ECON 308

Week 11

Chapter 10

Incentive Conflicts & Contracts

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Incentive Conflicts and Contracts

• Identify several kinds of incentive conflicts in firms

• Understand the role of contracts in reducing incentive conflicts

• Identify several pre- and post-contractual information problems

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Firm: a focal point of a set of contracts

• Simple econ model: firm makes decisions to max profits: Max TR, Min TC

• Firm is more complex– Many decision makers– Maximizing individual utility– Transfer pricing for internal allocation of

resources

• Use contracts to organize behavior– Explicit, Implicit

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Firm as focal point for set of contracts

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Spectrum of Organizations: Residual claimant

• Sole proprietorship: Owner/manager • Partnership: Shared by Partners• Corporation: Diverse stockholders• Mutual Insurance: owners are customers• Cooperative (Ocean Spray) owners are

suppliers• Employee owned: (United Airlines) owners are

employees• Charity: No owners.

5

Corporate Management

• Owners (Stockholders)

• Board of Directors (Meet quarterly)– Inside directors– Outside directors

• Chiefs (CEO, CFO, CIO, COO, ETC)

• Divisional Managers

• Team leaders

• Workers6

Examples of incentive conflicts• Manager versus Owner

– work hard or shirk – profits or salaries and perks– Excessive risk aversion: Manager

has large share of wealth in firm – Differential time horizon: Manager

has short term– Overinvestment: Empire Building,

reluctant to downsize

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Additional potential conflicts of interest

• Buyers vs Suppliers– (Cost+) Halliburton – Price v Quality

• Buyer: High quality, Low price• Seller: Low quality, high price

• Joint ownership can lead to Free-riders– Shirking: Ringelmann rope pull: As the number of

workers increased, the individual effort declined.– Never send instructions to a group (Randy Pauch)

8

Teamwork in a Cooperative

• 10 people run a grocery cooperative

• Share equally, jobs & profits

• Average daily earnings $ 2000 / 10 = $ 200

• Earnings vary from day to day…

Teamwork Shirking

• When earnings are shared among the team there is a tendency for shirking

• Shirking Decline in earnings

• Solutions ?

Shirking Monitoring

• Hire a monitor to reduce shirking

• Earnings go back up to $ 2000 / 11 = $ 182

• Problem: the monitor shirks

Reorganize Firm

• Employees get fixed wages day to day– Predictability is desirable

Owner begins to specialize work by worker– Increased output and earnings– Wages differ by difficulty of task

• Owner becomes the monitor

• Owner gets profits after wages (If any)

The Organization of Firms

• Teamwork and specialization

• Teamwork shirking

• Shirking monitoring

• Profits monitor the owners

The role of contracts

• Costless contracting– ideal contracts would align interests (minimize

incentive conflicts) at no or low cost

• Costly contracting and asymmetric information: Unequal access to information between two contracting parties.– Health insurance– Bonds– contracts costly to negotiate, write, administer– parties to contract have asymmetric information on

performance levels

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Precontractual information problems• Bargaining failures

– asymmetric information

• Adverse selection– use of private information in manner

detrimental to trading partner– Bad risk drives out good

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Postcontractual information problems

• Agency problems– principal contracts with agent for service– agent has postcontractual incentive to serve

own perceived best interests (Pilots refueling)

• Asymmetric information complicates resolution of agency problems– principal incurs monitoring costs and/or– agent incurs bonding costs

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Postcontractual information problems• Agency problems

– principal contracts with agent for service– agent has postcontractual incentive to serve

own perceived best interests

• Incentives to economize on agency costs– sharing increased gains from trade– Incentivize payment (stock options, mkt

share)– Monitoring: feedback, measurements, etc.

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Implicit contracts and Reputations

• Implicit contracts -- agreements and understandings that can’t be legally enforced

• Reputational concerns can motivate implicit contract compliance

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