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Chapter 10: Incentive Conflicts and Contracts

Chapter 10: Incentive Conflicts and Contracts. Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture , 4th ed. Incentive Conflicts and Contracts learning objectives. Students should be able to

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Chapter 10: Incentive Conflicts and Contracts

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  1. Chapter 10: Incentive Conflicts and Contracts Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.

  2. Incentive Conflicts and Contractslearning objectives Students should be able to • Describe and offer examples of several kinds of incentive conflicts in firms • State the role of contracts in reducing incentive conflicts • Describe and offer examples of several pre- and postcontractual information problems

  3. Examples of incentive conflicts • Owner versus manager • profits or salaries and perks • work hard or shirk • take chances or play it safe • Buyer versus supplier • Free ride or not • Management versus labor

  4. The role of contracts • Costless contracting • ideal contracts would align interests (minimize incentive conflicts) at no or low cost • Costly contracting and asymmetric information • contracts costly to negotiate, write, administer • parties to contract have asymmetric information on performance levels

  5. Firm as focal point for set of contracts

  6. Postcontractual information problems • Agency problems • principal contracts with agent for service • agent has postcontractual incentive to serve own perceived best interests • Asymmetric information complicates resolution of agency problems • principal incurs monitoring costs and/or • agent incurs bonding costs

  7. Optimal combination of compensation and perks CEO utility function, C is compensation, P is perquisites:U=f(C,P) Owners have precise knowledge of profit potential:p Realized profits are:R=p-P Therefore offer CEO compensation contract: C=S-(p-R)

  8. Optimal perquisite taking

  9. Postcontractual information problems • Agency problems • principal contracts with agent for service • agent has postcontractual incentive to serve own perceived best interests • Incentives to economize on agency costs • sharing increased gains from trade

  10. Agency Cost ExampleGood Tire Company and Brown & Brown • Good Tire’s marginal benefit from legal services:MB=200-2L • Brown & Brown’s marginal cost for providing legal services:MC=100 • Value maximization:MB=MC, or 200-2L=100, L*=50 • Fee of $6250 covers costs of $5000 and yields net benefits of $1250 each

  11. Agency Cost ExampleGood Tire Company and Brown & Brown • BUT Brown & Brown may have incentive to provide fewer than 50 hours • Costly for Good Tire to monitor or for B&B to provide guarantee • Possible outcome is reduced gain from trade (foregone surplus)

  12. Agency costs in legal contracting

  13. Precontractual information problems • Bargaining failures • asymmetric information • Adverse selection • use of private information in manner detrimental to trading partner

  14. Implicit contracts and reputations • Implicit contracts -- agreements and understandings that can’t be legally enforced • Reputational concerns can motivate implicit contract compliance

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