3 econ scenarios due October 1 at 8 pm cst

Main Points

· Principals want agents to work for their (the principals’) best interests, but agents typically have different goals than do principals. This is called incentive conflict.

· Incentive conflict leads to moral hazard and adverse selection problems when agents have better information than principals.

· Three approaches to controlling incentive conflict areIn a well-run organization, decision makers have (1) the information necessary to make good decisions and (2) the incentive to do so.

· Fixed payment and monitoring (shirking, adverse selection, and monitoring costs),

· Incentive pay and no monitoring (must compensate agents for bearing risk), or

· Sharing contracts and some monitoring (some shirking and some risk compensation).

· If you decentralize decision-making authority, you should strengthen incentive compensation schemes.

· If you centralize decision-making authority, you should make sure to transfer needed information to the decision makers.

· To analyze principal–agent conflicts, focus on three questions:

· Who is making the (bad) decisions?

· Does the employee have enough information to make good decisions?

· Does the employee have the incentive to make good decisions?

· Alternatives for controlling principal–agent conflicts center on one of the following:

· Reassigning decision rights

· Transferring information

· Changing incentives

The Principal-Agent Problem The last three chapters that we will discuss revolve around the Principal-Agent Problem.  In the principal-agent problem, there is one entity, the principal, who wishes to have someone else, the agent, perform some actions for him. The problems associated with the principal-agent relationship arise from the fact that the principal and agent have different incentives. Thus, the principle may wish the agent to take some action but it is in the agent’s best interest to perform some other action. We will study situations in which the principal-agent problem arises and examine potential solutions to the problem. In this chapter the agents will be employees and the agents are either their direct supervisors, higher-level managers or the owners or shareholders of the company. In Chapter 22, the agent will be a division of the firm, and in Chapter 23 the agent will be a vertically-related but separate business.

Principle-Agent Relationships in Firms Stockholders and owners have one goal for the firm: maximizing profits. They want everyone associated with the firm to make decisions with a focus solely on the profit of the firm. The CEO and board members likely share the desire for the firm’s profitability, perhaps through incentives in their contracts, but the board and CEO have additional motivations beyond the firm’s profitability. Among their motivations may be keeping their jobs, accumulating power, and accumulating the trappings of the position. This may cause the CEO to make sub-optimal decisions as far as the stockholders are concerned. Further down the chain are managers of divisions, stores or other subsections of the company. They may be focused on profitability, but perhaps only as it relates to decisions under their purview. Managers also may be motivated by the desire for promotions and other incentives and may make decisions that are not in the shareholder’s or upper management’s best interests. Employees have vastly different incentives – the salesperson on the floor, the cashier at the register, or the cook in the kitchen probably do not give one second’s thought to the profitability of the firm. Rather, they care about keeping their jobs, getting promotions, and the amount of pay and other non-pecuniary benefits they receive.

Thus, it should not be surprising that absent a well-designed incentive and evaluation system, employees may take an action or make a decision for which a principal would have desired a different action or decision. 

Fixing a Broken Principal-Agent Relationship: A good structure to eliminate the principle agent problem is based on aligning decision rights with the information the decision maker has, incentivizing the decision maker to ensure the desired decision, and effectively evaluating the decision maker’s performance.  If there is a problem, the book suggests the following checklist:

1. Who is making the (bad) decision?

2. Does the decision maker have enough information to make a good decision?

3. Does the decision maker have the incentive to do so – that is, how is the decision maker evaluated and compensated?

Note that the first item identifies the decision maker, and the second item asks if the decision maker has the appropriate information to make the correct decision. If not, the lack of sufficient information must be fixed. If the decision maker has enough information to make a correct decision but instead makes a bad decision, then the problem likely lies in the decision maker’s incentives or how they are evaluated.  When one of the aspects of the agent’s environment is changed, the others most likely need to be adjusted as well. That is, if the decision maker did not have sufficient information to make the correct decision then one solution would be to give the decision-making authority to someone else who has the information. If this leads to decentralization, where decisions are made by lower-level employees, the new decision-maker’s incentives and evaluation process must be adjusted to align the principal’s goals and those of the decision-maker. As the book states, when decision-making is decentralized, “you should also strengthen incentive compensation schemes.” If decision-making is centralized, then incentives must be designed to transfer information truthfully and accurately to the decision maker. Alternatively, if you increase an agent’s incentives but do not give them decision-making authority, the incentives will do nothing since the agent cannot respond to the incentives. 

So how should broken principal-agent relationships be repaired? The answer is that it depends. There are numerous approaches to changing decision rights, incentives, and evaluation systems, and they all have their strengths and weaknesses. What is the most appropriate in one situation may not be good in another. The book gives several examples but the underlying thread in all the solutions is that the decision maker must have incentives that align the agent’s desires with the principal’s.

Chapter 22

Main Points

· Companies are principals trying to get their divisions (agents) to work profitably in the interests of the parent company.

· Transfer pricing does not merely transfer profit from one division to another; it can result in moving assets to lower-value uses. Efficient transfer prices are set equal to the opportunity cost of the asset being transferred.

· A profit center on top of another profit center can result in too few goods being sold; one common way of addressing this problem is to change one of the profit centers into a cost center. This eliminates the incentive conflict (about price) between the divisions.

· Companies with functional divisions share functional expertise within a division and can more easily evaluate and reward division employees. However, change is costly, and senior management must coordinate the activities of the various divisions to ensure they work towards a common goal.

· Process teams are built around a multi-function task and are evaluated based on the success of the project on which they are working.

