Bad judgement

In 1921 Ford made 55% of the cars sold in the United States and General Motors (GM) made 11%. GM's business strategy had a number of fundamental flaws. The divisions (Chevrolet, Pontiac, Buick, Oldsmobile, and Cadillac) made very similar cars, so the divisions were competing with each other. The economy was in recession, and car sales were sluggish. Nevertheless, each division continued to overproduce, resulting in unprofitable inventory accumulation. The company did not have a strategy for making division managers take into consideration the cost that inventory accumulation imposed upon GM.

When Alfred P. Sloane took over the helm at GM the company was transformed. Decision making was decentralized. The head of GM made policy—for instance, each division was told to make a car targeted to a particular segment of the market—and each division manager was required to maximize the division's profit subject to guidelines set by the head. In particular, the division's inventory was charged to the division as a cost. Henry Ford, who was still the chairman of Ford and its largest stockholder in the 1920s, vigorously resisted the notion of decentralization. Ford felt that absolute control should flow from the top down. However, a large firm runs more efficiently if it takes advantage of the reduction in agency costs when decentralization is used. (All large modern corporations decentralize, at least to some extent.) By 1940 Ford's market share had fallen to16% and GM's had risen to 45%. (The last two paragraphs are based on Milgrom and Roberts, 1992, pp. 2-4.)

Between 1980 and 1990 GM spent $67.2 billion on research and development. GM could have purchased Toyota plus Honda for that, but by 1990 equity in GM was only $26.2 billion. The CEO was fired in 1992. General Tire (owned by General Corporation) had substantial excess capacity in 1985 due primarily to the introduction of radial tires, which last three to five times longer than bias-ply tires. Nevertheless, the General Tire management expanded capacity.

Incentives can be too strong. Consider the case of Salomon Brothers, the bond trading firm. In the 1980s they had a very comprehensive bonus system involving employees from top to bottom. The firm calculated an employee's contribution to profit from almost every transaction, and bonuses were based to a great extent on an employee's annual contribution to profit. This induced people to work very hard, but it did not yield the best outcome for the firm as a whole. Department A might withhold key information from Department B if disclosure would benefit B. On occasion, a department would "steal" another department's profit. In 1990 Salomon hired Myron Scholes, a Stanford professor who would win the Nobel Prize in Economics seven years later, to reform the incentive system. Scholes's key innovation was to have the employee's bonus money used to buy company stock, with the proviso that it could not be sold for five years. This gives the employee a sufficient interest in the profit of the firm as a whole, eliminating the incentive for dysfunctional behavior. (This story is from Milgrom and Roberts, 1992, pp. 10-1.)

We explain in Section 5 why a firm's ownersmaybe assumed tobe riskneutral: They want the firm to maximize the expected value of profit. The managers, however, are risk averse because a large fraction of their income comes from the firm that they manage. If the managers' pay is a function of their firms' profit, they may avoid decisions that increase the expected value of profit when that would result in a big increase in the variability of profit. This may be the rationale behind golden parachutes, which give a manager who is dismissed a huge severance payment. However, if the manager's pay is not sufficiently sensitive to profit then he or she may cause the firm to take excessive risk. In the 1980s, managers in the oil industry spent billions of dollars exploring for oil when proven reserves could have been purchased for less than a third of the money. Alternatively, the money could have been passed on to shareholders (Jensen, 1986; see also, McConnell and Muscarella, 1986).

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