Economic
Organizational Design
Incentives and Vertical Relationships
Incentives
Incentive: anything that changes the benefits and costs of an activity
Can be monetary or non-monetary
You need to figure out when more money will make a big difference in performance
People will respond to the same incentive in different ways
Principal Agent Model in Business
Principal: has responsibilities to undertake and delegates these responsibilities to an agent
Agent: takes actions that benefits the principal
Example:
A Manager/Owner (principal) directs an employee/salesperson (agent) to sell a good
The employee does the assigned work at the direction of an employer
A contractor or home builder (principal) subcontracts with a house painter (agent)
The house painter undertakes the responsibility of painting the house per the instructions of the home builder
A house seller (principal) contracts with a real estate agent to sell a house
The house seller delegates the responsibility of selling the house to the real estate agent
Conflicts/Problems in Principal Agent Models
Basic conflict in Principal Agent Models
Objectives/Goals of the principal and the agent are not aligned: Incentive Conflict
Moral Hazard: situation where the agent takes a hidden action that benefits the agent at the expense of the principal
Manager-Employee: Employee shirks or does not work hard which benefits the employee/agent and does not benefit his/her employer or manager
Stockholders-Executives: Executives spend then firm’s money non excessive perks which benefits the executive (agent), but does not benefit stockholders (agents)
One way of avoiding conflicts/problems: Monitoring behavior of agents
Monitoring employee behavior with cameras, office checks by manager, etc.
Problem with Monitoring
Monitoring may be too costly or impossible
Monitoring may affect employee morale
Agency costs: costs of monitoring and enforcing contracts
Principal Agent Model: Manager and Employee
Employee may have different goals and preferences than the manager
Some employees can take hidden actions, such as long lunch hours and coffee breaks, running personal errands during work
These preferences obviously conflict with the managers desire for the employee to work
With perfect monitoring, there is no way for the employee to take these hidden actions
However, perfect monitoring is often costly – not only in terms of money but in terms of morale
But some expenditures on monitoring may be beneficial in reducing hidden actions (Incremental Analysis)
Time clocks and spot checks (if just showing up for work is crucial)
For Manager Employee relationships, principal agent problems arise when effort is not totally and perfectly observable.
Reducing Hidden Actions: Fixed Salaries
If perfect monitoring is available, a contract that specifies the employee receives a salary if he/she works extra hard, but loses the job if he/she doesn’t will reduce hidden actions
Not working hard has a cost to the employee: the loss of the job
The firm receives all of the additional profit from the employee working hard
Assumes this kind of contract is enforceable!
If perfect monitoring is not available, paying a fixed salary will not reduce hidden actions, will not reduce shirking
Employee receives the same salary whether he/she works hard or not
Working hard imposes a cost on the employee: the extra effort he/she must utilize
If actions of the employee are not fully known or observable:
Employee will choose not to work that hard (will shirk) because there are no additional benefits of working harder (no change in pay with fixed salary) but there are additional costs
For some employees, the benefits of working harder will be lower than the costs
Profits are lower because the employee is not working as hard
Reducing Hidden Actions: Incentive Compensation Schemes
Incentive Compensation Schemes: Sales or Profit Sharing
Make payments to the employee contingent upon the desired outcome (higher profits or sales)
Employee has incentive to work hard toward the desired outcome because he/she benefits via higher payments
Payments have to be high enough to offset the employee’s costs of working harder
Employees have to believe that their actions/efforts do affect the desired outcome
The additional benefits of working harder (additional payments via bonuses) exceed the additional costs of working harder
Link between performance and compensation creates incentive for employees to act in the firm’s best interests
Worker’s interest is aligned with the firm
Reduces incentive to produce low quality products
Lower quality reduces sales, thus reducing compensation to those receiving sales or profit sharing incentives
Problems with Incentive Compensation
Employee performance must be accurately measured
Employee performance is partially determined by factors outside of the employee’s control
Performance is determined by effort and random shocks (weather, economy, etc.)
Incentive Compensation thus increases the variability of the Employee’s pay. It increases his/her risk.
Incentive Compensation Schemes
Designing an Incentive Compensation Scheme is not easy
There are no hard and fast rules for the best way to solve incentive conflicts
Centralize Decision Making with Managers: Manager need information to make decisions
Decentralize Decision Making with Employees: Employees need strong incentives
General Guidelines for Using Monetary Incentives
Performance is measurable
Performance of a task is highly responsive to extra effort
Very high rewards tend to make people “choke” or not perform as well
Incentive Compensations Schemes do not always involve dollars and cents
Reputation
Opportunity for Advancement
Do Incentive Compensation Schemes Work?
