Economics of Management Strategy BEE3027

1. Economics of Management StrategyBEE3027 Lecture 2

2. Recap • Last week we covered the basic arguments for why production may be organised within the firm vis-à-vis outsourcing production. • We looked at the neo-classical view of the firm and the scale & scope advantages of size. • We looked at how resorting to spot markets or long-term contracts on product-specific inputs may result in the hold up problem.

3. Vertically Integrated Production • We now focus our attention to the firm. • The more specific the transaction, the greater the incentive to produce in-house, rather than to outsource. • There are several reasons why firms may want to vertically integrate.

4. Vertically Integrated Production • There are two important differences to vertically integrated production vis-à-vis outsourcing: • Different ownership structure; • Difference governance structure. • Ownership of an asset is crucial in a world of incomplete contracts. • It determines residual controls rights over the asset.

5. Vertically Integrated Production • In other words, in an unforeseen event, the owner determines the use of the asset. • This solves (part of) the hold-up problem. • Differences in the governance are also important, especially from a legal perspective: • Legal obligations of employees are different than those of a supplier; • Contractual disagreements are solved internally rather than in court (lower costs).

6. Vertically Integrated Production • The owner of the firm has rights: • To be the residual claimant; • To hire/purchase production inputs (i.e. labour & capital); • To monitor/oversee factors of production; • To change the factors of production; • To sell these rights.

7. Principal-Agent Problem • Take the example of a manager who hires a worker to perform a given task. • The manager naturally wants the worker to work as hard as possible to raise revenue; • The worker, however dislikes working and will shirk if possible.

8. Principal-Agent Problem • Suppose for simplicity, that our worker can either work hard or not work at all. • Worker effort, e, is either equal to 2 or 0. • U = w – e if worker takes the job • U = 10 if he works somewhere else.

9. Principal-Agent Problem • Firm profits are a function of how hard the worker works. • Π = H – w if e = 2 • Π = L – w if e = 0 • What contract should the owner offer the worker in order to maximise profit?

10. Principal-Agent Problem • Since the owner cannot observe effort, he must set the wage based on revenues (H or L). • Wh is the wage when revenue is H • Wl is the wage when revenue is L • There are two constraints the owner must consider when setting wages: • It must be worth for the worker to take the contract • The contract must provide the incentive to work hard

11. Principal-Agent Problem • Since the worker can make at least 10 if he goes somewhere else: • Wh – 2 ≥ 10 – participation constraint • The contract must be done in such a way as for the worker to have higher utility by working hard: • Wh – 2 ≥ Wl – 0 – incentive constraint

12. Principal-Agent Problem • Therefore, the optimal contract is Wh = 12 and Wl = 10. • This means profits for the owner are: • H – 12 if e = 2 • L – 10 if e = 0. • This means that in order for the contract to be optimal for the owner: • H – 12 ≥ L – 10 <=> H ≥ L + 2.

13. Principal-Agent Problem • This is a rather easy way to solve a very complicated problem… • It is simple because worker effort can be directly inferred from revenues. • In a sense, owner can directly monitor worker • What happens when worker productivity is uncertain (and monitoring is imperfect)?

14. Principal-Agent Problem • Profits, Π(e) are given by: • Π(2) = H – w with prob = 0.8 • Π(2) = L – w with prob = 0.2 • Π(0) = H – w with prob = 0.4 • Π(0) = L – w with prob = 0.6 • Now, working hard only increases the likelihood of higher revenue.

15. Principal-Agent Problem • Worker’s utility is given by: • U = EW – e if worker takes the job • U = 10 if he works somewhere else. • EW = 0.8*Wh + 0.2*Wl when e = 2 • EW = 0.4*Wh + 0.6*Wl when e = 0

16. Principal-Agent Problem • The uncertainty has an impact in both participation and incentive constraints: • PC: 0.8*Wh + 0.2*Wl – 2 ≥ 10 • IC: 0.8*Wh + 0.2*Wl – 2 ≥ 0.4*Wh + 0.6*Wl – 0 • PC implies Wl = 60 – 4*Wh • IC implies Wl = Wh – 5. • Solving two equations gives Wh = 13, Wl = 8

17. Principal-Agent Problem • How much does it cost to implement this type of contract? • Expected cost to entrepreneur is: • 0.8*13+0.8*8 = 12 • Under symmetric information, Wh = 12, Wl=10. • Hence, the contract does away with the need to monitor worker.

18. Principal-Agent Problem • Let’s introduce a further twist in this story. Let’s suppose that the worker is more skeptical about the likelihood of H occurring if e =2. • In particular, the worker assigns a different probability to H occurring if he sets e=2, s.t.: • Π(2) = H – w with prob = 0.7 • Π(2) = L – w with prob = 0.3

19. Principal-Agent Problem • The worker will now have a different expected wage than the owner for any Wh, Wl: • PC is now given by: • 0.7*Wh + 0.3*Wl - 2 ≥ 10 =>Wh = (12 - 0.3*Wl)/0.7 • IC is now given by: • 0.7*Wh + 0.3*Wl - 2 ≥ 0.4*Wh + 0.6*Wl – 0 <=> Wh = 2/0.3 + Wl

20. Principal-Agent Problem • The owner will choose a contract which minimises his wage costs = 0.8Wh+0.2Wl • (remember that the owner has different subject probs over the different states of the world) • In equilibrium, Wh = 14, Wl = 22/3 • Expected wage bill is equal to: • 0.8*14+0.2*22/3=12.66 > 12

21. Principal-Agent Problem • The expected wage in equilibrium is higher than the worker’s reservation wage plus effort level. • The rationale behind this result is that the worker must be compensated for taking a random-wage contract. • The difference is a “risk-aversion” premium.

