INCENTIVES AND ORGANIZATIONManagerial 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

• Ownership– takeover

• Incentives

– shares and options

– bonuses– profit-sharing

Monitoring Board of Directors major shareholders

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?

MORAL HAZARD IN EMPLOYMENT

worker’s marginal cost

employer’s marginal benefit

worker’s marginal benefit

Quantity (units of effort)

Marg

. co

st/b

enefit

(cents

per

unit

)

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 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