lecture_2_tab - Incentive conflicts and contracts What...

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ECOS3003 Lecture 2 1 Incentive conflicts and contracts What happens within a firm? Defn . A firm is a focal point for a set of contracts - firm is a creation of the legal system (ie it is considered as an individual) - a firm is always one of the parties to each of the many contracts that constitute a firm - employee contracts, supply contracts, stock contracts, franchise agreements, insurance … Some contracts explicit, some implicit
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ECOS3003 Lecture 2 2 Incentive conflicts within a firm - each individual will attempt to max own utility - that is, incentives are not automatically aligned - owners max profits (residual claimants of profits) - others different objectives (max wages?)
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ECOS3003 Lecture 2 3 Owner-manager conflict owners often delegate to managers publicly listed company - shareholders residual claimants - managers run company Conflicts about - choice of effort; taking perks - differential risk exposure (mangers may be risk averse) - different horizons (managers limited tenure) - over investment – empire building Other incentive problems (other contractors, employees (free riding, perks)
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ECOS3003 Lecture 2 4 Controlling incentive problems with controls Costly contract Manager – M gets U=f(C,P) C money compensation P perks minimum salary needed, with no perks is S if owners have precise knowledge of profit potential of firm Πp (if M gets P = 0, C = S) Realised profit Πr is Πr = Πp – P - difference between potential profits and excess perks
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ECOS3003 Lecture 2 5 Owners can solve potential incentive problem: Offer M
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ECOS3003 Lecture 2 6
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ECOS3003 Lecture 2 7 This contract reduces C by amount of perks insuring incentives of the firm and the manager aligned
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ECOS3003 Lecture 2 8 Asymmetric information and contracting Asymmetric information (a) before contract signed (b) during implementation of contract Precontractual problems (a) bargaining - asymmetric info cause problems with bargaining (b) adverse selection - private information cause market to breakdown - screen different customer types offer contract that good types will take; offer another contract to bad types - signalling can be possible (warranties/guarantees, education)
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ECOS3003 Lecture 2 9 Post-contractual (a) Agency problems - agency relationship; principal wants the agent to perform some service on the principal’s behalf ie shareholders – managers owner/manager – workers Agency problems – agents have an incentive to take actions that increase their well being at the expense of the principal’s ie owner’s can’t observe actions of workers (work, not work) if principal could observe action – resolve problem with a contract (work hard or get fired)
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This note was uploaded on 12/02/2009 for the course ECOS a taught by Professor A during the Three '09 term at University of Sydney.

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lecture_2_tab - Incentive conflicts and contracts What...

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