Contracting, Governance and
Organizational Form
Chapter 15
• Coordination and control are problems for all business
organizations. The larger the organization, the larger the
problem.
• Contracts help insure performance, but most contracts
are incomplete. Goods are allocated in free markets by
using prices.
• However, there are alternative allocative mechanisms
that are adopted, such as vertical mergers to avoid using
prices.
2005 South-Western Publishing
Slide 1
Role of Business Contracting in
Cooperative Games
• The amount of advertising and service can be
viewed as a game.
• The outcome can be sub-optimal; that is, it is not
value maximizing. The cooperative solution
sometime yields better payoffs.
• To get to a value-maximizing solution, the
manufacturer may have to consider side
payments or credible commitments to the retailer.
Slide 2
Retail Distributor & Truck Manufacture
TABLE 15.1
• A retailer can but selling
Truck Manufacturer
effort into selling trucks
• A truck manufacture can
Advertise
No Advertisement
advertise
0
$2,000
Selling
• The cooperative solution
Effort
is for both to continue
$2,500
$3,000
Retail
efforts (payoff sum is
Distributor
$5,000
0
$7,000)
No
• But retail wants to
0
Selling $2,500
Effort
discontinue
• A contract to pay some of
retailers expenses will
Payoffs for the Retail Distributor
make both better off.
appear in lower triangles.
Slide 3
Contracts
• Contracts between players are binding, they specify
actions by both parties.
• Contracts must assign penalties for not living up to the
agreement. These payments are part of a several step
sequential game.
» If the retailer decides to discontinue a service for a product the
manufacturer produces, then the contract can provide
economic sanctions that make this decision unattractive.
• A vertical requirements contract is one in which the
firms in successive stages of production agree to
payments and/or penalties for taking an action.
» If the manufacturer spends a large amount to advertise the
product, the distributor promises to promote the product as
well.
Slide 4
Vertical Requirements Contract
• A vertical requirements contract is one in which the
firms in successive stages of production agree to
payments and/or penalties for taking an action.
• Contracts must assign penalties for not living up to
the agreement. These payments are part of a several
step sequential game.
» If the manufacturer spends a large amount to advertise
the product, the distributor promises to promote the
product as well.
• Expectation damages are a remedy for breach of
contract. These are payments for non-performance
of a contract.
Slide 5
Choice of Organizational Form
• A reliant asset is a non-redeployable durable asset.
Specialized equipment or specialized knowledge cannot
be transferred to other uses.
• In markets with reliant assets, one party could “hold-up”
the other party. The choice of organization will require
explicit contracts.
• The likely outcome is franchise contracts.
• Relational contracts are promissory agreements of
coordinated performance. A jet charter company is a
good example.
Slide 6
Vertical Integration
• An alternative to contracts between two parties is
vertical integration. If the retailer and manufacturer
merge, then both interests are reflected in a decision
whether or not to advertise or expand service.
• Spot markets present few incentive or informational
problems.
» The purchase of a dozen ears of corn at a roadside stand or the
sale of electricity at a spot rate off the grid, are examples of
spot markets.
» The products are relatively standardized and sold for
immediate delivery.
Slide 7
Incomplete Information and
Incomplete Contracting
• Incomplete Information -- uncertain knowledge of
payoffs, choices, or types of opponents a market player
faces.
• Insurance works when we can pool a group of possible
events (like injuries at work) to reduce the risk of loss to
any one party.
• But some risks are catastrophic, like a nuclear accident.
It is difficult to assess the likelihood or the damage;
hence, insurance in this case is often unavailable.
• Contracts can specify duties under several states of the
world, but sometimes the outcomes are too numerous or
unknowable for years. This creates incomplete
contracts.
Slide 8
Types
• Full contingent claims contract -- specifies all
possible future events.
• Incomplete contingent claims contract -- not
all possible future events are specified.
• Due to incomplete contracts, some people may
take advantage of spirit of the contract.
Accident insurance may permit people to succumb
to a moral hazard by acting recklessly.
Slide 9
Corporate Governance and the
Problem of Moral Hazard
• Doing business in markets involves the cost of contracts.
• When only incomplete contracts are possible, it is often the
best to integrate the operations within a firm.
• The moral hazard problem occurs when parties change their
behavior due to contracts. This is especially true when the
people’s effort is hard to observe.
• In a borrower-lender contract, a reliable borrower, once given
money in a loan, may elect to invest in highly risky projects.
» To try to avoid this moral hazard, the bank may insist on
costly monitoring or governance actions, forcing the
borrower to submit frequent financial data.
Slide 10
Transaction cost economics - involves the issue of
finding the lowest cost organizational structure.
» In some cases it is cheapest to vertically integrate and
avoid markets, especially when only incomplete
contracts are possible
» In other cases, firms create quasi-prices, known as
transfer prices, to create market-like pricing in a multidivisional firm.
» Still others find that market relationships work best, by
buying and selling at arm's length prices.
• Once a contract is issued, there is the possibility of
post-contract opportunistic behavior.
