In this article, Harold Demsetz presents the hypothesis that the differences in ownership concentration observed across firms respond to the benefits and costs of monitoring management. Demsetz and Lehn (1985) find that ownership is more concentrated in firms exhibiting higher firm-specific risk.
A higher firm-specific risk implies a larger demand for controlling shareholders. These controlling shareholders require a compensation for assuming greater firm-specific risk. An important part of this compensation comes from the acquisition of a comparative advantage in exercising control, which allows for the possibility of pecuniary and nonpecuniary returns. Furthermore, Demsetz argues that insider trading offers a secondary compensation to controlling shareholders. According to Demsetz, the wealth transfers generated by the insider trading can be viewed as a cost borne by minority shareholders to promote more effective monitoring of the firm.
Some questions related to this article are:
(1) Do institutional owners have the incentive to monitor management in the absence of investment specialization?
(2) What benefits motivate investors to specialize their investment in a single firm with high firm-specific risk?
(3) Why do firms with lower firm-specific risk exhibit a higher dispersion in ownership?
(4) How is the firm-specific risk related to the profit potential of insider trading?
(5) What are the equity problems that arise from insider trading profits?
(6) Are controlling shareholders entitled to a higher rate of return than the one of minority shareholders?
(7) Is Demsetz's argument that legislation seeking to reduce insider trading profit makes it more difficult to maintain controlling ownership interests so useful for monitoring purposes, valid?
The article can be found here:
http://www.jstor.org/discover/10.2307/1818787?uid=3737952&uid=2129&uid=2&uid=70&uid=4&sid=21100653701196
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