VIII

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit VIII At the end of this unit, you should be able to:

1. Evaluate the ethical outcomes of free market outcomes using supply and demand models.

2. Apply the different types of elasticity concepts to business scenarios.

3. Analyze how price and output influence profit maximization under different market structures.

4. Evaluate strategic pricing decisions.

5. Apply game theory to pricing and to output decisions in an oligopoly market.

6. Analyze the basis of trade.

7. Explain the implications of uncertainty in managerial decision-making. 7.4 Explain how incentives can affect various relationships in an organization.

Required Unit Resources Chapter 4: Extent (How Much) Decisions (ULO 7.4) Chapter 21: Getting Employees to Work in the Firm’s Best Interests (ULO 7.4) Chapter 22: Getting Divisions to Work in the Firm’s Best Interests (ULO 7.4) Chapter 23: Managing Vertical Relationships (ULO 7.4) Unit Lesson Lesson: Organizational Design and Incentives (ULO 7.4) This lesson covers the topics introduced in this final unit. The last unit’s topic on asymmetric information included a section on shirking. Recall that shirking is when employees do not work hard because the managers are not able to monitor their performance (either because of ability or cost). Another way to look at the problem of shirking is through the principal-agent problem. In the principal-agent problem, the principal (typically a business owner) wants their agent (typically the employee) to act on the principal’s behalf. The problem is that the agent often has different goals than the principal.

Incentives Incentives are one way to correct shirking and solve the principal-agent problem. Incentives can be tied directly to performance, such as commissions, as discussed in the last unit. Incentives can also be tied to specific actions or the overall performance of the company. Basing incentives on company performance can be dicey though. There are many factors outside the employees’ control that affect company performance. The less tied incentives are to employee performance, the less likely the incentives will be to promote the desired performance. Still, tying incentives to company performance does help align the goals of the principal and the agent.

UNIT VIII STUDY GUIDE Organizational Design and Incentives

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

As mentioned, employees may not have a lot of control over company performance, which can complicate attempts to align principal and agent goals. This can be because of large outside influences (demand for the product) or because of the nature of the job agents have. Perhaps agents have the information to promote the principal’s goals but lack the decision-making authority to realize them. In cases like this, it is important for principals to align decision-making power with those who have information. One model for aligning goals and addressing the principal-agent problem is the franchise model. In a franchise model, a parent company, or brand, franchises out the opportunity to open additional stores under the brand name for a percentage of sales. If a brand opened company-owned stores, they would have to rely on managers who may not be as motivated, or the job may attract unmotivated managers (recall the different explanation for similar problems with moral hazard and adverse selection). With a franchise model, however, the individual franchise owner is motivated to make the franchise a success, since that determines the profit. When companies grow, they are often divided into different divisions. Incentives can be tricky in ensuring the divisions are working toward the same goal. If the incentives are not structured correctly, the divisions may make decisions that are best for the division but not best for the company. Take for example a college admissions department and an academic department. The academic department might be interested in producing quality graduates that will earn the school a good reputation. The academic department can help realize those goals with stricter admissions standards. The admissions department, however, might be interested in reducing admissions standards in order to admit as many people as possible (or at least enough to meet departmental goals). Stricter admissions standards get in the way of admissions. Having too many, low quality students in a program can detract from the attention focused to turn the higher quality students into reputable graduates who will help build the department’s reputation. Sharing information and aligning the goals of the departments is key to getting both departments to act in the interest of the school as a whole. Sometimes there are exchanges between divisions in an organization. Tracking this and crediting each division is important. Transfer pricing is the price of an intermediate good, made in-house, and then “sold” to another division. Transfer pricing might be thought of most easily with manufacturing. When making a car, the engine is built and then put into the frame. Since it is just the car that is ultimately sold at a price, crediting the division that built the engine can be difficult. Obviously, the car would not be much good without the engine. Determining the price for the engine, however, is difficult and often controversial between the divisions. The engine division will want to be credited with a high price for the engine, but the division that built the frame will want to “pay” a low price for the engine. Each division wants to appear as profitable as possible. Giving one division an unfair price could hurt morale, and thus productivity, in that division. That would, obviously, hurt the company overall. Transfer pricing issues can be addressed by treating different divisions as profit centers or cost centers. Profit centers are evaluated based on profit or revenue. Cost centers are evaluated based on costs. Using these different centers and different goals, as long as the divisions are aligned to the proper center, their goals will align with helping the overall organization be more successful. Organizations can be ordered based on a variety of plans. Organizations might be organized by function, such as production and sales. Organizations can also be organized by products or by geographic region. The best organizational structure will depend on the type of firm and how they approach the market.

