Moral Hazard and performance incentives M/R chapter 6 The primary aim: Look at factors that influence the board and the personnel department when designing incentive efficient payments

Sum up transaction costs: Properties of transactions Asset specificity: measured as the percentage of investment value that is lost when the asset is used outside the specific setting or relationship. Cospecialized assets: they are most productive when used together and lose much of their value if used separately to produce independent products or services. The ‘hold-up problem : One who makes an asset specific investment can be harmed by a threat by other parties to terminate a relationship. This threat permits these parties to obtain better terms than were initially agreed.

Sum up transaction costs: Type of contracts Written contracts (can be enforced by court) Implicit contracts: Shared understandings that are not legally enforceable, but the parties consider it to be binding on one another’s conduct. The “end game problem” The value of reputation and the motivation for investing in trust relationships depends on the time horizon over which similar transaction are expected to occur.

Designing efficient incentive contracts The two objectives of incentive contracts: provide incentive and insulate from risk Efficient incentive contracts: balance the costs of risk bearing against the benefits of improved incentives A public company owned by many shareholders is an efficient mode of risk-sharing: employers are better prepared to bear risks of incentive payments than employees A close relationship between pay and performance.

Efficient balance of incentive and risk factors (employees): Avoids to motivate workers to increase productivity by paying bonus based on profitability The personnel department links reward to contributions made directly by the employees such as the volume of output, the number of defects, the number of days absent.

Managerial compensation: Arguable that incentive efficiency requires that managers bear some of the risks associated with returns and get rights to residual control (residual claimants) Performance related pay should decline with the total risk in an industry. A risk averse CEO, who is forced to accept a high-powered contract, demands a higher average pay level to compensate for increased variance in compensation (Gurgler p 44).

……Managerial compensation: Excluding stock option grants: a ten percent increase in firm profitability leads to a 1 to 1.5 percent increase in CEO compensation (large US companies) Stocks and stock options are the driving force behind the close pay- performance relationship in the USA Relative performance does not matter much for managerial compensation The presence of a family representative (in the management or the board) reduces the probability of adopting an equity-authorizing plan or a stock option plan

Career concern models: How are employees deterred from shirking? How are trainees prevented from leaving a job? Models for seniority provision Employees will not retire voluntarily at the appropriate day Mechanism that makes promises by the firms credible

Influence costs: Undesired employee activities that are intended to change a superior’s action to the sole benefit of the employee Costs of discretionary authority, which arise only when an authority exists whose decisions can be influenced.

Costs avoided in decentralized contexts: 1)Those with discretionary authority may misuse their authority directly, on their own initiative 2)Others in the organization may attempt to persuade or manipulate those with authority to use their authority excessively

Incentive contracts coexist with Labour Markets (LM) and Markets for Corp. Control (MCC): CEO interest to build reputation by signalling good behaviour (MCC) Golden parachutes to CEO a guarantee for investments in firm-specific assets (MCC) Benefits from shirking or misinforming that may be detected are less attractive if the labour market is thin (LM)