Slide 1  2002 South-Western Publishing Coordination and control are problems for all business organizations. The larger the organization, the larger the problem. Contracts help insure performance, but most contracts are incomplete. Goods are allocated in free markets by using prices. However, there are alternative allocative mechanisms that are adopted, such as waiting in line (queues) and auctions the avoid prices. Organizational Form, Governance and Mechanism Design Chapter 15

Slide 2 Role of Business Contracting in Cooperative Games The amount of advertising and service can be viewed as a game. The outcome can be sub-optimal; that is, it is not value maximizing. The cooperative solution sometime yields better payoffs. To get to a value-maximizing solution, the manufacturer may have to consider side payments or credible commitments to the retailer.

Slide 3 Choice of Organizational Form A reliant asset is a non-redeployable durable asset. Specialized equipment or specialized knowledge cannot be transferred to other uses. In markets with reliant assets, one party could “hold-up” the other party. The choice of organization will require explicit contracts. The likely outcome is franchise contracts. Relational contracts are promissory agreements of coordinated performance. A jet charter company is a good example.

Slide 4 Vertical Requirements Contract A vertical requirements contract is one in which the firms in successive stages of production agree to payments and/or penalties for taking an action. Contracts must assign penalties for not living up to the agreement. These payments are part of a several step sequential game. »If the manufacturer spends a large amount to advertise the product, the distributor promises to promote the product as well.

Slide 5 Vertical Integration An alternative to contracts between two parties is vertical integration. If the retailer and manufacturer merge, then both interests are reflected in a decision whether or not to advertise or expand service. Spot markets present few incentive or informational problems. »The purchase of a dozen ears of corn at a roadside stand or the sale of electricity at a spot rate off the grid, are examples of spot markets. »The products are relatively standardized and sold for immediate delivery.

Slide 6 Governance Mechanisms and the Problem of Moral Hazard Establishing a price for a product or service in a market involves a cost. Transaction cost economics - involves the issue of finding the lowest cost organizational structure. »In some cases it is cheapest to vertically integrate and avoid markets. »In other cases, firms create quasi-prices, known as transfer prices, to create market-like pricing in a multi-divisional firm. »Still others find that market relationships work best, by buying and selling at arm's length prices. »When only incomplete contracts are possible, it is often the best to integrate the operations within a firm.

Slide 7 Moral Hazard Moral hazard occurs when parties change their behavior due to contracts. This is especially true when the people's effort is hard to observe. Consider a borrower-lender contract. »A reliable borrower, once given money in a loan, may elect to invest in high risk projects. »To avoid this moral hazard, the bank may insist on costly monitoring or governance actions, forcing the borrow to submit frequent financial data.

Slide 8 An Optimal Design Mechanism What is the best way to divide a deceased individual’s estate? What mechanism will encourage open communication and a fair division? These are the types of issues discussed in finding an optimal design. Fair division of a decaying prize problem. Suppose the division of an award between two parties shrinks each time one party refuses the agreement. The incentive is created to agree to a 50:50 split; otherwise, the prize may get smaller.

Slide 9 The Service Queue Problem: Customers Wait in Line First-come, first-served  The people with the lowest cost of time get the tickets. Last-come, first-served  removes the incentive to wait in line. The best strategy is to show up anytime, whenever the ticket window is open. Stratified lotteries  advanced reservation tickets are assigned different prices than last minute walk-ups.

Slide 10 Auction Design and Information Economics Bid prices can be discrete or continuous  by agreed increments, as in 1/8 or 1/16 for stocks in the past or any decimal price now. Bids can be sealed or posted  sealed bids make them anonymous and secret to other bidders Bids can be one-time-only or multiple rounds. Simultaneous bidding  open outcry at estate auctions. Information about other bidders valuation is revealed »price discovery occurs Sequential bidding  such as private placement for newly issued securities.

Slide 11 Types of Auctions In English auctions, the prices rise as more bids arrive. In Dutch auctions, a high price is announced, and if no one agrees, the auctioneer lowers the price until the first bid arrives. »If mineral rights to 1,000 acres of land were auctioned, the winning bid may elect to purchase less than 1,000 acres or rights. Reservation price  the minimum acceptable bid.

Slide 12 Winner’s Curse If the true value of an item is not known, but bidders have a distribution of values that they are willing to pay, the winning bid is very likely to be higher than the true value. The regret for the bidder is that he or she paid too much: the winner’s curse. If everyone is aware of the winner’s curse, then all would bid less than what they think is its true value. This problem has led some auctions to award the highest bidder with the second-best price in a sealed bid auction. Even though you won, the price was a bit lower than what you paid.

Slide 13 Information Revealed in Common-Value Auctions Common-value auctions are ones where the bidders have identical valuation of the item when information is complete. For simultaneous, sealed-bid auctions, the bidder offers prices below their expected value. »No information is conveyed to competitors. For simultaneous, open-bidding auctions, information is revealed by the bids of others. One variation is multiple rounds. Bidding for broadcast spectrum bidding, the FCC used 112 rounds over a four-month bidding period.

Slide 14 Strategic Underbidding in Private-Value Auctions Private-value auctions are where bidders have different valuations for the item The highest value bidders may wish to wait-and-see in English open outcry auctions. In sealed-bid auctions, this strategy does not work. Even with sealed bidding, the fear of the winners curse may lead to underbidding. A Vickery auction is the second- highest sealed bid auctions. Second-highest sealed bids are used to reduce underbidding. Knowing that you pay less than bid helps to move bid closer to one’s private value. As the number of bidders rises, the percentage underbid tends to decline. Vickery shows the optimal underbidding is 1/N th the true value, with N the number of bidders.