Vertical Relationships Firms can also find profit potential by expanding operations vertically through their supply chain. This strategy is known as a vertical relationship. For a simple example of this, consider a landlord, particularly one constrained by rent control laws. The landlord may find him- or herself constrained in what he or she can charge for rent. There are other services, however, that can be provided to tenants beyond just the living space. A landlord might, for example, furnish the apartment for an extra fee. Firms can even use exclusions, forcing buyers to purchase their additional product or service rather than purchasing from a competitor. A similar approach is taken with movie theaters or ballparks who sell the tickets to the event and then also require that if customers want to enjoy refreshments, they must do so at the concession stands operated by the event.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Vertical relationships can also be used to manipulate realized profit. A firm may produce an early stage of a product in a high tax area but transfer the production to another location with lower taxes for finalization. The transfer can be done at a low price so that the high tax production does not produce much profit and then the product is sold by the low tax production area with a higher profit realized thanks to the low transfer/purchase price. The reverse can also be done where firms build in profit all along the production pipeline. This is known as double marginalization. Of course, if the markups are too much then the price of the product in the market will be too high. Sometimes the incentives between links in the supply chain, for example between manufacturers and retailers, come into conflict. Manufacturers might have an incentive to have the quality of their product maintained and displayed but the retailer many not have quite the same concern. Have you ever been in a store that sells high quality stereos and speakers? You might notice a special room set up to listen to the speakers. This is by the design of the stereo and speaker producer, not necessarily the store. The purpose is to provide an environment where you can really hear the quality of the higher priced stereos and speakers. In exchange for providing the fancy displays, the manufacturers put minimum prices on their products wherever they are sold. The purpose of these minimum prices is to prevent the fancy store from spending money on the display only to have consumers come in, listen to the stereos and speakers, decide what they want, and go to Walmart to buy it for a cheaper price. Similarly, you generally will not see retailers engage in too much advertising. Advertising is mostly handled by the producers of the product. A retailer advertising for a particular good may end up convincing consumers to buy the product but not necessarily from their location. Too much in the way of vertical relationships, however, can raise antitrust concerns. Strong vertical relationships can have a negative effect on market competition, so many countries have antitrust laws governing vertical relationships. In Europe, for example, Coke is prohibited from purchasing refrigerators in their retail locations. The fear is that Coke owning the refrigerators will lead to the exclusion of other soft drink producers being able to provide their product cold and ready to drink. So, vertical relationships can come with much potential for firms, but they can also come with risks firms should be aware of before pursuing them. A final word on vertical relationships—vertical relationships can be pursued through mergers. Simply merging with another organization in a business’s supply chain does not always work out. In a free market, where buyers and sellers are rational and have full information, the sellers would only accept a price equal to the discounted stream of future profits. That means, all else equal, the best the purchasing firm could expect to do is break even on the purchase. The potential for the merger to work out is based on some type of synergy to be realized that makes the purchased company/asset more valuable for being part of the purchasing company. Perhaps the smaller company will benefit from a larger distribution system already in place with the purchasing company. Suggested Unit Resources Article: An Evaluation of Alternative Market-Based Transfer Prices (Optional) This article further explores the topics covered in this unit.

