INCENTIVES AND ORGANIZATION Managerial Economics Jack Wu OUTLINE
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INCENTIVES AND ORGANIZATION Managerial Economics Jack Wu
OUTLINE organizational architecture moral hazard ownership vertical integration
ORGANIZATIONAL ARCHITECTURE Base – distribution of ownership Two pillars incentive schemes monitoring systems
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: 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 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, 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 based on observables
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 – grade on a curve
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
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 moral hazard, holdup can arise even if information is symmetric
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 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 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 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 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 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 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 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 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 for holdup
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