Time Inconsistency and a Stakeholder Theory of the Firm

15 June 2006 at 3:30 am 2 comments

| Joe Mahoney |

Recently I have become more persuaded that the incomplete contracting literature potentially offers a theoretical foundation for a stakeholder theory of the firm.

In this light, two industrial organization economists — Dan Kovenock and Stephen Martin — have “inspired” me to learn more about the concept of time inconsistency problems. In a world of incomplete contracting, we often face the potential for time inconsistency problems (Grossman and Hart, 1986) and opportunistic rent extraction. A policy that is optimal ex ante but sub-optimal ex post can be described as “time inconsistent.”

Mahoney, Sundaramurthy and Mahoney (1996) illustrate the time inconsistency problem with the following example: Ex post (once a takeover bid exists) stockholders would collectively benefit by prohibiting two-tier tender offers (thereby attenuating the risk of a corporate raider placing the stockholders in a Prisoners’ dilemma). However, ex ante, stockholders may prefer two-tier tender offers (mitigating the free-rider problem associated with dispersed stock ownership).

The concept of time inconsistency was introduced to the research literature by Strotz (1956) and has since been applied to: savings (Phelps and Pollak, 1968), capital taxation (Kydland and Prescott, 1977), inter-generational justice (Calvo, 1978), governmental policy (Fischer, 1980), monetary policy (Barro and Gordon, 1983), exhaustible resources (Chilton, 1984), liquidation decisions (Titman, 1984), dividend policy (Rock and Miller, 1985), counter-trade (Mirus and Yeung, 1986), stakeholder theory (Cornell and Shapiro, 1987), exchange rates (Dellas, 1988), tariffs (Lapan, 1988), reputation (Stokey, 1989), social norms (Elster, 1989), individual habits and self-control (Hoch and Lowenstein, 1991), IPOs (Hughes and Thakor, 1992), regulation (Kleit, 1992), fiscal policy (Crain and Tollison, 1993), debt restructuring (Faig, 1994), leasing (DeGraba, 1994), insurance derivatives (Harrington, Mann and Niehaus, 1995); urban development (Richer, 1995); network externalities (Regibeau and Rockett, 1996), R&D (Waldman, 1996), foreign direct investment decisions (Aizenman, 1996), intellectual property rights (Takeyama, 1997), environmental policy (Marsiliani and Renstrom, 2000), cartels (Groot, Withagen and de Zeeuw, 2003), behavioral decision-making (Barkan and Busemeyer, 2003); corporate governance (Almazan and Suarez, 2003),internal promotion policies (Waldman, 2003), litigation (Spier, 2003), correcting cognitive biases (Besharov, 2004), lending contracts (Albuquerque and Hopenhayen, 2004), vertical integration (Vallette,2004), voting mechanisms (Dal Bo, 2006), managerial selective intervention (Foss and Foss, 2006) and joint ventures (Yeung and Petrosyan. 2006).

Recently, I have become more focused on the time inconsistency problem in the context of under-investment in firm-specific human capital (Shleifer and Summers, 1988). To attenuate this time inconsistency problem leading to under-investment in firm-specific human capital, economic safeguards can encourage greater firm-specific human capital investment. Indeed, a general principle for dealing with the time inconsistency problem is to use an economic bonding mechanism to preclude suboptimal actions ex post (Tirole, 1988).

Entry filed under: Former Guest Bloggers, Recommended Reading, Strategic Management, Theory of the Firm.

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2 Comments Add your own

  • 1. Paul Walker  |  15 June 2006 at 6:32 pm

    I’m not sure I follow you here. As Hart 1995 points out control rights and income rights are highly complementary and so it makes sense to allocate them to the same person. If this is the case how would “stakeholder” theory makes sense? The “stakeholder” approach seems to be one which comes down to allocating control rights to some group without allocating income rights as well. Its not clear how having control divided among different groups with different aims improves the outcomes of the firm. Or have I missed something?

  • […] Joe writes below about time inconsistency, or the Ulysses problem: sometimes you can make yourself better off by deliberately limiting your own options ("tying your own hands behind your back"). This phenomenon has been widely studied in monetary policy (earning Finn Kydland and Edward Prescott a Nobel Prize), bargaining theory, and even internal organization. […]

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