I NCENTIVES AND O RGANIZATION Managerial Economics Jack Wu

O UTLINE organizational architecture moral hazard ownership vertical integration

O RGANIZATIONAL ARCHITECTURE Base – distribution of ownership Two pillars incentive schemes monitoring systems

O RGANIZATIONAL ARCHITECTURE : C ORPORATE GOVERNANCE Ownership – takeover Incentives – shares and options – bonuses – profit-sharing  Monitoring  Board of Directors  major shareholders

M ORAL H AZARD asymmetric information about action conflict of interest

M ORAL HAZARD : D OCTORS Brazil: among pregnant women, rate of cesarian section – 30% (81 of 269) in public hospitals – 66% (117 of 177) in private hospitals Happy coincidence?

M ORAL H AZARD IN E MPLOYMENT worker’s marginal cost employer’s marginal benefit worker’s marginal benefit Quantity (units of effort) Marg. cost/benefit (cents per unit) efficient effort

M ORAL H AZARD IN B ANKING premium for deposit insurance is not experience- rated riskier the investment, the greater the expected benefit for the bank owners and the higher the expected loss for the Central Bank  conflict of interest Central Bank cannot easily monitor actions of the bank

RESOLVING MORAL HAZARD incentive scheme conditional payment quota monitoring system incentives must be based on observables

I NCENTIVE VS R ISK Efficient scheme balances benefits of more effort costs of risk bearing degree of risk risk aversion

R ELATIVE P ERFORMANCE employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve

I NCENTIVES : P UBLIC LISTED COMPANIES U.S. listed companies report their total shareholder return relative to peer group

M ULTIPLE R ESPONSIBILITIES strong incentive more effort on that dimension less effort on other dimensions

N ON -P ROFIT O RGANIZATIONS school ’ s objective maximize profit maximize education of students other examples – hospital, museum non-profit organization to tone down profit incentive

H OLDUP Holdup = opportunistic behavior = action intended to exploit another party ’ s dependence unlike moral hazard, holdup can arise even if information is symmetric

R ESOLVING H OLDUP avoid specific investments write more detailed contracts vertical integration (redistribute ownership)

C OMPLETE C ONTRACT specifies actions and payments in every contingency degree to which a contract should be complete potential benefits and costs at stake extent of possible contingencies

O WNERSHIP Residual rights control -- rights that have not been contracted away income -- remaining after payment of all other claims

V ERTICAL I NTEGRATION Combination of assets for two successive stages of production under a common ownership upstream: away from final consumer Dominion Resources acquired Consolidated Natural Gas, 1999 downstream: closer to final consumer Phillips Petroleum acquired Tosco, 2001

V ERTICAL INTEGRATION : M AKE OR BUY ? Should gasoline refiner make or buy the crude that it processes? Should University make or buy its electricity? Should family cook meals at home or eat out?

V ERTICAL I NTEGRATION : I MPACT Owner gets rights to residual control and residual income reduces potential for holdup