount that is ultimately paid for the stock of the target corporation, assuming that

the target corporation loses the case.23 Managers of the target corporation can also

defend against a takeover by offering to repurchase the stock acquired by a raider at a

premiums; a practice known as greenmail Some studies indicate that greenmail imposes

significant negative returns on shareholders of the target (repurchasing) firm, but other

studies indicate that greenmail can result in small gains for the repurchasing firm’s

shareholders.24 Managers of the target corporation will want to be careful, however, if

23

Recall, unless otherwise indicated the studies cited are discussed in Jarrell, Brickley, and Netter, “The Market for Corporate Control: The Empirical Evidence Since 1980.”

24

Michael C Jensen and Richard S Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics, vol 11 (1983), pp 5-50; and Wayne H Mikkelson and Richard S

considering a policy of greenmail, since any gain to shareholders probably comes by

encouraging others to attempt a takeover in the hope of extracting greenmail Paying

greenmail on a consistent basis is obviously not a way of promoting the long-run

profitability of a firm

A very effective way for managers of a corporation to defend against a takeover is

through what is referred to as poison pills A poison pill describes a rule that allows

shareholders of the target corporation to acquire additional shares at attractive prices,

which serves to dilute the stock holding of the acquiring corporation Although there are

different types of poison pills, studies indicate that they are in general harmful to the

wealth of the target corporation’s shareholders.25

Managers can also protect themselves against takeovers by lobbying for

legislation that reduces the chances that a takeover will be successful Such legislation

imposes a variety of regulations on takeover activity, but the studies that have been done

suggest that, in general, they reduce shareholder wealth The stock price of firms

typically declines relative to the general stock prices when the state in which they are

incorporated passes anti-takeover legislation.26

Obviously, the interests of managers and those of shareholders are not in perfect

alignment in the case of takeovers But there are possibilities for overlap that are worth

noting A justification for a controversial severance-pay contract for top managers is

based on the desirability of reducing management opposition to takeover bids that benefit shareholders Top corporate managers are commonly granted what are referred to as

golden parachutes, which provide them with handsome compensation when they leave

the corporation Such compensation can be particularly useful in cases where top

managers have to invest heavily in knowledge that is highly specific to the corporation,

and therefore worth little elsewhere Golden parachutes can also encourage executives

to take greater risks, given that they know that they will receive a significant severance

pay package if the risks they take result in losses and they lose their jobs.27 The argument

is that when these managers are offered generous severance pay they are less likely to

oppose a takeover offer that promotes efficiency and increases shareholder wealth

Golden parachutes help bring the interests of top managers more in line with those of

their shareholders But as with all incentives, care has to be exercised Golden

Ruback, “An Empirical Analysis of the Interfirm Equity Investment Process,” Journal of Financial

Economics, vol 14 (1985), pp 523-553

25 Paul H Malatesta and Ralph A Walkling, “Poison Pill Securities: Stockholder Wealth, Profitability, and Ownership Structure,” Journal of Financial Economics, Journal of Finance, vol 20 (1988), pp 347-376

26

Michael Ryngaert and Jeffry Netter, “Shareholder Wealth Effects of the Ohio Antitakeover Law,” Journal

of Law, Economics, and Organization, vol 4 (1988), pp 373-383

27

In the absence of some form of handsome severance pay package, managers may be inclined to take too little risk, or less risk than the stockholders may want them to take The stockholders can have diversified portfolios of stocks and companies over which they can spread their risks Managers, on the other hand, can have a fairly narrowly invested portfolio, given that their talent, one of their biggest investments, is typically invested in one firm Without some incentive to do otherwise, managers may be inclined to protect their investments by investing their firm’s assets in safe ventures

parachutes should not be so lucrative that they make an executive indifferent about

keeping his or her job and losing it.28

Like all arrangements, golden parachutes can be poorly designed and abused It may make sense to provide golden parachutes to no more than just the CEO of a

corporation and a few members of the top-level management team Typically, a

significant number of managers are involved in facilitating a smooth transfer of control

But there is no reason to extend golden parachutes to managers not involved in such a

transfer Also, while golden parachutes can be too stingy to promote the shareholder

interests, they can also be too generous from the shareholders’ perspective Ideally,

golden parachutes will be provided only to those managers whose responsibilities are

relevant to a takeover, and the severance compensation provided will be tied to premiums

in share prices generated by the takeover

There is at least tentative support for the proposition that golden parachutes

promote the interests of shareholders According to one study of corporations that

adopted golden parachutes, corporate stock increases an average of about 3 percent when the adoption is announced One interpretation of this result is that the golden parachutes

increased the connection between the interests of shareholders and managers It is

possible, of course, that part of the increased stock value resulted from the belief that the announcement indicated that management was expecting a takeover bid and wanted to

protect themselves against it

* * * * *

The primary point of this chapter is that many so-called “hostile” takeovers are

not really hostile, at least not from the perspective of the owners of the corporation being taken over Throughout the chapter, we have suggested that hostile takeovers promote

efficiency by encouraging managers to behave as good agents for their stockholders

