An Analysis of Conflict

Illona Wahyudi - 121110032

Game theory, which models and predicts the outcome of conflict between rational
people, is necessary to fully understand economic consequences. Agency theory, a
version of game theory that looks at the process of contracting between two or more
individuals, will also be considered. Undoubtedly, economic consequences and
agency theory contain conflict. Game theory can help us to understand how
managers, investors and other parties can deal with the economic consequences of
financial reporting and why contracts depend on financial statements..
Keywords: game theory, conflict, agency theory, economic consequences
Game Theory
Game theory is the basis of many current issues in accounting theory. It models the
interactions of two or more players in an environment of uncertainty and information
asymmetry. As in decision theory, each player is assumed to maximize their expected utility,
however it requires that the players consider the actions of other players. The action that one
player chooses will depend on what action that player thinks the other will take. Therefore,
the actions of one player influence the others. This defines the conflict aspect of the model.
There are many different types of games. One way to distinguish them is as
cooperative and non-cooperative games. In a cooperative game, the parties can enter into a
binding agreement, such as a cartel. However, if this type of agreement were not possible, it
would be a non-cooperative game, such as an oligopolistic industry.
A Non-Cooperative Game Theory Model of Manager-Investor Conflict
When making decisions, investors are aware that managers do not always reveal all
information. It is too difficult and costly to provide each investor with desired information
about the company. Game Theory assumes each player chooses a strategy without knowing
the strategy choice of the other. Strategy Pair is a statement of the strategy taken by each
party. Nash Equilibrium is the only strategy pair, such that given the strategy choice of the
other player, each player is content with their strategy and does not wish to depart from their
choice. Nash equilibrium is the predicted outcome of a non-cooperative game.

In single-person decision theory, nature is an impartial force that does not think and
the strategy chosen by an investor does not affect these probabilities of nature. This theory
breaks down when the payoffs are generated by a thinking opponent (a manager) rather than
by nature, which leads us to the game theory.
Some Models of Cooperative Game Theory
Players engage in a game situation when entering into agreements they perceive as
binding (i.e. contracts). There are two important contracts:
1. Employment contracts - between firm and its managers
2. Lending contracts - between the firm and its lender
In these contracts, one party is the principal and the other is the agent. Agency theory
is a branch of game theory that studies the design of contracts between two or more people.
It motivates a rational agent to act on behalf of a principal when the agents interests would
otherwise conflict with those of the principal. It has characteristics of both cooperative and
non-cooperative games. Two parties do not specifically agree to take certain action but rather
the actions are motivated by the contract itself.
Agency Theory: An Employment Contract between Owner and Manager
A firm consisting of a principal and an agent faces uncertainty, expressed in the form
of random states of nature. The agent has two possible actions; to work hard; or to slack off.
The greater the effort put into the operation by the agent, the higher the probability of the
high payoff and the lower the probability of the low payoff. However, it is unlikely the
agents efforts could completely ensure the high payoff, because some of the factors are
beyond his or her control.
Effort is considered more than just the number of hours work; it is the care that the
agent takes in running the firm. The payoffs under each state of nature are assumed to be
observable to both parties.
It is important to note that in game theory, one player will not choose an act desired
by another player because the player says so. Each party will choose the act that maximizes
their own expected utility.

Designing a Contract to Control Moral Hazard

The tendency of an agent to slack off because they are paid a set salary is an example
of moral hazard. The owner has two choices, to run the business themselves or to go out of
business. The owner could observe the managers chosen act; the contract could be changed
to pay the manager a lower salary if an inferior action was chosen. This is an example of a
first-best contract. Unfortunately, this type of contract is often unattainable. Thus, there is a
case of information asymmetry, the manager knows the extent of their effort, but the owner
does not.
It is possible for the owner to indirectly monitor the manager as well. This case could
utilize moving support, that is, the set of possible payoffs would move depending on which
action is taken.

However, legal and institutional factors may prevent the owner from

penalizing the manager to choose a certain action. The owner may be tempted to rent the firm
to the manager, thus no longer caring which action is chosen.

This is referred to as

internalizing the managers decision problem. The owner is risk-neutral because a fixed
rental is received. The manager is risk-averse and must bear all of the risk.
As an alternative, the owner could give the manager a share of the payoff. The
contract provides motivation for the manager to choose the better action; this is referred to as
incentive-compatibility. Hence, the interests of the two parties are aligned, as they both wish
for the firm to do well. In a second-best contract, the agency cost is the cost to the principal to
motivate the agent by means of a profit sharing contract. The manager would have to bear
some risk to convince the owner that the work-hard alternative would be chosen.
Lender-Manager Agency Problem
The lender-manager agency problem is the second source of the moral hazard
problem. This arises from the fact that creditors cant usually observe the actions of managers
of the firm they have contracts with. Both the manager and the creditor want to maximize
their total expected utility. In order to prevent managers from manipulating accounting
figures lenders, include covenants in their contracts requiring managers to keep their debtequity ratio at a certain level for example.
The owner-manager and lender-manager agency examples illustrate that cooperation
is better for both parties involved. This feeds into the Positive Accounting Theory in that it
provides an incentive for managers to use accounting policies to manage their numbers,
which in turn results in the economic consequences.