Incentive conflicts and contracts
What happens within a firm?
Defn. A firm is a focal point for a set of contracts
– firm is a creation of the legal system (ie it is considered as an individual)
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– a firm is always one of the parties to each of the many contracts that constitute a firm
– employee contracts, supply contracts, stock contracts, franchise agreements, insurance …
Some contracts explicit, some implicit
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Incentive conflicts within a firm
– each individual will attempt to max own utility
– that is, incentives are not automatically aligned
– owners max profits (residual claimants of profits) – others different objectives (max wages?)
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Owner-manager conflict
Conflicts about
owners often delegate to managers publicly listed company
– shareholders residual claimants – managers run company
– choice of effort; taking perks
– differential risk exposure (mangers may be risk averse) – different horizons (managers limited tenure)
– over investment – empire building
Other incentive problems (other contractors, employees (free riding, perks) ECOS3003 Lecture 2 3
Controlling incentive problems with controls
Costly contract
Manager – M gets U=f(C,P)
C money compensation P perks
minimum salary needed, with no perks is S
if owners have precise knowledge of profit potential of firm
Πp (if M gets P = 0, C = S) Realised profit Πr is
Πr = Πp – P
– difference between potential profits and excess perks
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Owners can solve potential incentive problem: Offer M
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This contract reduces C by amount of perks insuring incentives of the firm and the manager aligned
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Asymmetric information and contracting
Asymmetric information
(a) before contract signed
(b) during implementation of contract
Pre-contractual problems (a) bargaining
– asymmetric info cause problems with bargaining (b) adverse selection
– private information cause market to breakdown
– screen different customer types offer contract that good types
will take; offer another contract to bad types
– signalling can be possible (warranties/guarantees, education) ECOS3003 Lecture 2 9
Post-contractual
(a) Agency problems
– agency relationship; principal wants the agent to perform some service on the principal’s behalf
ie shareholders – managers owner/manager – workers
Agency problems – agents have an incentive to take actions that increase their well being at the expense of the principal’s
ie owner’s can’t observe actions of workers (work, not work)
if principal could observe action – resolve problem with a contract (work hard or get fired)
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Principal can monitor agent – monitoring costs
Agent might incur bonding costs, help guarantee they act certain way (for example pay for insurance)
Residual loss – dollar equivalent of the loss of the gains from trade from contracting problems
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Implicit contracts
– contracts can be ‘implicit’; they consists of promises and understandings that are not formalised by legal documents (like promises of promotion or quality)
– not enforceable by a court
– depend on private incentives
Why doesn’t a party choose to renege on its part of an implicit contract?
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low/high quality input
input quality only known after purchase price is P
high quality costs cH to make low quality costs cL to make
profit making high is p – cH = πH profit making high is p – cL = πL
Long-term relationship, trade every period forever – discount factor δ
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Trigger strategy
– if high quality, pay P in next period
– if low quality input at any time in the past, offer price in future of cL.
Cooperate get:
(P – cH) + δ(P – cH) + … = [P – cH]/(1 – δ)
Cheat get:
P – cL + 0 + 0 … = πL
= πH/(1 – δ)
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Cooperate need
πH/(1 – δ) ≥ πL
δ* ≥[πL–πH]/πL
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Reputation concerns
(1) gains from cheating smaller
(2) likelihood of detection higher
(3) expected sanction imposed for cheating higher and for a longer period
(self-enforcing)
Incentives to economise on contracting costs
– contracting problems reduce surplus
– more surplus, greater surplus for everyone
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Basic principle: Value maximisation
Incentive problems generate costs that reduce value. It is in the interests of all parties to a contract to develop efficient solutions to agency problems. More value is created, which can be shared among all
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Organisational architecture
Organisational architecture
– the assignment of decision rights within the firm
– the method of rewarding individuals
– the structure of systems to evaluate the performance of both
individuals and business units
Getting these aspects of the firm right can dramatically increase profit/value of a firm
– can determine the success or fail of a firm (Coles versus Woolworths) – organisational architecture provides managers with powerful tools
for altering a firm’s performance
– but use can be counterproductive
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The fundamental problem
Primary goal – deliver good to customers at lowest possible cost
– complicated by important information for eco decisions making held by many different individuals (also specific not general)
2nd complication – decision makers might not have appropriate incentives to make most effective decisions
In sum – the principal’s challenge in designing both firm’s and economic systems is to maximise the likelihood that decision makers have both relevant information to make good decisions and the incentives to use information productively
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Alternative methods – markets
– firms (mutual, partnerships, corporations, …) All alternatively involve costs as well as benefits
– individuals have incentive to choose system that maximises value
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Architecture of markets
– price system solves information and incentive problems
– property rights – owner benefits from productive use
– strong incentives to use it productively
Through market transactions decision rights for resources rearranged so tend to be held by individuals with specific information about productive resource use
– those with specific knowledge willing to pay most for those resources Market provides a mechanism for evaluating and rewarding performance
– owners get benefit of productive use of resources This occurs spontaneously with little/no thought or direction
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Architecture within firms
– no automatic system for assigning decision rights to individuals with information or for motivating individuals to use their info to promote firm’s objectives
– organisational architecture created by executives through implicit and explicit contracts that constitute the firm
– decision rights granted to employees through formal and informal job descriptions; rewards are specified in formal and informal
compensation contracts; evaluation through formal and informal mechanisms
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Decision rights
– most resources allocated administratively within a firm
– senior management decides how to assign decision rights among employees of the firm
– ie should the CEO make decisions? Lower-level managers?
Controls – employees granted decisions rights are not owners have fewer Incentives to worry about efficient use of resources, hence need a control system (use reward & performance evaluation systems to help align interests of decision makers) with owners
– optimal control system depends on how decision rights are allocated
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Trade offs
– CEO make decision uninformed
– CEO makes decision trying to acquire information
– CEO can decentralise decision making authority to those with information
What is the optimal form of decision making?
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Architectural determinants
Architecture differs systematically between firm types
– no coincidence similar structure in firms in same industry
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Business environment changes in architecture
– reputation – technology
Strategy – affects architecture, but also other way – internal structure can affect strategy
Changing architecture
– changing can be costly, need to weigh expected benefits against these costs
– direct costs (new contracts, technology)
– indirect costs (attitudes of employees, especially with
frequent changes)
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Interdependence with organisation
Decision rights-control systems-performance evaluation 3 sides of the same problem
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Corporate culture
Corporate culture – ways, work and authority are organised, way people rewarded customs, taboos, company slogans social ritual
– corresponds closely to architecture (authority, decision making, evaluation) are explicit about mechanism (formal and informal)
– formal architecture, but also enhancing communication and helping set employee expectations
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Corporate culture & communication
– not all features are written down – often communicated informally
– social ritual help disseminate information by increasing interaction among employees
– these features can reinforce communication in the architecture (can also increase cost of change)
– take time to dismantle as well as create
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Corporate culture and employee expectations
– architecture can help set expectations of employees – also use informal mechanisms to foster expectations
(slogans/employee relations campaigns, ethos of quality)
Note – softer ‘corporate culture’ rituals and role models complements not substitutes for formal incentive structures
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When architecture fails?
(1) Fire the manager
(2) Market for corporate control (3) Product-market competition
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Organisational architecture
(1) assignment of decision rights
(2) Methods of rewarding individuals
(3) Structure of systems to evaluate performance of both individuals and business units
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– owners rewarded
– ownership traded to those with highest value
Firms – not automatic
– market conditions, technology, regulations determine appropriate strategy and architecture
– strategy architecture major determinant of firm value
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