8. The Internal Organization of the Firm

1. 8. The Internal Organization of the Firm business enterprises need certain services for their production hence decision necessary how these should be provided, i.e. internally or from a market furthermore, how to motivate employees to do well on the job has to be decided 8.1 The Decision to Start a Firm When setting up an enterprise its organizational structure needs to be decided on the one hand, employees can be hired and supervised within the enterprise, or contracts for production of certain output can be made with individual workers (these are then not employees)

2. also capital goods can be produced by hiring and supervising workers to produce them or they can be obtained on a market if both labor and capital goods are obtained on markets, enterprise is not a firm in classical sense firm: entity that transforms inputs into outputs, services for production are hired and supervised within the enterprise Consulting Report 8.1: To decide whether to start a firm or to contract out the work, the entrepreneur should weigh costs and benefits, e.g. contracting out saves costs of supervision, but maintaining many independent contracts can be costly as well, possibly mix both forms, i.e. perform some services within the firm, rely for others on the market classical advise by an economist: it depends (in this case on the nature of the activity)

3. inputs can be distinguished into • general inputs: have alternative uses • specific inputs: have only use for the specific production • contracting out specific inputs causes a problem that the entrepreneur has an incentive to renegotiate after the capital good is produced because there is no alternative demand for the good, hence contracts have to be complicated and monitoring compliance is costly • Ex: bowl-contracting game (Fig 8.1) • if costs for hiring and supervising employees are lower than to contract all work and monitor compliance, establishing a firm is preferred • quality control might be easier within a firm

4. 8.2 Motivating Workers to Work: The Moral Hazard Problem in a firm, output is measurable, but the effort of individual workers is usually not this creates a moral hazard problem: workers are paid fixed salary, but because their effort cannot be monitored, they have an incentive to work less hard than it is expected 8.3 Solutions to the Moral Hazard Problem of Workers Not Working Possible Solutions to moral hazard problem will influence the firm structure and the compensation scheme of the employees Proposal 1: Combining Efficiency Wage and Monitoring Consulting Report 8.2: Pay workers more than their opportunity wage, check performance randomly, fire them if they do not perform as expected. With sufficiently high wage, this will induce workers to work as expected

5. worker will only shirk if this yields a higher expected payoff than performing assume the workers utility from exerting effort e and obtaining wage w is u(w,e)=w – c(e), c increasing, c(0) = 0 now let workers be monitored with probability p, their opportunity wage (the wage they can obtain elsewhere after being fired) be w, the wage being offered w* and the expected effort level e* then if a worker shirks (in that case he would choose effort 0, since he will be fired at any effort <e*) his expected utility EU(s) = p (w – c(0)) + (1-p) (w* – c(0)) = pw + (1-p) w* his expected utility from not shirking is EU(ns) = w* - c(e*) hence he will not shirk if w* - c(e*) > pw + (1-p) w* or if w* - w > c(e*) / p w* is then called the efficiency wage Problem: if monitoring is expensive, p is low, thus w* high

6. Proposal 2: Revenue-Sharing Plan Consulting Report 8.3: motivating workers by letting them share in the revenues of the firm. Hence they have an interest in the success of the firm and thus an incentive to work without monitoring would save monitoring costs, paying excessive efficiency wage and building up a hierarchical structure say there are n workers and the revenue is R then according to revenue-sharing plan, worker i would receive a share si R of the revenue with i=1,,.,nsi  1 problem: each worker has an incentive to shirk, i.e. work less than the optimal level e*, because he will save the cost of effort, but suffer only a share siof the revenue loss hence for large n, high effort is not a Nash-equ., but no effort is why could plan still work: workers have an incentive to monitor each other, because they will suffer if others work less

7. Proposal 3: Forcing Contract Plan Consulting Report 8.4: fix an output target. If output meets target pay workers opportunity wage (plus effort costs to make them accept), if not fire them and pay them nothing let e* be the effort necessary by all workers to meet the target is it a Nash-equ if all workers put in e*? Yes: given that all other workers exert e*, if a worker does so as well, the output will meet target and his payoff will be w – c(e*) > 0 if he deviates to e’<e*, the output will miss the target and his payoff will be 0 – c(e’)  0 hence no player has an incentive to deviate and all choosing e* is a Nash-equ.

8. Problems: • plan is very harsh, all workers are punished if only one shirks • while all choosing e* is a Nash-equ, all choosing no effort is one as well. If a worker suspects that others deviate, he will prefer to choose no effort • plan creates new moral hazard: employer has an incentive to lie to workers that target was not met counterarguments: • no-effort equilibrium should not occur because worker who intends to shirk would not accept the contract but rather work at another firm • workers would self-select, only those who intend to work sufficiently hard would work under forcing contract • employer dishonesty would make it lose workers and make it unable to hire new workers and hence in the long run there is no incentive to lie about revenues

9. Proposal 4: Plan Involving Tournaments Consulting Report 8.5: in a rank-order tournament workers are not compensated on the basis of absolute output but on their output relative to others’ if the output does not only depend on effort but also on luck and output, but not effort, can be measured, a tournament may be useful to induce effort ex: with two workers the firm defines two prizes M > m m could be a monthly base salary and M - m a bonus for the more successful worker these prizes define a game with the strategies of the workers being the effort choices prizes can be chosen such that in Nash-equ all workers choose desired effort (without random element no pure strategy Nash-equ) Problem:individual output has to be observable

