13: Chapter Incentives and Organization
Chapter
13
Incentives and Organizations
CHAPTER SUMMARY
The architecture of an organization comprises the distribution of ownership, incentive
schemes, and monitoring systems. Ownership means the rights to residual control.
Incentive schemes and monitoring systems are related as incentives must be based on
behavior that can be observed. An efficient incentive scheme balances the incentive for
effort with the cost of risk.
An efficient organizational architecture resolves four internal issues holdup,
moral hazard, monopoly power, and economies of scale. Holdup and moral hazard
arise between parties with a conflict of interest. Additionally, moral hazard depends on
one party not being able to observe the actions of the other. Holdup can also be
resolved through more detailed contracts, moral hazard through incentive schemes and
monitoring systems, and internal monopoly power through out-sourcing.
KEY CONCEPTS
organizational architecture
moral hazard
performance pay
performance quota
relative performance
h o ld u p
specificity
complete contract
ownership
residual control
residual income
vertical integration
GENERAL CHAPTER OBJECTIVES
1.
2.
3.
4.
5.
6.
Discuss the problem of moral hazard.
Analyze monitoring systems and incentive schemes to resolve moral hazard.
Appreciate the risk imposed by incentive schemes.
Appreciate how to give incentives for multiple responsibilities.
Discuss the problem of holdup.
Analyze how the distribution of ownership affects moral hazard and the potential for
holdup.
7. Discuss the design of organizational architecture.
2001, I.PL. Png & C.W.J. Cheng
1
Chapter 13: Incentives and Organization
NOTES
1. Organizational architecture.
(a) Organizational architecture comprises incentive schemes, monitoring systems,
and the distribution of ownership. The vertical and horizontal boundaries of
the organization are two implications of the organizational architecture.
(b) An efficient organizational architecture revolves and should be designed to
balance 4 internal issues: moral hazard, holdup, monopoly power, and
economies of scale and scope.
2. Moral hazard.
(a) Moral hazard exists when one partys actions affect but are not observed by
another party with whom it has a conflict of interest, e.g., delivery persons,
sales representatives are subject to moral hazards.
(b) Moral hazard arises only when there is asymmetric information about the
future actions of the better-informed party.
(c) Economic efficiency. The relevant parties would like to resolve the moral
hazard so that the better-informed party will make the economically efficient
choice.
i. The degree of moral hazard is measured by the discrepancy between
the actual action or effort and the economically efficient level.
ii. Economically efficient level of action:
(1). Employers profit = employers benefit (revenue other costs)
wages and incentives paid to the worker subject to moral
hazard.
(2). Workers net benefit = wages and incentives cost of effort.
(3). Employers marginal benefit from the workers effort = change
in employers profit from workers increase in effort.
(4). Workers marginal cost from effort = additional cost required
to increase effort.
(5). Economic efficiency for the group: a level of effort when
employers marginal benefit balances workers marginal cost.
iii. The actual action or effort chosen by a party subject to moral hazard
will be lower than the economically efficient level.
(1). Worker acts independently and considers only her personal
marginal benefit and marginal cost from effort, not the
employers marginal benefit.
(2). The lower the workers marginal benefit relative to the
employers marginal benefit, the lower the effort the worker
chooses relative to the economically efficiency level.
iv. A profit can be made by resolving the workers moral hazard. The
greater the moral hazard, the greater the gain in net benefit from
resolving the moral hazard.
2001, I.PL. Png & C.W.J. Cheng
2
Chapter 13: Incentives and Organization
3. Monitoring systems and incentive schemes.
(a) 2 complementary approaches to resolve moral hazard: monitoring systems
(e.g., time clock, vehicle log, random checks by supervisors, customer reports)
and incentive schemes.
(b) Incentive schemes align incentives of the party subject to moral hazard with
those of the less-informed party by tying payments to some observable
measure of performance. They depend on:
i. A link between the unobservable action and some observable measure
of performance.
ii. Information provided by monitoring systems.
(c) Performance pay is an incentive scheme that bases pay on some measure of
performance (e.g., a commission per delivery).
i. An incentive scheme is stronger (resulting in higher level of workers
effort) if it provides a higher personal marginal benefit for effort.
