Incentives and Organization IMBA Managerial Economics Jack Wu
Dec 24, 2015
Moral Hazard in Employment
worker’s marginal cost
employer’s marginal benefit
worker’s marginal benefit
Quantity (units of effort)
Mar
g. c
ost/
bene
fit (c
ents
per
uni
t)
efficient effort
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 r
ose by 240%
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 conditional payment 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
AT&T Incentive Scheme
1995: AT&T awarded CEO Robert E. Allen options for 108,000 shares at $43.94 exercise price
0
50
100
150
200
250
300
'95 '96 '97 '98
AT&T S&P Tel Index
Relative Performance
employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve
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
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
Hong Kong: Traffic Wardens
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
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
Ownership
Residual rights control -- rights that have not been contracted
away income -- remaining after payment of all other
claims
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
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: Impact
Owner gets rights to residual control and residual
income reduces potential for holdup
holdup
verticalintegration
externalcontractor
moral hazardinternal monopolyscale economies
Make or buy?
Airbus: Production
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?