Motivation: contracts, information and incentives M/R Chapter 5 The primary aim: Discuss theory about contracts that promote efficient outcomes of organizational processes

Costs of allocating resources through ”organisations” Assumption: conditions for ”no wealth effects” are not satisfied Costs for bargaining about employment contracts (managers and other employees) Payments for performance incentives

Illustrative example Actions that can be taken when a company is too big to be managed effectively: Slicing-up the value chain Split up property Out-sourcing Limitiations on possibilities to divide property: Assets are cospecialized (loose much of their value if used separately to produce independent products or services) Secure growth opportunities by appropriate contracts with skilled employees

Efficient organisation to secure future growth opportunities

Motivation problem when ”no Wealth Effects” Contracts are imperfect future events impossible to forecast and parties have private information they do not want to reveal as they can gain from keeping it secret Opportunistic behaviour Moral hazard: Opportunism arising when actions required or desired under the contract is not observable Adverse selection: Opportunism arising when one party has private information about something that affects the other’s net benefit from the contract and when only those whose private information implies that the contract will be disadvantageous for the other party agree to a contract.

Motivation problem To align different interests as far as possible An efficient allocation mechanism: There is no alternative method that is feasible in the presence of incentive constraints and that all the relevant parties prefer it to the original mechanism.

Incentive efficient mechanisms in case of ”no Wealth Effects” Engineers, who are going to collaborate about a project to obtain a certain type of technological knowledge This knowledge is a public good: All participants are free to use the knowledge as they want after the project is terminated. Each participant is free to leave the project. If they do so, they do not get the benefits of the project Total cost of the project: 1 euro Two groups of engineer: 1) getting a value of 2 euro from its being undertaken and 2) indifferent to the project getting 0 euro. No one can be forced to pay more than it is worth to her Private information: each individual’s valuation of the project Somebody may ‘free-ride’, falsely declaring that they value the project to 0 euro hoping that someone else will pay for it (Adverse selection) The probability that any single individual values the project positively: p The costs are split equally among the m individuals