Managerial Economics and Organizational Architecture, 5e Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved. Managerial Economics and Organizational Architecture, 5e Chapter 10: Incentive Conflicts and Contracts McGraw-Hill/Irwin

Managerial Economics and Organizational Architecture, 5e Firms Markets use prices to allocate resources Firms us managers Firms have many decision makers The firm is a focal point for a set of contracts Individual incentives (utility maximization) may not be aligned with the objectives of the firm (profit maximization) 10-2

Managerial Economics and Organizational Architecture, 5e Incentive Conflicts within Firms Owner versus manager –salaries and perks –work hard or shirk –risk aversion –differential time horizons –overinvestment 10-3

Managerial Economics and Organizational Architecture, 5e Other Conflicts Buyer versus supplier Free ride or not Management versus labor 10-4

Managerial Economics and Organizational Architecture, 5e Firm as Focal Point for Set of Contracts Employees Bondholders Insurance providersThe firm Labor unionsSuppliers Customers Stockholders Banks 10-5

Managerial Economics and Organizational Architecture, 5e The Role of Contracts Contracts control incentive conflicts Contracts define the firm’s organizational architecture –decision rights –performance evaluation –reward systems 10-6

Managerial Economics and Organizational Architecture, 5e Contracts Costless contracting –ideal contracts would align interests (minimize incentive conflicts) at no or low cost 10-7

Managerial Economics and Organizational Architecture, 5e 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 ) 10-8

Managerial Economics and Organizational Architecture, 5e Optimal Perquisite Taking Cash compensation C* S $ Expenditures on perquisites P* S $ Slope = -1 Compensation plan 10-9

Managerial Economics and Organizational Architecture, 5e Contracts Costly contracting and asymmetric information –contracts are costly to negotiate, write, administer –parties to contract have asymmetric information on performance levels 10-10

Managerial Economics and Organizational Architecture, 5e Postcontractual Information Problems Agency problems –principal contracts with agent for service –agents have postcontractual incentives to increase their well-being at the expense of the principals Asymmetric information complicates resolution of agency problems –principal incurs monitoring costs –agent incurs bonding costs 10-11

Managerial Economics and Organizational Architecture, 5e Agency Cost Example 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 10-12

Managerial Economics and Organizational Architecture, 5e Agency Cost Example Good Tire Company and Brown & Brown 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) 10-13

Managerial Economics and Organizational Architecture, 5e Agency Costs in Legal Contracting Marginal costs and benefits of legal services (in dollars $ Hours of legal services L MB MC S Surplus is split at P = $6,250 for 50 hours $ MC O R MB L 40 Hours of legal services 10-14

Managerial Economics and Organizational Architecture, 5e Precontractual Information Problems Bargaining failures –asymmetric information Individuals may overreach during negotiations to the point that negotiations stop Adverse selection –use of private information in manner detrimental to trading partner 10-15

Managerial Economics and Organizational Architecture, 5e Implicit and Reputational Contracts Implicit contracts -- agreements and understandings that can’t be legally enforced –depend on private incentives Reputational concerns can motivate implicit contract compliance 10-16