· When divisions are rewarded for reaching a budget threshold, they have an incentive to lie to make the threshold as low as possible, thus ensuring they get their bonuses. In addition, they will pull sales into the present, and push costs into the future, to make sure they reach the threshold. A simple linear compensation scheme solves this problem.

The Principal-Agent Problem Redux In Chapter 21 we discussed the Principal-Agent problem as it related to employees. In this chapter, we examine the relationship between the firm and divisions within the firm. One division of the firm may not directly care about the overall profit of the firm and thus it could make decisions not in the firm’s best interest. The same checklist used to identify the problem when an employee is an agent can be used to identify the problem with a division as the agent. 

Structures of Organizations: Cost Centers and Profit Centers To understand the incentives of divisions, one must first know how they are evaluated. A division of a firm that acts as a profit center is evaluated on the profit generated by that division. The profit generated by a division is calculated as if it were a firm on its own: the costs of the division are subtracted from the revenues of the firm, and the money left over is the profit of the division. To ensure that a profit center is run as it is intended, with profit as the only goal, the manager of the division should be rewarded based on the profit of the division. In this way the firm’s desires to have the division run as a profit center align with the agent responsible for making decisions for the division.  A division of a firm can also be a cost center. A cost center is evaluated on the costs required to generate output. Like the profit center, the manager of a cost center should be rewarded based on the division’s mission. In this case, the manager’s incentives should be tied to keeping costs low. 

Incentive Conflicts and Transfer Pricing Conflict can arise if two profit centers inside a company transact with each other. When one division sends an intermediate product to another division, the division receiving the product must pay the other division some price for receiving the good. Since the price represents a cost for one division and a revenue for the other division, one division would want a high price and the other division would want a low price. If the transfer price – the price charged to one division – is set by an entity inside the company, tension can arise. The two divisions may incur completely avoidable costs by lobbying the price-setter for a more favorable price. One way to avoid the lobbying and tension is to use market prices, since market prices reveal the true value of the particular good.

Another solution that the book discusses is to turn the supplier of the intermediate good into a cost center. In that event, the division supplying the good no longer cares what price it receives for the good since the revenue does not affect its costs. If the transfer price is the marginal cost to produce the intermediate good, then the profit center will act in the firm’s best interest, since its marginal costs of production are the same as the firm’s marginal cost of production. However, as described below, if one division is changed from a profit center to a cost center, care must be taken so that the new cost center continues to operate in the firm’s best interest. Its incentives and evaluation process must be changed to completely align with the new status of the division.

Pitfalls of Compensation Schemes As with solutions to the Principle-Agent problem when the agent is an employee, the solutions to the problem when the agent is a division of the firm usually have costs in addition to the benefits of ‘solving’ the principal-agent problem. As the text describes, if there is tension between two divisions that are profit centers, turning one division into a cost center will alleviate the tension between the two divisions, but now the new cost center faces new incentives since its goal has been changed to minimize costs. That may change some of the division’s decisions, perhaps to use inferior raw materials which will lead to an inferior finished product which may not be in the firm’s best interest. As with changes to the employee’s environment, when making changes to the environment of a division care must be taken to make sure that the decision rights, incentives, and evaluation system remain aligned.

Chapter 23

Main Points

· Do not purchase a customer or supplier merely because that customer or supplier is profitable. There must be a synergy that makes them more valuable to you than they are to their current owners. And do not overpay.

· If unrealized profit exists at one stage of the vertical supply chain – as often happens when regulations limit profit – a firm can capture some of the unrealized profit by vertical integration, by tying, by bundling, or by excluding competitors.

· The double-markup problem occurs when complementary products compete with one another. Setting prices jointly eliminates the double-markup problem and is often a motive for vertical integration or maximum price contracts between a manufacturer and retailer.

· Restrictions on intra-brand competition like minimum resale price maintenance or exclusive territories provide retailers with higher profit, giving them incentives to provide demand-enhancing services to customers.

· If a product has two retail uses, a manufacturer may find it profitable to integrate downstream so that the firm can capture the profit through price discrimination. Vertical integration stops arbitrage between the two products, which allows price discrimination.

· Outsource an activity if the outsourcer can perform the activity better or more cheaply than you can.

The Principal-Agent Problem Redux, Part II The principal-agent problem can also apply to separate businesses in the same vertical supply chain. A manufacturer typically uses a retailer to deliver its product to the consumer. The aims and goals of the retailer are not the same as the manufacturer.  The retailer is concerned with its profit, which is not (strongly) influenced by the particular product that it sells. However, the manufacturer’s profit strongly depends on which product the retailer sells. For instance, a grocery store likely makes a similar profit by selling a two-liter bottle of Coca-Cola as it does by selling a two-liter bottle of Pepsi. Thus, there is no incentive for the grocer to promote one product over the other.  However, Coca-Cola (or Pepsi) most definitely would want their product promoted over their competitors. In this case, the retailer is acting as the manufacturer’s agent. Solving, or attempting to solve, the principal-agent problem in this situation is more difficult than in the situations in the previous two chapters; if the agent is employed by the firm, then the firm can simply set the terms of employment to set up decision-making rights, incentives and the evaluation system to align the agent’s incentives with the firm’s incentives. In this case, the principal cannot dictate terms to the agent. Other methods, some of which are described in the text, must be used to align the agent’s incentives with the principal’s.

I will let the chapter cover the remainder of the material, as it is mostly applying concepts from the previous two chapters to the relationship between two separate firms in a vertical supply chain.