I NCENTIVES AND O RGANIZATION Managerial Economics Jack Wu

O UTLINE organizational architecture moral hazard ownership vertical integration

O RGANIZATIONAL ARCHITECTURE Base – distribution of ownership Two pillars incentive schemes monitoring systems

O RGANIZATIONAL ARCHITECTURE : C ORPORATE GOVERNANCE Ownership – takeover Incentives – shares and options – bonuses – profit-sharing  Monitoring  Board of Directors  major shareholders

M ORAL H AZARD asymmetric information about action conflict of interest

M ORAL HAZARD : D OCTORS Brazil: among pregnant women, rate of cesarian section – 30% (81 of 269) in public hospitals – 66% (117 of 177) in private hospitals Happy coincidence?

M ORAL H AZARD IN E MPLOYMENT worker’s marginal cost employer’s marginal benefit worker’s marginal benefit Quantity (units of effort) Marg. cost/benefit (cents per unit) efficient effort

M ORAL H AZARD IN B ANKING 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

RESOLVING MORAL HAZARD incentive scheme Performance pay Performance quota monitoring system incentives must be based on observables

I NCENTIVE VS R ISK Efficient scheme balances benefits of more effort costs of risk bearing degree of risk risk aversion

R ELATIVE P ERFORMANCE employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve

I NCENTIVES : P UBLIC LISTED COMPANIES U.S. listed companies report their total shareholder return relative to peer group

M ULTIPLE R ESPONSIBILITIES strong incentive more effort on that dimension less effort on other dimensions

N ON -P ROFIT O RGANIZATIONS school ’ s objective maximize profit maximize education of students other examples – hospital, museum non-profit organization to tone down profit incentive

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

R ESOLVING H OLDUP avoid specific investments write more detailed contracts vertical integration (redistribute ownership)

C OMPLETE C ONTRACT 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

O WNERSHIP Rights to residual control -- rights that have not been contracted away Transfer of ownership: shifting the rights of residual control to another party.

EXAMPLE Saturn borrowed $5 million from a bank to develop a supermarket, which it has rented to Luna on a five-year lease. The bank has a mortgage against the building.

RIGHTS TO RESIDUAL CONTROL Rights that Saturn has contracted away: (1)The bank has legal right to take possession of the building if Saturn fails to make a loan payment (2)Luna has the right to use the property for five years Rights to residual control: (1)It may have the right to enter into a second mortgage on the building. (2)It has the right to use the building after the expiration of Luna’s lease.

RESIDUAL INCOME One dimension of residual control The owner of an asset has the right to receive the residual income from the asset. Residual income -- remaining after payment of all other claims

EXAMPLE Suppose Saturn collects $100,000 a month in rent from Luna. Saturn’s expenses include $50,000 in interest and principal to the bank as well as $20,000 in taxes and other expenses. Saturn receives the residual income: $100,000-$50,000- $20,000=$30,000.

V ERTICAL I NTEGRATION 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

V ERTICAL INTEGRATION : M AKE OR BUY ? Should gasoline refiner make or buy the crude that it processes? Should University make or buy its electricity? Should family cook meals at home or eat out?

V ERTICAL I NTEGRATION : I MPACT Owner gets rights to residual control and residual income reduces potential for holdup