Lecture 7: rational choice theory

Problem with Agency Theory

Assumption: managers are self-serving robber-barons Hence the goal of corporate governance is to design structures and mechanisms to contain managerial opportunism - e.g. incentive alignment schemes (e.g. performance pay for managers: bonuses, options, shares) But these can make managers: - overly selfish if they were selfish already - selfish if they were not yet selfish Or lead to a double hermeneutics

Individualism

Causal accounts of social phenomena explain how they derive from the actions and motivations of individual agents. Does not allow for trait-based differences across individuals; all observed behavioral differences are explained situationally through incentives or endowments.

Agency Theory as Rational Choice Why individualism?

- Agency theorists are not interested in character- or identity-based differences across CEOs - CEOs are assumed to be rational - Pay differences amongst CEOs are explained in reference to situational, contingent factors (like firm size or duality)

Aims & 3 Assumptions

Explanatory model: to explain behaviour and social phenomena from the rational choices of individual agents. Assumptions: 1. Explanations would always start from the choices of individual agents: methodological individualism 2. Agents are perfectly rational 3. Agents are fully self-interested

What makes European Managers strong?

Firm-level corporate governance defects: - CEO duality - CEO ownership - CEO tenure - Board size - One tier board structure - Employees on board - Percentage non-executives Country-level legal and extra-legal factors: - Anti-self-dealing provisions - Shareholder protection - Union power - Employee protection - Power distance

Rational Agents

Have a complete and consistent preference ordering, - all options are included in preference ordering - transitivity: if a > b and b > c then a > c Have all relevant information - all relevant knowledge - all relevant conditions Have a perfectly functioning and costless computer on board!

Why Agency relationships lead to agency problems

Agency relationships lead to agency problems because of conflicts of interests between the agent and the principal. - Metering problem - Adverse selection - Moral hazard - Holdup

Agency Theory

Agency relationships: a separation between decision making (by the agent) and being exposed to the consequences of these decisions (the principal) = Rational Choice

Self - Interest

Agents exclusively maximize their own welfare. The welfare of others is only relevant when it figures in one's own preference ordering. Rational choice theories differ in terms of the degree of opportunism they expect agents to demonstrate.

Game theory

- Explaining patterns of behavior and institutions from interdependent rational choices - Designing institutions (to prevent suboptimal outcomes) - Strategic rationality - Coordination problems (no conflict of interests) - Motivational problems (conflicts of interests)

Game Theory as rational choice Why individualism?

- Game theorists are not interested in character- or identity-based differences across players - Players are assumed to be rational - Outcomes of games are explained in terms of individually rational behavioral choices (though rooted in strategic rather than parametric rationality)

Agency problems lead to agency cost

- Monitoring costs (borne by the principal) - Bonding costs (borne by the agent) - Incentivising costs (borne by the principal) - Residual loss (borne by the principal) The challenge is to minimize the sum of agency costs because agency costs constitute a (welfare economic) deadweight loss!! Agency costs stand in the way of economic development (e.g. corruption)

Agency Theory as Rational Choice Why Explanatory ?

- Seeks to describe CEO pay in a way that clarifies the antecedents (power, job complexity) of that construct, while accounting for contextual variables. - Aims to identify 'laws' that generalize towards other phenomena (sports all-stars, popular musicians, scientists, talk show hosts) and towards other contexts (CEOs in North America, Latin America, and Asia).

Game Theory as rational choice Why explaining?

- Seeks to describe game outcomes in a way that clarifies the antecedents (knowable payoff structures, interdependent choices) of these outcomes. - Aims to identify 'laws' that generalize towards other game settings of a similar structure (e.g., nuclear deterrence, effort in sports competition, self-promotion amongst junior lawyers).

Evaluation of Rational Choice Thory

1) Inveracious behavioral assumptions e.g. agents are everything but rational as a matter of fact (behavioral theory) 2) Risk of self-fulfilling prophecy (a form of the double hermeneutic) - If agents were not already selfish, they will become so: Selection effect Adjustment effect 3) Does injustice to the phenomenological complexity of human behaviour 4) Is everything in social reality reducible to individual behaviour? 5) Yet rational choice theory remains a very powerful explanatory theoretical framework, that moreover forms the basis for legal and institutional design

What is game theory from view of payoff matrix?

1. Action is reaction: - Accepts that in real life, the decisions of actors influence one another; 2. Only partial control: - No single actor has full control over the final outcome of an interactive situation, so actors are interdependent; 3. Gain seekers: - Game theory assumes that actors act rationally, and seek to improve their lot; 4. Empathy: - 'Putting yourself in the other person's shoes' is necessary to foresee others' moves affecting you.

