Knowledge that Transforms

An incentive problem exists in franchise relationships because of the failure of franchisees to take account of franchisor profit. Franchise contracts ameliorate this malincentive not by specifying a proxy for desired franchisee performance, but by creating a premium stream that facilitates a self-enforcing agreement. The structure of credible commitments within this self-enforcing arrangement is elucidated, with initial franchisee investments shown to serve no performance guaranteeing purpose. Franchisors do not demand large initial lump sum payments from franchisees because doing so makes it more difficult to terminate franchisees for nonperformance. Franchisors use vertical integration when the premium necessary to assure franchisee performance is large.

Using confidential data of executive-specific short-term bonus plans, we investigate the extent to which executives manipulate earnings to maximize the present value of bonus plan payments. As such, this paper extends the work of Healy (1985). Like Healy, we find evidence consistent with the hypothesis that managers manipulate earnings downwards when their bonuses are at their maximum. Unlike Healy, we find no evidence that managers manipulate earnings downwards when earnings are below the minimum necessary to receive any bonus. We demonstrate that Healy's results at the lower bound are likely to be induced by his methodology.

We examine whether the structure of compensation for the divisional CEO is related to subsequent innovative activity within the division, and whether the divisional CEO's compensation is structured as a function of the expected innovation opportunity set facing the division. Both the expected innovation opportunity set and the divisional executive's compensation contract are treated as endogenous variables by adopting a simultaneous equation approach. We find modest evidence that the proportion of total compensation tied to long-term components has a positive relation with future innovation, but no evidence that this proportion has a positive relation with the expected innovation opportunity set.

Empirical validity of the claim that overhead costs are driven not by production volume but by transactions resulting from production complexity is examined using data from 32 manufacturing plants from the electronics, machinery, and automobile components industries. Transactions are measured using number of engineering change orders, number of purchasing and production planning personnel, shop-floor area per part, and number of quality control and improvement personnel. Results indicate a strong positive relation between manufacturing overhead costs and both manufacturing transactions and production volume. Most of the variation in overhead costs, however, is explained by measures of manufacturing transactions, not volume.

We study the decision to fund R&D through a separate financing organization (an ‘RDFO’) that takes the form of either a limited partnership or a corporation. The RDFO offers tax and financial reporting benefits. As a form of external funding, it also creates moral hazard and adverse selection problems (information costs). Using convertible debt as a comparative form of external funding, we find that debt-related (but not equity-related) financial reporting benefits affect the decision to form RDFOs, the evidence is mixed on whether taxes influence the formation decision, and the information costs of RDFOs restrict their use.

Return models (returns regressed on scaled earnings variables) are commonly preferred to price models (stock price regressed on earnings per share). We provide a framework for choosing between these models. An economically intuitive rationale suggests that price models are better specified in that the estimated slope coefficients from price models, but not return models, are unbiased. Our empirical results confirm that price models' earnings response coefficients are less biased. However, return models have less serious econometric problems than price models. In some research contexts the combined use of both price and return models may be useful.

The paper analyzes the use of reported accounting earnings and price as a basis for compensating a manager when he trades on private information, and share price is set rationally based on privately held information, publicly available and contractible information, and publicly available but noncontractible information. In addition, we analyze the comparative statics of the compensation on reported earnings and price with respect to changes in the economy.

We analyze how analysts' forecasts relate to investor beliefs and describe the implications of these relations for price and volume reactions to earnings surprises. We show that dispersion among forecasts does not fully capture investor uncertainty. We also show how the relations between market reactions and forecast properties differ under the alternative assumptions of exogenous and endogenous private information acquisition. Finally, the analysis suggests refined tests for volume reactions at the time of an announcement. Our results indicate that the model is useful for understanding and interpreting empirical work and developing empirical tests of market reactions to announcements.

Using a simulated method of moments approach, the author evaluates a representative consumer asset pricing model in which the consumer is assumed to have time nonseparable preferences of several forms. Examining the model's implications for several moments of asset returns, he finds evidence for the local substitution of consumption with habit formation occurring over longer periods of time. The interaction between these two effects is important. The author also shows that, when accounting for sampling error, a model with local substitution and long-run habit persistence is consistent with the Hansen and Jagannathan (1991) bounds. Copyright 1995 by The Econometric Society.

Continuous-time Markov processes can be characterized conveniently by their infinitesimal generators. For such processes there exist forward and reverse-time generators. We show how to use these generators to construct moment conditions implied by stationary Markov processes. Generalized method of moments estimators and tests can be constructed using these moment conditions. The resulting econometric methods are designed to be applied to discrete-time data obtained by sampling continuous-time Markov processes.