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  • Print publication year: 2006
  • Online publication date: June 2012

4 - Corporate Governance


This chapter investigates incentives in firms. We explore the hidden action problems of a modern corporation. Section 1 compares firms in several leading industrialized countries. Section 2 examines the relationship between two senior executives who share the firm's profits and is followed by a brief look at the relationship between the owner and employees in an owner-managed firm (Section 3). The rest of the chapter is devoted to the hidden action problem confronting a widely dispersed group of shareholders whose objective is to have the firm that they jointly own maximize the value of their shares. Can they rely on the board of directors to provide the appropriate incentives to the company's management team, even though it is extremely costly for the shareholders to monitor the management and the board members themselves?


We are primarily concerned with the attempt of a firm's owners to obtain a satisfactory return on the capital they supply to the firm. The owners provide financing through the purchase of shares in the firm and also when the firm uses retained earnings for replacement of, or addition to, the capital equipment. Firms also borrow financial capital, and in many industrialized countries bank loans are a much more important source of finance than in the United States. All of the firm's suppliers of finance wish to ensure that management runs the firm in a way that brings them a high return. We refer to this as the agency problem.

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