Chapter 9
Analysis on Conflict
Summary and Quiz
Chapter 9
ANALYSIS OF CONFLICT
9.2 – GAME THEORY
Game Theory attempts to model and predict outcomes of conflict between rational
individuals. It models the interaction between two or more players in the presence of
uncertainty and information asymmetry. Game Theory requires that players formally take
the actions of the other players into account, making it more complex than decision
theory and theory of investment. The number of players in a game theory is sufficiently
small that the actions of one player do influence the other players. One way to classify
these games is as cooperative (parties enter into a binding agreement) and noncooperative.
9.3 – NON-COOPERATIVE GAME MODEL OF MANAGER-INVESTOR
CONFLICT
When making decisions, investors are aware that managers do not always reveal all
information. It is too difficult and costly to provide each investor with desired
information about the company. Game Theory assumes each player chooses a strategy
without knowing the strategy choice of the other. Strategy Pair is a statement of the
strategy taken by each party. Nash Equilibrium is the only strategy pair, such that given
the strategy choice of the other player, each player is content with their strategy and does
not wish to depart from their choice. Nash equilibrium is the predicted outcome of a noncooperative game.
In single-person decision theory, nature is an impartial force that does not think and the
strategy chosen by an investor does not affect these probabilities of nature. This theory
breaks down when the payoffs are generated by a thinking opponent (a manager) rather
than by nature, which leads us to the game theory.
9.4 – COOPERATIVE GAME THEORY
Players engage in a game situation when entering into agreements they perceive as
binding (i.e. contracts). There are two important contracts:
1. Employment contracts - between firm and its managers
2. Lending contracts - between the firm and its lender
In these contracts, one party is the principal and the other is the agent. Agency theory is
a branch of game theory that studies the design of contracts between two or more people.
It motivates a rational agent to act on behalf of a principal when the agent’s interests
would otherwise conflict with those of the principal. It has characteristics of both
cooperative and non-cooperative games. Two parties do not specifically agree to take
certain action but rather the actions are motivated by the contract itself.
9.4.2 – AGENCY THEORY: EMPLOYMENT CONTRACT
It assumes the payoffs are observable by both parties. It puts onus on firm’s accounting
policies to report information fully and accurately, so both parties in the game are willing
to accept reported net income as a measure of the payoff.
Reservation utility is the minimum utility a manager will accept before deciding to go
elsewhere. One player will not choose an act desired by another player because that
player says so. Each player chooses the act that maximizes his or her own expected
utility. Utility maximizing behaviour by all parties is one of the important and
distinguishing characteristics of positive accounting theory and economic theory of
games.
Effort-Adverse - the manager dislikes effort; the greater the level of effort, the greater
the dislike. This disutility of effort by the agent is subtracted from the utility of
remuneration of the agent. As a result, the agent will choose to shirk instead of work hard
and this creates a moral hazard situation.
Options available to control moral hazard:
1. Hire manager and accept the shirk work – unlikely to occur
2. Direct monitoring (First-Best contract)

Ex. manager is paid $25 if alt. 1 is chosen and $12 if alt.2 is chosen

Gives the owner maximum attainable utility and gives the agent reservation
utility.

Risk-sharing properties – risk-neutral owner bears all the risk; if owner is
risk-adverse, manager and owner share risk.

First-best contract often unattainable – difficult to determine effort of
manager.
3. Indirect monitoring

Does not work for fixed support cases - possible payoffs is fixed regardless
which action is taken

Moving support – the set of possible payoffs differ depending on the actions
taken

Cannot ensure first-contracts will be attained because many contracts use
fixed support

If the moving support holds, legal/institutional factors prevent owner from
penalizing manager sufficiently to force a better alternative.
4. Owner rents firm to manager

Owner guaranteed fixed rent no matter what and does not care about the
actions of the manager (this is called internalizing the manager’s decision
problem)

Manager bears all the risk
5. Give manager a share of the payoff (most efficient alternative after first-best)

Manager given a certain percentage of the payoff

Contract motivates the manager to choose the best alternative for the principal
(called incentive-compatibility because manager’s incentive is compatible
with owner’s interests) – interests are aligned

