Seperation of Ownership and Control

6.2 of The Economy 1.0 & The Economy #4

What does residual claimant entail?

-The person who takes all the income left over from a firm/project after the payment of all contractual costs.

Why do owners claim the residual claimants of the firms?

-The firm profit’s, which are the residual as it is after all costs and taxes are factored in, go towards the firm owners because profits legally belong to the owners.

What does the division of revenue in a firm infer?

-Should the firm’s revenue rise because managers or employees become more productive, the owners will benefit, but the managers and employees will not.

-Thus, all actors may not have the same interests at heart, even if they do want the firm to succeed.

What does a share mean?

-Part of the assets of a firm that may be traded. Gives the holder the right to have a slice of the firm’s profits, and to benefit when a firm’s assets become more valuable

-Also known as common stock

How can the separation of ownership and control occur?

-In small firms, owners usually are the managers, who may also be the employees. The owners will do all jobs simply because there is not enough revenue to hire others

-In large firms, many owners exist because of shares being issued. Thus, a group of specialised managers acts on behalf of the owners. They essentially control the firm

-And here, when senior management can decide on other people’s (owners) funds, a separation is in play

Why may a separation of ownership and control lead to conflicts of interest?

-What management does can affect profits, and profits affect the incomes of owners. So they have a keen interest here

-But management may not align with the notion of maximising profits, but rather to bill the company card, increase their own power, or whatever is not in harmony with the owner’s interests.

-Of course, owners don’t need to maximise their profits, but any loss in profits is a direct cost to their projects.

What does Adam Smith say about senior management?

-That senior management will not treat other people’s money as they would treat their own money. They will be more negligence and waste will follow.

How can owners incentivise management to serve their interests?

-Structure contracts such that managerial compensation depends on the performance of the firm’s share price.

-Let the board of directors, which reflects the owners and usually has shares of its own, monitor management’s performance, and it can lead to dismissal.

Why do we assume the firm wants to maximise profits?

-The owner’s wealth is literally due to the firm’s profits

-Market competition will punish/eliminate firms that don’t make good enough profits for their owners.