Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright RENTS AND EFFICIENCY Transaction Cost Economics Lecture 8

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Rents and Efficiency Rents: Returns in excess of minimum required to attract resources required Efficiency wage: Excess over market wage Should wages always be minimized? –Henry Ford and market for Model-T Might excess wages be applied efficiently? For the payer? Spending on education of workers beyond training needs – Result? Is it efficient? For when? Worker? Employer? Economy?

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Rents and Efficiency (cont’d) What will limit cheating by employees? –Termination threat? –Excessive compensation? –Monitoring? (vault, lock-in, no pockets, etc.) –Ethics (alternative – assembly line) How do you manage those that you can not observe? Efficiency v. Incentives (too targeted?)

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Rents and Efficiency (cont’d) If efficiency wage is widely implemented, does effectiveness decrease? Does value decrease? Investment banks, accounting firms, law firms and use of efficiency wage in hiring! Are these concerns when wages are negotiated (unions) and based on job title and/or seniority rather than individualized measures? Non-wage factors –Reputation –Career path –Other valuables that lead to effectiveness

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Rents and Efficiency (cont’d) Monitoring v. Reputation, etc. or ownership to minimize cheating Capitalism leads to overpaid and underpaid? Concept of ESOP socialismWhat can they explain?

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Efficient Incentives: Optimal Contract Informativeness principle – Payments should depend only on variables that can lead to accuracy of performance measurement Incentive – intensity principle – incentives should be an increasing function of marginal returns, accuracy of measurement, effectiveness of incentive and risk tolerance Monitoring intensity principle – the greater the incentive the more emphasis on monitoring to reduce errors

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Efficient Incentives: Optimal Contract (cont’d) Equal Compensation Principle – must avoid overincenting one responsibility (ignoring other responsibilities) The Ratchet Effect – Don’t adjust trigger for incentives upward based on past performance – Make sure desired performance (against a norm) is continuing to be rewarded (problem of upping quota for successful performances) Be willing to pay for results of incentive

Lecture 8 – ECON.S-1620 Prof. Charles Moran Copyright Incentive Pay 1.Can performance be measured? –Can determinants be efficiently communicated 2.Can performance inputs be linked to outputs desired? 3.Can external factors be identified and subtracted out? 4.Can behavior be incented without unintended influence on risk taking? (either pos. or neg.) 5.Is there full accounting of all executive activities (i.e. compliance, cooperative/collaborative activities) to assure that incentives do not result in essential activities being ignored 6.Does standardization of wage (union – seniority, etc.) disincent performance 7.Is the uncertainty of equity incentives v. cash incentives of value 8.Role of risk sharing between organization and individual