The efficiency of hostile takeovers will surely remain subject to debate And

certainly no serious person would argue that all hostile (or even friendly) takeovers are

efficient Mistakes are made in the market for corporate control that, after the fact, leave all parties worse off So the debate over hostile takeovers will continue, and so will

hostile takeovers Of course, from the perspective of most managers, the fact that hostile takeovers will continue is more important than the debate over their efficiency But the

best way for managers to protect themselves against unwelcome attention in the takeover market is to do a good job enhancing the long-term profitability of the firm And this is

probably the best argument in support of the efficiency of hostile takeovers Even if

every hostile takeover that is attempted was itself inefficient, the fact that they can and do occur creates a strong incentive for managers to manage firms efficiently on behalf of

their shareholders

28

For a more detailed discussion of golden parachutes, see Jensen, “The Market for Corporate Control.”

Concluding Comments

Although the analysis of imperfect competition tells us something about the working of

real-world markets, it does not answer all the questions economists have asked The

theories presented here have not done a good job of predicting the consequences of

imperfect competition Thus our conclusions regarding the pricing and production

behavior of firms in monopolistically competitive and oligopolistic markets are tentative

at best

Economists seeking to make solid, empirically verifiable predictions about market behavior rely almost exclusively on supply-and-demand and monopoly models

Although predictions based on those models may sometimes be wrong, they tend to be

easier to use and may be more reliable than predictions based on models of imperfect

competition Predictions aside, it is important to remember that most markets are

imperfect

In the Manager’s Corner for this chapter, we tried to show how markets for goods can be affected by the market for capital Indeed, the two markets are intrinsically bound

up together The competitiveness of the capital market – including the market for entire

firms – will act as a discipline on managers who might believe that they can take

advantage of their discretionary authority Capital markets also induce managers to find

the most cost-effective methods of production

Review Questions

1 Under what circumstances could a monopolistic competitor earn an economic

profit in the long run?

2 To achieve the efficiency of perfect competition, must a market consist of

numerous producers? If not, what other conditions are required?

3 How does the number of producers in a market affect the chances of forming a

workable cartel?

4 How do the costs of entering a market affect the chances of forming a workable

cartel?

5 Must a monopolist employer share the monopoly profits with the managers and

workers? If not, why not? If so, what does the “profit sharing” do to the

monopolist’s output level? Prices?

6 Should antitrust law attempt to eliminate all forms of imperfect competition?

Why or why not?

7 “In an economy in which resources can move among industries with relative ease,

a cartel attempting to maximize short-term profits will sow the seeds of its own

destruction.” Explain

8 How would a cartel in a market for a network good collude on price? Explain

9 Suppose that the managers of a firm allowed their internal departments to act as

little monopolies or suppose that the managers paid their workers more than the labor market would bear What would happen in capital markets? To the firm?

10 Would you expect government-run organizations to be more or less efficient than privately owned firms? Explain your answer with reference to capital markets

Business Regulation

If anyone can find such a thing as an “unregulated industry,” he can sell it at a profit to the Smithsonian

ame an industry that has not, in some way, been under the authority of a

government regulatory agency at some time At the start of the century such a

task would have been relatively simple Today, with government extending its

activities in all directions, it is not Almost every economic activity either is or has been,

at some time in the past, subject to some type of regulation at one stage in the

manufacturing, wholesaling, or retailing functions The list of federal regulatory agencies virtually spans the alphabet FAA, FDA, FEA, FPC, FRS, FTC, ICC, NTHSA, OSHA, SEC – to say nothing of the various state utilities commissions, licensing boards, health

departments, and consumer protection agencies As a result, it is much easier to list

regulated industries than to name an unregulated one Air transport, telephone service,

trucking, natural gas, electricity, water and sewage systems, stock brokering, health care, taxi services, massage parlors, pharmacies, postal services, television and radio

broadcasting, toy manufacturing, beauty shops, ocean transport, legal advice,

slaughtering, medicine, embalming and funeral services, optometry, oyster fishing,

banking, and insurance—all are regulated Regulation was in the 1960s and 1970s,

especially, one of the nation’s largest growth industries (although there was something of

a “recession” in regulations in the 1980s) Why have people been willing to substitute

the visible foot of government for the invisible hand of competition?

