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Incentives & Organization

Incentives & Organization. moral hazard ownership vertical integration organizational architecture. Airbus.

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Incentives & Organization

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  1. Incentives & Organization • moral hazard • ownership • vertical integration • organizational architecture (c) 1999-2001, I.P.L. Png

  2. Airbus "In the future, growth in shareholder value and efficiency can result only from an overall change in our organization. There is a need for greater centralization and central authority." Noel Forgeard, Managing Director (c) 1999-2001, I.P.L. Png

  3. Organizational Architecture • distribution of ownership • incentive schemes • monitoring systems (c) 1999-2001, I.P.L. Png

  4. Moral Hazard • asymmetric information about action • conflict of interest (c) 1999-2001, I.P.L. Png

  5. Moral Hazard in Employment employer’s marginal benefit worker’s marginal cost worker’s marginal benefit Marg. cost/benefit (cents per unit) efficient effort Quantity (units of effort) (c) 1999-2001, I.P.L. Png

  6. Happy Coincidence? Between 1970-82, • U.S. fertility rate fell by 13.5% from 1.84 to 1.59 per hundred population • proportion of deliveries by cesarean section rose by 240% (c) 1999-2001, I.P.L. Png

  7. Banking Example, I *Assume zero interest rate (c) 1999-2001, I.P.L. Png

  8. Banking Example, II:Safe Investment (c) 1999-2001, I.P.L. Png

  9. Banking Example, III: Risky Investment (c) 1999-2001, I.P.L. Png

  10. Moral Hazard in Banking • 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 (c) 1999-2001, I.P.L. Png

  11. Resolving Moral Hazard • incentive scheme • conditional payment • quota • monitoring system • incentives must be based on observables (c) 1999-2001, I.P.L. Png

  12. Incentive vs Risk Efficient scheme balances • benefits of more effort • costs of risk bearing • degree of risk • risk aversion (c) 1999-2001, I.P.L. Png

  13. AT&T Incentive Scheme • 1995: AT&T awarded CEO Robert E. Allen options for 108,000 shares at $43.94 exercise price (c) 1999-2001, I.P.L. Png

  14. Relative Performance • employment -- promote the best worker • sports -- gold, silver, bronze • examination – grade on a curve (c) 1999-2001, I.P.L. Png

  15. Multiple Responsibilities, I Example: • client engages systems integrator to implement new system • client concerned about • length of code -- easy to monitor • re-usability -- difficult to monitor (c) 1999-2001, I.P.L. Png

  16. Multiple Responsibilities, II • strong incentive • more effort on that dimension • less effort on other dimensions • equal incentive principle • low-powered contracts (c) 1999-2001, I.P.L. Png

  17. Non-Profit Organizations • school’s objective • maximize profit • maximize education of students • other examples – hospital, museum • non-profit organization to tone down profit incentive (c) 1999-2001, I.P.L. Png

  18. Hong Kong: Traffic Wardens • 20-30% of vehicles at expired meters did not get citations • monitored traffic wardens issued 69-215% more citations • proposal: assign each warden a daily quota of citations (c) 1999-2001, I.P.L. Png

  19. Holdup When Airbus assigned A-318 production to DASA, Aerospatiale threatened to quit the consortium • conflict of interest • no asymmetry of information (c) 1999-2001, I.P.L. Png

  20. Resolving Holdup • avoid specific investments • write more detailed contracts • vertical integration (redistribute ownership) (c) 1999-2001, I.P.L. Png

  21. Floating Investments How to retrieve investment in politically unstable country? • Saigon Floating Hotel • floating power plants in Philippines (c) 1999-2001, I.P.L. Png

  22. Complete Contract • 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 (c) 1999-2001, I.P.L. Png

  23. Rick Schroder: NYPD Blue contract “You may be required from time to time to show the buttocks. No genitalia will be shown.” (c) 1999-2001, I.P.L. Png

  24. IMCO’s Saginaw Plant • IMCO built new $22 million aluminium plant in Saginaw, MI – three miles from GM casting plant • GM contracted to buy over $1 billion of aluminium from IMCO over 13 years (c) 1999-2001, I.P.L. Png

  25. Ownership Residual rights • control -- rights that have not been contracted away • income -- remaining after payment of all other claims (c) 1999-2001, I.P.L. Png

  26. Saigon Floating Hotel • 1987: built in Singapore • 1987-89: Great Barrier Reef, Australia • 1989-96: Saigon River • 1996: Vietnam Government refused to renew operating license (c) 1999-2001, I.P.L. Png

  27. Vertical Integration 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 (c) 1999-2001, I.P.L. Png

  28. Vertical Integration: Impact Owner • gets rights to residual control and residual income • reduces potential for holdup (c) 1999-2001, I.P.L. Png

  29. Make or buy? vertical integration external contractor holdup moral hazard internal monopoly scale economies (c) 1999-2001, I.P.L. Png

  30. Airbus: Production, I • annual “poker game”: consortium fixed transfer prices with partners • partners received proportionate share of consortium profit • Where was partner’s incentive greater -- for self or Airbus? (c) 1999-2001, I.P.L. Png

  31. Airbus: Production, II “It was quite a dishonest system… Each partner’s prime motivation was to look after its own interest.” Mike Turner, Airbus Board Member (c) 1999-2001, I.P.L. Png

  32. Airbus: Production, III “Airbus Industries’ production system is one of the most efficient – and flexible – in the world. Approximately 96 percent of the aircraft work is performed in plants operated by the partner companies.” Airbus: Corporate Overview, Dec. 1999 (c) 1999-2001, I.P.L. Png

  33. Corporate Governance • monitoring -- Board of Directors, major shareholders • incentives -- stock options, bonuses, profit-sharing • ownership -- proxy fight, takeover (c) 1999-2001, I.P.L. Png

  34. Gillette, October 2000 Gillette fired CEO Michael C. Hawley • Warren Buffett: “We thought there was someone better to do the job” • shares rose 15%  market capitalization increased by $4 billion (c) 1999-2001, I.P.L. Png

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