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ECON 308

ECON 308. Week 11.1 Chapter 10 Incentive Conflicts & Contracts. 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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ECON 308

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  1. ECON 308 Week 11.1 Chapter 10 Incentive Conflicts & Contracts

  2. 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

  3. 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

  4. Firm as focal point for set of contracts

  5. 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.

  6. Corporate Management • Owners (Stockholders) • Board of Directors (Meet quarterly) • Inside directors • Outside directors • Chiefs (CEO, CFO, CIO, COO, ETC) • Divisional Managers • Team leaders • Workers

  7. 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

  8. 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)

  9. 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…

  10. Teamwork  Shirking • When earnings are shared among the team there is a tendency for shirking • Shirking Decline in earnings • Solutions ?

  11. Shirking  Monitoring • Hire a monitor to reduce shirking • Earnings go back up to $ 2000 / 11 = $ 182 • Problem: the monitor shirks

  12. 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)

  13. The Organization of Firms • Teamwork and specialization • Teamwork  shirking • Shirking  monitoring • Profits monitor the owners

  14. 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

  15. Precontractual information problems • Bargaining failures • asymmetric information • Adverse selection • use of private information in manner detrimental to trading partner • Bad risk drives out good

  16. 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

  17. 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.

  18. 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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