Transcript lecture 1

Any Questions from Last
Class?
Chapter 18
Getting Employees to Work in
the Best Interests of the Firm
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson
Corporation. Thomson, the Star logo, and SouthWestern are trademarks used herein under license.
Chapter 18 – Take Aways
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Principals want agents to work in their (the principals’)
best interests, but agents typically have different goals than
do principals. This is called incentive conflict.
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Incentive conflict leads to moral hazard and adverseselection problems when agents have better information
than principals do.
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Three approaches to controlling incentive conflicts are fixed
payment and monitoring (shirking, adverse selection, and
monitoring costs), incentive pay and no monitoring (must
compensate agents for bearing risk), or sharing contract
and some monitoring (some shirking and some risk
compensation).
Chapter 18 – Take Aways
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In a well-run organization, decision makers have
(1) the information necessary to make good
decisions and (2) the incentive to do so.
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If you decentralize decision-making authority,
you should strengthen incentive compensation
schemes.
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If you centralize decision-making authority, you
should make sure to transfer needed information
to the decision makers.
Review of Chapter 17
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Moral hazard is post-contractual (hidden action) problem caused
by asymmetric information
 Problem is excessive risk taking after insurance
 Looks similar to adverse selection
Lessons of moral hazard
 Anticipate moral hazard; it happens
 You may be able to consummate the unconsummated wealth
creating transaction by gathering info to remove the information
asymmetry
Solutions
 Information (costly monitoring)
 Incentives
Shirking is moral hazard
 May be too costly to solve
Introductory Anecdote
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Auction house employed art experts to convince art
owners to use auction services
Auction house earns money by charging the art
owners a percentage of the final price at auction, a
percentage negotiated by the art expert.
Problem: Low negotiated prices (“commissions”) by
art experts
Experts “traded” low prices for kickbacks
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Wine, furs, automobiles
Discussion: Find at least two solutions
Principal-Agent Models
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Definition: A principal wants an agent to act on her
behalf
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Agents have preferences different than those of
principals.
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Called “incentive conflict”
Two problems
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Auction house is principal; art expert is agent.
Adverse selection: how does principal pick right agent?
Moral hazard: how does principal motivate agent?
Problem caused by information asymmetry
Incentive Conflict Examples
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Without proper control, incentive conflicts
deter profitable transactions from occurring
and result in “agency costs”
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Shareholders/Managers
Employer/Employee
Customer/Seller
Marketing/Sales
Agency Costs
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Costs associated with moral hazard and adverse
selection are often called “agency costs”
Firms should attempt to reduce agency costs
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Costs can be reduced if the principal incurs costs to gather
information about
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The agent’s type (adverse selection)
The agent’s actions (moral hazard)
Information gathering
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Adverse selection – background checks
Moral hazard – monitoring agent behavior
Incentive Pay vs. Risk
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Incentive pay imposes risk on agents
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A portion of compensation is not guaranteed, i.e.,
“at risk”
Agents must be compensated for taking on
additional risk
Becomes a cost-benefit calculation
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Does the benefit (harder work by agent) outweigh
the cost (extra compensation for bearing risk)?
Organizational Ideal
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In an ideal organization
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Decision-makers have information necessary to make
profitable decisions; and
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Incentive to do so
1st Principle: Information
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Decentralization: move decision rights to those with information; or
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Centralization: move information to those with decision rights
2nd Principle: Incentives
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Decentralization requires strong incentives
Controlling Incentive Conflict: Three
Levers
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Decision rights: who decides what?
Information: does the decision-maker have good information?
Evaluation and Compensation
 Performance evaluation
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If you can’t measure it, you can’t control
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How is compensation tied to performance evaluation?
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Solves moral hazard and adverse selection
Reward good performance; and/or
Penalize bad performance
Limited by agent risk aversion and poor performance metrics
Discussion: Auction house solutions?
 Centralize decision making (what they did); or
 Decentralize decision making + incentive compensation
Example: Marketing vs. Sales
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Large telecommunications equipment company
sends sales agents out to various countries in South
America to bid to supply telephone switching
equipment to governments
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Sales people all want to bid more aggressively to make
sure that they win the contract
Marketing wants the sales’ agents to bid less aggressively,
so that when they do win, the contracts are more profitable
Solutions?
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Centralize decisions and transfer information
Decentralize and change incentives
Example: Franchising
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Companies face fundamental choice when expanding and
opening new stores
 Company-owned
 Franchises
Incentive conflict exists between company owners/managers and
those running stores
 In a company-owned store, both adverse selection and moral
hazard are concerns
 Franchising is a form of incentive compensation scheme to help
address the conflict
 As always, addressing the conflict is costly
The right choice: “It Depends!”
 Compare the cost of franchising vs. its benefits
 Consider “hybrid” solutions as well
Framework
To analyze principal-agent problems, begin with
the bad decision that is causing the problem, and
then ask three questions.
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Who is making the (bad) decision?
Did the employee have enough information to make a
good decision?
Did he have the incentive to do so, i.e., how is the
employee evaluated and compensated?
Answers generally suggest alternatives for
reducing agency costs
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Change decision rights
Transfer information
Change incentives
Example: Declining Store Profits
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Large retail chain of “general stores” that target low income
customers in cities with less than 50,000 people
As the company has grown, the CEO, and the stock analysts
who follow the company, notice that newly opened stores are not
meeting sales projections
Development agents find new store locations and negotiate
leases with property owners – the company rewards these
agents with generous bonuses if they open fifty new stores in a
single year
Agents are supposed to open new stores only if their sales
potential is at least one million dollars per year, but this is
obviously not happening – recently opened stores earn half this
much
Discussion: Ask questions and suggest solutions
Alternate Intro Anecdote
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Whaling ventures in the 1800s were managed by agents, who
would purchase supplies, hire a captain and crew, and plan the
voyage on behalf of the investors.
Agent’s performance difficult for investors to observe or evaluate
Actions of crew on multi-year voyages even more difficult to
evaluate
Contracts and organizational forms century evolved in response
to these problems
 Most whaling enterprises were closely held by a small number
of local investors
 Ownership rights were allocated to create powerful incentives
for their managers
 Agents usually held substantial ownership shares in their
ventures
Alternate Intro Anecdote (cont.)
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Attempting to run these ventures via corporation form in the
1830s and 1840s failed
 They paid their crews the same ways, used similar
vessels, and employed agents with similar
responsibilities
 Only main difference was in ownership structures and
hierarchical governance
 They were unable to create the incentives requisite for
success in the industry. The managers of these
corporations, who did not hold significant ownership
stakes, did not perform as well as their peers in
unincorporated ventures.