22. Alternative contractual solutions • Performance-related pay. • Piece rates. In other words, workers get w for each unit (q) they produce. • This type of contract goes back to Taylor in the XIX century; it is still widely used in the agricultural sector. • Individuals will work until MC(q) = w.

23. Alternative contractual solutions • However, how does one set w? • If w is set based on previous performance, there is a moral hazard problem: workers have an incentive to underperform. • Also, the applicability of piece rates is limited to agricultural or industrial contexts.

24. Alternative contractual solutions • Another alternative is to pay workers based on their relative performance: • Promotion Tournaments. • These contracts work much like sports competitions: • The individual who is more productive wins either a bonus or a promotion. • A variant of this type of contract was in place at GE under their former CEO, Jack Welsh. Every year, the bottom 10% managers would be sacked!

25. Tournaments • Consider a firm with 2 workers. • Their probability of success depends on both workers’ effort, which is costly • High effort has a cost of 1. • Table outlines the probability of success for each player as a function of effort.

26. Tournaments • If both players are paid the same, then the Nash equilibrium of this game is for both players to submit zero effort • (why? This is a homework question.) • However, if the winner of the tournament is paid sufficiently highly, then the unique Nash equilibrium is for both players to submit high effort.

27. Alternative contractual solutions • Another possibility is to set a fixed target to a team. • If achieved, bonus is shared by the group. • If not, each group member is paid a basic wage, which is typically low (unless you are an investment banker). • Target-based schemes are very popular in the services industry (e.g. retail, inv. banking).

28. Alternative contractual solutions • How do these types of contracts compare? • Bandiera et al. (2006) compare piece rates to a productivity-based compensation contract. • Wage = βK, where K is amount of fruit picked by worker and β = w/y. • w = minimum wage + constant, • y = mean daily productivity of group.

29. Bandiera et al. (2006) • Under this contract, working hard implies (all else constant): • Higher earnings (K ↑); • Increases average effort, thus increasing average productivity (y ↑), which in turn lowers earnings for everyone else. • This contract has a PG game aspect to it, since it contrasts the individual gain vs. the detrimental effect to other group members. • The relative performance contract was introduced to control for productivity shocks (e.g. weather conditions).

30. Bandiera et al. (2006) • Paper looks at worker productivity under piece rates and relative performance scheme. • Farm workers were temporary workers from outside the UK. • Productivity under piece rates was 50% higher than under relative performance scheme. • The reason is that social norms are created among co-workers, promoting cooperation (i.e. lower effort).

31. Bandiera et al. (2006) • Given heterogeneity in backgrounds, they find that individuals who have higher piece rates work harder. • Although piece rate is equal across workers, the value in local currency of each worker will be different. • The larger the value of the piece rate as a function of average salary in home country, the higher the productivity of the worker.

32. Alternative contractual solutions • Bull, Schotter and Weigelt (1987) compare tournaments to piece rates in controlled experiments. • They find that, on average, subjects’ effort is close to what theory would predict. • However, they find that behaviour in tournaments is much more variable.

33. Alternative contractual solutions • Nalbantian and Schotter (1997) compare a number of group incentive institutions: • Tournaments; • Revenue sharing; • Target-based schemes. • They find that: • Relative performance schemes more effective than target based schemes; • Monitoring is effective but very costly.

34. Alternative contractual solutions • Müller and Schotter (2003) study tournaments where they manipulate individual subject ability. • They find that: • High ability subjects work harder than predicted; • Low ability subjects simply drop out. • So, relative performance mechanisms may lead to dropout/workaholic behaviour. • Even if total output is higher, it is unclear whether it is desirable to have such a corporate culture.

35. Alternative contractual solutionsOverview • Piece rates appear to be useful tools to boost productivity. • However, their applicability is limited. • While tournaments can be useful alternatives, they lead to high variability in worker behaviour.

36. Team production

37. Minimum-effort game • The game we just played is called the minimum-effort game. • In certain activities, the productivity of a given worker or department depends on the productivity of the worker/department in the previous step of the production process. • It captures two key ideas in team production: • Public good problem; • Coordination problem.

38. Minimum-effort game • This game has a very large number of equilibria in pure strategies • In all equilibria, all players choose the same level of effort. • Although theoretically, individuals should be able to coordinate on the maximum amount, they often don’t.

39. Minimum-effort game • The reason is that the equilibrium where all players choose 7 is very risky. • If by chance, one player decides not to play 7, all players can lose up to 110 points, while that player will only lose up to 50! • On the other hand, the equilibrium where all choose 1 is quite safe: there is no way you can lose money.

40. Minimum-effort game • This problem increases the larger the group size:

41. Summary • Property-rights motivation for existence of firms; • Team production; • Compensation schemes; • Coordination problem in production • Next week: • Managerial compensation. • Pricing and marketing strategies.