In Chapter I, five major issues were raised regarding the proliferation of downsizing in the US during the 1990s. With the econometrics, game theory, and three case studies, the questions can now be addressed in terms of the empirical findings, the computed equilibria, and the observed actions of firms.

1. Why does the value of a firm increase when it announces a downsizing, especially since downsizing is supposedly a signal of rough economic times ahead?

This question needs to be re-formulated in terms of expectations. An analysis of the major downsizings in the US proved that downsizing was relevant news to firm value. More than half of the firms experienced statistically significant volatility on the day of the downsizing, but the actual returns did not indicate that firms that downsized were bid up. In fact, the daily return for several of the firms fell by more than two standard deviations. Once this issue was addressed in terms of expectations, the results became clear. Investors have an opinion as to how many workers the firm should downsize to optimize profitability, given business conditions. Firms that downsize below the market’s expectations were sold off. The prevailing reason is that by not cutting enough workers, the managers demonstrate that they don’t realize the precariousness of the firm’s current health. Investors realize that the firm, as it is currently managed, must be heading for disaster, and they dump the stock. The stock of firms that downsize more than expectations appears to be bought heavily following a downsizing. Presumably, the firm’s grandiose visions for the future excites investors, as a reorganization of the firm, and the divestiture of units that are not performing as well as expected will trim the fat, and improve firm value. The firm’s productivity is much higher than investors had surmised, so it can afford to cut more workers than expected and still produce the same top-quality output.

Of course, this seems to contradict two very sensible hypotheses as to how investors should really behave. When a firm downsizes less than expectations, perhaps it is signaling to the market that by not cutting "enough" jobs, its economic future is rosier than investors had anticipated. If management has more information as to the health of the firm, this could be the case, but such an observation is rarely made. When a firm downsizes more than expectations, it could be the case that the firm’s business prospects are much more dismal than the investors had expected, and it needs to relieve many workers of their positions in order to brace for rough economic times. Yet this phenomenon also never appears in equilibrium. Perhaps in every case, the investors feel that they understand the health of the firm better than the management, and they judge the management’s actions based on their own opinions as to the health of a firm.

Perhaps downsizing higher than expectations evolved into a signal of strength, and downsizing below expectations evolved into a signal of weakness. News variables pertaining to why the firm downsized surprisingly had no predictive power on the sign of the return. The only thing that ever seemed to matter was if the firm downsized below expectations, which slashed the stock return.

Downsizing was at first a signal of rough economic times ahead, and then it became a symbol of phenomenal productivity. A firm’s workers were so amazingly productive, that it could slash the work force and still earn record profits. It could now be the case that downsizing has become a signal of absolutely nothing. In the AT&T game, when downsizing was always observed, the investor’s calculated Bayesian probabilities of strength were simply just the prior probabilities, since firms of all types were observed downsizing. Downsizing offered no information as to whether a firm was strong or weak, so investors simply discard the news of a downsizing, and buy stocks based on the prior probability of whether or not a company is strong. If the economy is strong, and the observation of downsizing does nothing to improve the investor’s perception of whether the particular company is strong, then the investors will buy the stock, since in equilibrium, they will have bought more good companies than bad companies. This may very well be why downsizing is associated with investors buying stocks and bidding up the value of companies. Note that in the AT&T game, in which the economy is strong, the investors never sell in equilibrium. This could possibly be associated with the rapid appreciation of equities during the mid 1990s, at the height of the downsizing craze. Investors only bought, and never sold in the observed equilibrium.

2. Why do strong firms lay off workers in a boom, but not in a recession?

The manipulation of the probabilities of strength and weakness directly confirms this observation. Investors know that downsizing capacity is a good business strategy for a weak firm, and that maintaining capacity is a good strategy for a strong firm. Investors are compensated in the game for holding the stock of a company that makes the right decisions. In a recession, the stakes are a bit higher. If everyone downsizes, or if everyone maintains the labor force, then downsizing becomes a meaningless symbol, since it does not help the investors to judge who is weak and who is strong. There is no equilibrium in which this will happen, since the last thing a strong firm wants is to be mistaken as a weak firm. (The equilibrium in which everyone does the same thing works during a boom however, since weak firms would like nothing more than to be mistaken as strong). In a bad economy, strong firms need to differentiate themselves from weak firms—or else they will be mistaken for weak, and be sold off. No strong firm will ever want to downsize. Weak firms however are torn in two directions: there is a positive payoff to downsizing (making the good business decision) and a positive payoff to not downsizing (the firm can be mistaken as strong, and the stock price will go up). In the only equilibrium of this game, strong firms never downsize, and weak firms are indifferent, and randomize.