(d) A performance quota is a minimum standard of performance (set at the
economic efficient level of effort, e.g., minimum number of deliveries), below
which penalties (e.g., deferral of promotion, pay reduction, dismissal) apply.
i. A performance quota is cost effective. It does not reward effort below
or above the economically efficient level.
(e) An economically efficient scheme (one that maximizes net benefit) must
balance the incentive for effort with the cost of risk.
i. Risk arises whenever incentives are based on an indicator that
depends on extraneous factors (deliveries made by a delivery person
depends on traffic, weather, customers ordersetc) and the party
subject to moral hazard has imperfect information about those
extraneous factors.
ii. The costs of risk depend on 3 factors:
(1). The structure of the incentive scheme: the stronger the
scheme, the higher the risk to the party subject to moral
hazard.
(2). The degree of risk aversion of the party subject to moral
hazard, and
(3). The importance of extraneous factors: when the indicator is
sensitive to these factors and the factors are subject to wide
swings, the higher the risk. Note: Incentive schemes based
on relative performance (e.g., fixed pay plus a commission for
each delivery above an average level) are an effective way of
reducing risk due to common extraneous factors (whose effect
is cancelled out to the extent they affect all workers equally).
iii. Stronger schemes should be adopted when the party subject to moral
hazard is less risk adverse and extraneous factors are weaker.
(f) A party may be subject to moral hazard with respect to multiple
responsibilities, i.e., when one partys multiple actions (as opposed to a
2001, I.PL. Png & C.W.J. Cheng
3
Chapter 13: Incentives and Organization
single action) affect but are not observed by another party with whom it has a
conflict of interest.
i. An incentive scheme should balance the multiple responsibilities:
monitoring each of the unobservable actions and with incentives based
on each of the corresponding indicators.
ii. An incentive scheme that focuses on one responsibility may aggravate
moral hazard associated with other functions.
iii. When there are responsibilities for which it is difficult to measure
performance, a deliberate use of weak incentives is a way to achieve
the necessary balance among responsibilities.
4. Holdup.
(a) Holdup is an action intended to exploit another partys dependence. It arises
only when there is a conflict of interest the between parties.
(b) It does not require asymmetric information.
(c) The prospect of a holdup deters investments in specific assets.
i. The specificity of an investment in an asset is the percentage of the
investment that will be lost if the asset is switched to another use.
ii. The costs of holdup will be higher if the relevant assets are more
specific.
(d) The prospect of a holdup lead other parties to take precautions which either
reduce the benefit from the relationship or increase costs, reducing the groups
net benefit.
i. A profit can be made by resolving the holdup.
(e) A complete/more detailed contract would resolve holdup, but would be very
costly to prepare.
i. A complete contract specifies what each party must do and the
corresponding payments under every possible contingency.
ii. The degree to which a contract should be incomplete depends on:
(1). The (lower) potential benefits and costs at stake, and
(2). The (smaller) extent of possible contingencies.
(f) Another way to resolve holdup is through changing the ownership of the
relevant assets, e.g., vertical integration.
i. Ownership is the rights to residual control (rights that have not been
contracted away). Rights to residual control include:
(1). The right to receive residual income from the asset (i.e., the
income remaining after the payment of all other claims) and
the benefit of changes in income and costs.
(2). The right to withhold the services of the asset.
ii. A transfer of ownership means shifting the rights of residual control to
another party.
5. Vertical integration: affects moral hazards and resolves holdup.
2001, I.PL. Png & C.W.J. Cheng
4
Chapter 13: Incentives and Organization
(a) Vertical integration is the combination of the assets for two successive stages
of production under a common ownership.
i. Downstream: closer to the final consumer.
ii. Upstream: further from the final consumer. The make or buy
decision is a decision to vertically integrate upstream.
iii. Vertical integration changes ownership of assets and alters the rights
to residual control and residual income.
(b) With vertical integration:
i. Holdup can be resolved.
ii. The degree of moral hazard is increased. The internal supplier is
subject to moral hazard.
iii. The internal supplier may acquire monopoly power. One can
outsource (purchase of services or supplied from external sources)
whenever the internal providers cost exceeds that of external
sources/competitive level in the market.
iv. The internal supplier may lack economies of scale and scope as
compared with external suppliers. Note: however, at some point,
scope economies are outweighed by the degree of moral hazard within
the various operational units of a huge organization (with wide
horizontal organizational boundaries).
