1. Week 11 Chapter 10 Incentive Conflicts & Contracts

2. Incentive Conflicts and Contracts
Identify several kinds of incentive conflicts in firms
Understand the role of contracts in reducing incentive conflicts
Identify several pre- and post-contractual information problems

3. Firm: a focal point of a set of contracts
Simple econ model: firm makes decisions to max profits: Max TR, Min TC
Firm is more complex
Many decision makers
Maximizing individual utility
Transfer pricing for internal allocation of resources
Use contracts to organize behavior
Explicit, Implicit

4. Firm as focal point for set of contracts

5. Spectrum of Organizations: Residual claimant
Sole proprietorship: Owner/manager
Partnership: Shared by Partners
Corporation: Diverse stockholders
Mutual Insurance: owners are customers
Cooperative (Ocean Spray) owners are suppliers
Employee owned: (United Airlines) owners are employees
Charity: No owners.

6. Corporate Management Owners (Stockholders)
Board of Directors (Meet quarterly)
Inside directors
Outside directors
Chiefs (CEO, CFO, CIO, COO, ETC)
Divisional Managers
Team leaders
Workers

7. Examples of incentive conflicts
Manager versus Owner
work hard or shirk
profits or salaries and perks
Excessive risk aversion: Manager has large share of wealth in firm
Differential time horizon: Manager has short term
Overinvestment: Empire Building, reluctant to downsize

8. Additional potential conflicts of interest
Buyers vs Suppliers
(Cost+) Halliburton
Price v Quality
Buyer: High quality, Low price
Seller: Low quality, high price
Joint ownership can lead to Free-riders
Shirking: Ringelmann rope pull: As the number of workers increased, the individual effort declined.
Never send instructions to a group (Randy Pauch)

9. Teamwork in a Cooperative
10 people run a grocery cooperative
Share equally, jobs & profits
Average daily earnings $ 2000 / 10 = $ 200
Earnings vary from day to day…

10. Teamwork  Shirking
When earnings are shared among the team there is a tendency for shirking
Shirking Decline in earnings
Solutions ?

11. Shirking  Monitoring Hire a monitor to reduce shirking
Earnings go back up to $ 2000 / 11 = $ 182
Problem: the monitor shirks

12. Reorganize Firm Employees get fixed wages day to day
Predictability is desirable
Owner begins to specialize work by worker
Increased output and earnings
Wages differ by difficulty of task
Owner becomes the monitor
Owner gets profits after wages (If any)

13. The Organization of Firms
Teamwork and specialization
Teamwork  shirking
Shirking  monitoring
Profits monitor the owners

14. The role of contracts Costless contracting
ideal contracts would align interests (minimize incentive conflicts) at no or low cost
Costly contracting and asymmetric information: Unequal access to information between two contracting parties.
Health insurance
Bonds
contracts costly to negotiate, write, administer
parties to contract have asymmetric information on performance levels

15. Precontractual information problems
Bargaining failures
asymmetric information
Adverse selection
use of private information in manner detrimental to trading partner
Bad risk drives out good

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

17. 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
Incentivize payment (stock options, mkt share)
Monitoring: feedback, measurements, etc.

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