1. Incentives and Organization and Regulation Managerial Economics Jack Wu

2. Outline organizational architecture moral hazard ownership vertical integration

3. Organizational Architecture distribution of ownership incentive schemes monitoring systems

4. Moral Hazard asymmetric information about action conflict of interest

5. Moral Hazard in Employment worker’s marginal cost employer’s marginal benefit worker’s marginal benefit Quantity (units of effort) Marg. cost/benefit (cents per unit) efficient effort

6. 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

7. Resolving Moral Hazard incentive scheme ▫conditional payment ▫quota monitoring system ▫incentives must be based on observables

8. Incentive vs Risk Efficient scheme balances benefits of more effort costs of risk bearing ▫degree of risk ▫risk aversion

9. Relative Performance employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve

10. Multiple Responsibilities strong incentive ▫more effort on that dimension ▫less effort on other dimensions

11. Non-Profit Organizations school ’ s objective ▫maximize profit ▫maximize education of students other examples – hospital, museum non-profit organization to tone down profit incentive

12. Holdup Holdup = opportunistic behavior = action intended to exploit another party ’ s dependence unlike moral hazard, holdup can arise even if information is symmetric

13. Resolving Holdup avoid specific investments write more detailed contracts vertical integration (redistribute ownership)

14. 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

15. Ownership Residual rights control -- rights that have not been contracted away income -- remaining after payment of all other claims

16. 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

17. Vertical Integration: Impact Owner gets rights to residual control and residual income reduces potential for holdup

18. Regulation

19. natural monopoly potentially competitive market asymmetric information externalities public goods

20. Natural Monopoly Average cost minimized with single supplier large scale/scope economies relative to market demand

21. Marginal Cost Pricing Require provider set price equal to marginal cost supply quantity demanded demand marginal cost

22. Average Cost Pricing Require provider set price equal to average cost supply quantity demanded demand marginal cost average cost

23. Rate of Return Regulation maximum rate of return on rate base disallowed profit returned to users

24. Potentially Competitive Market Economies of scale/scope are small relative to market demand technology market demand

25. Structural Regulation Bar franchise holder from vertically related markets ▫prevent monopoly from extending market power

26. Moral Hazard in Medicine supply inflated demand true demand quantity (million hours a mth) price ($/hour) a b

27. Resolving Information Asymmetry mandatory disclosure regulation of conduct structural regulation

28. Emissions marginal cost to society quantity (tons/year) marg. cost/benefit ($/ton) 35 8000 marginal benefit to society

29. Emissions Fee user fee quantity (tons/year) marg. cost/benefit ($/ton) 35 8000 marginal benefit to society

30. Accidents marginal cost to driver quantity (units of care) marg. cost/benefit s marginal benefit to society

31. Public Goods legal framework enables excludability ▫copyright ▫patent trade-off ▫incentive for knowledge creation ▫economically efficient usage of information

32. Public Provision For some public goods, practically difficult to enforce exclusion national defense clean air fireworks

33. Congestible Facilities social marginal cost varies with usage resolve through user fee = social marginal cost ▫time ▫usage