ANSWERS TO PROGRESS CHECKS
13A.
The new marginal cost curve lies above the original. Please refer to Figure 13A
on page 548 of the text. (1) The economically efficient effort will be lower. (2)
The effort that the worker actually chooses will be lower.
13B.
Draw any personal marginal benefit curve that crosses the marginal cost curve at
120 units of effort.
13C.
See Figure 13C on page 548 of the text.
13D. Marys incentive scheme should be stronger.
13E.
The salesclerks incentive to process returns will be reduced.
13F.
On-the-job training.
13G. Walt Disney integrated downstream; Broken Hill integrated downstream; Loral
integrated downstream; Dominion Resources integrated upstream.
13H. There are scale economies in processing credit card transactions. Mercury is too
small to operate the service efficiently.
2001, I.PL. Png & C.W.J. Cheng
5
Chapter 13: Incentives and Organization
ANSWERS TO REVIEW QUESTIONS
1. [omitted].
2. As it is costly for the insurer to monitor Leahs precautions, information is
asymmetric. With insurance, Leah bears the cost of precautions but receives only
part of the benefit, and so , there is a conflict of interest.
3. With moral hazard, the marginal benefit of effort exceeds the marginal cost. By
resolving the moral hazard, the potential profit is the marginal benefit less the
marginal cost.
4. Method (b) provides more incentive to the lawyer.
5. (a) Pay or quotas based on sales relative to the average. (b) Rewards or quotas
based on the number of accidents or breakdowns relative to average.
6. The scheme will reduce the secretarys incentive for effort in the other tasks.
7. (a) Index of small stocks;
Japanese stocks.
(b) Index of U.S. government bonds;
(c) Index of
8. (b) Airbus-340 training.
9. Because the additional cost of preparing a complete contract outweighs the
potential benefit in avoidance of holdup.
10. (i) Shareholders have residual control (rights that have not been contracted away).
For instance, they may dismiss the current board of directors and management. (ii)
Shareholders also have the rights to residual income (income remaining after the
payment of all other claims). They receive dividends only after all other claims,
such as interest and trade debts, have been paid.
11. [omitted].
12. False. Internal production would give rise to problems of moral hazard and internal
monopoly.
13. If the internal supplier quotes a price that is too high, internal customers will outsource. This constrains the monopoly power of the internal supplier.
2001, I.PL. Png & C.W.J. Cheng
6
Chapter 13: Incentives and Organization
14. Vertical integration involves combining assets for the two successive stages of
production under common ownership. Horizontal integration involves combining
assets for the same or similar stage of production under common ownership.
15. For: reduces potential for hold up. Against: increases moral hazard, creates internal
monopoly, and does not benefit from scale economies.
WORKED ANSWER TO SAMPLE DISCUSSION QUESTION
Mars Power has built an electric power generating plant next to the Mercury coal mine.
Mars has tailored its plant to the grade of Mercury's coal. The other customers for
Mercury's coal are relatively distant.
(a) Use this example to explain specific assets.
(b) How can Mars take advantage of Mercury? How can Mercury take advantage
of Mars?
(c) If Mars acquires the coal mine, how will that affect (i) the potential for hold up,
and (ii) unobservable efforts by Mercury managers?
Answer
(a) By building a power plant adjacent to and tailored to the grade of Mercurys
coal, Mars Power had made an investment in an asset that was specific to its
relationship with Mercury. This means that if Mars decides to switch to another
coal source, it will lose its specialized investment in the power plant.
(b) Mercury can take advantage of this specific relationship (Marss need for coal)
by holding up or refusing delivery of coal unless Mars pays a higher price. To
the extent that Mercurys other customers are relatively distant, Mars can also
engage in holdup.
(c) If Mars vertically integrates with Mercury, it will reduce the potential for holdup
since now both the coal source and power generation are under common
ownership. There is no incentive for holdup in either direction. A new problem
will arise the managers of the coal mine will be subject to moral hazard. Mars
may have difficulty in monitoring the effort of the mine managers and there will
be the usual employee-employer conflict of interest.
2001, I.PL. Png & C.W.J. Cheng
7