Incentives and
Organization
IMBA Managerial Economics
Jack Wu
Outline
 organizational architecture
 moral hazard
 ownership
 vertical integration
Organizational Architecture
 distribution of ownership
 incentive schemes
 monitoring systems
Moral Hazard
 asymmetric information about action
 conflict of interest
Moral Hazard in Employment
employer’s
marginal benefit
worker’s
marginal
benefit
Quantity (units of effort)
worker’s marginal
cost
efficient effort
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%
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
Resolving Moral Hazard
 incentive scheme


conditional payment
quota
 monitoring system

incentives must be based on observables
Incentive vs Risk
Efficient scheme balances
 benefits of more effort
 costs of risk bearing


degree of risk
risk aversion
AT&T Incentive Scheme
 1995: AT&T awarded
CEO Robert E. Allen
options for 108,000
shares at $43.94
exercise price
300
250
200
150
100
50
0
'95
AT&T
'96
'97
'98
S&P Tel Index
Relative Performance
 employment -- promote the best worker
 sports -- gold, silver, bronze
 examination – grade on a curve
Multiple Responsibilities
 strong incentive


more effort on that dimension
less effort on other dimensions
Non-Profit Organizations
 school’s objective
 maximize profit
 maximize education of students
 other examples – hospital, museum
 non-profit organization to tone down profit
incentive
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
Holdup
 Holdup = opportunistic behavior = action
intended to exploit another party’s
dependence
 unlike moral hazard, holdup can arise even if
information is symmetric
Resolving Holdup
 avoid specific investments
 write more detailed contracts
 vertical integration (redistribute ownership)
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

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
Ownership
Residual rights
 control -- rights that have not been contracted
away
 income -- remaining after payment of all other
claims
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
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
Vertical Integration: Impact
Owner
 gets rights to residual control and residual
income
 reduces potential for holdup
Make or buy?
vertical
integration
external
contractor
holdup
moral hazard
internal monopoly
scale economies
Airbus: Production
 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?
Corporate Governance
 monitoring -- Board of Directors, major
shareholders
 incentives -- stock options, bonuses, profitsharing
 ownership -- takeover