1. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Incentive Conflicts and Contracts

2. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Incentive Conflicts and Contracts learning objectives Students should be able to Describe and offer examples of several kinds of incentive conflicts in firms State the role of contracts in reducing incentive conflicts Describe and offer examples of several pre- and postcontractual information problems

3. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Examples of incentive conflicts Owner versus manager –profits or salaries and perks –work hard or shirk –take chances or play it safe Buyer versus supplier Free ride or not Management versus labor

4. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin The role of contracts Costless contracting –ideal contracts would align interests (minimize incentive conflicts) at no or low cost Costly contracting and asymmetric information –contracts costly to negotiate, write, administer –parties to contract have asymmetric information on performance levels

5. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Firm as focal point for set of contracts

6. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Postcontractual information problems Agency problems –principal contracts with agent for service –agent has postcontractual incentive to serve own perceived best interests Asymmetric information complicates resolution of agency problems –principal incurs monitoring costs and/or –agent incurs bonding costs

7. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Optimal combination of compensation and perks CEO utility function, C is compensation, P is perquisites: U=f(C,P) Owners have precise knowledge of profit potential:  p Realized profits are:  R =  p -P Therefore offer CEO compensation contract: C=S-(  p -  R )

8. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Optimal perquisite taking

9. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Postcontractual information problems Agency problems –principal contracts with agent for service –agent has postcontractual incentive to serve own perceived best interests Incentives to economize on agency costs –sharing increased gains from trade

10. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Agency Cost Example Good Tire Company and Brown & Brown Good Tire’s marginal benefit from legal services: MB=200-2L Brown & Brown’s marginal cost for providing legal services: MC=100 Value maximization: MB=MC, or 200-2L=100, L*=50 Fee of $6250 covers costs of $5000 and yields net benefits of $1250 each

11. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Agency Cost Example Good Tire Company and Brown & Brown BUT Brown & Brown may have incentive to provide fewer than 50 hours Costly for Good Tire to monitor or for B&B to provide guarantee Possible outcome is reduced gain from trade (foregone surplus)

12. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Agency costs in legal contracting

13. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Precontractual information problems Bargaining failures –asymmetric information Adverse selection –use of private information in manner detrimental to trading partner

14. © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Implicit contracts and reputations Implicit contracts -- agreements and understandings that can’t be legally enforced Reputational concerns can motivate implicit contract compliance