UNIVERSITY OF ESSEX Department of Economics EC 951 Economics of Organizational Management David Reinstein Some key concepts

This is an incomplete summary of the material Introduction Examples of organization: –Ford/General Motors/Toyota –Hudson Bay Company –Salomon Brothers –Enron –…–… Some lessons from examples: –Organization matters –Organization is a choice –No ‘one size fits all’ organizational structure

This is an incomplete summary of the material Themes Perspectives on organizations Bounded rationality Asymmetric information Performance measures Group incentives Internal labour markets CEO compensation Internal structure of the firm External boundaries of the firm

This is an incomplete summary of the material Theme 1: Perspective on organizations Description of organizations –created entities within and through which people interact to reach individual and collective goals Objective of organizations: –Satisfy wants or needs of individuals Evaluation of organizations: –evaluated in terms of performance, notably efficiency

This is an incomplete summary of the material Some key elements: –Coordination –Transaction costs Coase theorem

This is an incomplete summary of the material Theme 2: bounded rationality Complete contracts –Specifies actions for every thinkable contingency Limits to complete contracts –Transaction costs –Bounded rationality Incomplete contracts –Room for opportunistic behaviour Responses to opportunism: –Inflexible contracts –Implicit/relational contracts –Integration –Commitment –reputation

This is an incomplete summary of the material Theme 3: asymmetric information A key concepts: private information –Incentive constraints Adverse selection Nonrandom selection of people trading Consequences: –Rationing or closing markets Solutions to adverse selection: –Government intervention –Signalling (warranties…) –Screening (own risk…)

This is an incomplete summary of the material Moral hazard: –Unobservable actions Framework: principal-agent model –Conflicting objectives –Gains from cooperation –Principal cannot fully verify or monitor agent’s actions

This is an incomplete summary of the material Contracts: –Observable effort No conflicts of interest Compensate for disutility –Unobservable effort Fixed wage gives no incentives Pay-for-performance Trade-off between power of incentives and costs –High-powered incentives lead to high efforts but costs are higher since agent must be compensated for risk (if agent is risk averse)

This is an incomplete summary of the material Theme 4: performance measures Some basic principles of incentives: –Incentive-intensity principle Optimal intensity incentives depends on: –Incremental profits: P’(e) –Precision performance evaluation: var(x) –Risk aversion: r –Responsiveness to incentives: c’’(e) –Informativeness principle In an optimal contract, all information should be used. That is, pay should be contingent on every relevant indicator.

This is an incomplete summary of the material –Equal compensation principle For all activities that cannot be monitored, marginal rate or return to time spent to each activity must be equal if there is an activity for which performance cannot be measured, incentive pay cannot be used for any other activity

This is an incomplete summary of the material Ratchet effect –Tendency for standards to increase over time –Can be fixed by rotating jobs, reputation … Relative performance measure Subjective performance –Commitment problem reputation –Reluctance by managers to differentiate between workers Forced distribution

This is an incomplete summary of the material Theme 5: group incentives Contracts for groups –Profit sharing –Gain sharing Advantages include –Easier to determine –Sharing risk among members –Group has information –Cooperation encouraged? Disadvantages include –Group conflicts –Free riding Worse for larger groups

This is an incomplete summary of the material Theme 6: internal labour markets How to penalize worker if you cannot fine him/her? Termination of relationship Efficiency wages –Wage above market-clearing wage to prevent shirking Why internal labour markets? –Rigid instrument Reasons include: –Efficiency wages –Firm specific capital –Assessing performance

This is an incomplete summary of the material Why steep upward sloping age-wage profile? –Selection workers who stay –Prevents shirking Promotions –Assign people to jobs –Give incentives to work Problems –Delay promotions –Peter principle Tournaments –Less information needed –Commitment for firm –Too few/many incentives?

This is an incomplete summary of the material Why tenure? –Commitment –Prevent seniors selecting least qualified juniors Why up-or-out rules? –To prevent delay promotions –Careful evaluations

This is an incomplete summary of the material Theme 7: CEO compensation CEO compensation special in at least two respects –High level –High powered (?) Can be explained by principles of incentives Are they taking enough risks? –Human capital at stake (reputation concerns) How to promote risk-taking? –Give insurance (stock options, consensus system…) Are incentives strong enough? DR: Tradeoffs between incentive to perform and risk- taking

This is an incomplete summary of the material Theme 8: internal structure What is the optimal design of an organization? Key aspects: –information flows –Coordination –Authority –decentralization

This is an incomplete summary of the material Common forms: –Unitary form or U-form –Multidivisional form or M-form –Matrix U-form: –Functional economies of scale –Coordination between product lines and geographic area –Congestion at the top –Poor quality of information

This is an incomplete summary of the material M-form: –Efficient cross-functional coordination within product lines –Good quality of information –Weak coordination across product lines Matrix: –Strong coordination across products and across functions –Preserves some of the information efficiency of the m-form –Very (too?) Complex to implement –Agents are overwhelmed by the cross-flow of information –Lack of clarity in authority lines

This is an incomplete summary of the material Some basic trade-offs: –How to assign authority? Production costs –Using local information versus economies of scale Incentives and control –Using local information versus moral hazard problems –Product versus functional organisation: The product organisation relies on simpler contracts but imposes restrictions on the combinations of effort levels that can be implemented

This is an incomplete summary of the material Theme 9: boundaries of the firm Part 1: internal boundaries Transfer prices –Not only redistribution –Double marginalization problem if there is no outside competitive market Multidivisional firm –Distortive transfer prices versus performance measure

This is an incomplete summary of the material Part 2: external boundaries Integrate vertically or not? –Advantages market procurement economies of scale Economies of scope Core competencies Independent (no favoritism problems) Competitive (sometimes through competitive bidding)

This is an incomplete summary of the material –Some advantages vertical integration Improved coordination Protection investments Monitoring more easy Less dependent Barrier against entry by competitors No monopoly distortions Price discrimination Alternative vertical relations –Co-op –Franchise –Supplier organization

This is an incomplete summary of the material Expand horizontally or not? –Some Advantages of horizontal expansion Exploiting economies of scope Creating monopoly power –Merger paradox –bundling –Some Disadvantages of horizontal expansion: Coordination problems Conflicting cultures Some Alternatives: Business alliances Keiretsu