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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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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

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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 bottles TVB: Total Variable Costs R: Anticipated Revenue from Soda Pop Sales TVP: Variable Costs of Making Pop Excluding the Costs of Bottles S: Salvage Value of the Machinery T: Cost of Searching Alternative Bottle Suppliers on Short-Notice

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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.

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Holdup Problem III The Advantage of Maintaining the Relationship: V – O -- The Total Amount of Quasi-Rent V – O = Q = F – S + T F – S: Supplier (Bottle Making Company) T: Buyer (Pop Making Company) If Q > 0, there are advantages to maintaining a trading relationship once established.

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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

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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.

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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.

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Three Possible Ownership Structures Lets go back to our simple example: Process B: Raw Material Intermediate Goods Process 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

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Shareholder Monitoring and Incentive Contracts The question of how the owners of a firm can induce the manager to pursue the owners 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.

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An Optimal Incentive Contract with Hidden Actions Suppose that the profits of the firm in the good state of the world are π G =36. In the bad state, π B =6. The manager of the firm can either exert high (e H =2) effort or low effort (e L =1). If he exerts high effort, the probability of good state (p H ) is 2/3 and the probability of low state is 1/3. If he exerts low effort, the probability of good state (p L ) is 1/3 and the probability of low state is 2/3.

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An Optimal Incentive Contract with Hidden Actions II Let the utility function of the manager be: u = y 1/2 – (e – 1), where y is his income and e is his effort. The reservation utility u = 1.

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Full-information contract? If the firm wants to contract for high effort, u = (y H ) 1/2 – (e H – 1), Similarly for low effort. We will obtain: y H = 4 and y L = 1.

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What level of effort is profit maximizing for the firm? π H = p H π G + (1 – p H ) π B – y H π L = p L π G + (1 - p L ) π B – y L By substituting all variables, we will obtain: π H =22 and π L = 15. If the effort is observable, the contract will be: If e = e H =2, y H = 4. If e = e L =1, y L = 1.

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Incentive Compatible? If the effort is unobservable, this contract is not incentive compatible. (y H ) 1/2 – (e L – 1) = 2 > u = 1. In addition, notice: π = p L π G + (1 - p L ) π B – y H = 12 < 15. The manager has an incentive to promise to exert high effort, but in fact exerts low effort.

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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.

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An Incentive Contract It will specify that the manager be paid y G if the firms profit is π G and y B if the firms profit is π B. The firm will choose y G and y B to maximize the profits subject to two constraints Individual rationality constraints; Incentive compatibility constraints.

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Individual Rationality Constraints It requires that the manager should voluntarily accept the contract. p H (y G ) 1/2 + (1 – p H )(y B ) 1/2 – (e H – 1) u By substituting all the numbers, we will have: (1) 2/3 X (y G ) 1/2 + 1/3 X (y B ) 1/2 – 1 1.

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Incentive Compatibility Constraints It requires that the manager finds it in his interests to actually exert high effort. p H (y G ) 1/2 + (1 – p H )(y B ) 1/2 – (e H – 1) p L (y G ) 1/2 + (1 – p L )(y B ) 1/2 – (e L – 1). By substituting all the numbers, we will have: (2) 2/3 X (y G ) 1/2 + 1/3 X (y B ) 1/2 – 1 1/3 X (y G ) 1/2 + 2/3 X (y B ) 1/2.

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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.

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Optimal Contract Finally, we will obtain the following contract. If the effort is unobservable, the contract will be: If π G is realized, y G = 9. If π B is realized, y B = 0. Compared to the full-information contract (y H = 4 & y L = 1), it is much greater if the good state is realized and worse if the bad state is realized.

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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 = 2 (in this example).

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