Hierarchies, incentives and firm structure ECOS3003 Tutorial 2 answers
1. Is it worthwhile for shareholders to seek to completely eliminate incentive problems with managers and directors through means such as monitoring? Why or why not?
Possibly not; cost of monitoring versus benefit. If the variables are continuous, monitor up to the point where the MB = MC (of monitoring); eg the MB from the increased effort by a worker = the increase cost from monitoring.
It is possible that spot checks and limited monitoring may be optimal.
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Another issue is who monitors the monitor? (There is scope for the monitor to collude with the party they are meant to be observing.)
2. How does concerns about reputation aid in the enforcement of contracts?
Future punishments (cost to reputation) may outweigh short-term gain from cheating.
3. Consider a model with one worker who works for one boss. In each period the worker can work hard or not work at all. If the worker works hard she will create $8 worth of profit. The boss can then decide how to share this profit with the worker (that is, how much of the $8 the worker gets). If the worker does not work she creates $0 profit. There are an infinite number of periods and both parties discount future payoffs by δ.
There is a social convention that the worker will work hard if in every previous period the boss gave the worker half of the profit. If this is not the case the worker will not work again in any future periods. What is the δ required to sustain this social convention as an equilibrium?
Interpret this social convention as an implicit contract.
Boss’s decision, taking worker’s trigger strategy as given.
If worker works hard and the boss shares in every period the payoff to the boss is: 4 + δ.4 + δ2.4 + … = 4 / (1 – δ)
If don’t share (in the first period) the boss gets: 8 + 0 + 0 + … = 8
The boss will share if:
4 / (1 – δ) ≥ 8, or if
Implicit contract: if share output, worker will continue to do the right thing and work hard (note: sharing could take different forms like a bonus, time off etc).
4. What is a firm’s organisation architecture?
Assignment of decision rights; method of rewarding individuals; structure of systems to evaluate the performance of both individuals and business units.
ECOS 3003 Tutorial 2 1
Note, the fundamental problem is trying to ensure that decision makers have the relevant information to make good decisions and that these decisions makers have appropriate incentives to use their information productively.
5. What is the architecture of markets?
The price system and property rights provides the architecture through market transactions decision rights end up in the possession of those with specific knowledge. Since owners bear the wealth effects, the market mechanism provides incentives to choose efficient actions.
6. The Australian Competition and Consumer Commission recommends changes in the way anti-competitive law should analyse mergers. Among other things, the recommendations would likely make it easier to justify mergers on the grounds that it reduces costs or increases competition. The idea is that some mergers between competitors result in significant cost savings, enhance competition and result in lower prices. Would these recommendations affect organization architecture if adopted? Explain the connection.
If ACCC proposal accepted, regulation will change. The environment will become, arguably more competitive and interdependent. As a result, companies could have to adjust their strategies, which in turn could require changes in architecture.
7. Which of the following will affect the design of the optimal architecture?
a. market conditions
b. regulation
c. technology
d. all of the above***
e. none of the above
8. Bob is the owner of a chain of tyre stores in Melbourne and Sydney. Bob makes the pricing a stock decisions for all of the Sydney outlets, but allows each of the Melbourne store managers to make their own pricing and stock decisions. How will this change affect the other aspects of the firm’s architecture?
Bob makes the pricing decision is Sydney market. In Melbourne, managers do prices (use specific knowledge).
Other aspects of architecture affected;
– how Sydney outlets managed/operated/owned (by Bob?)
– Melbourne franchises? perhaps Melbourne managers have more info on competitors, or the outlets are located in such a way that there are externalities between stores than in the Sydney market.
The question is really how is this assignment of decision rights going to affect incentive problems and the need for performance measurement? Given the differences, need different architecture in two cities.
(2) Incentive contracts
• bonuses/sales payments
• franchise businesses (make managers residual claimants (3) performance evaluation
9. Sharon wants to buy a widget but she knows that 20 per cent of the people she has to deal with are dishonest. If she deals with a dishonest person she gets $0 benefit. If she deals with an honest person she gets $20 benefit from the trade. To Sharon, dishonest and honest people look alike ex ante.
ECOS 3003 Tutorial 2 2
a. Sharon is matched with a potential trader. Will she be willing to trade?
If the potential trading partner is honest he will all make a fair deal and Sharon will receive $20 benefit. The honest person will get $10. A dishonest person however can choose to be honest or dishonest. If he is honest the benefits to Sharon and to himself are $20 and $10; if he is dishonest Sharon gets $0 and the trader gets $25 benefit. There are two periods in which trade can occur.
b. In the last period, if trade in the first period was ‘honest’, will Sharon trade again?
c. Now consider the first period. Will an dishonest trader act dishonestly or honestly in the first
d. Now trade can occur potentially an infinite number of times. Sharon adopts a trigger- strategy if trade is ever dishonest. Both parties have a discount factor of δ. When will the dishonest trader act honestly?
a. Risk neutral EV = 0.8 (20) = 16 >0
b. Worst case scenario – all dishonest people played honest in first period
EV = $16 > 0; hence trade c. Trader can choose in first period
Strategy 1: If cheat straight away gets $25 + 0 in the future. Payoff Uc1 = 25 + 0 = 25 Strategy 2: If plays honest in first period, can anticipate trade will occur in period 2
Uh1c2 = 10 +25 = 35
Hence Strategy 2 is better than Strategy 1 – therefore play honest in first period.
The possibility for future trade keeps the trader honest, even if only temporarily. Sharon knows this is the strategy of a dishonest players, but continues to trade as benefits from trade and probability trader is dishonest is sufficiently small. (Key – trade will occur in the last period, so don’t get a finitely-repeated prisoners’ dilemma situation.)
d. Honest payoff:
Vh = 10 + δ.10 + δ2.10 + … = 10 / (1 – δ)
Cheat: Vc = 25
Pay Honest if: 10 / (1 – δ) ≥ 25
10. What factors encourage a trading party to take another on trust, rather than enforce ‘good’ behaviour with a contract?
1. reputation
2. repeated interaction
3. local/friend
4. punishment for cheating high
5. past interaction positive (learned to trust; increased likelihood future interaction positive)
ECOS 3003 Tutorial 2 3
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