1 Business Economics I Coordination through Contracts I

2 Plan of the Topic 1. Introduction 2. The firm –relations and potential conflicts of interests 3. Conflicts of interests and incentives 4. Contracts 5. Information related contractual problems 6. Contractual design 7. Ex ante problems 8. Ex post problems 9. Agency Costs 10. The Role of Reputation 11. Implicit contracts

3 Introduction I Which were the countries fighting in the battle of Waterloo? And in the Crimean war? Is it strange? There are no lifelong friends or enemies – there are just long lasting interests What happened at Worldcom? What is a whistle- blower? Was the action of the whistle-blowers right? Why has the New York chief prosecutor investigating the big Wall Street banks? What happened at Enron?

4 Introduction II Conflicts of interests/incentives: Between two persons/firms In the same person/firm Examples: Shareholders vs. Managers Marketing department vs. Operations Department Boris I as a king vs. Boris I as a father Our purpose: to minimize the damage resulting from the conflicts of interests/incentives in the cheapest way.

5 The firm – relations and potential conflicts of interest Firm EmployeesManagersShareholdersCustomersSuppliersInsurers Labour Unions Creditors

6 Conflicts of interest and incentives I Why do we have such problems? Self interested actors Divergent interests Example: A manager is paid with a salary. A salary is a cost that decreases profits. Shareholders are paid with the profits of the firm. Is there a conflict of incentives between the manager and the shareholders?

7 Conflicts of interest/incentives between shareholders and managers Effort level The shareholders benefit from/want a high level of effort on behalf of the management. Hard work, however, is not pleasant to the managers (they prefer playing golf, for example). Perquisites The shareholders want higher profits. The management wants high salaries and perquisites such as luxury office furniture, company jets, company cars, chauffer, etc. This hurts the shareholders Attitude towards Risk Shareholders have diversified investment and want risky projects, while managers are locked to the company and prefer less risk.

8 Conflicts of interest and incentives II How do we approach the problem from the contractual perspective on the firm? By designing contracts that provide incentives aligning the interests of the different actors. Example: A manager is asked by the unions to pay the employees 20% more. If he does so, profits are reduced by 10%. What are his incentives to do if he is paid with a salary? and with shares? And if he offers the workers shares instead of cash? What is likely to happen afterwards?

9 Contracts What is a contract? A contract is a voluntary agreement to organize a relationship/exchange. A contract can be explicit or implicit. Examples: Mortgage contracts Life long employment in the Japanese companies The acquisition of Seat by Volkswagen Marriage contracts Codified Law

10 The Firm What is the firm? An organization participating in the exchange of goods and servicesorganization A contractual nexuscontractual nexus Serves to attenuate transaction costs BUT is also subject of transaction costs A legal entity

11 Information related contractual problems I Why did Soviet Russia move the Siberian divisions to defend Moscow when the Japanese were at the gates of Siberia? What happened to the clients of Opening? Why do health insurance companies cover pregnancy only from the 10 th moth onwards? Why do insurance companies charge more for sport cars if they insure them at all?

12 Information related contractual problems II Information Scarcity Information scarcity refers to the fact that we usually don’t have much of the information relevant for contracting. Why? Remember, Information is Costly!!!Information is Costly Examples : What would you think if someone you don’t know offered to you a shining stone that he claims is a diamond for euros and you had the money?

13 Information related contractual problems III Asymmetric information When the participants in the exchange don’t have the same information, we say that there is asymmetric information. Usually each of the actors has more knowledge about some of the relevant variables. Examples: Miguel knows that he can earn € 500 more if Maria works for him, BUT Maria does not know it. Maria earns € 300 in the shop, BUT Miguel does not know it.

Source: Arruñada (1998) 14 Information related contractual problems IV

15 Information related contractual problems V Information Scarcity Coordination Problems (no negotiation; no contracting) Asymmetric Information Bargaining Problems (negotiation; no contracting) Default ( contracting and no fulfillment of the contract/opportunism) Asymmetry Before the Contract - Adverse Selection Asymmetry After the Contract - Moral Hazard

16 Informational Problems in Bargaining I Experiment: discussion of the results Bargaining problems arise when one or more of the parties know something the others don’t know (for example, the value of the good/service for them). In such a case, one should guess what the others think and offer/ask prices, for example, that can be unacceptable for the other party.

17 Informational Problems in Bargaining II Consequently, the parties could decide not to exchange, when there is place for mutually beneficial trade. Example: Maria will agree to work for € 301and Miguel offers 295 because he thinks that she works for € 294. Maria rejects and they both lose. Solutions: auctions (e-bay); bargaining in general