Economics of Business

Economics of Business Class 6 Outline Harvard Extension School Instructor: Bob Wayland Teaching Assistant: Natasha Wambebe

In Previous Episodes of E1600 • What are the four pillars of our framework? • Why did Coase say firms emerged from the market? • What factor did Coase (and others) say was the long term limit to firm growth? • How did Stigler explain the industry life cycle? • Beginning state of integration • Variety of cost functions • Increase in extent of the market • What characteristic of the firm vv the market did Alchian and Demsetz emphasize? incomplete w/o oral presentation

In Previous Episodes… What is an undesirable consequence of team production and human nature? What is the role of management in the Alchian and Demsetz model? How are managers stimulated to reduce shirking? How can different types of firms be defined and distinguished? What sort of overall conceptual model did Alchian (1950) apply to the theory of the firm? How did Knight distinguish risk and uncertainty? Is profit maximization a good guide to decision-making under uncertainty? How do Nelson and Winter characterize routines ? incomplete w/o oral presentation

In Previous Episodes What is the degree of agreement among experts at the beginning of a product life cycle? What can you say about the relative product innovation capability of successive cohorts in the Klepper PLC model? To what ends do new entrants offer more innovative products? What factors finally choke off new entrants in the Klepper model? What motivates incumbents to stay, potential entrants to enter? incomplete w/o oral presentation

Previous Episodes… • If a firm produces two intermediate goods and a final good and sells only the final good into a competitive market how should it: • Determine the quantity of the final good? • Determine the quantity of the intermediate good that is transferred to the selling division? • Should firms always set their internal transfer prices equal to market prices? • What factors does Williamson use to describe transactions? • What are the dimensions used by Williamson to define the range of human asset governance structures? incomplete w/o oral presentation

Incentives and Control Systems • Our rules vs. Nature’s • Divergence, Nature prevails, we are “surprised” • Ignorance: more surprise, believe Nature is capricious • Behavioral economics and psychology • Social vs. Market norms • Sense of fairness • Altruism and tit-for-tat • Hard to assess inter temporal trade-offs incomplete w/o oral presentation

Principal-Agent Problem, Asymmetric Information, and Incentives Classical model did not distinguish among motives of principals and agents Alchian and Demsetz define manager role and incentive to avoid shirking in terms of claim on residual created by teams Agency theory is directed at the ubiquitous superior-subordinate relationship One party (the principal) delegates work to another (the agent), who performs that work. incomplete w/o oral presentation

Principal-Agent Problem, Asymmetric Information, and Incentives… • Agency theory is concerned with resolving two problems: • The desires or goals of the principal and agent conflict and • It is difficult or expensive for the principle to verify what the agent is actually doing • As usual, Adam Smith was aware of the problem: …and the wages of labor are everywhere understood to be, what they usually are, when the labourer is one person, and the owner of the stock which employs him another.What are the common wages of labour, depends everywhere upon the contract usually made between those two parties, whose interests are by no means the same. The workmen desire to get as much, the masters to give as little as possible. The former are disposed to combine in order to raise, the latter in order to lower the wages of labour incomplete w/o oral presentation

Dimensions of the Principal Agent Problem Agents possess an informational advantage (also referred to as asymmetric information) over the principal. Thus the principal can never be completely aware of the agent’s actions. People at various levels in the hierarchy and locations in the firm have different amounts and quality of information. People with an informational advantage are tempted and sometimes succumb to the urge to game the system, or worse, criminally abuse it. To deal with the problem of differential information firms often invest substantially in control and monitoring systems incomplete w/o oral presentation

Dimensions of the Principal Agent Problem Costs associated with agents failing to maximize their efforts on behalf of the principal are called “agency costs” and the general problem is sometimes called the “agency dilemma.” The modern approach posits separate utility functions for the owners (principals) and their managers (agents). External, unplanned, and random events beyond the manager’s control may influence greatly the results of his efforts or make them difficult to measure. (recall Alchian, 1950) incomplete w/o oral presentation