10. Experimental Evidence: • Nalbantian and Schotter (AER,1997): in groups with six “workers” forcing contracts perform even slightly worse (i.e. average efforts are lower) than revenue sharing plans, although they have a high effort equilibrium, probably because they are risky (if others shirk, one may end up with a loss) • Bull, Schotter, ans Weigelt (JPE, 1987): in 2-person tournaments mean effort level converged to Nash-equ level • Schotter and Weigelt (QJE, 1992): in an uneven tournament (one side has higher cost), disadvantaged players may drop out. This effect can be countered by making it also unfair (the rules favor one side). The cost-disadvantaged group now has an incentive to put in effort and also the advantaged side will increase effort Hence contrary to common view affirmative action (providing advantages to disadvantaged groups) can lead to overall better results

11. 8.5 Designing the Optimal Contract – Principal-Agent Problems How to write the optimal incentive for a person (agent) who acts on your (principal) behalf: ex: if an architect gets 15% of total cost of project, these are wrong incentives, because it is in his interests to drive up costs but if a personal injury lawyer gets 33% of the awarded damages, these are correct incentives, because his interests than coincide with yours (maximizing awarded damages) principal-agent game: principal proposes contract, agent accepts or rejects. If he accepts, he is assumed to maximize his own utility, hence incentives have to be set correctly the optimal contract depends on the information of the principal, i.e. whether he can observe the actions taken by the agent or only the outcome of the actions

12. Writing Contracts When Actions Are Observable principal wants to hire a worker Example: the worker is risk-neutral, i.e. his utility is linear in income and his effort cost can be measured in monetary units, his opportunity wage (net of effort cost) is 150, his cost for high effort aH is 50 and for low effort aL it is 10. if the agent chooses aH the chance for a good outcome and firm’s earnings of 500 are 70% and for bad outcome and earnings of 200 are 30%, for aL they are 50% and 50% let R(a) be the firm’s revenue and w(a) be the agent’s wage (note that this can condition on the effort because it is observable) then the principal wants to maximize (a) = R(a) – w(a) and the agent wants to maximize w(a) – C(a), so there is clearly a conflict of interest

13. the optimal contract is then: w(aH) = 201, and w(aL) = 0 Consider the expected revenues for the different effort levels: E(R(aH)) = 0.7 * 500 + 0.3 * 200 = 410 E(R(aL)) = 0.5 * 500 + 0.5 * 200 = 350 the agents must be paid at least 150 for joining the firm and in addition 50 for aH, and 10 for aL. so paying the agent enough for and insisting on aH yields expected profit 410 – 201 = 209 while paying just enough for and accepting aL yields 350 – 160 = 190 the worker will accept and work hard because this yields 151 and this is better than the outside option 150

14. generally, the problem is solved in the following way: to get the agent to join the firm and exert high effort, find the contract with the minimal w(aH) that fulfills the agent’s participation constraint w(aH) – C(aH)  150 and his incentive compatibility constraint w(aH) – C(aH)  w(aL) – C(aL) do the same for low effort, i.e. find the minimal wage such that the worker will join the firm and prefer to exert low effort. Call these wages wmin(aH) and wmin(aL). Decide which action of the agent is preferred by the principal by comparing the expected profits E((aH)) = 410 – wmin(aH) and E((aL)) = 350 – wmin(aL)

15. Writing Contracts When Actions Are Unobservable Observable actions are not realistic, hence need contracts that condition on outcomes only wages depend on whether outcome is good or bad, wG, wB to get the worker join the firm and exert high effort at the lowest expected wage, we have to solve Min 0.7wG + 0.3wB subject to 0.7 (wG – 50) + 0.3 (wB – 50)  150 (participation constraint) 0.7 (wG – 50) + 0.3 (wB – 50)  0.5 (wG – 10) + 0.5 (wB – 10) (incentive compatibility constraint) solution: wG = 260, wB = 60 to get the agent to join and exert low effort: Min 0.5wG + 0.5wB subject to 0.5 (wG – 10) + 0.5 (wB – 10)  150 (participation constraint) 0.5 (wG – 10) + 0.5 (wB – 10)  0.7 (wG – 50) + 0.3 (wB – 50) solution: also wG = 260, wB = 60, agent is indifferent

16. to break indifference we can just add a bit to wG if we want high effort and to wB if we want low effort to see that the principal prefers high effort, observe E(H) = 0.7 (500 – 260) + 0.3 (200 – 60) = 210  E(L) = 0.5 (500 – 260) + 0.5 (200 – 60) = 190 Experimental Evidence: Fehr, Kirchsteiger, and Riedl (QJE, 1993): if people are reciprocal, i.e. reward friendly behavior and punish unfriendly behavior, the incentive problems might not arise labor market game where wage cannot be conditioned on output: subgame-perfect equilibrium predicts lowest possible effort and hence lowest wage that induces workers to accept contract results are much different: high wages and efforts increase with wage, hence ignoring reciprocity can lead to wrong predictions BUT: the robustness of the results is a debated issue, hence relying on the existence of reciprocity is dangerous, too