» If a CEO gets a big salary for a five-year contract and
then decides to go golfing everyday – this is a form of
moral hazard
Slide 11
Corporate Governance and the
Problem of Moral Hazard
• Moral hazard occurs when parties change their
behavior due to contracts. This is especially true when
the people's effort is hard to observe.
• Consider a borrower-lender contract.
» A reliable borrower, once given money in a loan, may elect to
invest in high risk projects.
» To avoid this moral hazard, the bank may insist on costly
monitoring or governance actions, forcing the borrow to
submit frequent financial data.
Slide 12
The Principal-Agent Problem
• The agents (managers) may wish to maximize leisure and
minimize risk, whereas the principal (shareholders) may wish
hard work and high risk-return investments.
• Example: an employee knows that working hard helps the
whole firm, and helps himself only a little. Why not let the
other workers be grinds and take it easy (be a free rider)?
• Principal-Agent problems may lead to:
• Risk Avoidance in Managers
• Managers have Short Time Horizons
• Sales Maximization
• High Levels of Social Amenities at the Work Site
• Satisficing or Sufficing Behavior
Slide 13
Mechanisms for
Corporate Governance
• Monitoring by an independent board of director
subcommittee
• Monitoring by creditors
• Monitoring by owners of large blocks of stock
• Auditing and variance analysis
• Internal benchmarking
• Corporate culture of ethical duties
• High employee morale supportive of whistle
blowers
Tables 15. 3 page 686
Slide 14
Principal-Agent Problem
in Managerial Labor Markets
• Stockholders (principals) hire managers
(agents) with different incentives.
• Alternative labor contracts
Pay based on profits
Paying a bonus on top of a salary when goals are
exceeded
Have manager own stock
• Benchmarking involves a comparison of similar
firms, plants, or divisions
Slide 15
Signaling and Sorting of
Managerial Talent
 Applicants
to positions know more about
themselves than they reveal, which is the problem
of asymmetric information.
Asymmetric Information -- unequal or
dissimilar knowledge among market participants.
 For example, is the applicant highly risk averse or
a risk taker?

If I ask you if you are highly risk averse, you will likely
tell me what I want to hear.
 How
can we sort between risk-takers and risk
averse candidates?
Slide 16
Screening and Sorting of Managerial Talent
with Optimal Incentives Contracts
• A Linear Incentive Contract is a combination of salary
and (plus or minus!) a profit sharing rate.
• Pooling Equilibrium is an offer that dominates all other
offers will not help distinguish among applicants.
• Separating equilibrium is an offers that distinguishes
between behaviors
• For example, a risk averse person would tend to
select an offer which primarily paid a base salary
• Whereas the risk-loving individual would tend to
select an offer with more profit sharing.
Slide 17
Sorting Managers with Incentives
• Contract A has lower
profit sharing rate and
lower base rate than
Indifference
curve for the
Contract B
risk lover
• Both a risk averse
person and a risk
lover picks B over A
• This results in a
pooling equilibrium.
Indifference
curve for the
risk averse person
Base Rate
Salary
B
A
Figure 15.4
Profit Sharing Rate
in  percentages
Profit sharing points of
Equal profit to the firm
Slide 18
Sorting Managers with Incentives
Base Rate
Salary
A
• However, in the choice
between job offer A and
C
Indifference
curve for the
• The Risk Lover picks
risk lover
Contract C
• The Risk Averse picks
Contract A
• A separating
equilibrium.
Indifference
curve for the
risk averse person
C
Profit Sharing Rate
in  percentages
Profit sharing points of
Equal profit to the firm
Slide 19
The Holdup Problem
• A holdup is a tactic in many contracting
situations.
• One party wants all the gains in the deal. If
they don’t get them, they promise not to carry
out their end of the deal. They block progress,
so they ‘hold-up’ of the other parties.
• Government use the right of eminent domain to
side step someone who uses a holdup to
development.
Slide 20
Choice of Efficient Organizational Form
• The nature of the product and the assets that produce it, affect the choice of
organizational form.
• A reliant asset is a non-redeployable durable asset. Specialized equipment or
specialized (specific vs. general) knowledge cannot be transferred to other
uses.
» Rental cars are redeployable, so we may expect use of spot market rentals.
» A paper-cup-making machine is non-redeployable, so we may expect long
term rental agreements.
• Relational contracts are promissory agreements of coordinated performance.
A jet charter company is a good example, where long term relationships
matter.
• Vertical integration is a way to avoid transaction costs, such as moral hazard,
in arm's length dealing. The two stages of production are merged: the
producer ships goods to the next stage of the same firm.
• If each stage of production has some monopoly power, the profits can be
higher by merging the two stages.
Slide 21
Vertical Integration in the Hosiery Market
Ph’
Ph
Py’
Py
MRh
• Suppose yarn is used in
making hosiery (socks) in
fixed proportions.
• Let the marginal cost of
Py’ +MCh
yarn (MCy) and hosiery
manufacture (MCh) be
MCy +MCh
constant.
• The profit maximizing
MCh
hosiery price is Ph
Higher yarn prices • But if the price of yarn is
raised to Py’ the price ends
MCy
up too high at Ph’ with
DEMANDh smaller total profits for the
hosiery + yarn industries.
Slide 22