Note that in the recession, investors do a lot of selling. Any firm that downsizes is presumed correctly to be weak, and is sold off. Investors are indifferent between buying and selling the stock of companies that don’t downsize. They buy and sell with equal probabilities. This result explains why equity markets are in a slump during recessions, and why investors can dump even strong firms. Strong firms need to differentiate themselves from weak firms to avoid getting sold. The best way to accomplish this is to never downsize in a recession—that’s something a weak firm simply does not have the luxury to do. Strong firms are only observed downsizing in a boom. During a boom, investors can be fairly confident that the probability that a given firm is strong is greater than the probability it is weak. As the explanation to question (1) dictates, downsizing becomes a meaningless gesture in the quest for a firm to convince the market that it is strong.

3. Did the proliferation of stock options in executive compensation contribute to the wave of downsizing, especially downsizing that engendered short-term gains, but reduced long-term firm value?

Perception is a highly important issue in valuation. There exist two separate values of the firm, its actual value, which only the management knows, and its perceived value, which both the investors and the managers observe. The perceived value is how the investors judge the future stream of cash flows of a firm based on the limited information that they have available. The actual value of the firm is observed by the management, and pertains to what the cash flow actually is. Even though investors are rational, the perceived and the actual value of the firm differ substantially since investors are not privy to information. The games that modeled information flow demonstrated that the perceived value and the actual value of the firm are the same only when investors know all pertinent information. There is only one equilibrium, and weak firms cannot fool their investors into thinking that they are strong. Once the investor is asked to make a decision in an information set, the actual value of the firm and the perceived value diverge. As the information games demonstrate (and as common sense would dictate), strong firms are hurt by the information asymmetry and weak firms are helped. Investors never do better when the information barrier is erected; the best they can hope to do is randomly make an accurate prediction of firm value. However, investors take whatever information they have and compute a value of the firm based on their limited information.

One element of information investors have is whether or not the company downsizes. In some situations, knowledge of the downsizing improves the probability that the investor is facing a certain kind of firm, and in other cases (like the basic AT&T case), it does not. Managers are compensated in two ways: they receive a salary for making the right decision (such as downsizing in a recession), and they receive stock options, because a group of business school professors concluded that stock options reduce agency costs. The first component of their compensation is tied to the actual value of the firm; the second is tied to the perceived value. To the extent that doing something that promotes the actual value of the firm will also elevate the perceived value, there is no conflict.

Consider the basic AT&T equilibrium, in which the stock of downsizing firms is always bought, and the stock of non-downsizing firms is always sold. The management of a strong firm must make a choice. It can downsize, and watch the stock price soar, or it can not downsize, and watch the stock price sink, but at least receive some compensation for making the wise move of not reducing capacity in the face of an economic boom. In this model, the compensation from stock options is higher than the compensation for making good business moves. Executives are paid more to pay attention to the perceived value of the firm and less to pay attention to the actual value of the firm. Downsizing raises the perceived value of the firm but lowers the actual value. Delta Airlines might be a perfect example of this. The stock of Delta soared on the news of the downsizing, but the company was crippled, and eventually under-performed relative to similar carriers like United. AT&T also appears like a good example. By merely announcing to downsize, the CEO was able to raise the perceived value of the firm, but did nothing to augment the actual value. In both Delta’s and AT&T’s cases, the CEOs left the firms before the true impact of the downsizing (or pseudo-downsizing) took effect. Both parted with lucrative compensation, based on the run-up in the equity value during their last few months at the helm.

