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Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama
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Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

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Page 1: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Industrial Economics(Econ3400)

Week 4August 14, 2008Room 323, Bldg 3Semester 2, 2008Instructor: Dr Shino Takayama

Page 2: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Agenda for Week 4

Review: The Holdup Problem Complete vs. Incomplete Contract Property Rights Approach An Optimal Incentive Contract with

Hidden Actions Overview of Chapter 3 Government Restriction on Entry

Page 3: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Holdup Problem I Consider the problem of sourcing bottles

for a firm that produces soda pop. F: Fixed Cost of the Machinery necessary to

make bottlesTVB: Total Variable CostsR: Anticipated Revenue from Soda Pop SalesTVP: Variable Costs of Making Pop Excluding

the Costs of BottlesS: Salvage Value of the MachineryT: Cost of Searching Alternative Bottle

Suppliers on Short-Notice

Page 4: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Holdup Problem II

The Gain From Trade After F has been committed:

V = R – TVB – TVP. The Return of Soda Pop Company by

sourcing another firm for bottles:V – F – T.

The Outside Surplus The Aggregate Surplus by Terminating the

Relationship

O = (V – F – T) + S.

Page 5: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Holdup Problem III The Advantage of Maintaining the

Relationship: “V – O”-- The Total Amount of Quasi-Rent

V – O = Q = F – S + TF – S: Supplier (Bottle Making Company)T: Buyer (Pop Making Company) If Q > 0, there are advantages to

maintaining a trading relationship once established.

Page 6: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Holdup Problem: “Renegotiation”

After the bottle maker acquired the bottle-making equipment by spending F, the soda pop firm has an incentive to renegotiate.

Instead of Paying F + TVB, offer to pay only S + TVB + $1.

The bottle maker can also renegotiate. Requiring F + T + TVB - $1 instead of

F + TVB. The risk of having your quasi-rents

expropriated by an opportunistic trading partner is called the holdup problem.

The Bottle Maker <-> The Pop Maker

Page 7: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Complete vs. Incomplete Contracts

A complete contract is the one that will never need to be revised or changed and is enforceable.

When contracts are incomplete, incentives are aligned imperfectly and there is a possibility of being disadvantaged by self-interested, opportunistic behaviour.

Page 8: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Property Rights Approach to the Theory of the Firm

Firm = the rights of its owners (shareholders)

Grossman and Hart Vertical integration does not

change the nature of governance. It does change the ownership of

assets of the firm.

Page 9: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Three Possible Ownership Structures Let’s go back to our simple example:

Process B: Raw Material → Intermediate GoodsProcess A: Intermediate Goods → Output Goods

Vertical Separation The input supplier owns asset b, the downstream

firm asset a. Downstream Integration

The input supplier owns both asset a and b. Upstream Integration

The downstream firm owns both asset a and b. Vertical integration of input supply implies

differences in assets ownership and governance. These reduce or eliminate the possibility of holdup problem. → Monitoring Problem

Page 10: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Shareholder Monitoring and Incentive Contracts

The question of how the owners of a firm can induce the manager to pursue the owner’s objectives rather than their own is an example of principal-agent problem.

Principal-agent problems arise when there are information asymmetries due to either hidden information or hidden actions and when the preferences of the agent are not those of the principal.

Page 11: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

An Optimal Incentive Contract with Hidden Actions

Suppose that the profits of the firm in the good state of the world are πG=36. In the bad state, πB=6.

The manager of the firm can either exert high (eH=2) effort or low effort (eL=1).

If he exerts high effort, the probability of good state (pH) is 2/3 and the probability of low state is 1/3.

If he exerts low effort, the probability of good state (pL) is 1/3 and the probability of low state is 2/3.

Page 12: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

An Optimal Incentive Contract with Hidden Actions II

Let the utility function of the manager be:

u = y1/2 – (e – 1),where y is his income and e is his effort.

The reservation utility u = 1.

Page 13: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Full-information contract?

If the firm wants to contract for high effort,

u = (yH)1/2 – (eH – 1), Similarly for low effort. We will obtain:

yH = 4 and yL = 1.

Page 14: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

What level of effort is profit maximizing for the firm?

πH= pH πG + (1 – pH) πB – yH

πL = pL πG + (1 - pL) πB – yL

By substituting all variables, we will obtain:

πH =22 and πL = 15. If the effort is observable, the contract

will be: If e = eH=2, yH = 4. If e = eL=1, yL = 1.

Page 15: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Incentive Compatible?

If the effort is unobservable,this contract is not incentive compatible.

→ (yH)1/2 – (eL – 1) = 2 > u = 1.In addition, notice:π = pL πG + (1 - pL) πB – yH = 12 < 15.

The manager has an incentive to promise to exert high effort, but in fact exerts low effort.

Page 16: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

What can the firm do? The firm could offer y = 1. What else? An incentive contract ties the pay

of the manager to the profits of the firm.

Page 17: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

An Incentive Contract It will specify that the manager be

paid yG if the firm’s profit is πG and yB if the firms’ profit is πB.

The firm will choose yG and yB to maximize the profits subject to two constraints Individual rationality constraints; Incentive compatibility constraints.

Page 18: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Individual Rationality Constraints

It requires that the manager should voluntarily accept the contract.

pH(yG)1/2 + (1 – pH)(yB)1/2 – (eH – 1) ≥ u By substituting all the numbers, we will

have:(1) 2/3 X (yG)1/2 + 1/3 X (yB)1/2 – 1 ≥ 1.

Page 19: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Incentive Compatibility Constraints It requires that the manager finds it in

his interests to actually exert high effort. pH(yG)1/2 + (1 – pH)(yB)1/2 – (eH – 1) ≥

pL(yG)1/2 + (1 – pL)(yB)1/2 – (eL – 1). By substituting all the numbers, we will

have:(2) 2/3 X (yG)1/2 + 1/3 X (yB)1/2 – 1

≥ 1/3 X (yG)1/2 + 2/3 X (yB)1/2 .

Page 20: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Comparison of the two contracts

Maximizing expected profits will involve minimizing the expected payment to the manager.

The optimal solution must involve satisfying (1) and (2) as equalities.

Page 21: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Optimal Contract

Finally, we will obtain the following contract.

If the effort is unobservable, the contract will be: If πG is realized, yG = 9. If πB is realized, yB = 0.

Compared to the full-information contract (yH = 4 & yL = 1), it is much greater if the good state is realized and worse if the bad state is realized.

Page 22: Industrial Economics (Econ3400) Week 4 August 14, 2008 Room 323, Bldg 3 Semester 2, 2008 Instructor: Dr Shino Takayama.

Agency Costs

A measure of agency costs to a firm is the difference between its expected profit when the effort is observable (the first best) and the optimal incentive contract (the second best) when the effort is not observable.

2/3 (36 – 9) + 1/3 (6 – 0) = 20. 22 – 20 = 2 (in this example).