ECON 308 Week 11 Chapter 10 Incentive Conflicts Contracts 1 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 2 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 3 Firm as focal point for set of contracts 4 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 Workers 6 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 7 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 14 Precontractual information problems Bargaining failures asymmetric information Adverse selection use of private information in manner detrimental to trading partner Bad risk drives out good 15 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 16 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 17 Implicit contracts and Reputations Implicit contracts agreements and understandings that can t be legally enforced Reputational concerns can motivate implicit contract compliance 18