Note that no one is doing anything "wrong"—this is an equilibrium after all. Investors are right to buy the stock of downsizers, since more often than not, a downsizer will be a strong firm, if all firms downsize. Yet, this equilibrium is sub-optimal in an economy-wide sense. Investors will never get their highest payoff if they observe downsizing. They have either bought the stock of a weak company, or have bought the stock of a strong company that has shot itself in the foot by firing its workers just when business has started to pick up.

Nevertheless, with the information flow and payoffs, the management of strong companies has huge incentives to lay off workers if this move will increase the perceived value of the firm at the expense of the actual value. The investors are not mis-valuing the firm, or making systematic errors in judgement. The difference between the perceived and actual values is not a function of stupidity and irrationality of investors; it’s a function of the lack of information flow. Once the executive’s compensation is tied more to the actual value of the firm than to the perceived value, as the game of Section V.3. illustrates, there will no longer be an incentive to make a bad business choice. Stock options can compel managers to make bad business decisions, since they are compensated according to the perceived value of the firm, and not its actual value.

4. Is downsizing a signal of the strength of a firm? If so, why do firms in similar situations in a given market follow markedly different employment policies?

The answer to this question depends on the structure of the game. In the basic AT&T game, downsizing revealed no pertinent information about firm strength. When the AT&T game was played during a recession, downsizing was a perfect indication of the market power of a firm, since only weak firms downsized. In the Delta/United game, it was an imperfect signal, since both strong and weak firms were observed downsizing, and both strong and inefficient firms were observed maintaining the workforce.

In that game, strong firms were observed both downsizing and not downsizing. This indicates that two identical firms playing the game can potentially make two different labor decisions. Whether a company will follow a certain strategy is a function of the probability that the investor will buy or sell the stock at a certain node. When the probabilities are aligned to make the company indifferent between buying and selling, then either strategy, or any combination of the strategies will have the same payoff. Similar firms follow different employment policies if and only if they are indifferent between downsizing and maintaining the labor force. This observation is consistent with the strategy choice of United. United’s management was equally prepared to execute a plan of downsizing, or an employee-buyout. It knew that if it downsized, the stock price could be bid up, and it knew that if it didn’t downsize, the actual value of the firm would increase. The investors’ probabilities of buying and selling made the United management indifferent between the two proposals. Its willingness to follow two strategies in the game is a signal of indifference, but its actual choice not to downsize was the result of other complicated factors not captured in the simple game of strategy. Simple indifference could help explain (but not necessarily prove) why United’s management let the unions choose the future of the firm.

This is the only section of the thesis that ever challenges the efficient market hypothesis. In every other case, even though the perceived value of the firm and the actual value can move in two different directions, markets are still efficient, and make use of all relevant information (such as a downsizing). In the AT&T case, the downsizing contains no information about firm value, so any reaction to a downsizing is therefore overreaction. The market didn’t learn anything it already didn’t know. The event study could not reject the hypothesis that news of a downsizing was irrelevant to firm value, projected immediately, or as far out as 100 days. However, expectations of a downsizing were proven to be relevant, if the firm delivered a downsizing of fewer workers than expected.

The stock returns did display a statistically significant momentum between the day of the downsizing and the following day. If the stock price rose on day 0, it will rise on day 1. The market is slow to digest the news of a downsizing, anticipated or not. However, relative to the five-day return, the one-day return appears to be an over-reaction. An investor buying the stock the day of the downsizing will make a better return if she sells at the end of the day, instead of at the end of the week (if the stock price goes up). From the peak stock price, at the end of day 1, the predicted return going forward is lower than the average return in the sense of statistical significance, suggesting eventual over-reaction to the news. This bizarre pattern is consistent with other recent event studies, but merits further investigation. The stock market under-reacts to a downsizing the day it is announced, but eventually over-reacts to the news by the end of the week. The sign of the return the day of the downsizing predicts the sign of the return for holding periods at least 100 days from the downsizing. The first hunch is always right. If the stock trades above (below) its pre-downsizing price at the end of day 0, it is guaranteed with 95% confidence to trade above (below) the pre-downsizing price out to day 100.

