INCENTIVES AND ORGANIZATION Managerial Economics Jack Wu OUTLINE

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INCENTIVES AND ORGANIZATION Managerial Economics Jack Wu

INCENTIVES AND ORGANIZATION Managerial Economics Jack Wu

OUTLINE organizational architecture moral hazard ownership vertical integration

OUTLINE organizational architecture moral hazard ownership vertical integration

ORGANIZATIONAL ARCHITECTURE Base – distribution of ownership Two pillars incentive schemes monitoring systems

ORGANIZATIONAL ARCHITECTURE Base – distribution of ownership Two pillars incentive schemes monitoring systems

ORGANIZATIONAL ARCHITECTURE: CORPORATE GOVERNANCE § Monitoring § Board of Directors § major shareholders •

ORGANIZATIONAL ARCHITECTURE: CORPORATE GOVERNANCE § Monitoring § Board of Directors § major shareholders • Ownership – takeover • Incentives – shares and options – bonuses – profit-sharing

MORAL HAZARD asymmetric information about action conflict of interest

MORAL HAZARD asymmetric information about action conflict of interest

MORAL HAZARD: DOCTORS • • Brazil: among pregnant women, rate of cesarian section –

MORAL HAZARD: DOCTORS • • Brazil: among pregnant women, rate of cesarian section – 30% (81 of 269) in public hospitals – 66% (117 of 177) in private hospitals Happy coincidence?

Marg. cost/benefit (cents per unit) MORAL HAZARD IN EMPLOYMENT employer’s marginal benefit worker’s marginal

Marg. cost/benefit (cents per unit) MORAL HAZARD IN EMPLOYMENT employer’s marginal benefit worker’s marginal benefit Quantity (units of effort) worker’s marginal cost efficient effort

MORAL HAZARD IN BANKING premium for deposit insurance is not experience-rated riskier the investment,

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

RESOLVING MORAL HAZARD incentive scheme Performance pay Performance quota monitoring system incentives must be

RESOLVING MORAL HAZARD incentive scheme Performance pay Performance quota monitoring system incentives must be based on observables

INCENTIVE VS RISK Efficient scheme balances benefits of more effort costs of risk bearing

INCENTIVE VS RISK Efficient scheme balances benefits of more effort costs of risk bearing degree of risk aversion

RELATIVE PERFORMANCE employment -- promote the best worker sports -- gold, silver, bronze examination

RELATIVE PERFORMANCE employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve

INCENTIVES: PUBLIC LISTED COMPANIES U. S. listed companies report their total shareholder return relative

INCENTIVES: PUBLIC LISTED COMPANIES U. S. listed companies report their total shareholder return relative to peer group

MULTIPLE RESPONSIBILITIES strong incentive more effort on that dimension less effort on other dimensions

MULTIPLE RESPONSIBILITIES strong incentive more effort on that dimension less effort on other dimensions

NON-PROFIT ORGANIZATIONS school’s objective maximize profit maximize education of students other examples – hospital,

NON-PROFIT ORGANIZATIONS school’s objective maximize profit maximize education of students other examples – hospital, museum non-profit organization to tone down profit incentive

HOLDUP Holdup = opportunistic behavior = action intended to exploit another party’s dependence unlike

HOLDUP Holdup = opportunistic behavior = action intended to exploit another party’s dependence unlike moral hazard, holdup can arise even if information is symmetric

RESOLVING HOLDUP avoid specific investments write more detailed contracts vertical integration (redistribute ownership)

RESOLVING HOLDUP avoid specific investments write more detailed contracts vertical integration (redistribute ownership)

COMPLETE CONTRACT specifies actions and payments in every contingency degree to which a contract

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

OWNERSHIP Rights to residual control -- rights that have not been contracted away Transfer

OWNERSHIP Rights to residual control -- rights that have not been contracted away Transfer of ownership: shifting the rights of residual control to another party.

EXAMPLE Saturn borrowed $5 million from a bank to develop a supermarket, which it

EXAMPLE Saturn borrowed $5 million from a bank to develop a supermarket, which it has rented to Luna on a five-year lease. The bank has a mortgage against the building.

RIGHTS TO RESIDUAL CONTROL Rights that Saturn has contracted away: (1)The bank has legal

RIGHTS TO RESIDUAL CONTROL Rights that Saturn has contracted away: (1)The bank has legal right to take possession of the building if Saturn fails to make a loan payment (2)Luna has the right to use the property for five years Rights to residual control: (1)It may have the right to enter into a second mortgage on the building. (2)It has the right to use the building after the expiration of Luna’s lease.

RESIDUAL INCOME One dimension of residual control The owner of an asset has the

RESIDUAL INCOME One dimension of residual control The owner of an asset has the right to receive the residual income from the asset. Residual income -- remaining after payment of all other claims

EXAMPLE Suppose Saturn collects $100, 000 a month in rent from Luna. Saturn’s expenses

EXAMPLE Suppose Saturn collects $100, 000 a month in rent from Luna. Saturn’s expenses include $50, 000 in interest and principal to the bank as well as $20, 000 in taxes and other expenses. Saturn receives the residual income: $100, 000 -$50, 000 -$20, 000=$30, 000.

VERTICAL INTEGRATION Combination of assets for two successive stages of production under a common

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

VERTICAL INTEGRATION: MAKE OR BUY? Should gasoline refiner make or buy the crude that

VERTICAL INTEGRATION: MAKE OR BUY? Should gasoline refiner make or buy the crude that it processes? Should University make or buy its electricity? Should family cook meals at home or eat out?

VERTICAL INTEGRATION: IMPACT Owner gets rights to residual control and residual income reduces potential

VERTICAL INTEGRATION: IMPACT Owner gets rights to residual control and residual income reduces potential for holdup