Risk is shared

Second-best - most efficient contract short of first-best
Summary
Agency theory studies how to design the optimal contract with the lowest possible cost.
Contracts can only be written in terms of performance measures that are jointly
observable by both principal and agent.
-
If the agent’s effort can be observed, directly or indirectly, a fixed salary is the
optimal solution when the principal is risk neutral. (Effort is the performance
measure)
-
If effort cannot be observed, but payoff can, the optimal contract will give the
agent a share of the payoff. Agent will be motivated but is second best
because of the additional risk imposed on the agent. (Payoff is the
performance measure). Payoff is usually measured in terms of net income.
The higher the correlation between net income with effort, the closer the
second-best contract is to first-best contract and the lower the agency costs for
the owner (“hard income”).
-
If neither payoff nor effort can be observed, the optimal contract is a rental
contract, where the principal rents the firm to the manager for a fixed rental
rate, thus internalizing the agent’s effort decision (no performance measure)
Share price is another way to measure firm’s performance and most efficient payoff
depends on firm’s organizational structure and environment.
9.4.3 – AGENCY THEORY: BONDHOLDER-MANAGER LENDING
CONTRACT
Even in lending contracts, there exists a moral hazard problem where the managers may
act contrary to the best interests of the lenders. Rational lenders will raise their interest
rates and managers may commit not to act against the lender’s interests by entering into
covenants. The manager agrees to limit dividends, or limit additional borrowing while
loan is outstanding. With these covenants, a firm is able to lower the interest rates
charged by the lender.
9.5 – IMPLICATIONS OF AGENCY THEORY FOR ACCOUNTING
Holmstrom’s Agency Model
Assumes the agent’s effort is unobservable by the principal, but payoff is jointly
observable. Payoffs can be measured through net income, but principal may not believe
net income is creditable because the manager controls the accounting system and policies
used; thus, GAAP and auditing play a role in contracting. GAAP limits a manager’s
incentive to influence reported net income and auditing adds creditability.
Contracts based on payoff are less efficient than first-best; raising questions of whether
second-best can be made more efficient by biasing it on a second variable such as shareprice. Both net income and share price can be used to reduce agency costs provided both
variables are observable and conveys information about manager’s effort. Analysis
shows that no matter how noisy the second variable is, as long as it can be used to
increase efficiency of the second-best contract, it contains some additional information
about effort.
9.5.2 – RIDGITY OF CONTRACTS
Contracts tend to be rigid once signed. It is impossible to anticipate all contingencies
when entering a contract. Contracts that do not anticipate all possible state realisations are
called incomplete. Things that are hard to predict include a change in the way net income
or covenant ratios are calculated. Renegotiations are possible for incomplete contracts but
all or majority of bondholders would need agreement because bondholders need to be
compensated to positive changes in net income. Unforeseen state realizations impose
costs on firm and/or manager.
9.6 – RECONCILIATION OF EFFICIENT SECURITIES MARKET THEORY
WITH ECONOMIC CONSEQUENCES
Net income and other financial statement numbers matter to managers because manager’s
remuneration depends on net income and usually long term lending contracts involve
covenants where manager commits not to take certain actions that may be contrary to
lender’s interests. Nothing in the theory of efficient securities markets conflicts with
managerial concern about accounting policies. Considering both theories helps us see that
managers may well intervene in accounting policies even though these policies would
improve the decision usefulness of financial statement to investors. Agency theory is not
the only explanation for economic consequences, but also managers do not accept
securities market efficiency, believing that investor reaction and cost of capital are
affected by accounting policy choice irrespective of any impact on cash flow. Managers
believe that accounting policies are a way to communicate inside info to the market.
Chapter 9
Analysis Of Conflict
Multiple Choice (18 minutes)
Use the following utility table to answer question 1
INVESTOR
MANAGER
(investor, manager)
Honest (H)
Distort (D)
Buy (B)
12, 8
4, 16
Refuse to Buy (R)
7, 4
7, 6
1. For the non-cooperative game model above, which strategy pair represents the Nash
Equilibrium?
a.)
b.)
c.)
d.)
BH
RD
BD
RH
2. Which one of the following statements about Game Theory is false?
a.) Game theory models the interaction of two or more players, frequently in the
presence of uncertainty and information asymmetry.
b.) The number of players is sufficiently small that the actions of one player do
not influence the other players.
c.) The conflict aspect of a game is where the players take the actions of the other
players into account.
d.) Agency theory is a version of game theory that models the process of
contracting between two or more persons.
3. One way of classifying game theory is cooperative. A cooperative game is one:
a.) Where players in a game can enter into agreements that they perceive as
binding.
b.) That is concerned with two types of contracts, employment and lending
contracts.
c.) Where it is difficult to envisage a binding agreement between managers and
investors about what specific information is to be supplied.
d.) Both (a) and (b)
4. When a manager is said to be Effort-adverse, this means:
a.) The manager is indifferent to the effort he or she must contribute.
b.) The manager likes effort and the lower the effort level, the greater the dislike.
c.) The manager dislikes effort and the greater the level of effort, the greater the
dislike.
d.) None of the above.
5. An example of moral hazard is when a manager shirks. There are several ways to