Critics say that money is not a good motivator
Critics say that it is difficult to design an effective compensation scheme
Empirical evidence shows that agents do respond to incentives
Problem #1
Like most fast food restaurants, Chipotle has a high rate of employee turnover. However, for Chipotle, this occurred not only at the entry-level, server jobs, but also at the shift supervisor, store manager, and area manager levels. Why did their enactment of a policy of exclusively promoting from within the organization reduce their turnover problem in these supervisory roles?
Answer to Problem #1
Especially for lower level supervisory jobs, employees did not consider that the pay was worth the work. Under the promote-from-within policy, the probability that any supervisor would be promoted to the next level up is significantly higher. This means that they have an incentive not only to do their job competently but to make themselves noticed for promotion to the next better job. They are working as much for the pay in their next job as they are for the pay in their current job
Reducing Hidden Actions: Franchising
Decision whether to open a company-owned store or sell the rights to own a branded store to a franchisee.
Companies with franchisees usually have a well known brand with similar quality products across all stores (example: McDonalds)
These companies want to protect their brand reputation
When you go into any McDonalds, you expect the same quality food as all other McDonalds
Managers in company owned stores can take hidden actions to ruin this reputation
There is little incentive for managers on salary in company owned stores to protect the reputation of McDonalds
Franchisees are owners of a store, have made a significant monetary investment in building the store and usually are managers of the store (or provide almost perfect or closer monitoring of stores)
Since franchisees receive most of the profit from the store, they have strong incentives to protect the reputation of the brand via maintaining high quality
Reducing Hidden Actions: Piece Rates
Piece Rates: paying workers for the quantity of output
Paying a typist a fixed amount per page typed
Paying a farm worker a fixed amount per pound of produce picked
Employees are paid based on the amount of output produced
Problem: employees will produce quantity at the expense of quality
Can be used when quality is not an important issue.
Summary of Manager-Employee Relationships
Employee and Manager may have different goals and preferences
If perfect monitoring is not available, the employee can take hidden actions which harm the firm
These hidden actions can be minimized by providing the correct incentive payment scheme, assuming that performance is measurable
Incentive schemes include:
Payment based on level of revenues, profits or customer satisfaction
Piece rate compensation (when quality is not important)
Franchising (when monitoring is very costly)
Time clocks and spot checks (if showing up for work is crucial)
Developing the correct incentive scheme is difficult
Vertical Integration or Make or Buy Decision: Caveat
For those of you who are following in the textbook, most of the subject matter in the lecture notes will not be covered in the Textbook.
Please focus on the lecture notes and the Additional Readings/Videos in your studies.
Make or Buy Decision
Inputs, such as labor, capital and materials, are needed to produce the final good sold by the firm
The firm has a decision
Should the firm “buy” or “obtain its needed inputs from the market” or “outsource”?
Should the firm “make” or “produce in-house” or “vertically integrate” its inputs?
The firm will make this decision in order to maximize profits
Take into account all relevant costs, including the costs of the transaction between firms (“transaction costs”)
Firms may not want to make its own inputs because it get benefits from specializing in producing its final good
On the other hand, if the firm needs to assure that the supply of inputs is steady and timely, it may want to vertically integrate and produce its own inputs
Consider a rental car company which needs to service its cars (tune-ups, oil changes,etc.) It has several choices to make this happen:
Spot Exchange: It can take the cars to a firm that services automobiles and pay the market price
Paying the market price for inputs by buying at other firms (without a contract) is called “Spot Exchange”
Contracting: Sign a contract with a firm that services automobiles and pay the price negotiated in the contract
Vertical Integration: Create within the firm a division that services automobiles
The firm pays its own employees to do tune-ups and oil changes
Broad Overview of 3 Methods to Acquire Inputs
Spot Exchange: buyer and seller meet, exchange and then go their separate ways
Firm specializes in what it does best: converting inputs into outputs
Input manufacturer does what it does best: producing inputs
Often used when inputs are “standardized” and is readily available at many firms (lots of competition)– so the firm simply purchases inputs from one of many suppliers
Acquire Inputs Under Contract:
Contract is a legal document with terms under which the 2 parties agree to the exchange over a given time horizon
Firm still specializes and so does the input manufacturer
Contracts allow firms to purchase “non-standardized” inputs for which there are not many suppliers
Works well when it is easy to write a contract with all of the contingencies known
Contract must be able to take into account all future changes in trading relationship
Any potential future event affecting the exchange must be specified in the contract
Of course, contracts can be costly and complex (lawyers!)
