1. Incentive Conflicts and Contracts

2. Incentive Conflicts and Contracts learning objectives
Students should be able to
Describe and offer examples of several kinds of incentive conflicts in firms
State the role of contracts in reducing incentive conflicts
Describe and offer examples of several pre- and postcontractual information problems

3. Examples of incentive conflicts
Owner versus manager
profits or salaries and perks
work hard or shirk
take chances or play it safe
Buyer versus supplier
Free ride or not
Management versus labor

4. The role of contracts Costless contracting
ideal contracts would align interests (minimize incentive conflicts) at no or low cost
Costly contracting and asymmetric information
contracts costly to negotiate, write, administer
parties to contract have asymmetric information on performance levels

5. Firm as focal point for set of contracts

6. Postcontractual information problems
Agency problems
principal contracts with agent for service
agent has postcontractual incentive to serve own perceived best interests
Asymmetric information complicates resolution of agency problems
principal incurs monitoring costs and/or
agent incurs bonding costs

7. Optimal combination of compensation and perks
CEO utility function, C is compensation, P is perquisites: U=f(C,P)
Owners have precise knowledge of profit potential: p
Realized profits are: R=p-P
Therefore offer CEO compensation contract:
C=S-(p- R)

8. Optimal perquisite taking

9. Postcontractual information problems
Agency problems
principal contracts with agent for service
agent has postcontractual incentive to serve own perceived best interests
Incentives to economize on agency costs
sharing increased gains from trade

10. Agency Cost Example Good Tire Company and Brown & Brown
Good Tire’s marginal benefit from legal services: MB=200-2L
Brown & Brown’s marginal cost for providing legal services: MC=100
Value maximization: MB=MC, or
200-2L=100, L*=50
Fee of $6250 covers costs of $5000 and yields net benefits of $1250 each

11. Agency Cost Example Good Tire Company and Brown & Brown
BUT Brown & Brown may have incentive to provide fewer than 50 hours
Costly for Good Tire to monitor or for B&B to provide guarantee
Possible outcome is reduced gain from trade (foregone surplus)

12. Agency costs in legal contracting

13. Precontractual information problems
Bargaining failures
asymmetric information
Adverse selection
use of private information in manner detrimental to trading partner

14. Implicit contracts and reputations
Implicit contracts -- agreements and understandings that can’t be legally enforced
Reputational concerns can motivate implicit contract compliance