control moral hazard, which option is an owner most likely will not choose?
a.)
b.)
c.)
d.)
Direct Monitoring
Hire the manager and put up with the shirking
Rent the firm to the manager
Give the manager a chare of the payoff
6. _________ is needed as a cost-effective way to put limits on the manager’s incentive
to influence reported income by selecting from alternative policies.
a.)
b.)
c.)
d.)
Risk Premium
An Audit
Internalizing
GAAP
7. It is generally impossible to anticipate all contingencies when entering a contract.
Contracts that do not anticipate all possible state realizations re termed:
a.)
b.)
c.)
d.)
Covenants
Complete
Incomplete
None of the Above
8. Auditing is needed to add ___________ to the reported net income number.
a.)
b.)
c.)
d.)
Credibility
Information
Volatility
Completeness
9. Agency theory contracts have characteristics of which of the following:
a.)
b.)
c.)
d.)
Cooperative games
Binding Games
Non-Cooperative games
Both a and b
Short Answer Questions (12 minutes)
1. What is agency theory? (2 minutes)
2. Briefly define the two important types of contracts of Cooperative game Theory.
(4 minutes)
3. There are different contracts that can be designed to control moral hazard; one option
is to use direct monitoring, which formulates a First-best contract. Briefly explain
First-best contracts. (6 minutes)
Chapter 9
Analysis Of Conflict
(Solution Key)
Multiple Choice (18 minutes)
Use the following utility table to answer question 1
INVESTOR
MANAGER
(investor, manager)
Honest (H)
Distort (D)
Buy (B)
12, 8
4, 16
Refuse to Buy (R)
7, 4
7, 6
1. For the non-cooperative game model above, which strategy pair represents the Nash
Equilibrium?
a.)
b.)
c.)
d.)
BH
RD
BD
RH
2. Which one of the following statements about Game Theory is false?
a.) Game theory models the interaction of two or more players, frequently in the
presence of uncertainty and information asymmetry.
b.) The number of players is sufficiently small that the actions of one player
do not influence the other players.
c.) The conflict aspect of a game is where the players take the actions of the other
players into account.
d.) Agency theory is a version of game theory that models the process of
contracting between two or more persons
3. One way of classifying game theory is cooperative. A cooperative game is one:
a.) Where players in a game can enter into agreements that they perceive as
binding.
b.) That is concerned with two types of contracts, employment and lending
contracts.
c.) Where it is difficult to envisage a binding agreement between managers and
investors about what specific information is to be supplied.
d.) Both (a) and (b)
4. When a manager is said to be Effort-adverse, this means:
a.) The manager is indifferent to the effort he or she must contribute.
b.) The manager likes effort and the lower the effort level, the greater the dislike.
c.) The manager dislikes effort and the greater the level of effort, the greater
the dislike.
d.) None of the above.
5. An example of moral hazard is when a manager shirks. There are several ways to
control moral hazard, which option is an owner most likely will not choose?
a.)
b.)
c.)
d.)
e.)
Direct Monitoring.
Hire the manager and put up with the shirking.
Rent the firm to the manager.
Give the manager a share of the payoff.
Direct Monitoring
6. _________ is needed as a cost-effective way to put limits on the manager’s incentive
to influence reported income by selecting from alternative policies.
a.)
b.)
c.)
d.)
Risk-Premium
An Audit
Internalizing
GAAP
7. It is generally impossible to anticipate all contingencies when entering a contract.
Contracts that do not anticipate all possible state realizations re termed:
a.)
b.)
c.)
d.)
Covenants
Complete
Incomplete
None of the above.
8. Auditing is needed to add ___________ to the reported net income number.
a.)
b.)
c.)
d.)
Credibility
Information
Volatility
Completeness
9. Agency theory contracts have characteristics of which of the following:
a.)
b.)
c.)
d.)
Cooperative Games
Binding Games
Non-Cooperative Games
Both (a) and (b)
Short Answer Questions
1. What is agency theory? (2 minutes)
Agency theory is a type of game theory. It studies the design of contracts to
motivate a rational agent to act on behalf of a principal when the agent’s
interests would otherwise conflict with those of the principal.
2. Briefly define the two important types of contracts concerned with Cooperative game
Theory. (4 minutes)
The two types of contracts concerned with cooperative theory are employment
contracts and lending contracts.
Employment contract is between the firm and its top manager. The main
concern of employment contracts is moral hazard due to shirking. The goal here
is to align the interests of both the owner and the manager.
Lending contract is between the firm and the bondholder. Managers may act
contrary to the best interest of the lenders, which causes rational lenders to
increase interest rates. Covenants are inserted into lending agreements to get
managers to act in the best interest of the lenders.
3. There are different contracts that can be designed to control moral hazard; one option
is to use direct monitoring, which formulates a First-best contract. Briefly explain
First-best contracts. (6 minutes)
Under direct monitoring, a manager’s contract would be amended to pay a
salary that depends on the closeness of the manager’s decision to the interest of
the owner. For example, paying a salary of $25 for choosing to work hard or $12
for shirking.
The owner (principal) receives a maximum attainable utility and gives the
manager (agent) the reservation utility. A risk-sharing property arises where
the manager bears no risk because a fixed salary is received, regardless of the
payoff. If the manager is risk-adverse, this option is desirable. The owner, on
the other hand, bears all the risk of the random payoff. If the owner is riskneutral, he or she does not mind bearing all the risks.
Usually, first-best contracts are unattainable because it is unlikely the owner
could monitor the agent’s effort in a managerial setting. As well, information
asymmetry plays a factor due to the fact the owner is unaware of the manager’s
effort level; only the manager knows the amount of effort he puts in.