Now that a clearer view of downsizing has been presented in terms of addressing the five major issues relating to downsizing, the next step is to ask if the behavior of investors and management was optimal, or in a sense, irrational. The way the game is set up, which closely mirrors actual payoffs in terms of incentives, demonstrates that the behavior of management and investors is individually optimal, in the Nash Equilibrium sense. The solutions obtained for each game were determined by each player asking himself the question which strategy will maximize my payoffs?, and then executing that choice. This sort of behavior appears to be perfectly rational in the sense of expected utility maximization. But just because a strategy profile is a Nash Equilibrium does not indicate that it is the solution in which everyone is made happiest; it is simply a solution that will be observed in equilibrium, since each player’s actions are a best response to the other player’s actions, and no one has an incentive to deviate from those strategies. Once each player decides to play his Nash strategy, no other behavior will be observed, since no one will ever want to deviate from the Nash behavior. In games with several Nash Equilibria, there were cases in which some players were better off in one equilibrium than another. Of course, there were certainly high payoffs that were never obtained in the equilibria.

Even though each player was behaving rationally at all nodes, it seems that something quite sub-optimal is lurking in the solution to each game. For example, there are instances in which strong firms downsize, and cases in which investors buy the stock of weak firms. In and of themselves, these decisions are clearly stupid, but they are simply products of the information asymmetry between the managers and the investors. Strong firms have an incentive to downsize, since investors have announced that they will buy the stock of downsizing firms and sell all other stocks. The stock of weak companies is bought since investors know that the chances that they are buying a strong company are higher. This second sub-optimal outcome can’t be helped, as it is just the product of uncertainty. But the first observation, that of strong firms downsizing, can be helped by changing the payoffs to the game. Strong companies downsize since the managers know that investors will buy the stock, and since managers are rewarded heavily when the stock price rises, they will want to downsize. If the board of directors changes the payoffs to management, and reduces the importance of stock-based compensation relative to business performance compensation, then it is no longer a Nash strategy to downsize if the firm is strong.

So in a certain sense, while the behavior of each participant is optimal given the incentives, the incentives themselves may not be optimal. Once the prevalence of stock options were reduced relative to other forms of compensation, then even in the presence of the information asymmetry, the Nash equilibrium actually corresponded to the proper business strategies: buy the stock of strong companies, sell the stock of weak companies, downsize of you are weak, maintain the labor force if you are strong. In other words, once the incentives to the management were revalued, decisions that improved the perceived value of the firm improved the actual value of the firm as well. The perceived value and the actual value move in two different directions when strong companies downsize. While no one can say for certain without getting into the minds of the CEOs of AT&T and Delta, something appears quite suspicious regarding their strategies. They announced massive downsizings, watched the stock price soar, and then left the firms, collecting millions, before the implications of their value-destroying strategies (or pseudo-strategy, in the case of AT&T) were fully understood.

Investors have an incentive to re-set the management’s payoffs, but this is clearly not observed in the marketplace. Any number of factors may be at fault: a misperception that stock options are the cure-all to the principal-agent problem, management control of the board of directors, which basically rubber-stamp everything the CEO does, or the inability of individual investors to collude and determine who the board members should be. It could be the case that stock options are optimal in a weak sense if they work better than the alternative, which are no stock options. Additionally, it is easy to compensate the management based on the stock price (the perceived value of the firm), but quite difficult to compensate the management for improving the actual value of the firm, for which there is no precise measurement. Stock options may be the best, albeit imperfect, method to compensate managers for improving the actual value of the firm, and downsizing may be the case in which this method fails.

If the alternative is simply no stock options altogether, then that would be completely undesirable. If management is just given a base salary, then there is no incentive to improve either the perceived or the actual value of the firm. The only motivation for managers would be the fear of bankruptcy or being fired for incompetence. Another alternative to stock options might be performance-based compensation. Management could be rewarded for how the firm’s customer service ratings improve, or how the firm’s market share fares relative to the rest of the industry. But forcing the managers to share too much risk with the investors could be disastrous, especially in managers are risk averse, and tend to maximize the payoff to the worst possible situation instead of concentrating on maximizing the expected value of the firm.