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit VIII At the end of this unit, you should be able to:

1. Evaluate the ethical outcomes of free market outcomes using supply and demand models.

2. Apply the different types of elasticity concepts to business scenarios.

3. Analyze how price and output influence profit maximization under different market structures.

4. Evaluate strategic pricing decisions.

5. Apply game theory to pricing and to output decisions in an oligopoly market.

6. Analyze the basis of trade.

7. Explain the implications of uncertainty in managerial decision-making. 7.4 Explain how incentives can affect various relationships in an organization.

Required Unit Resources Chapter 4: Extent (How Much) Decisions (ULO 7.4) Chapter 21: Getting Employees to Work in the Firm’s Best Interests (ULO 7.4) Chapter 22: Getting Divisions to Work in the Firm’s Best Interests (ULO 7.4) Chapter 23: Managing Vertical Relationships (ULO 7.4) Unit Lesson Lesson: Organizational Design and Incentives (ULO 7.4) This lesson covers the topics introduced in this final unit. The last unit’s topic on asymmetric information included a section on shirking. Recall that shirking is when employees do not work hard because the managers are not able to monitor their performance (either because of ability or cost). Another way to look at the problem of shirking is through the principal-agent problem. In the principal-agent problem, the principal (typically a business owner) wants their agent (typically the employee) to act on the principal’s behalf. The problem is that the agent often has different goals than the principal.

Incentives Incentives are one way to correct shirking and solve the principal-agent problem. Incentives can be tied directly to performance, such as commissions, as discussed in the last unit. Incentives can also be tied to specific actions or the overall performance of the company. Basing incentives on company performance can be dicey though. There are many factors outside the employees’ control that affect company performance. The less tied incentives are to employee performance, the less likely the incentives will be to promote the desired performance. Still, tying incentives to company performance does help align the goals of the principal and the agent.

UNIT VIII STUDY GUIDE Organizational Design and Incentives

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

As mentioned, employees may not have a lot of control over company performance, which can complicate attempts to align principal and agent goals. This can be because of large outside influences (demand for the product) or because of the nature of the job agents have. Perhaps agents have the information to promote the principal’s goals but lack the decision-making authority to realize them. In cases like this, it is important for principals to align decision-making power with those who have information. One model for aligning goals and addressing the principal-agent problem is the franchise model. In a franchise model, a parent company, or brand, franchises out the opportunity to open additional stores under the brand name for a percentage of sales. If a brand opened company-owned stores, they would have to rely on managers who may not be as motivated, or the job may attract unmotivated managers (recall the different explanation for similar problems with moral hazard and adverse selection). With a franchise model, however, the individual franchise owner is motivated to make the franchise a success, since that determines the profit. When companies grow, they are often divided into different divisions. Incentives can be tricky in ensuring the divisions are working toward the same goal. If the incentives are not structured correctly, the divisions may make decisions that are best for the division but not best for the company. Take for example a college admissions department and an academic department. The academic department might be interested in producing quality graduates that will earn the school a good reputation. The academic department can help realize those goals with stricter admissions standards. The admissions department, however, might be interested in reducing admissions standards in order to admit as many people as possible (or at least enough to meet departmental goals). Stricter admissions standards get in the way of admissions. Having too many, low quality students in a program can detract from the attention focused to turn the higher quality students into reputable graduates who will help build the department’s reputation. Sharing information and aligning the goals of the departments is key to getting both departments to act in the interest of the school as a whole. Sometimes there are exchanges between divisions in an organization. Tracking this and crediting each division is important. Transfer pricing is the price of an intermediate good, made in-house, and then “sold” to another division. Transfer pricing might be thought of most easily with manufacturing. When making a car, the engine is built and then put into the frame. Since it is just the car that is ultimately sold at a price, crediting the division that built the engine can be difficult. Obviously, the car would not be much good without the engine. Determining the price for the engine, however, is difficult and often controversial between the divisions. The engine division will want to be credited with a high price for the engine, but the division that built the frame will want to “pay” a low price for the engine. Each division wants to appear as profitable as possible. Giving one division an unfair price could hurt morale, and thus productivity, in that division. That would, obviously, hurt the company overall. Transfer pricing issues can be addressed by treating different divisions as profit centers or cost centers. Profit centers are evaluated based on profit or revenue. Cost centers are evaluated based on costs. Using these different centers and different goals, as long as the divisions are aligned to the proper center, their goals will align with helping the overall organization be more successful. Organizations can be ordered based on a variety of plans. Organizations might be organized by function, such as production and sales. Organizations can also be organized by products or by geographic region. The best organizational structure will depend on the type of firm and how they approach the market.

