i ncentives and o rganization managerial economics jack wu
TRANSCRIPT
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