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Unformatted text preview: McWane Industries Case McWane Industries Case
► How do (some) managers attempt to minimize the total cost of risk? ► Do managers (always) minimize the total cost of risk? ► Are private outcomes (always) socially desirable? Do Managers Maximize Firm Value? Do Managers Maximize Firm Value? No guarantees: managers exhibit human characteristics including risk aversion, psychological biases, perception problems, laziness, selfinterest… Some factors influence manager behavior in the direction of maximizing value
►Management compensation (bonuses, stock) ►Market for corporate control (hostile takeovers, management labor market) ►Monitoring by shareholders (board of directors) ►Legal duty of managers (lawsuits) Interests of other Stakeholders Interests of other Stakeholders Maximizing shareholder wealth does not necessarily imply that the costs of risk for employees, customers, creditors or other stakeholders are ignored
►If they are informed and ►If markets are competitive
►They will demand compensation for risk and this will decrease the value of the firm by raising costs or reducing revenues Interests of Society Interests of Society
Does minimizing the Cost of Risk to the firm (maximizing the value of the firm) achieve the best outcome from society’s perspective? Firm: Society: Minimize Total Cost of Risk to Firm Minimize Total Cost of Risk to Society Conflicts Between Business and Conflicts Between Business and Societal Objectives What if business cost of risk < societal cost of risk?
►Possible scenarios: Customers may be injured from product Workers may be injured from unsafe working environment Waste dumped in a river pollutes the drinking water supply Socially Optimal Safety: Example Socially Optimal Safety: Example
► Potential loss to worker from jobrelated injury = $10,000 ► Probability of loss depends on safety expenditures taken by the employer Safety expenditures reduce the probability of loss ► What level of safety expenditure minimizes the total cost of risk (to society)? Example: Safety Expenditures Reduce Probability Example: Safety Expenditures Reduce Probability of Worker Injury Prob of Loss 0.070 0.055 0.043 0.033 0.026 0.018 0.011 Safety Expenditure $0 $45 $130 $220 $400 $590 $900 Socially Optimal Safety Level Socially Optimal Safety Level
► Minimize Total Cost of Risk ► For now, assume no indirect costs or costs of uncertainty ► Total Cost of Risk = E(loss) + cost of safety investment (s) Minimize Society’s TCOR Minimize Society’s TCOR
Firm’s Safety Expenditure $0 $45 $130 $220 $400 $590 $900 Expected Loss to Worker $700 $550 $430 $330 $260 $180 $110 Total Cost of Risk (TCOR) Prob of Loss 0.070 0.055 0.043 0.033 0.026 0.018 0.011 Socially optimal safety expenditure minimizes TCOR Socially Optimal Safety Level, cont. Socially Optimal Safety Level, cont.
► ► Choose safety level (s) to Minimize Total Cost of Risk This is the same as choosing s so that MB(s) = MC(s) In our (simplified) example: Marginal benefit of safety expenditures is the reduction in expected accident costs with increase in s ► ► More generally MB(s) includes Marginal reduction in expected indirect costs Marginal reduction in costs of uncertainty Set Society’s MB(s) = MC(s) Set Society’s MB(s) = MC(s)
Expected Loss to Worker $700 $550 $430 $330 $260 $180 $110 Marginal Benefit of Safety Marginal Cost of Safety Prob Safety of Loss Expenditure 0.070 $0 0.055 $45 0.043 $130 0.033 $220 0.026 $400 0.018 $590 0.011 $900 Socially optimal safety expenditure sets MB = MC Will Firm Choose Socially Optimal Safety Will Firm Choose Socially Optimal Safety
► In the absence of a legal liability or regulatory system, the firm’s MB of safety investment may be lower than society’s MB of safety investment: ► Externality problem: Worker bears injury risks and costs ► In the absence of substantial indirect losses and cost of uncertainty firm may invest too little in safety. What s sets Firm’s MB(s) = MC(s)? What s sets Firm’s MB(s) = MC(s)?
Firm’s Marginal Benefit of Safety Prob Safety of Loss Expenditure 0.070 $0 0.055 $45 0.043 $130 0.033 $220 0.026 $400 0.018 $590 0.011 $900 Expected Loss to Worker $700 $550 $430 $330 $260 $180 $110 Marginal Cost of Safety $45 $85 $90 $180 $190 $310 Firm’s optimal safety expenditure sets MB = MC Private RM Objectives Private RM Objectives
In extreme case, firm’s MB of safety investment could be considered to be 0! Private MC Private MB
RM RM Level Private RM Objectives Private RM Objectives
In general, firm will face at least some indirect costs of worker injury, so MB will be positive Private MC Private MB RM Level
RM Societal RM Objectives Societal RM Objectives
But if private MB is lower than social MB, Excess injury costs arise due to spending too little on RM Private MC Social MB Private MB
RM RMs* RM Level Can Market Correct Firms’ Incentives? Can Market Correct Firms’ Incentives?
► Market forces may lead to indirect costs and costs of uncertainty for the firm if it has a poor safety record ► But what about: Information problems Unequal bargaining power Can Society Correct Firm’s Incentives? Can Society Correct Firm’s Incentives?
► Liability system ► Government regulation ► Criminal sanctions ► Reputation penalties (moral sanctions) ...
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This note was uploaded on 05/07/2009 for the course PAM 4230 taught by Professor Tennyson during the Spring '07 term at Cornell University (Engineering School).
- Spring '07