Vertical Relationships Firms can also find profit potential by expanding operations vertically through their supply chain. This strategy is known as a vertical relationship. For a simple example of this, consider a landlord, particularly one constrained by rent control laws. The landlord may find him- or herself constrained in what he or she can charge for rent. There are other services, however, that can be provided to tenants beyond just the living space. A landlord might, for example, furnish the apartment for an extra fee. Firms can even use exclusions, forcing buyers to purchase their additional product or service rather than purchasing from a competitor. A similar approach is taken with movie theaters or ballparks who sell the tickets to the event and then also require that if customers want to enjoy refreshments, they must do so at the concession stands operated by the event.

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

Vertical relationships can also be used to manipulate realized profit. A firm may produce an early stage of a product in a high tax area but transfer the production to another location with lower taxes for finalization. The transfer can be done at a low price so that the high tax production does not produce much profit and then the product is sold by the low tax production area with a higher profit realized thanks to the low transfer/purchase price. The reverse can also be done where firms build in profit all along the production pipeline. This is known as double marginalization. Of course, if the markups are too much then the price of the product in the market will be too high. Sometimes the incentives between links in the supply chain, for example between manufacturers and retailers, come into conflict. Manufacturers might have an incentive to have the quality of their product maintained and displayed but the retailer many not have quite the same concern. Have you ever been in a store that sells high quality stereos and speakers? You might notice a special room set up to listen to the speakers. This is by the design of the stereo and speaker producer, not necessarily the store. The purpose is to provide an environment where you can really hear the quality of the higher priced stereos and speakers. In exchange for providing the fancy displays, the manufacturers put minimum prices on their products wherever they are sold. The purpose of these minimum prices is to prevent the fancy store from spending money on the display only to have consumers come in, listen to the stereos and speakers, decide what they want, and go to Walmart to buy it for a cheaper price. Similarly, you generally will not see retailers engage in too much advertising. Advertising is mostly handled by the producers of the product. A retailer advertising for a particular good may end up convincing consumers to buy the product but not necessarily from their location. Too much in the way of vertical relationships, however, can raise antitrust concerns. Strong vertical relationships can have a negative effect on market competition, so many countries have antitrust laws governing vertical relationships. In Europe, for example, Coke is prohibited from purchasing refrigerators in their retail locations. The fear is that Coke owning the refrigerators will lead to the exclusion of other soft drink producers being able to provide their product cold and ready to drink. So, vertical relationships can come with much potential for firms, but they can also come with risks firms should be aware of before pursuing them. A final word on vertical relationships—vertical relationships can be pursued through mergers. Simply merging with another organization in a business’s supply chain does not always work out. In a free market, where buyers and sellers are rational and have full information, the sellers would only accept a price equal to the discounted stream of future profits. That means, all else equal, the best the purchasing firm could expect to do is break even on the purchase. The potential for the merger to work out is based on some type of synergy to be realized that makes the purchased company/asset more valuable for being part of the purchasing company. Perhaps the smaller company will benefit from a larger distribution system already in place with the purchasing company. Suggested Unit Resources Article: An Evaluation of Alternative Market-Based Transfer Prices (Optional) This article further explores the topics covered in this unit.