Joe Mahoney University of Illinois at Urbana-Champaign

1. Economics, Organization and ManagementChapter 5: Bounded Rationality and Private Information Joe Mahoney University of Illinois at Urbana-Champaign

2. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management Chapter 5: Bounded Rationality and Private Information “Any attempt to deal seriously with the study of economic organization must come to grips with the combined ramifications of bounded rationality and opportunism in conjunction with a condition of asset specificity.” Oliver Williamson (1985)

3. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • The coordination problem is to determine what things should be done, how they should be accomplished, and who should do what. At the organizational level, the problem is also to determine who makes decisions and with what information, and how to arrange communications systems to ensure that the needed information is available. • The motivation problem is to ensure that the various individuals involved in these processes willingly do their parts in the whole undertaking, both reporting information accurately to allow the right plan to be devised and acting as they are supposed to act to carry out the plan.

4. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management Perfect Complete Contracts • In principle, a perfectly fashioned complete contract could solve the motivation problem. It would specify precisely what each party is to do in every possible circumstance and arrange the distribution of realized costs and benefits in each contingency (including those where the contract’s terms are violated) so that each party individually finds it optimal to abide by the contract’s terms. • If the original plan were an efficient one, then a complete contract could ensure implementation of the plan leading to an efficient outcome. Motivation problems arise because some plans cannot be described in a complete, enforceable contract.

5. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • What would be involved in reaching and enacting a complete contract? • The contractual parties must each foresee all the relevant contingencies that might be important to them in the course of the contract and to which they might want to adapt the contractually specified actions and payments. • The contractual parties must be able to describe these contingencies accurately so that they can unambiguously determine before the fact just what possibilities are being discussed.

6. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • What would be involved in reaching and enacting a complete contract? • The contractual parties must also be able to know after the fact which of the particular circumstances they considered beforehand has now actually occurred. • The contractual parties must be willing and able to determine and agree upon an efficient course of action for each possible contingency, as well as the payments that are to accompany each action.

7. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • What would be involved in reaching and enacting a complete contract? • The contractual parties must be willing to abide by the terms of the contract. • To be credible, the contractual parties must not mutually desire to renegotiate the contract. • Each contractual party must be able to determine freely whether the contract’s terms are being met, and, if they are being violated, each party must be willing and able to enforce the agreed performance.

8. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • In actual transactions, enacting and enforcing a complete and perfect contract is fraught with problems. Limited foresight, imprecise language, the costs of calculating solutions, and the costs of writing down a plan --- collectively, the bounded rationality of real people – mean that not all contingencies are fully accounted for. • In complicated relationships, contingencies inevitably arise that have not been planned for and, when they do, the parties must find ways to adapt. These adaptations introduce the possibility of opportunistic behavior, including reneging.

9. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Fear of opportunistic behavior may deter contractual parties from relying on one another as much as they should for efficiency. Incomplete and unenforceable contracts lead to problems of imperfect commitment. • Even if a contingency can be foreseen and planned for an contractual commitments can be enforced, one of the bargainers may have relevant private information before the contract is signed that interferes with the possibility of reaching a value-maximizing agreement. • E.g. “the market for lemons” --- used cars and an adverse selection problem (ex ante opportunism).

10. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Even if there is no private information before the agreement is made, there may be inadequate information afterward to tell whether the terms of the agreement have been honored, or acquiring that information may be costly. This opens the possibility of self-interested misbehavior, and the recognition of this moral hazardproblem (ex post opportunism) limits the contracts that can be written and enforced. Real contracts are not perfect. • The motivation problem is to mitigate these adverse selection and moral hazard problems to the extent possible.

11. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Bounded rationality. Real people are neither omniscient nor perfectly far-sighted. Contractual parties cannot solve complex problems exactly, costlessly, and instantaneously, and they cannot communicate with one another freely and perfectly. Instead, they are boundedly rational, and they know it. They recognize that they cannot possibly foresee all the things that might matter for them, they understand that communication is costly and imperfect and that all understandings are often flawed, and they know that they are not likely to find the mathematically best solution to difficult problems. They then try to act in an intendedly rational manner, trying to do the best they can given the limitations under which they work. And, they learn.

12. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Relational Contracts. A contractual response to bounded rationality is relational contracting, which does not attempt the impossible task of complete contracting but instead settles for an agreement that frames the relationship. The contractual parties do not agree on detailed plans of action but on goals and objectives, on general provisions that are broadly applicable, on the criteria to be used in deciding what to do when unforeseen contingencies arise, on who has the power to act and the bounds limiting the range of actions that can be taken, and on dispute resolution mechanisms to be used if disagreements do occur.

13. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Relational Contracts. • Employment contracts, which typically delegate authority to the employer to direct the employee’s actions rather than describing the work to be done in every contingency, are a response to the necessity of incomplete, imperfect contracting. When an employee is hired, he or she (implicitly) agrees to follow the employer’s directions, so long as they fall within certain bounds that may be quite vaguely defined.

14. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Relational Contracts. • Implicit contracts: An important adjunct to incomplete written contracts are the unarticulated but (presumably) shared expectations that the parties have concerning the relationship. • To the extent that expectations are actually shared and commonly understood, implicit contracts can be a powerful means of economizing on bounded rationality and contracting costs. • Corporate culture --- seen as a shared set of values, ways of thinking, and beliefs about how things should be done --- is a key aspect of implicit contract.

15. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Commitment and Reneging. Achieving commitment can be very valuable because it can afford others’ expectations about your behavior and thereby the behavior they adopt. • For example, in 1066 William the Conqueror burned his fleet behind his invasion army, cutting off its only means of retreat and committing his men to fighting. • Cortes repeated this strategy in his invasion of Mexico. • An example of an economic commitment would be a sunk-cost investment (e.g., build a highly specialized plant with high exit costs).

16. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • Commitment and Reneging. • Commitment runs into two sorts of problems. The simpler and more obvious problem is that one side or the other may try to renege on the deal. The second problem is ex post renegotiation of the contract. • These problems are especially severe when investments in specific assets are required. • E.g., human capital, and co-specialized assets

17. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • An important special case of specific assets are co-specialized assets. • Two assets are co-specialized if they are most productive when used together and lose much of their value if used separately to produce independent products or services. • For example, consider the electrical power generation industry. Most electrical generating plants are located either near the customers they serve or near a source of energy. Coal-burning electrical plants, for example, tend to be located near coal mines.

18. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • The problem that arises when investments are made to create co-specialized assets is that much of the value depends on the behavior of another asset owner with his or her own selfish interests. This opens the possibility of various of (ex post) opportunistic behavior that endangers the investment. • Mine owners who invest in expanding their mine, for example, may find themselves to be at the mercy of the electric utility. On the other hand, the electric utility owner might worry that after the plant is built, the mine owners will try to raise their price of coal.

19. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • The Hold-Up Problem. The general business problem in which each party to a contract worries about is being forced to accept disadvantageous terms later, after it has sunk an investment, or worries that its investment may be devalued by the actions of others --- the so-called hold-up problem. • It is the specificity of assets together with imperfect contracting that is at the core of the hold-up problem. • E.g., Fisher Body and General Motors

20. Milgrom and Roberts (1992): Chapter 5 Economics, Organization & Management • The Hold-Up Problem. In the 1920s, General Motors purchased their automobile bodies from an independent firm, the Fisher Body company. As the technology of auto-making advanced and the car companies moved from wooden bodies to metal bodies, General Motors began to design a new automobile plant to assemble their cars. In order to improve the reliability of supply and to reduce shipping costs, GM asked Fisher Body to build a new auto body plant adjacent to the new GM assembly plant. The plants would have no need to for shipping docks, bodies would be transferred on the production line right from the Fisher Body plant to the General Motors plant. Fisher Body refused to make the requested investment, perhaps for fear that the new plant, so closely tailored to GM’s needs, would be vulnerable to demands that GM might later make. The issue was eventually resolved by vertical integration: General Motors purchased Fisher Body. The hold-up problem is an example of post-contractual opportunism.