Explaining regulation why and how it happens is a major challenge to

economists.1 Although several insightful theories have been proposed, statistical tests of those theories are incomplete and are at times based on crude data Some instances of regulation or changes in regulatory policy cannot be explained by current theories At

best, we can only review what is known about regulation and project the economic

results

Today regulatory agencies are increasingly criticized by economists,

businesspeople, consumers, and consumer advocates The major concern is the extent to which regulation is designed to benefit the regulated industry Some critics want more

regulation, others less, depending largely on how they view the process of regulation

1

The major alternatives are reviewed in James C Bonbright, Albert L Danielsen, and David R

Kamerschen, Principles of Public Utility Rates, 2nd ed (Arlington, VA: Public Utilities Reports, Inc., 1988), Ch 2

N

To understand the controversy surrounding regulatory policy, we must first understand

the theory This chapter begins with a brief description of several major federal

regulatory agencies and then proceeds to the various theories

Major Federal Regulatory Agencies

Federal regulatory agencies have existed for about a century From their origins and

functions we can learn much about the regulatory process The four broad sectors of

interstate commerce that have been regulated, in some cases for almost one hundred

years, are communications, energy, transport, and urban services Most regulating

commissions—consisting of 3 to 7 members, typically appointed but sometimes

elected—try to achieve basic economic goals of efficiency, and promoting certain

social-political goals, including safety

Beyond setting minimum and maximum prices, government regulations often

control the entire rate structure of an industry They may limit entry into the industry or

stipulate what services and goods will be provided at what levels, and to whom

Regulatory approval is required to offer new services, or to expand, modify, curtail, or

abandon a particular service In short, regulation can and often does pervade all

dimensions of production and distribution

The Interstate Commerce Commission (ICC)

The Interstate Commerce Commission (ICC) was established n 1887 to deal with unfair

business practices in the railroad industry By the latter half of the nineteenth century,

railroad companies had overbuilt and were engaging in cutthroat competition through

customer rebates and price discrimination In self-defense, several companies had

formed a cartel to divide the market and set prices The ICC was established to protect

both consumers and small competitors and was supported by both the railroad and their

customers

Since then, the ICC’s regulatory authority has been expanded to cover all motor

carriers except airplanes engaged in interstate commerce—mainly trucks, boats, and

buses In the past, the commission has been authorized to set minimum and maximum

rates It is also responsible for ensuring adequate service The seven members of the

commission are nominated by the president and approved by the Senate for a term of

seven years No more than a simple majority of the commissioners may belong to the

same political party, and a commissioner may be removed for “just cause,” including

conflict of interest

Some muse that while regulation has tended to favor those who are regulated at

the expense of consumers, even the regulated industries have been harmed by regulation One economist put it this way:

A good way to understand what has happened [to railroads] is to imagine a

business that is prevented from adjusting its prices to changing market conditions and from negotiating with its customers Furthermore, imagine that the business

is not permitted to decide how much of its principal inputs to purchase, how much

it will pay for them or even how to use them, and it may not decide where it will

operate Worse yet, imagine that it faces strong competitors who are not

encumbered by similar constraints It would be surprising if such a business

survived at all This is only a slight exaggeration of the railroads’ position before

1980.2

For decades now, economists have advocated reducing the ICC’s power Finally,

in 1980 the trucking and railroad industries were partially deregulated Although the ICC

no longer sets truck rates and routes, it still controls market entry through its authority to

issue licenses

The Federal Trade Commission (FTC)

The independent five-member Federal Trade Commission (FTC) was an agency

established by Congress in 1914 to enforce the antitrust laws, especially the Clayton Act The Antitrust Division of the Department of Justice is the other federal antitrust

enforcement agency dealing especially with the Sherman Act FTC commissioners are

appointed and serve seven-year terms To carry out their duties, they are given the power

to probe through corporate records and summon corporate executives to hearings on

unfair competitive practices They can also issue formal complaints and order a company

to cease its illegal acts For example, state bar associations once restricted lawyers from advertising their services The FTC ordered a halt to such restrictions on the grounds that they thwarted competition

The Reagan administration tried to reduce the regulatory power of the FTC by cutting its budget—a ploy resisted by Congress In the early 1980s, however, FTC decisions began

to reflect the free market views of its new chairman, James C Miller, a Reagan appointee who later served as the head of the Office of Management and Budgeting

The Federal Communications Commission (FCC)

The Federal Communications Commission (FCC), established by the Communication

Act of 1934, regulates telephone, telegraph, and broadcasting companies Its seven

commissioners, who are appointed for seven-year terms, set rates for interstate telephone and telegraph services and issue licenses to radio and television stations The FCC

determines who can engage in broadcasting, and it prescribes the nature of broadcast

services, the location of radio and television stations, and the areas they serve Licenses

are issued for three years, after which the station’s programming is reviewed for license

renewal To ensure renewal, a station must engage in some public-service broadcasting

2

“The Track Record,” Regulation No 1 (1987): 23—24