Broad Overview of 3 Methods to Acquire Inputs
Vertical Integration: firm produces the inputs needed for production within the firm
Firm loses gain from specialization of producing just its final goods if it purchased goods from independent supplier
Firms incurs bureaucratic costs associated with a larger organization
But, firm does not have to rely on other firms to provide desired inputs
Firm can utilize highly “non-standardized” inputs
Problem #1
Identify whether the following transactions involves spot exchange, contracts, or vertical integration.
Barnacle Inc has a legal obligation to purchase 2 tons of structural steel per week to manufacture conveyor frames
Exxon-Mobil uses the oil extracted from its wells to produce raw polypropylene, a type of plastic
Boat Lifts R Us purchases generic motors from a distributor
Kaspar Construction – a home-building contractor – purchases 50 pounds of nails from Home Depot
Answer to Problem #1
Contracting: involves a legal obligation via a contract
Vertical Integration: Exxon-Mobil manufactures its own oil, an input into Exxon-Mobil’s production of polypropylene. Since Exxon-Mobil produces/owns the input used in the production of its final good, polypropylene, this is vertical integration.
Spot Exchange: Boats R Us buys from an independent supplier without any contract or legal obligation
Spot Exchange: Kaspar Construction buys from an independent supplier without any contract or legal obligation
Transaction Costs
Transaction Costs: play a crucial role in determining which of the 3 ways is optimal
Transaction Costs include:
Costs of searching for a supplier willing to sell a given input
Costs of negotiating a price at which the input will be purchased, such as the opportunity costs of time, legal fees, etc.
Other investments and expenditures needed to facilitate the exchange of inputs from buyer to seller
Examples of Transaction Costs:
Home Depot charges $25 for a 5 gallon drum of paint used as an input by painters
Transaction costs to the painter include the costs of the trip to Home Depot and personnel needed to pick up the paint.
The relevant price for the paint is not only the $25 but the transaction costs to pick up the paint.
Some transaction costs are less obvious – those involving “specialized investments”
Some transactions are general in nature while others are specific to the trading relationship
If investments are specific to a firm/transaction, these are called “specialized investments”
Specialized investments are dollars spent that cannot be recovered; they are sunk costs.
The investment has no other uses outside of its intended purpose. Cannot be sold or used elsewhere
Specialized investments have little or no value outside of the relationship between the 2 firms
Types of Specialized Investments
Site Specificity: buyer and seller of an input must locate their plants close to one another to exchange the input.
Ex. Coal mines and electricity. Electric power plants locate close to coal mines to minimize transportation costs of coal. The costs of building the power plant close to the coal mine represents a specialized investment that would have little value if the parties were not involved in exchanging coal for electricity
Physical Asset Specificity: machinery, computers, software, etc. needed to produce an input is designed solely to meet the needs of the particularbuyer of the input.
Ex.: If producing a lawn mower engine requires a special machine that is useful only to the production of engines for Toro (a producer of lawn mowers), this machine is a specific physical asset for producing engines for Toro (and no other producer of lawn mowers).
Types of Specialized Investments (cont.)
Dedicated Assets: general assets made by a firm that allows it to sell to a particular buyer
Ex, Suppose a computer manufacturer opens up a new assembly line solely to produce enough computers for a large government purchaser. If opening up the new assembly line is profitable only if the government actually purchases the computers, the investment in the assembly line is a dedicated asset
Employees/Workers: workers learning specific skills to work in a particular firm (which is not valuable outside of the firm).
