Incentives and Organizations of Managerial Economics:
 
Chapter Summary:

The architecture of an organization includes the distribution of ownership, monitoring systems and incentive schemes. Ownership signifies the rights to residual control. Incentive schemes and monitoring systems are associated as incentives should be based on behavior which can be observed. An efficient incentive scheme balances the incentive for effort with the cost of risk.

An efficient organizational architecture solves four internal issues: holdup, moral hazard, monopoly power, and the economies of scale. Holdup and moral hazard occur between parties with the conflict of interest. Additionally, moral hazard based on one party not being capable to examine the actions of other. Holdup can as well be resolved via more detailed contracts, moral hazard via incentive schemes and monitoring systems, and internal monopoly power via out-sourcing.
 
Key Concepts:

General Chapter Objectives:

A) Discuss the trouble of moral hazard.

B) Examine monitoring systems and incentive schemes to solve moral hazard.

C) Appreciate the risk enforced by incentive schemes.

D) Appreciate how to provide incentives for many responsibilities.

E) Discuss the trouble of holdup.

F) Examine how the distribution of ownership influences moral hazard and the potential for holdup.

G) Discuss the design of an organizational architecture.

Notes:

1) Organizational architecture:

a) Organizational architecture includes monitoring systems, incentive schemes, and the distribution of ownership. The horizontal and vertical boundaries of the organization are two implications of an organizational architecture.

b) An efficient organizational architecture revolves and must be designed to balance four internal issues: holdup, moral hazard, monopoly power, and economies of scope and scale.

2) Moral hazard:

a) Moral hazard lives whenever one party’s actions influences however are not examined by the other party, with whom it has a clash of interest, example: delivery persons, sales representatives are subject to the moral hazards.

b) Moral hazard occurs only whenever there is asymmetric information regarding the future actions of the better-informed party.

c) Economic efficiency: The relevant parties would like to solve the moral hazard and hence the better-informed party will build the economically efficient selection.

i) The degree of moral hazard is evaluated by the discrepancy between the real action or effort and the economically proficient level.

ii) Economically efficient level of action:

• Employer’s profit = employer’s benefit (revenue – other costs) – wages and incentives paid to worker subject to the moral hazard.
• Worker’s total benefit = wages and incentives – cost of effort.
• Employer’s marginal benefit from the worker’s effort = change in employer’s gain from worker’s raise in effort.
• Worker’s marginal cost from effort = additional cost needed to raise effort.
• Economic efficiency for the group: a height of effort whenever employer’s marginal benefits balance worker’s marginal cost. 

iii) The real action or effort selected by a party subject to moral hazard will be less than the economically proficient level.

• Worker acts independently and considers just her personal marginal cost and marginal benefit from effort, not the employer’s marginal benefit.
• The lower the worker’s marginal benefit associative to the employer’s marginal benefit, the lower the effort, the worker selects relative to the economically efficiency level.

iv) A gain can be made by solving the worker’s moral hazard. The greater the moral hazard, the bigger the gain in total benefit from solving the moral hazard.

3) Monitoring systems and incentive schemes:

a) Two complementary approaches to solve moral hazard: monitoring systems (example: time clock, random checks by supervisors, vehicle log and customer reports) and incentive schemes.

b) Incentive schemes align incentives of the party, subject to moral hazard with such of the less-informed party by tying payments to several observable measure of performance. They based on:

i) A link among the unobservable action and several observable measure of performance.

ii) Information given by monitoring systems.

c) Performance pay is an incentive scheme which bases pay on certain measure of performance (example: a commission per delivery).

i) An incentive scheme is much stronger (that is, resultant in higher level of worker’s effort) when it gives a higher personal marginal benefit for effort.

d) The performance quota is a minimum standard of performance (that is, set at the economic efficient level of effort, example: minimum number of deliveries), beneath which penalties (example: deferral of promotion, pay reduction and dismissal) apply.

i) Performance quota is cost efficient. It doesn’t reward effort beneath or above the economically efficient level.

e) An economically efficient scheme (one which maximizes total benefit) should balance the incentive for effort with the cost of risk.

i) Risk occurs whenever incentives depend on an indicator which based on extraneous factors (that is, deliveries made up by a delivery person based on traffic, weather, customer’s order and so on) and the party subject to moral hazard consists of imperfect information regarding those extraneous factors.

ii) The costs of risk based on 3 factors as:

• The structure of incentive scheme: the stronger the scheme, the greater the risk to the party subject to moral hazard.
• The degree of risk aversion of party subject to moral hazard, and
• The significance of extraneous factors: whenever the indicator is sensitive to such factors and the factors are subject to broad swings, the higher the risk. 