As this is an exercise in economics, it remains instructive to determine if downsizing is socially optimal. Abstracting from the utility of workers for the time being, downsizing is sub-optimal since neither the management nor the investors receive the highest possible payoff when the firm is strong. For the equilibrium in which all firms downsize and investors buy all downsizing firms, the management of a strong firm receives 2 (2 points for having the stock bought, and 0 points for making a bad business move), and the investors receive 1 (1 point for buying the stock of a strong company, and 0 points for holding the stock of a company that has made a poor business choice). The optimal outcome would have been for management not to downsize, and for the investors to have bought the stock. Management would receive 3 in this case, and investors would receive 2. Both players are unambiguously better off in this situation. However, this outcome is not observed in equilibrium, due to the information barrier, which unambiguously hurts strong firms and investors.

Moreover, the information barrier between management and investors also worsens the utility of workers, who are downsized in the Nash Equilibrium, and are not downsized in the optimal situation, in which management and investors receive their highest payoffs. Clearly, there is room to improve the utility of managers, workers, and investors (without improving the utility of one party at the expense of another’s); the deadweight loss (agency cost) of the information barrier is quite apparent. Without resorting to the debatable mechanics of a social utility function that incorporates managers, investors, and workers, it appears rather obvious that downsizing is socially undesirable. The prime example of this is the AT&T game, which also describes the situation of Procter & Gamble or Xerox, all very powerful firms. It seems that jobs are being destroyed for absolutely no reason, since in the AT&T game, downsizing is a signal of nothing. These games don’t really include the utility of workers, but workers are unambiguously hurt during the interaction of management and investors. Downsizing appears as a problem of public economics, as every player is individually behaving optimally, but social welfare is not at all maximized.

History and common sense remind us that expectations cannot be divorced from reality for too long. Following the disastrous and highly publicized downsizing attempts of firms such as Delta and AT&T, investors may have realized the high costs that a downsizing entails. The AT&T case taught investors that the announcement of a downsizing might not even be credible. The Delta case taught investors and management that company loyalty, productivity, and firm-specific skills need to be seriously weighed if a company wants to consider a downsizing. Delta Airlines fired 18,000 workers, only to find that it was short in baggage handlers, customer service workers, and maintenance workers. Delta might have saved some money in the short run, but the loss of skilled labor and innovation was quite costly, as it tried to rehire many workers. This could prove difficult, as the fired workers who were most skilled and capable of landing other jobs did, while a pool of labor of lesser quality was left behind.

By mid 1997, a lull had appeared in corporate downsizing, and was matched by a rise in expectations of future job prospects, as measured by the Conference Board survey data presented in Chapter II. As downsizing becomes less and less prominent, workers gain more and more confidence about future job prospects. To the extent that a reduction in respondents who fear net job destruction will continue, the econometrics presented in Chapter II might suggest that the rate of inflation could pick up.

For many industry analysts and corporate policy experts, the tidal wave of downsizing is over. To many, it was no more than a fad that slashed quality and productivity along with jobs. A survey by the American Management Association found that cutting the labor force failed to improve product quality in most companies. Furthermore, less than half the companies that had cut jobs since 1990 had seen a rise in profitability.

By the end of 1996, a backlash in downsizing was apparent, and the words "rightsizing" and "upsizing" were coined. The American Management Association’s annual survey, released in October 1996, showed that for every job cut, one was created, in the overall economy. Only one-fifth of firms were planning job cuts in the next six months, and 68% claimed that they had created positions during the year. Firms that reported a marked increase in their worker training budgets demonstrated improvement in worker productivity and higher profits than other firms. Several firms that refused to downsize during the 1993 – 1996 wave have shown significant stock price appreciation relative to the rest of their industry. Examples include Gillette, Hewlett-Packard, United Airlines, and Ford Motor Corporation. A year-end article in The Economist, entitled "The Year Downsizing Grew Up" reported that one of the biggest downsizers (General Motors, which vowed to cut its workforce from 800,000 in 1979 to 450,000 in 1990) was set to add 11,000 to its payroll. Also, Hughes Electronics, which had downsized in small, successive quantities by a quarter since the beginning of the decade, attempted to hire 8,000 workers. A survey of human resources directors reveals a changing attitude towards downsizing. The percentage of managers who believe that their company is understaffed has risen from 40% in 1992 to 58% in 1998.