Dimensions of the Principal-Agent Problem… • Prevention (can be thought of as a type of “control”) • First line of defense is to employ better agents • People tend to inflate (e.g. O’Leary at ND) • Prevention costs declining as databases become more accessible • Control • Basic requirement of metering and evaluation • Technology aided control systems increase management and labor productivity • Sometimes encourage colleagues to spy and inform on one another (offset management’s asymmetric information disadvantage) incomplete w/o oral presentation

Dimensions of the Principal-Agent Problem… • A second order effect of control: the more extensive the control system, • the higher the compliance costs, • the greater the power of the controllers and • the more likely is smeergeld and steekpenning • Principals will invest in control systems up to the point where the incremental cost of additional control just equals the avoided loss due to opportunism incomplete w/o oral presentation

Incentives • Kerr provides a litany of counter productive and sometimes perverse behaviors stimulated by poorly designed incentive systems incomplete w/o oral presentation

Incentives… Kerr offers four reasons: incomplete w/o oral presentation

Designing Incentives- The Basics of Money and Leisure Assume a max 16 hour workday, three successively higher indifference curves (I1,I2, I3 ), three successively greater income lines (Y1, Y2, Y3) reflecting corresponding money wages: incomplete w/o oral presentation

Designing Incentives- The Basics of Money and Leisure Identifying hours worked (Wi = 16-Hi) for each income line, we can plot a labor supply curve as a function of wages, Mi, associated with each income line in previous slide: incomplete w/o oral presentation

Designing Incentives- The Basics of Money and Leisure We add 3 new money income and indifference curves, causing the hours of leisure to first decline and then to increase. To extent that many people have this sort of preference, explains why rich country work weeks are shorter incomplete w/o oral presentation

Agent-Principal Incentive model Assumptions: • The Principal (owner, entrepreneur, etc) retains the profit or wealth maximizing objective and utility function. (Recall the motivating factor in Alchian and Demsetz) • Agents, people within the firm, have different values and hence different utility functions expressing their trade-offs • The principal seeks to provide the agent incentives to align his or her effort to the benefit of the principal • The agent can perform some act or function which advances the principal’s interest but at a cost to herself (pain, loss of leisure…) • The agent often enjoys an informational advantage that enables her to mask her actions or to better understand the alternatives facing the firm. • This asymmetric information position is key to moral hazard and the need for management control systems • Thus the interests of principal and agent are not aligned and are in at least partial conflict --- the Principal-Agent Problem, sometimes called Agency Theory. • The costs associated with agents failing to maximize the benefit of their effort are called agency costs incomplete w/o oral presentation

Agent-Principal Incentive model The conflict in objectives is shown for a case where the agent perceives reward for both profitability and employee count The profit maximizing agent would operate at point b, the utility maximizing agent goes beyond to c incomplete w/o oral presentation

The Sharecropping Model • Perhaps the oldest form of risk-sharing model and still in wide use • Basic model involves a land-owner (principal) and a tenant farmer • Following Gibbons, we assume: • The production function defines output, y, as a function of agent effort, a, plus an exogenous shock term, e : y= a + e incomplete w/o oral presentation

The Sharecropping Model • The principal offers the agent a contract where total compensation, w equals a salary component, s, and bonus rate b applied to y; this is a linear equation: w= s + by • Now the principal’s profit is y-w which of course he seeks to maximize – e.g. find the greatest difference between y and w – considering both the agent’s contribution to y and his wage incomplete w/o oral presentation

The Sharecropping Model… The agent seeks to maximize the difference between her expected wage based on y and the cost of her effort a. I.e. she optimizes her pay-off: w-c(a). incomplete w/o oral presentation

The Sharecropping Model… The intercept, s, or fixed salary does not vary with respect to output so it does not influence the level of effort and hence output. Influences the agent’s employment decision by reducing risk of taking the job. If s = 0, the agent bears the risk of total failure The steeper the wage curve, e.g. higher b, the greater the share of output that goes to the agent and more incentive she has to put forth effort The principal will not pay knowingly a bonus rate that results in his expected profits being less than his own opportunity costs Contracts may have a negative s which is a fee for the right to operate the franchise incomplete w/o oral presentation