Specialized Investment and Transaction Costs
Specialized Investments increase transaction costs by:
Costly bargaining: Market price exists via forces of supply and demand when there are lots of firms making similar products. No time needed to determine price. With specialized investment:
Obtaining an input the buyer needs requires that a specialized investment is made before the input is produced
There will therefore not be a lot of suppliers of the input and there will not be a “market price” for the input
The 2 parties will have to spend time and money bargaining over the price
And there will be problems as each party tries to make themselves better off:
Buyer may refuse to accept delivery of the input unless the seller of the input lowers the price
Supplier of input may provide inputs that are of lower quality than the buyer of the input desires
UnderInvestment: if machinery or other assets is specialized and cannot be used elsewhere, the suppler of inputs has an incentive to invest in cheaper machinery and produce inputs of inferior quality
If an input supplier must invest in a specific machine to produce an input used by one particular buyer (and cannot be used elsewhere), the supplier has an incentive to invest in a cheaper machine that produces an input of inferior quality
The input supplier does not want to be stuck with an expensive machine that cannot be used elsewhere
Lower quality results in higher transaction costs
Opportunism/”Hold Up Problem”: once a supplier of inputs has invested in a specialized capital good, firm will attempt to capitalize on the sunk nature of this investment by asking for lower prices for the input
: Once the firm is at the point in its manufacturing process to use its input, the supplier of inputs may ask for a higher price to capitalize on the sunk investment by the firm in the specialized input
Hold Up Problem
When a specialized investment is made, the buyer or seller may attempt to capitalize on the “sunk cost” nature of the investment by engaging in opportunism (acting in their own self interests)
Note the assumption of everyone acting in their own self-interest
Example: Suppose the buyer of an input must make a specialized investment of $10 to verify the quality of any supplier’s input
Manager who buys the input knows that there are many suppliers willing to supply the input at $100 each.
Once the manager has paid the sunk cost of $10, the supplier can take advantage of this specialized investment and behave opportunistically
The supplier attempts to “hold up” the manager by asking for a price of $109
Since manager has already spent $10 inspecting this supplier’s input, the manager is better off spending the $109 than spending an additional $10 inspecting another supplier’s input
Note the use of incremental analysis and that sunk costs does not affect decision-making
Hold Up Problem: Once the firm makes a specialized investment, the other party may attempt to “rob” the firm of its investment by taking advantage of the investment’s sunk cost nature.
If both parties need to make specialized investments, both parties may engage in such behavior
Hold Up Problem only occurs if the specialized investment incurs sunk costs.
If specialized investment is a fixed cost – meaning that its costs can be recovered by reselling – holdup is not as significant a problem
Note: this is discussed in pages 57-59 of the book
Example of Hold Up Problem #1
An automobile manufacture needs automobile part “X”
This automobile part can only be used by the automobile manufacturer
In order to produce automobile part “X”, specialized machinery is needed by the automobile parts manufacturer
Once the automobile parts manufacturer makes the investment in specialized machinery, the automobile manufacturer may attempt to capitalize on sunk nature of investment in specialized machinery by asking for lower price.
Once automobile manufacturer is ready to use automobile part “X”, automobile parts supplier will do the same thing: the parts manufacturer will not deliver the part unless the automobile manufacturer pays a higher price for the part
Example of Hold Up Problem #2
In the 1970s, Fisher Auto Body had an exclusive 10 year relationship with General Motors (GM). GM buys all of its auto bodies from Fisher.
GM cannot hold up Fisher, because the contract states that GM can only buy from Fisher
Fisher is thus certain that it will get back its investments in specialized assets/machinery dedicated to GM bodies
Fisher can hold up GM by demanding higher prices from GM. Stopping production of cars is very costly to GM.
This was anticipated in the contract: Fisher got costs + 17% markup.
Fisher could not charge GM more than other auto makers
But Fisher could hold up GM by other means:
Shirking on quality
Slowing delivery of the auto bodies
What Fisher actually did:
Use labor intensive more costly methods, since costs were passed onto GM
Refused to locate near GM plants, which increased costs
What do you think happened in the relationship between Fisher and GM?
Hold Up Problem is only an issue if Costs are Sunk
Suppose a supplier has the following total costs
Specialized Machinery with life of 1 year = $1M
Other Variable costs = $1M
Total Annual Costs $2M
If it sells 2M units of its input each year, its average cost will by $1 per unit
The firm’s decision: are the incremental costs of producing the 2 million units greater than or less than the incremental revenues
Before the investment in specialized machinery is made, incremental costs are $2M and the firm would seek a price of over $1 per unit (or incremental revenues above $2M = $1 price x 2 million units) in order to make a profit
Once the investment in specialized machinery is made, assume that the $1M is a sunk cost. Its resale and scrap value is $0.
Once the $1M investment in specialized machinery is made, the incremental costs of producing 2M units is $1M in other variable costs
Once the specialized investment is made, the supplier is willing to provide the inputs at a price of $0.50 or more
At a price of $0.50, incremental revenues would be $1M and incremental costs would be $1M
A savvy buyer of the inputs would wait for the specialized investment to be made; and then ask for a price below $1 per unit (and above $0.50)
The buyer of inputs pays a lower price after the specialized investment (with a sunk cost) is made
Now suppose the $1M in machinery is not a sunk cost. Machinery can be resold for $1M at any time.