Wall Street analyst Stephen Roach symbolizes the changing sentiment towards downsizing. As the Chief Economist at Morgan Stanley, he once touted downsizing as the cure to any corporation’s ailments. Downsizing was alleged to improve productivity, increase profitability, and in some respects, to ensure the health of the overall economy by hampering inflationary expectations (via wage inflation). In a May 1997 report, Roach reversed his opinion, warning against the "hollowing out" of corporate America. Roach is not only unconvinced that downsizing will engender a long-run productivity gain, but also is concerned that "tactics of open-ended downsizing and real-wage compression are ultimately recipes for industrial extinction."

Downsizing failed as a method to boost shareholder value in the 1990s since very few firms did it correctly, or it was a tactic employed too often, so that the market couldn’t tell when it was needed and when it wasn’t. Companies that followed "last-in first-out" policies (firing those most recently hired) lost on out on the skills and innovation of recent graduates (not to mention the lower wages they were willing to accept). Companies that fired middle management lost experienced workers familiar with the day-to-day micro-operations of specific sub-divisions of the company, and widened the gap between the rank-and-file workers and the top management. The companies also lost an intangible, yet essential asset: worker loyalty. Many who feared losing their jobs stopped caring about the long-term prospects of the firm, and had less incentive to perform well if they know that after all of their efforts, the probability was higher that they would be fired.

A recent study in Finland has attempted to quantify the impacts of downsizing on the remaining workforce. The researchers studied the correlation between downsizing and ill health in the workers who were not downsized. According to the study, the rate of long-term sick leave was in a confidence interval of 1.9 to 6.9 times greater after a major downsizing as compared to a normal work environment. Additionally, a 16 to 31 percent increase in sick leave was measured for employees during the period of the downsizing. This survey either indicates that a firm fires all of its healthy workers in a downsizing, or that the drop in morale and increased pressures to perform the same tasks with fewer workers causes illness in the workforce. A company clearly needs to examine the increases in health care costs, sick leave pay, and possible productivity slowdown that a downsizing may entail. The evidence in employee-owned United Airlines seems related to this issue: following the employee buyout that reduced the probability of a downsizing, sick leave and employee grievances fell substantially.

A study of the largest 250 Canadian companies finds no link between firm performance and downsizing. The researchers were unable to reject the hypothesis that downsizing is unrelated to past performance, nor could they reject the hypothesis that downsized companies are no more profitable than companies that don’t downsize. According to the researchers, "these results imply that many organizations are downsizing even though it is not necessary, because it seems to be the popular—and therefore safe—thing to do." Another study of 148 Canadian companies displayed mixed results as to the benefits of downsizing. A reduction in expenses did not materialize for 40% of the surveyed companies that downsized. Furthermore, 60% of the companies that reduced their workforces did not experience an increase in profitability. More than half of the companies that fired workers reported that they hired new staff not long after the downsizing.

Very little work has been done on the social ramifications of downsizing. The decrease in job security might give workers less of an incentive to make efforts to improve firm value. If the mentality in the workplace becomes "I’m going to get fired anyway," then workers will have little reason to enhance performance or innovate. If the US economy is truly transitioning to an economy in which a worker is expected to have several jobs during her lifetime, with periods of unemployment between them, it could be that the equilibrium wage will rise to compensate workers for the extra risk they take. Another theoretical possibility is that the cost of unemployment insurance will rise as the probability of individual unemployment rises. Luckily, none of these trends have been observed in the data for the US as a result of the downsizing era. One likely explanation is that a sectoral shift from employment at large corporations to employment at small enterprises is emerging in the US; Delta hiring its laid-off employees as consultants is one example.

