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Understanding Organizational Architecture, Incentives, and Moral Hazard in Business Management

This piece explores the critical concepts of organizational architecture, ownership distribution, and moral hazards within firms, elaborated through real examples from I.P.L. Png and historical case studies. It discusses the implications of incentive schemes, the need for centralization in authority, and the resolution strategies for moral hazards in employment and banking. It addresses how vertical integration and other structures can impact efficiency and shareholder value, emphasizing the importance of observable incentives for effective management.

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Understanding Organizational Architecture, Incentives, and Moral Hazard in Business Management

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  1. Incentives & Organization • moral hazard • ownership • vertical integration • organizational architecture (c) 1999-2001, I.P.L. Png

  2. Airbus "In the future, growth in shareholder value and efficiency can result only from an overall change in our organization. There is a need for greater centralization and central authority." Noel Forgeard, Managing Director (c) 1999-2001, I.P.L. Png

  3. Organizational Architecture • distribution of ownership • incentive schemes • monitoring systems (c) 1999-2001, I.P.L. Png

  4. Moral Hazard • asymmetric information about action • conflict of interest (c) 1999-2001, I.P.L. Png

  5. Moral Hazard in Employment employer’s marginal benefit worker’s marginal cost worker’s marginal benefit Marg. cost/benefit (cents per unit) efficient effort Quantity (units of effort) (c) 1999-2001, I.P.L. Png

  6. Happy Coincidence? Between 1970-82, • U.S. fertility rate fell by 13.5% from 1.84 to 1.59 per hundred population • proportion of deliveries by cesarean section rose by 240% (c) 1999-2001, I.P.L. Png

  7. Banking Example, I *Assume zero interest rate (c) 1999-2001, I.P.L. Png

  8. Banking Example, II:Safe Investment (c) 1999-2001, I.P.L. Png

  9. Banking Example, III: Risky Investment (c) 1999-2001, I.P.L. Png

  10. 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 (c) 1999-2001, I.P.L. Png

  11. Resolving Moral Hazard • incentive scheme • conditional payment • quota • monitoring system • incentives must be based on observables (c) 1999-2001, I.P.L. Png

  12. Incentive vs Risk Efficient scheme balances • benefits of more effort • costs of risk bearing • degree of risk • risk aversion (c) 1999-2001, I.P.L. Png

  13. AT&T Incentive Scheme • 1995: AT&T awarded CEO Robert E. Allen options for 108,000 shares at $43.94 exercise price (c) 1999-2001, I.P.L. Png

  14. Relative Performance • employment -- promote the best worker • sports -- gold, silver, bronze • examination – grade on a curve (c) 1999-2001, I.P.L. Png

  15. Multiple Responsibilities, I Example: • client engages systems integrator to implement new system • client concerned about • length of code -- easy to monitor • re-usability -- difficult to monitor (c) 1999-2001, I.P.L. Png

  16. Multiple Responsibilities, II • strong incentive • more effort on that dimension • less effort on other dimensions • equal incentive principle • low-powered contracts (c) 1999-2001, I.P.L. Png

  17. Non-Profit Organizations • school’s objective • maximize profit • maximize education of students • other examples – hospital, museum • non-profit organization to tone down profit incentive (c) 1999-2001, I.P.L. Png

  18. Hong Kong: Traffic Wardens • 20-30% of vehicles at expired meters did not get citations • monitored traffic wardens issued 69-215% more citations • proposal: assign each warden a daily quota of citations (c) 1999-2001, I.P.L. Png

  19. Holdup When Airbus assigned A-318 production to DASA, Aerospatiale threatened to quit the consortium • conflict of interest • no asymmetry of information (c) 1999-2001, I.P.L. Png

  20. Resolving Holdup • avoid specific investments • write more detailed contracts • vertical integration (redistribute ownership) (c) 1999-2001, I.P.L. Png

  21. Floating Investments How to retrieve investment in politically unstable country? • Saigon Floating Hotel • floating power plants in Philippines (c) 1999-2001, I.P.L. Png

  22. 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 (c) 1999-2001, I.P.L. Png

  23. Rick Schroder: NYPD Blue contract “You may be required from time to time to show the buttocks. No genitalia will be shown.” (c) 1999-2001, I.P.L. Png

  24. IMCO’s Saginaw Plant • IMCO built new $22 million aluminium plant in Saginaw, MI – three miles from GM casting plant • GM contracted to buy over $1 billion of aluminium from IMCO over 13 years (c) 1999-2001, I.P.L. Png

  25. Ownership Residual rights • control -- rights that have not been contracted away • income -- remaining after payment of all other claims (c) 1999-2001, I.P.L. Png

  26. Saigon Floating Hotel • 1987: built in Singapore • 1987-89: Great Barrier Reef, Australia • 1989-96: Saigon River • 1996: Vietnam Government refused to renew operating license (c) 1999-2001, I.P.L. Png

  27. 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 (c) 1999-2001, I.P.L. Png

  28. Vertical Integration: Impact Owner • gets rights to residual control and residual income • reduces potential for holdup (c) 1999-2001, I.P.L. Png

  29. Make or buy? vertical integration external contractor holdup moral hazard internal monopoly scale economies (c) 1999-2001, I.P.L. Png

  30. Airbus: Production, I • annual “poker game”: consortium fixed transfer prices with partners • partners received proportionate share of consortium profit • Where was partner’s incentive greater -- for self or Airbus? (c) 1999-2001, I.P.L. Png

  31. Airbus: Production, II “It was quite a dishonest system… Each partner’s prime motivation was to look after its own interest.” Mike Turner, Airbus Board Member (c) 1999-2001, I.P.L. Png

  32. Airbus: Production, III “Airbus Industries’ production system is one of the most efficient – and flexible – in the world. Approximately 96 percent of the aircraft work is performed in plants operated by the partner companies.” Airbus: Corporate Overview, Dec. 1999 (c) 1999-2001, I.P.L. Png

  33. Corporate Governance • monitoring -- Board of Directors, major shareholders • incentives -- stock options, bonuses, profit-sharing • ownership -- proxy fight, takeover (c) 1999-2001, I.P.L. Png

  34. Gillette, October 2000 Gillette fired CEO Michael C. Hawley • Warren Buffett: “We thought there was someone better to do the job” • shares rose 15%  market capitalization increased by $4 billion (c) 1999-2001, I.P.L. Png

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