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Incentives and Organization and Regulation Managerial Economics Jack Wu
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Outline organizational architecture moral hazard ownership vertical integration
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Organizational Architecture distribution of ownership incentive schemes monitoring systems
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Moral Hazard asymmetric information about action conflict of interest
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Moral Hazard in Employment worker’s marginal cost employer’s marginal benefit worker’s marginal benefit Quantity (units of effort) Marg. cost/benefit (cents per unit) efficient effort
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Moral Hazard in Banking premium for deposit insurance is not experience-rated ▫riskier the investment, the greater the expected benefit for the bank owners and the higher the expected loss for the Central Bank conflict of interest Central Bank cannot easily monitor actions of the bank
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Resolving Moral Hazard incentive scheme ▫conditional payment ▫quota monitoring system ▫incentives must be based on observables
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Incentive vs Risk Efficient scheme balances benefits of more effort costs of risk bearing ▫degree of risk ▫risk aversion
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Relative Performance employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve
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Multiple Responsibilities strong incentive ▫more effort on that dimension ▫less effort on other dimensions
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Non-Profit Organizations school ’ s objective ▫maximize profit ▫maximize education of students other examples – hospital, museum non-profit organization to tone down profit incentive
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Holdup Holdup = opportunistic behavior = action intended to exploit another party ’ s dependence unlike moral hazard, holdup can arise even if information is symmetric
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Resolving Holdup avoid specific investments write more detailed contracts vertical integration (redistribute ownership)
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Complete Contract specifies actions and payments in every contingency degree to which a contract should be complete ▫ potential benefits and costs at stake ▫ extent of possible contingencies
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Ownership Residual rights control -- rights that have not been contracted away income -- remaining after payment of all other claims
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Vertical Integration Combination of assets for two successive stages of production under a common ownership upstream: away from final consumer ▫Dominion Resources acquired Consolidated Natural Gas, 1999 downstream: closer to final consumer ▫Phillips Petroleum acquired Tosco, 2001
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Vertical Integration: Impact Owner gets rights to residual control and residual income reduces potential for holdup
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Regulation
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natural monopoly potentially competitive market asymmetric information externalities public goods
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Natural Monopoly Average cost minimized with single supplier large scale/scope economies relative to market demand
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Marginal Cost Pricing Require provider set price equal to marginal cost supply quantity demanded demand marginal cost
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Average Cost Pricing Require provider set price equal to average cost supply quantity demanded demand marginal cost average cost
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Rate of Return Regulation maximum rate of return on rate base disallowed profit returned to users
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Potentially Competitive Market Economies of scale/scope are small relative to market demand technology market demand
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Structural Regulation Bar franchise holder from vertically related markets ▫prevent monopoly from extending market power
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Moral Hazard in Medicine supply inflated demand true demand quantity (million hours a mth) price ($/hour) a b
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Resolving Information Asymmetry mandatory disclosure regulation of conduct structural regulation
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Emissions marginal cost to society quantity (tons/year) marg. cost/benefit ($/ton) 35 8000 marginal benefit to society
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Emissions Fee user fee quantity (tons/year) marg. cost/benefit ($/ton) 35 8000 marginal benefit to society
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Accidents marginal cost to driver quantity (units of care) marg. cost/benefit s marginal benefit to society
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Public Goods legal framework enables excludability ▫copyright ▫patent trade-off ▫incentive for knowledge creation ▫economically efficient usage of information
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Public Provision For some public goods, practically difficult to enforce exclusion national defense clean air fireworks
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Congestible Facilities social marginal cost varies with usage resolve through user fee = social marginal cost ▫time ▫usage
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