Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama

Agenda for Week 4 Review: The Holdup Problem Complete vs. Incomplete Contract Property Rights Approach An Optimal Incentive Contract with Hidden Actions Overview of Chapter 3 Government Restriction on Entry

Holdup Problem I Consider the problem of sourcing bottles for a firm that produces soda pop. F: Fixed Cost of the Machinery necessary to make bottles TVB: Total Variable Costs R: Anticipated Revenue from Soda Pop Sales TVP: Variable Costs of Making Pop Excluding the Costs of Bottles S: Salvage Value of the Machinery T: Cost of Searching Alternative Bottle Suppliers on Short-Notice

Holdup Problem II The Gain From Trade After F has been committed: V = R – TVB – TVP. The Return of Soda Pop Company by sourcing another firm for bottles: V – F – T. The Outside Surplus The Aggregate Surplus by Terminating the Relationship O = (V – F – T) + S.

Holdup Problem III The Advantage of Maintaining the Relationship: V – O -- The Total Amount of Quasi-Rent V – O = Q = F – S + T F – S: Supplier (Bottle Making Company) T: Buyer (Pop Making Company) If Q > 0, there are advantages to maintaining a trading relationship once established.

Holdup Problem: Renegotiation After the bottle maker acquired the bottle- making equipment by spending F, the soda pop firm has an incentive to renegotiate. Instead of Paying F + TVB, offer to pay only S + TVB + $1. The bottle maker can also renegotiate. Requiring F + T + TVB - $1 instead of F + TVB. The risk of having your quasi-rents expropriated by an opportunistic trading partner is called the holdup problem. The Bottle Maker The Pop Maker

Complete vs. Incomplete Contracts A complete contract is the one that will never need to be revised or changed and is enforceable. When contracts are incomplete, incentives are aligned imperfectly and there is a possibility of being disadvantaged by self-interested, opportunistic behaviour.

Property Rights Approach to the Theory of the Firm Firm = the rights of its owners (shareholders) Grossman and Hart Vertical integration does not change the nature of governance. It does change the ownership of assets of the firm.

Three Possible Ownership Structures Lets go back to our simple example: Process B: Raw Material Intermediate Goods Process A: Intermediate Goods Output Goods Vertical Separation The input supplier owns asset b, the downstream firm asset a. Downstream Integration The input supplier owns both asset a and b. Upstream Integration The downstream firm owns both asset a and b. Vertical integration of input supply implies differences in assets ownership and governance. These reduce or eliminate the possibility of holdup problem. Monitoring Problem

Shareholder Monitoring and Incentive Contracts The question of how the owners of a firm can induce the manager to pursue the owners objectives rather than their own is an example of principal-agent problem. Principal-agent problems arise when there are information asymmetries due to either hidden information or hidden actions and when the preferences of the agent are not those of the principal.

An Optimal Incentive Contract with Hidden Actions Suppose that the profits of the firm in the good state of the world are π G =36. In the bad state, π B =6. The manager of the firm can either exert high (e H =2) effort or low effort (e L =1). If he exerts high effort, the probability of good state (p H ) is 2/3 and the probability of low state is 1/3. If he exerts low effort, the probability of good state (p L ) is 1/3 and the probability of low state is 2/3.

An Optimal Incentive Contract with Hidden Actions II Let the utility function of the manager be: u = y 1/2 – (e – 1), where y is his income and e is his effort. The reservation utility u = 1.

Full-information contract? If the firm wants to contract for high effort, u = (y H ) 1/2 – (e H – 1), Similarly for low effort. We will obtain: y H = 4 and y L = 1.

What level of effort is profit maximizing for the firm? π H = p H π G + (1 – p H ) π B – y H π L = p L π G + (1 - p L ) π B – y L By substituting all variables, we will obtain: π H =22 and π L = 15. If the effort is observable, the contract will be: If e = e H =2, y H = 4. If e = e L =1, y L = 1.

Incentive Compatible? If the effort is unobservable, this contract is not incentive compatible. (y H ) 1/2 – (e L – 1) = 2 > u = 1. In addition, notice: π = p L π G + (1 - p L ) π B – y H = 12 < 15. The manager has an incentive to promise to exert high effort, but in fact exerts low effort.

What can the firm do? The firm could offer y = 1. What else? An incentive contract ties the pay of the manager to the profits of the firm.

An Incentive Contract It will specify that the manager be paid y G if the firms profit is π G and y B if the firms profit is π B. The firm will choose y G and y B to maximize the profits subject to two constraints Individual rationality constraints; Incentive compatibility constraints.

Individual Rationality Constraints It requires that the manager should voluntarily accept the contract. p H (y G ) 1/2 + (1 – p H )(y B ) 1/2 – (e H – 1) u By substituting all the numbers, we will have: (1) 2/3 X (y G ) 1/2 + 1/3 X (y B ) 1/2 – 1 1.

Incentive Compatibility Constraints It requires that the manager finds it in his interests to actually exert high effort. p H (y G ) 1/2 + (1 – p H )(y B ) 1/2 – (e H – 1) p L (y G ) 1/2 + (1 – p L )(y B ) 1/2 – (e L – 1). By substituting all the numbers, we will have: (2) 2/3 X (y G ) 1/2 + 1/3 X (y B ) 1/2 – 1 1/3 X (y G ) 1/2 + 2/3 X (y B ) 1/2.

Comparison of the two contracts Maximizing expected profits will involve minimizing the expected payment to the manager. The optimal solution must involve satisfying (1) and (2) as equalities.

Optimal Contract Finally, we will obtain the following contract. If the effort is unobservable, the contract will be: If π G is realized, y G = 9. If π B is realized, y B = 0. Compared to the full-information contract (y H = 4 & y L = 1), it is much greater if the good state is realized and worse if the bad state is realized.

Agency Costs A measure of agency costs to a firm is the difference between its expected profit when the effort is observable (the first best) and the optimal incentive contract (the second best) when the effort is not observable. 2/3 (36 – 9) + 1/3 (6 – 0) = – 20 = 2 (in this example).