The Fallacy of Pure Objectivity • Many people believe that well-defined and strictly enforced contracts are the best way to handle or govern almost all internal and external relationships and transactions. • Those people are ignoring or ignorant of asymmetrical information and monitoring costs • As Kerr points out, unintended consequences often seem the rule in incentive compensation. Gibbons notes: • H.J. Heinz; gaming the accounting of sales • Dun & Bradstreet, misleading the clients • Sears Automotive, inflating the repairs • Fund management distortion • Job Training Partnership, skew trainee selection incomplete w/o oral presentation

The Sharecropper Model… • If direct contribution to output or profit is not observable, principals may use objective proxies; e.g. w= s + bp • The closer p is to y, the more efficient the system, but if p diverges from y, the agent’s behavior will become misaligned with the principal’s objective incomplete w/o oral presentation

Incentive Systems… • In many cases, the difficulty of measuring precisely y and people’s contribution to it is so great that a system of modest bonuses and subjective evaluations is superior to a strict “by the numbers” approach. • Baker showed that under some relationships of p to y, it was impossible to determine optimal incentives = social marginal benefits • Under many cases of uncertainty, it is also impossible to create an incentive in which marginal agent action = marginal social value • “Tournament” models, in which agents compete for a prize can lead to sabotage as well as effort. • Impossible to contract on single agent’s contribution to team value (recall joint input problem) • Introduction of private or multiple objectives shows how managers may focus on private gains incomplete w/o oral presentation

Incentive Systems… • Gibbons summarized his interim judgment on objective performance systems thus: • Objective performance measures typically cannot be used to create ideal incentives • Efficient bonus rates are consequently often small • Small bonus rates can create useful incentives if agents have few distractions, so job design may be an important complement to incentive contracting incomplete w/o oral presentation

Incentive Systems and Relationships • Various forms of relational contracts* involving subjective performance assessment can be effective with or in place of enforceable contracts • Desire(s) to maintain the relationship (repeated game) • Worker is paid base salary plus conditional bonus depending on high or low contribution • Company has no incentive to pay in a single period game • In multi-period game, the discounted value of the contribution is critical • Low interest rates, high incentive to maintain relationship, pay larger bonus • High interest rates, NPV of contribution is smaller, may result in low bonus or reneging *recall Williamson’s taxonomy of employee characteristics and governance structures incomplete w/o oral presentation

Promises and Skill Investments • Promises (or potential) of raises or promotions may be an incentive to invest in skills • Worker must expect increase in wages to have NPV greater than opportunity cost of investment • Company must expect value of increased productivity to exceed the cost of the higher wages • Consider situation where the employee and employer are considering investment in employee skill(s) incomplete w/o oral presentation

Complementary Incentives to Invest in Skills… we = 10 = wage in easy job (untrained) wd = 30 = wage in hard job c = 15 = opportunity cost of training Worker will invest if wd – we > c e.g. 30- 10 > 15 Firm will promote trained worker if productivity, y, gain exceeds wage increase: ydt – wd > yet – we or ydt- yet > wd –we But, recall that wd – we > c has to hold: ydt- yet > wd –we > c Plugging: 30 -20 > 30 – 10 > 15 NOPE! incomplete w/o oral presentation

Conditional Promises • Some form of conditional promises may discourage investment in skills and may waste human capital (up-or-out policies) • Promotional promises may waste little acquired skill of those not promoted • Up-or-out often wastes acquired skills • Gibbons’ contract forms may be used for both internal and external contracts and are consistent with the determination of firm boundaries by Williamson incomplete w/o oral presentation

Next Week The Midterm is on-line for everyone Take the sample test to make sure you can sign on and execute on your computer Natasha and I do not grade the on-line tests but we curve the results and will get them to you when we get back There is no March 13th Class because of Spring Break Good luck on your midterm and enjoy your break! incomplete w/o oral presentation

Economics of Business