In the models I present, workers have little say over their future employment status. Too often, workers feel the brunt for the mistakes made by management with regard to labor policy. It seems that being fired is an externality from the interaction between the firm’s principal and its agents. Public economics would suggest that a negative externality be taxed by the government to discourage one party from harming another. A so-called downsizing tax imposed on companies would reduce the incentives for managers to downsize in order to cut costs, since they would have to pay a penalty. While such a policy seems almost ludicrous for the United States, downsizing taxes are in effect in many countries in the European Union, particularly in France, where unemployment is quite high. Any company that fires over 40 workers must file in writing with France’s labor department, pay hefty severance fees, lose exemption from many payroll taxes, contribute to an unemployment fund, and submit a plan to the government of how it will re-train its displaced employees for future employment. Moreover, many find themselves out of favor when bidding for government contracts. Further empirical work could trace the equity value of a French enterprise that decides to brave the government tax, and proceeds with a downsizing. Air France, the country’s semi-privatized national airline, is currently contemplating a significant reduction in its workforce.

Yet a downsizing tax could cause more problems than it solves. The inability to fire workers without entailing substantial costs helps workers who are already on the payroll, but could harm those looking for employment. Firms must be very confident that they will need this employee for life, since firing him in a time of economic difficulty will be next to impossible. Many economists consider such downsizing taxes (among other things) as evidence of the labor market rigidity, the low rate of job creation, and the high rate of unemployment that are currently plaguing the European Union, notably France. Ironically, these policies designed to keep workers from becoming unemployed have the side effect of potentially preventing those that are in search of work from ever finding a company willing to hire them. Hiring and firing workers in the US is accomplished in a more flexible environment, but this flexibility comes at the price of frequent downsizings, especially recently.

Downsizing was first done by GE and GM for the "right reasons:" namely, to recognize the massive substitution of capital for labor in their given industries, and to focus on productivity, and efficiency, and cut non-essential elements out of the business. Downsizing went awry because of what strategy profile 2 from the model suggests: firms facing strong markets will fire workers—even though they shouldn’t—to convince investors of their plans for profit growth and cost cutting. Like many trends, it went too far, and was outdone by the excesses that it promoted. Today, investors are relatively "wiser" from experience, and the announcement of a downsizing does not nearly have the glamour for Wall Street that it used to convey.

However, the trend of downsizing appears on the rise again. Recall that downsizings tend to occur more often than not at the very end and very beginning of the calendar year. December 1997 and January 1998 workforce cuts included notable firms such as J. P. Morgan, and Citibank. Columbia HCA announced plans to trim its workforce by one-third. AT&T has announced yet another downsizing: this one of 18,000 workers in January 1998. The stock market wasn’t fooled this time, and AT&T closed lower for the day. Other major downsizings of NYSE-listed companies in 1998 have included Cypress Semiconductor, and Sunbeam, Inc., which plans to cut 50% of its workforce.

This thesis has constantly stressed the importance of information flows and incentives. Investors must realize that stock options are not the panacea to the principal-agent problem. While they work much more often than not, the phenomenon of strong firms downsizing is a costly side-effect to executive stock options, not just for firm value, but also for the workers who are forced into unemployment. I hope that the leading and influential professors of economics and finance explore this subject further, and I urge stockholders and company board members to closely examine the stock options package of their executives to make sure their incentives are really geared towards improving the value of the firm. While the example in this thesis is highly stylized, it does closely mirror what went wrong when executives are awarded hefty stock options.

Despite all of the rigorous analysis of this thesis, downsizing itself remains elusive. Downsizing has proven to be a signal of strength, of weakness, and of nothing. If anything, it has gone too far, but it’s hard to blame anyone for this mistake. Wall Street analysts who praised CEOs for slimming their workforces were only expressing investor sentiments. CEOs that fired thousands of workers were merely following a path of incentives that their contracts contained. Investors were doing the best job possible to make a return, given their limited amount of information. And somewhere along the line, the workers paid the price. Not so much in that they were fired and could not find work (although this was true for some), but the insecurity of walking in the door every morning and expecting to find a pink slip waiting for you is nerve-wracking, stressful, unfair, and in no way contributes to building firm value.