2 different cases of principal agent theory

1. Case of complete information - The principal knows what the agent has done, and a contract based on behaviour would be the most efficient 2. Case where the principal does not know exactly what the agent has done - Moral Hazard (lack of effort on the part of the agent) - Adverse selection (misrepresentation of ability by the agent e.g. agent claims to have certain skills which he does not have)

5 Basic Games of Game Theory

1. The coordination game 2. The prisoner's Dilemma 3. The Chicken Game 4. The Battle of the Sexes Game 5. The Assurance Game

5 reasons why business use game theory:

1. Understanding conflict and cooperation - Finding 'gains from trade' 2. Weighing risks - Predicting the likelihood of hurtful actions 3. Gaining bargaining power - Understanding fallback options 4. Using information strategically - Send credible signals and interpret those of others 5. Designing contracts and incentives - Rewarding one player for choosing actions benefitting both

Why Agency theory arises

1. formal delegation of decision rights (legal mandate) 2. De facto delegation of decision rights (information asymmetry) e.g. lawyers and doctors vs. clients

2 governance mechanisms of positivist agency theory

1. outcome based contracts are effective in curbing agent opportunism - When the contract between the principal and the agent is outcome based (rewards), the agent is more likely to heave in the interest of the principal. 2. information systems also curb opportunism, since they inform the principal about the agent's behaviour - When the principal has information to verify agent behaviour, the agent is more likely to behave in the interests of the principal

2 Forms of Rationality Strategic Rationality

A form of rationality that additionally takes into consideration the rational choices of other agents, who in turn take into consideration and try to anticipate your actions (the situation is one of interdependent choice). Example: Supermarket promotions

2 Forms of Rationality Paramedic Rationality

A form of rationality that assumes the choices of others to be known in advance (they are the 'given' parameters for a decision). Example: Incentive pay

The payoff matrix

A payoff matrix defines the structure of a strategic interaction between two players. it is a core instrument in game theory, illustrating the interactive decision making

Explaining

A set of propositions developed to describe a set of facts in a way that clarifies the antecedents, context, and consequences of those facts. Aimed at discovering rules or laws that generalize towards other, related facts

Double Hermeneutics

If you design structures and incentives in corporate governance based on the premise that managers are crooks, you run the risk that managers will adjust to these structures and incentives in exactly the way you have assumed them to behave at the beginning

Rational Choice theory

Individualism (Ontology) - Explaining (Epistemology) It is a model through which one try to understand social institutions and social changes as resulting from the actions and interactions of rational individuals Rational Choice Theory considers society to be a cooperation of individuals who tune their behaviour, since it is the best way for them to achieve their goals - Assumes that all individuals act as perfectly rational beings

Methodological Individualism vs Ontological Individualism

Methodological individualism - Social phenomena (e.g. rules, structures) really exist (e.g. money), but we need to explain these social phenomena only from the actions and behaviors of individuals Ontological individualism - Only individual agents really exist. Social phenomena (e.g. rules, structures, money) do not really exist. Social phenomena are nothing but the aggregate result of the actions and behaviors of individuals

7 essential key questions

Who are the players? What options are open to the players? What goals are the players pursuing? What are the sources of gains from trade? Can any of the players make credible commitments? What is the time structure of the game? What is the information structure of the game?

Nash equilibrium

comprises a combination of choices of which the outcome is equal and no player benefits of another player

Positivist agency theory

focus on situations where the principal and agent have conflicting goals, and then describe the governance mechanisms that limit the agent's self-serving behaviour

What is Game theory ?

is a application of the rational choice theory. It analyses situations in which the individuals choices are interdependent (the results depend on more than one individual). The results of the own behaviour depends on the behaviour of others, which is why one should anticipate the behaviour of the other players Tries to explain why societies have made all kinds of rules, making it the cause of conventions

Strategic rationality

is the act of anticipating others choices as well as possibilities, since some situations have a level of strategic uncertainty about which choice the others will make.

Principle Agent Resesrch

less applicable to organisational scholars broader focus on greater interest - indicates which contract is the most efficient under varying levels of outcome uncertainty, risk aversion, information, and other variables

Conflicting model

shows how peoples interests may coincide, which makes them willing to cooperate in their mutual interest. However, when they are able to benefit at the cost of others, people will use the opportunity to do so

Pareto Optimal results

those combinations of choices in which non of the players can benefit from changing their choice without harming one of the other players

Rational Individuals

try to optimise their own preferences to the fullest