After the investment in the machinery is made, suppose the buyer of the parts asks for a price below $1
The profit maximizing action or the seller of inputs would be simply to sell the machinery for $1M.
Incremental revenues of $1M from selling the machine , incremental costs are $0, so incremental profits would be $1M
If the seller of the inputs accepted a price below $1 for the 2 million units:
Incremental revenues would be less than $2M ($1 x 2 million units) and incremental costs would be $1M (the $1M in other variable costs to produce 2 million units)
Incremental profits would be less than $1M
Hold Up Problem only exists if there are sunk costs
When to Vertically Integrate or Not
When to Use Spot Exchange
No transaction costs with many buyers and sellers in the market
No specialized investments
“Standardized” Product
Steady and timely supply of inputs is not required
When to Use Contracts
Specialized investments are needed
Contracts do require substantial up front expenditures such as legal fees
Contract can specify prices before parties make specialized investments
Contract can reduce incentives for skimping on specialized investments by guaranteeing price for a longer term
Example: Guaranteed employment contract for 3 years will incent worker to undergo specialized training
When to Vertically Integrate or Not (continued)
When to Use Vertical Integration
Complete contracts will be costly or impossible to write when:
Specialized investments generate significant transaction costs
Product being purchased is extremely complex
Economic environment is extremely uncertain
Steady and timely supply of key inputs is required
If economies of scale in the production of the input exists, vertical integration is not recommended
Economies of scale: larger firms with larger amounts of production of the input have lower costs and therefore lower prices
Vertically integrated firms with smaller amounts of production of the inputs will produce the input with higher costs and be at a competitive disadvantage.
Reduces opportunism by uniting previously distinct firms
Costs of vertical integration:
Replacing the market with an internal regulatory mechanism is difficult
Firm must bear the costs of setting up production facilities, etc.
Firm no longer specializes in producing the good
Vertical Integration should be seen as a last resort, only if spot exchange and contracting have failed
Problem #2
Jiffyburger, a fast food outlet, sells approximately 8,000 quarter-pound hamburgers in a given week. To meet that demand, Jiffyburger needs 2,000 pounds of ground beef delivered to its premises every Monday morning by 8:00 AM sharp.
As the manager of a Jiffyburger franchise, what problems would you anticipate if you acquired ground beef on the spot exchange?
As the manager of a firm that sells ground beef, what problems would you anticipate if you were to supply meat to Jiffyburger through spot exchange?
Answer to Problem #2
While ground beef for hamburgers is a relatively standardized product, the delivery of 1 ton of meat to a particular store at a particular time involves specialized investments (dedicated assets) on the part of both Jiffyburger and the supplier.
Jiffyburger may face hold up problem if the supplier showed up at 8AM and refused to unload the meat unless Jiffyburger paid a “ransom”
It would be difficult to find another supplier that could supply the meat on such short notice
The supplier could also supply meat of inferior quality.
Spot exchange does not protect Jiffyburger from opportunism, underinvestment in quality or bargaining
Answer to Problem #2 continued
2. By showing up at Jiffyburger at 8AM with one ton of meat, the supplier is making a specific investment in selling to Jiffyburger. Supplier will therefore also face a hold up problem.
Jiffyburger could behave opportunistically and ask other suppliers to show up with meat at 8AM
Since the suppliers would rather unload its meat, Jiffyburger could bargain with the suppliers to get the lowest price
Summary: Factors Affecting Vertical Integration
Managerial Implications
Pay attention to Specialized Assets
Pay attention to economies of scale
Rely on markets if outside suppliers of inputs can capture economies of scale (lower costs) that your firm cannot
Rely on markets if outside suppliers of inputs have already made significant investments in either physical capital or organizational capabilities
Vertical Integration tends to be more efficient for large firms than for small firms
Vertical Integration is better when high coordination costs exists
a. Technological changes (telecommunications, computers) have tended to decrease such costs
Factors Favoring Vertical IntegrationFactors Favoring Spot Markets
1. Firm-Specific Good or Service1. Standardized Good or Service
2. Outside Risks: input quality, supply2. Competitive market available
disruptions
3. High degree of coordination required3. Low degree of coordination required