Note: Incentive schemes depend on relative performance (example: fixed pay plus a commission for each and every delivery above an average level) is an effective manner of decreasing risk due to general extraneous factors (whose consequence is cancelled out to the extent they influence all workers uniformly).

iii) Stronger schemes must be adopted whenever the party subject to moral hazard is less risk adverse and extraneous factors are much weaker.

f) A party might be subject to moral hazard with respect to multiple responsibilities, that is, whenever one party’s multiple actions (as opposed to the single action) influence however are not observed by the other party with whom it has a conflict of interest.

i) An incentive scheme must balance the multiple responsibilities: monitoring all unobservable actions and with incentives depend on each of the equivalent indicators.

ii) An incentive scheme which focuses on one responsibility might aggravate moral hazard related with other functions.

iii) When there are responsibilities for which it is hard to calculate performance, a deliberate utilization of weak incentives is a way to attain the essential balance among responsibilities.
 
4) Holdup:

a) Holdup is an action intended to exploit the other party’s dependence. It occurs only whenever there is a conflict of interest among the parties.

b) It doesn’t need asymmetric information.

c) The prospect of a holdup deters investments in the particular assets.

i) The specificity of an investment in an asset is the percentage of investment which will be lost when the asset is switched to the other use.

ii) The costs of holdup will be very high when the relevant assets are more particular.

d) The prospect of holdup leads other parties to acquire precautions that either decrease the advantage from the relationship or raise costs, decreasing the group’s total benefit.

i) A profit can be made up by solving the holdup.

e) A complete or more detailed contract would solve holdup, however would be much costly to prepare.

i) A complete contract identifies what each party should do and the corresponding payments beneath each and every possible contingency.

ii) The degree to which a contract must be incomplete based on:

• The lower potential benefits and costs at stake, and
• The smaller extent of probable contingencies.

f) The other way to solve holdup is via changing the ownership of the relevant assets, example: vertical integration.

i) Ownership is the rights to residual control (that is, rights which have not been contracted away). Rights to residual control comprise:

• The right to obtain residual income from asset (that is, the income remaining subsequent to the payment of all other claims) and the gain of changes in costs and income.
• The right to with-hold the services of asset.

ii) A transfer of ownership signifies shifting the rights of residual control to the other party.
 
5) Vertical integration: influences moral hazards and solves holdup.

a) Vertical integration is the grouping of assets for two successive phases of production beneath a common ownership.

i) Downstream: nearer to the final consumer.
ii) Upstream: farther from the final consumer. The “make or buy” decision is a choice to vertically integrate the upstream.
iii) Vertical integration modifies ownership of assets and modifies the rights to residual control and residual income.

b) With vertical integration:

i) Holdup can be solved.

ii) The degree of moral hazard is raised. The internal supplier is subject to the moral hazard.

iii) The internal supplier might acquire monopoly power. One can outsource (that is, purchase of services or supplied from the external sources) whenever the internal provider’s cost surpasses that of external sources or competitive level in the market.

iv) The internal supplier might lack economies of scope and scale as compared with exterior suppliers.

Note: Though, at some point, scope economies are out-weighed by the degree of moral hazard in the different operational units of a big organization (that is, with wide horizontal organizational boundaries).

Question-Answer:

Jupiter Power has built an electric power producing plant subsequently to the Venus coal mine. Jupiter has tailored its plant to the grade of Venus’s coal. The other customers for Venus’s coal are comparatively distant.

a) Use this illustration to describe specific assets.

b) How can Jupiter take benefit of Venus? How can Venus take benefit of Jupiter?

c) When Jupiter acquires the coal mine, how will that influence the potential for hold up, and un-observable efforts by the Venus managers?
 
Answer:

a) By building a power plant adjoining to and tailored to the grade of Venus’s coal, Jupiter Power had made an investment in an asset which was particular to its relationship with Venus. This signifies that when Jupiter decides to switch to the other coal source, it will lose its particular investment in the power plant.

b) Venus can take benefit of this specific relationship (Jupiter’s require for coal) by holding up or declining delivery of coal unless Jupiter pays a higher price. To the extent which Venus’s other customers are comparatively distant, Mars can as well engage in holdup.

c) When Jupiter vertically incorporates with Mercury, it will decrease the potential for holdup as now both the coal source and power generation are beneath common ownership. There is no incentive for holdup in any direction. A new trouble will occur-the managers of the coal mine will be subject to the moral hazard. Jupiter might have difficulty in monitoring the effort of mine managers and there will be the typical employee-employer clash of interest. 

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