Incentives and Organization

IMBA Managerial Economics

Jack Wu

Outline

organizational architecture moral hazard ownership vertical integration

Organizational Architecture

distribution of ownership incentive schemes monitoring systems

Moral Hazard

asymmetric information about action conflict of interest

Moral Hazard in Employment

worker’s marginal cost

employer’s marginal benefit

worker’s marginal benefit

Quantity (units of effort)

Mar

g. c

ost/

bene

fit (c

ents

per

uni

t)

efficient effort

Happy Coincidence?

Between 1970-82, U.S. fertility rate fell by 13.5% from 1.84 to 1.

59 per hundred population proportion of deliveries by cesarean section r

ose by 240%

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 conditional payment 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 risk aversion

AT&T Incentive Scheme

1995: AT&T awarded CEO Robert E. Allen options for 108,000 shares at $43.94 exercise price

0

50

100

150

200

250

300

'95 '96 '97 '98

AT&T S&P Tel Index

Relative Performance

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

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

20-30% of vehicles at expired meters did not get citations

monitored traffic wardens issued 69-215% more citations

proposal: assign each warden a daily quota of citations

Hong Kong: Traffic Wardens

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

IMCO’s Saginaw Plant

IMCO built new $22 million aluminium plant in Saginaw, MI – three miles from GM casting plant

GM contracted to buy over $1 billion of aluminium from IMCO over 13 years

Ownership

Residual rights control -- rights that have not been contracted

away income -- remaining after payment of all other

claims

Saigon Floating Hotel

1987: built in Singapore 1987-89: Great Barrier Reef, Australia 1989-96: Saigon River 1996: Vietnam Government refused to renew

operating license

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: Impact

Owner gets rights to residual control and residual

income reduces potential for holdup

holdup

verticalintegration

externalcontractor

moral hazardinternal monopolyscale economies

Make or buy?

Airbus: Production

annual “poker game”: consortium fixed transfer prices with partners

partners received proportionate share of consortium profit� Where was partner’s incentive greater --

for self or Airbus?

Corporate Governance

monitoring -- Board of Directors, major shareholders

incentives -- stock options, bonuses, profit-sharing

ownership -- takeover